Best way to avoid a bailout?

GOP, Democrats back dif­fer­ent plans for wind­ing down a doomed fi­nan­cial firm

Los Angeles Times - - MONDAY BUSINESS - BY JIM PUZZANGHERA jim.puzzanghera@la­times.com Twit­ter: @JimPuz­zanghera

WASH­ING­TON — In the af­ter­math of the 2008 fi­nan­cial cri­sis, a con­sen­sus quickly de­vel­oped in Wash­ing­ton: no more bank bailouts.

No­body — law­mak­ers, gov­ern­ment of­fi­cials, reg­u­la­tors and cer­tainly not av­er­age Amer­i­cans — was happy about the hun­dreds of bil­lions of dol­lars of tax­payer money pumped into banks and other firms to pre­vent a fi­nan­cial melt­down.

Although the money even­tu­ally was re­paid, with the fed­eral gov­ern­ment even earn­ing a small profit, Democrats and Repub­li­cans united in the de­sire to pre­vent a re­peat.

But nearly nine years since the cri­sis, there’s no agree­ment on how to ac­com­plish that goal.

The vastly dif­fer­ent ap­proaches of the two par­ties are at the cen­ter of the de­bate about fi­nan­cial reg­u­la­tion as the Trump ad­min­is­tra­tion and con­gres­sional Repub­li­cans tar­get the slew of new rules put in place by Democrats with the 2010 Dodd-Frank Wall Street Re­form and Con­sumer Pro­tec­tion Act.

Each side says that its plan is the best way to avoid fu­ture bailouts and that the other’s ac­tu­ally in­creases the risks of them.

Dodd-Frank gives reg­u­la­tors new power called or­derly liq­ui­da­tion au­thor­ity to step in to safely and quickly wind down a ma­jor fi­nan­cial firm if it is too com­plex for a bank­ruptcy pro­ceed­ing in the midst of a cri­sis.

The law al­lows for fed­eral money to be used to keep com­mer­cial banks and other sub­sidiaries of the firm run­ning dur­ing the shut­down. Any money not re­cov­ered by the sale of the firm’s as­sets is sup­posed to be re­cov­ered by an assess­ment on the fi­nan­cial in­dus­try, so Democrats said this plan pre­vents fu­ture bailouts.

But Repub­li­cans said the use of fed­eral money to wind down a firm is a bailout and they doubt the funds ever would be re­cov­ered from the in­dus­try.

In April, Pres­i­dent Trump or­dered Trea­sury Sec­re­tary Steven T. Mnuchin to con­duct a six-month re­view of the or­derly liq­ui­da­tion au­thor­ity, be­lieved to be the first step to­ward rec­om­mend­ing that Congress get rid of it.

The Fi­nan­cial Choice Act, passed by the House on a party line vote in June, does just that. It re­peals the au­thor­ity while chang­ing bank­ruptcy law to bet­ter han­dle a large fi­nan­cial firm.

Here’s a look at the is­sue.

Dodd-Frank’s strat­egy

The 2008 fi­nan­cial cri­sis was trig­gered by the fail­ure of Lehman Bros.

A scram­ble by fed­eral of­fi­cials to en­gi­neer a sale of the tee­ter­ing in­vest­ment bank­ing gi­ant fell apart in early Septem­ber af­ter the Trea­sury and the Fed­eral Re­serve de­cided not to pro­vide gov­ern­ment money to help se­cure a deal, as was done six months ear­lier for an­other fail­ing in­vest­ment bank, Bear Stearns.

On Sept. 15, 2008, Lehman filed for the largest bank­ruptcy in U.S. his­tory. In­vestors pan­icked. The Dow Jones in­dus­trial av­er­age plum­meted 504 points and an­other fi­nan­cial gi­ant, in­surer Amer­i­can In­ter­na­tional Group, teetered near bank­ruptcy.

Fear­ing a to­tal melt­down of the fi­nan­cial sys­tem, fed­eral of­fi­cials stepped in to seize AIG in the com­ing days and pushed Congress to ap­prove the $700-bil­lion Trou­bled As­set Re­lief Pro­gram to help prop up the bank­ing in­dus­try.

The AIG seizure was a com­pli­cated ef­fort in­volv­ing a pledge of $182 bil­lion from the Fed and Trea­sury in ex­change for a 92% own­er­ship stake. The res­cue al­lowed share­hold­ers to avoid be­ing wiped out, although they com­plained the gov­ern­ment didn’t com­pen­sate them enough for the stake it ac­quired.

