Yes, Virginia, there is a bailout in the Dodd bill
posted at 3:35 pm on April 26, 2010 by Ed Morrissey
Or Joan, or whomever. While those empirical-based advocates of the Democratic Party continue to insist that the financial-regulation reform bill offered by Sen. Chris Dodd won’t institutionalize federal bailouts, Peter Wallison read the bill and discovered a lot of mechanisms for shielding large institutions from the normal bankruptcy process. In today’s Wall Street Journal, Wallison explains exactly what they do — and how we’ll end up paying for them:
If the Dodd-Obama resolution plan is ever actually put to use, the direct or indirect costs could be many times greater. For example, the bill authorizes the Federal Deposit Insurance Corporation to borrow from the Treasury “up to 90 percent of the fair value of assets” of any company the FDIC is resolving. Yet one institution alone—Citigroup—has assets currently valued at about $1.8 trillion. The potential costs of resolving it (not to mention others) would be spectacularly higher than $50 billion. In short, the $50 billion in the resolution fund is a political number—a fraction of what the FDIC is authorized to borrow and spend.
Why would this vast sum be necessary? The Dodd bill has one answer. It says that the FDIC “may make additional payments,” over and above what a claimant might be entitled to in bankruptcy, if these payments are necessary “to minimize losses” to the FDIC “from the orderly liquidation” of the failing firm.
In other words, the agency would be able to borrow huge sums so that it could make more generous payments to creditors than they would receive in a bankruptcy. Generous payments to creditors would certainly make unwinding a firm “orderly”—but it would also encourage lending to the too-big-to-fail financial institutions while disadvantaging smaller, less favored institutions. This in itself will have a profound and destructive effect on competition.
Another possible purpose for the FDIC’s borrowing power is to enable the agency to provide what it calls “open bank assistance.” Here, instead of liquidating a failed bank, the agency keeps it in operation by paying off its creditors and avoiding the disruption a bank closing might entail. This practice is a straightforward bailout of all creditors, and it has been criticized extensively by Congress over the years. Yet here it is, back again, in the guise of an innocuous power to make additional payments to some creditors, coupled with virtually unlimited authority to borrow from the Treasury.
The FDIC certainly knows what to do with a failed bank, but it has no experience taking control of a giant financial institution like Lehman Brothers. It is authorized to borrow against the assets of the failed firm because eventually, in theory, the assets could be sold to repay the Treasury. However, the FDIC’s operation of the failed firm could easily be unsuccessful, with losses quickly diminishing the value of its assets.
“Open bank assistance” is another term for bailout. It would do exactly what the bailouts of 2008-9 did, which is to keep the doors open on a company while floating it on taxpayer money. The FDIC and its political masters would bypass the bankruptcy procedure, in which investors get treated in a rational and predictable manner, in order to pick winners and losers on an arbitrary basis. We saw that in the bailouts of GM and Chrysler.
In fact, the market and the regulatory system already have a rational manner in which to “wind down” financial institutions that can’t meet their obligations to creditors in bankruptcy. It requires no political intervention, and allows investors to make good decisions on risk-taking in a stable regulatory environment. Unfortunately, politicians can’t get their fingers into that process, so instead they want to declare institutions as “too big to fail” and create political solutions instead of legal outcomes. The result? Investors will stay out of the market, and especially avoid larger institutions — unless they have good political ties.
The proper solution to the issue would be to create a regulatory system that incentivized against the “too big to fail” situation. The Dodd bill doesn’t address that problem at all, which is why Goldman Sachs endorses it. The bill creates a safety net for executives, which will only encourage poor risk-taking in the future and leave everyone with the impression that the US government will indemnify everyone against losses. That’s exactly what got us into the financial collapse in the first place.