Dodd Liquidation Panel

by Chidem Kurdas

There is one new regulation that is truly needed—a way to wind down, without major disruption to markets, failing broker-dealers and other financial companies. The new financial industry bill introduced by Senator Christopher Dodd claims to do this and solve the “too-big-to-fail” problem.

Reading the particulars of the bill, however, makes one queasy. To use a metaphor, what’s needed is a commitment to defensive war when necessary. What this and a related bill  sneak under the radar is authority for pre-emptive war—with all the wide-open discretion that implies.

Lehman Brothers’ bankruptcy in September 2008 had a big impact on markets largely because the assets of its clients got tied up in courts, not just in the US but in the UK. With their capital frozen in years-long litigation, the clients – in particular hedge funds – sold securities to raise money. This selling put downward pressure on markets.

So, instituting a process by which large financial companies can be shut down without a lengthy bankruptcy case would reduce the impact of failures and get rid of the notion that investment banks need to be bailed out—expeditious and orderly winding down of a failed firm is the obvious solution.

While this process may be similar to established procedure for dealing with insolvent commercial banks, broker-dealers don’t have Federal Deposit Insurance Corp.-insured deposits. Their customers get only limited aid from the Securities Investor Protection Corp.—as the Bernard Madoff investors discovered.

The bill would establish a liquidation fund financed by the industry and authorize the appointment of FDIC as receiver for insolvent companies, with SIPC acting as trustee for broker-dealers. All that sounds reasonable. You don’t notice the danger until you’re deep into the 1,336 page bill.

The government is to take over not only defaulting financial companies but those “in danger of default”. Five conditions are listed to define default and in-danger-of-default. Two are straightforward—the company will be filing for bankruptcy shortly or its board or shareholders agree to a government takeover.

The other three conditions allow the government to take over even when a company is not filing for bankruptcy and its board/shareholders do not consent. What it means is that the secretary of the Treasury can decide that a company is about to collapse even if it does not look that way to other people.

Notice that this is different from the Lehman Brothers situation, where there was no question the bank was going bankrupt once the expected merger with Barclays Capital was nixed by British regulators. (Barclays later bought parts of Lehman in the bankruptcy proceeding.) Arranging an orderly wind-down would have been a defensive move. What the Dodd bill adds is the power to intervene pre-emptively.

Perish the thought, but suppose a secretary of the Treasury has a crony who really wants to buy an investment bank on the cheap—and will provide some future quid pro quo.  Pick a time when equities are down and you could make a case that a financial company is wobbly. Voila, it gets liquidated in a fire sale.

Maybe this sounds far fetched—a politician would not do something just for his own interest, would he? In any event the Dodd bill provides what looks like oversight mechanisms. The Treasury has to get the OK of a panel consisting of several bankruptcy judges.

But consider these judges’ incentive. If they say no to the Treasury and then the company runs into trouble, it will be on their heads. If they say yes, there’s little risk to them. Almost certainly the panel will agree to such requests. The FDIC and the Federal Reserve also have a say. But in 2008-2009, these agencies acted together with the Treasury and likely will do so in future stress situations. Therefore they do not provide checks and balances.

Moreover, consider that if there is any public suspicion of what’s going on, the company is dead. Once the Treasury decides a company is doing down, this decision will become self-fulfilling. That company will go down. The way the bill is written, it  vastly expands government power to make arbitrary choices—like liquidate bank x but let bank y stand. A preview of this happened in 2008, when the Treasury and Fed decided to backstop Bear Stearns but not Lehman Brothers.

The useful part of this regulation is to quickly unwind companies that have defaulted. Not could, might or may default. Have defaulted. To allow the government to make a determination of what could or might happen is to create a whole new arena for political corruption.

Peter Klein recently pointed out that an agency created in the 1930s to fight the Great Depression now helps raise money for a politically well-connected company —an instance of the Higgs effect, aptly named after economic historian Robert Higgs, of temporary crises being used to permanently ratchet up government interventionism and the cronyism that goes with it.

While we don’t know how exactly the new powers contained in Dodd’s monster bill would be used, the past provides no assurance that the discretion it gives government agents will be deployed wisely or even as expected.

9 thoughts on “Dodd Liquidation Panel

  1. The power that concerns Chidem already exists for insured depository institutions. It is called Prompt Corrective Action.

    If a depository institution’s capital falls below a pre-determined level — albeit still positive — the relevant regulatory agency can issue a Cease and Desist Order rquiring the institution to raise additional capital within a certain time frame. If the bank fails to do so, it can be closed before all capital is depleted.

    The reality is that regulators are too slow and wait too long (rather than jumping the gun as Chidem is concerned about). The proof is that the FDIC suffers losses on these cases, which would not happen if capital were still positive.

    PCR exists to protect taxpayers who are ultimately on the hook. Recent policy toward nondepositiroy institutions has extended protection to all creditors of major financial institutions. Given that, it is logical to apply PCR to all large financial institutions.

    Too-big-to-fail is the culprit. Dodd’s bill would actually incorporate the policy of too-big-to-fail by statute and name the institutions so covered. That creates about 35 new Fannie Mae & Freddie Macs (as Peter Wallison pointed out in the Wall Street Journal).

