The Dodd Bill: Bailouts Forever

The Dodd Bill: Bailouts Forever. By PETER J. WALLISON AND DAVID SKEEL
The Lehman Brothers liquidation shows that bankruptcy works fine. The FDIC has no experience with such large institutions.WSJ, Apr 07, 2010

There are many reasons to oppose Sen. Chris Dodd's (D., Conn.) financial regulation bill. The simplest and clearest is that the FDIC is completely unequipped by experience to handle the failure of a giant nonbank financial institution.

The country should be grateful for the determination with which the FDIC Chair, Sheila Bair, has thus far guided the agency through the financial crisis. But it is wrong to think that because the FDIC can handle the closure of small banks it is equipped to take over and close a giant, nonbank financial firm like a Lehman Brothers or an AIG.

Consider first that the largest bank the FDIC closed in the recent financial crisis, IndyMac, had assets of $32 billion. The largest bank ever to fail, Continental Illinois in 1984, had assets of $40 billion. At $639 billion, Lehman Brothers was nearly 15 times bigger; AIG had over $1 trillion in assets when it was kept from failing by the Federal Reserve.

The assets of a large, nonbank financial institution are also different. Neither Lehman nor AIG had insured depositors—or depositors of any kind—and their complex assets and liabilities did not look anything like the simple small loans and residential and commercial mortgages the FDIC deals with.

Moreover, the policies the FDIC follows when it closes small banks would be positively harmful if they were used to close a huge nonbank financial institution. The agency is used to operating in secret, over a weekend; its strategy is always to find a buyer. When applied in the case of a large, failing nonbank financial institution, this means that some other large, "too big to fail" institution will only become that much larger.

When the FDIC can't find a buyer, it can usually transfer a failed bank's deposits to another bank, because deposits have real business value for banks. This is not true of the liabilities of large financial institutions, which consist of derivatives contracts, repurchase agreements, and other complex instruments that no one else is interested in acquiring.

The real choice before the Senate is between the FDIC and the bankruptcy courts. It should be no contest, because bankruptcy courts do have the experience and expertise to handle a large-scale financial failure. This was demonstrated most recently by the Lehman Brothers bankruptcy.

It didn't get a lot of media attention, but an important financial event occurred on March 15, when Lehman Brothers offered a blueprint for its reorganization and exit from Chapter 11—18 months to the day after it filed its bankruptcy petition. In the course of Lehman's resolution, its creditors, shareholders and management all took severe losses.

The firm's principal assets—its broker-dealer, investment-management and underwriting businesses—were all sold off to four different buyers within weeks of the filing of its petition. At the time of its failure, the firm had over 900,000 derivatives contracts, more than 700,000 of which were canceled and the rest either enforced or settled, if its creditors agreed, in the blueprint for the firm's reorganization.

The FDIC has no significant experience with broker dealers, investment management, securities underwriting, derivatives contracts, complex collateral arrangements for repos, or the vast number of creditors that had to be included in the Lehman settlement. Is it at all likely the agency could have done any better?

There is another lesson in the Lehman bankruptcy. Mr. Dodd claims his bill cures the too-big-to-fail problem because it requires the liquidation of a failing firm. But Lehman has been liquidated; what is left is a shell that may or may not struggle back to profitability.

The difference between the Lehman bankruptcy and what the Dodd bill proposes is important to understand. The Dodd bill provides for a $50 billion fund, collected in advance from large financial firms, that will be used for the resolution process. In other words, the creditors of any company that is resolved under the Dodd bill have a chance to be bailed out. That's what these outside funds are for. But if the creditors are to take most of the losses—as they did in Lehman—a fund isn't necessary.

Which system is more likely to eliminate the moral hazard of too big to fail? In a bankruptcy, as in the Lehman case, the creditors learned that when they lend to weak companies they have to be careful. The Dodd bill would teach the opposite lesson. As Sen. Richard Shelby (R., Ala.) wrote in a March 25 letter to Treasury Secretary Tim Geithner, the Dodd bill "reinforces the expectation that the government stands ready to intervene on behalf of large and politically connected financial institutions at the expense of Main Street firms and the American taxpayer. Therefore, the bill institutionalizes 'too big to fail.'"

Mr. Shelby is right on target. It doesn't matter where the money comes from—whether it's the taxpayers or a fund collected from the financial industry itself. The question is how the money is used, and if it is used to bail out creditors of large firms—reducing their lending risks—it will encourage large firms to grow ever larger.

Like Fannie and Freddie, these large financial firms will be seen as protected by the government and, with lower funding costs, will squeeze out their Main Street competitors. Then, if these financial giants are on their way to failure, they are handed over for resolution to a government agency that has no experience with firms of this size or complexity. Surely the Senate will see the flaws in this idea.

Mr. Wallison is a senior fellow at the American Enterprise Institute. Mr. Skeel is a law professor at the University of Pennsylvania.