    The Dodd bill is misguided response to a real problem. But the status quo is too-big-to-fail. There is no credible way for the gov’t. to end that policy in the near- to medium-term. Indeed, we’re going headlong in the opposite direction even absent Dodd.

    So what do classical liberals want to do with zombie financial institutions protected by government policy. The walking financial dead are amongst us. Shall we keep them alive ala Fannie Mae and Freddie Mac, bleeding taxpayer money, or drive a stake through their hearts? Today, tomorrow, or in an enternity?

  2. Jerry, no contest that there is a similarity here with the FDIC powers. No contest also that some provision is needed to unwind failing financial companies. I would not object if the bill said, if an investment bank falls below a certain capital ratio, it can be seized even if it is not at the point of bankruptcy. My point is the broad discretion allowed in this (and related) bill. Not some definite metric, like violating a capital requirement, but somebody’s judgment call.

  3. “The walking financial dead are amongst us.” By all means, get out the proper stake–that is, an orderly liquidation process that will shut them down, not bail them out.

  4. This is an important post, Chidem. You can read the bill here:

    Click to access ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf

    In a speech on “A Minsky Meltdown”

    Click to access 0416.pdf

    the president of the San Francisco Fed, Janet Yellen, calls for the “micro-prudential” regulation of “systemic institutions.” She says, “Systemic institutions would be defined by key characteristics, such as size, leverage, reliance on short-term funding, importance as sources of credit or liquidity, and interconnectedness in the financial system—not by the kinds of charters they have.”

    In the Dodd bill echoes Yellen’s language. The “Financial Stability Oversight Council” would be responsible for identifying financial institutions for “enhanced supervision and prudential standards” (p. 40). The Council would identify institutions whose “material financial distress . . . would pose a threat to the financial stability of the United States” (p. 31). The “considerations” in making such a determination include:

    1) “the amount . . . of the financial assets of the company,” i.e. Yellen’s “size”
    2) “the degree of leverage of the company; including the degree of reliance on short-term funding,” i.e. “Yellen’s “leverage”
    3) “the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system,” i.e. Yellen’s “importance as sources of credit or liquidity”
    4) “the extent and type of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies,” i.e. Yellen’s “interconnectedness in the financial system”

    The last “consideration” is “any other factors that the Council deems appropriate” (p. 32).

    In “Avoiding and Resolving Financial Crises: The Rule of Law
    or the Rule of Central Bankers?” Larry White shows that the rule of law was largely abandoned in favor of the “rule of men” in the Great Recession.

    Click to access White%20EFNkeynote%20Cambodia%2009.pdf

    The Dodd bill would push this trend even further. As far as I can tell, a financial institution should be subject to Yellenish “micro-prudential standards” if and only if the Financial Stability Oversight Council says it should be. It is hard to imagine a more complete abandonment of the rule of law in the field of financial regulation.

    Be afraid. Be very afraid.

  5. From Roger: “Larry White shows that the rule of law was largely abandoned in favor of the “rule of men” in the Great Recession.”

    There is a frightening recent example of this from 2008 in Andrew Ross Sorkin’s book, Too Big to Fail. Timothy Geithner, then head of the New York Federal Reserve and now secretary of the Treasury, in effect ordered Morgan Stanley chief John Mack to sell the bank to JP Morgan for a song. Mack refused to do so because he believed — correctly as it turned out — that a Japanese bank would provide the capital to steady Morgan Stanley. The merger would have almost certainly killed off thousands of jobs, because there is a lot of overlap in the two banks’ businesses. If Dodd’s bill had been the law then, Mack could have been legally compelled to sell the company. He would have no chance to save it.

  6. I’d like to amend the last sentence of my previous post: If Dodd’s bill had been the law then (2008), the government could simply take control of Morgan Stanley & sell it. Mack, or any other Morgan Stanley executive, would have no authority at all at that stage–if this law, as written, were in place. The company has survived because the government could not take it over for liquidation and Mack was tough & experienced enough to resist.

  7. I fear it may be pretty much a done deal. The House passed a bill sponsored by Barney Frank, H.R. 4173, that calls for a similar “Financial Services Oversight Council.” The language is pretty similar too. The Council in H.R. 4173 would be required to
    “subject a financial company to stricter prudential standards . . . if the Council determines” that either “material financial distress at the company could pose a threat to financial stability or the economy” or “the nature, scope, size, scale, concentration, and interconnectedness, or mix of the company’s activities could pose a threat to financial stability or the economy.”

    Click to access getdoc.cgi

    It’s such a shame. We have some really brilliant and serious macroeconomists such as Janet Yellen diagnosing the problem in Minskyian terms and prescribing discretionary *regulation* as the cure. We are right back to old arguments about rules vs. discretion, the volatility of investment, and, really, all the old issues. It’s time to have another look at the years of high theory to see what the paths not taken might look like. A good place to start might be this paper by F. Meacci:

    Click to access meacci.pdf

    Dave Prychtiko also has a nice paper on Minsky issues coming out in the Review of Austrian Economics. It is entitled, “Competing explanations of the Minsky moment: The financial instability hypothesis in light of Austrian theory.”

  8. It does look likely to go through, in some version or another. And if you consider that Janet Yellen is reported to be the “leading contender” for vice chairwoman of the Federal Reserve Board, obviously this viewpoint is going to become more dominant at the Fed, too.

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