It took more than a year, start­ing in 2011, for fed­eral of­fi­cials to ex­tri­cate the gov­ern­ment from AIG. Trea­sury said the res­cue net­ted tax­pay­ers $22.7 bil­lion in profit, but reg­u­la­tors and law­mak­ers agreed af­ter the cri­sis they didn’t want to be put in that po­si­tion again.

Democrats and key reg­u­la­tors be­lieved the so­lu­tion was or­derly liq­ui­da­tion au­thor­ity, which would man­date a shut­down of a com­pany — not a res­cue — but in a way that is de­signed to limit dam­age to the broader fi­nan­cial sys­tem.

Bank­ruptcy is the first choice for a fail­ing fi­nan­cial gi­ant. Dod­dFrank re­quired such firms to sub­mit plans called “liv­ing wills” to reg­u­la­tors in ad­vance, de­tail­ing how they would be wound down if they neared col­lapse.

But if reg­u­la­tors de­ter­mine the firm could not be shut down in Bank­ruptcy Court with­out threat­en­ing the broader U.S. fi­nan­cial sys­tem, they could use the au­thor­ity to put it in fed­eral re­ceiver­ship.

The Fed­eral De­posit In­sur­ance Corp. then would wind down the com­pany in the same way it now does with fail­ing banks.

The law re­quires that the FDIC fire the firm’s man­age­ment and that losses be taken by cred­i­tors and share­hold­ers. The firm must be liq­ui­dated and Dodd-Frank specif­i­cally pro­hibits tax­payer money from be­ing used to pre­vent the liq­ui­da­tion.

Dodd-Frank al­lows the FDIC to bor­row money from the Trea­sury to wind down the com­pany. But if the sale of the com­pany’s as­sets doesn’t cover the cost of that, the money must be re­cov­ered through an assess­ment on the fi­nan­cial in­dus­try.

That mech­a­nism would be sim­i­lar to the assess­ment that banks now pay to the FDIC to cover de­posit in­sur­ance.

“The mech­a­nism is harsher than bank­ruptcy. The board is out. Top man­age­ment is out. In bank­ruptcy, fre­quently they keep the board’s man­age­ment in place,” said Sheila Bair, the former chair­woman of the FDIC.

“This is not a bailout mech­a­nism,” she said. “This is a tax­payer-pro­tec­tion mech­a­nism.”

With­out or­derly liq­ui­da­tion au­thor­ity, Bair and other sup­port­ers ar­gue, the prospect of an­other com­plex and lengthy bank­ruptcy like that of Lehman Bros. could lead to a bailout to pro­tect the fi­nan­cial sys­tem.

GOP prefers bank­ruptcy

“Con­trary to Dodd-Frank … we will end bank bailouts once and for all,” Rep. Jeb Hen­sar­ling (R-Texas) told House mem­bers in June in push­ing for the Fi­nan­cial Choice Act.

“We will re­place bailout with bank­ruptcy,” said Hen­sar­ling, who wrote the leg­is­la­tion and op­posed the TARP leg­is­la­tion.

Af­ter the bailouts of the 2008 fi­nan­cial cri­sis, Repub­li­cans said they don’t trust reg­u­la­tors to stick to the liq­ui­da­tion au­thor­ity rules, which would ul­ti­mately cost tax­pay­ers money.

In a cri­sis that would war­rant us­ing the or­derly liq­ui­da­tion au­thor­ity, reg­u­la­tors would not want to fur­ther stress the fi­nan­cial sys­tem by assess­ing com­pa­nies to pay for it, said J.W. Ver­ret, an as­sis­tant pro­fes­sor at Ge­orge Ma­son Univer­sity and ex­pert on fi­nan­cial reg­u­la­tion.

“I think every­body un­der­stands that’s go­ing to be un­likely in a cri­sis,” he said. “There’s no way in 2008 the gov­ern­ment would have done a $200-bil­lion to $300-bil­lion assess­ment on the in­dus­try be­cause it would have brought down a num­ber of other in­sti­tu­tions.”

In 2010, House Democrats wanted to set up a $150-bil­lion fund as part of Dodd-Frank to pay for or­derly liq­ui­da­tion au­thor­ity ahead of time. But Repub­li­cans la­beled it a bailout fund and Se­nate Democrats re­moved it.

Bair said hav­ing a fund in place in­stead of count­ing on an af­ter-the-fact assess­ment would help ease con­cerns that the liq­ui­da­tion au­thor­ity would cost tax­pay­ers money.

“We fought hard for it,” said Bair, who headed the FDIC from 2006 to 2011. “Be­ing able to pre-fund it would give peo­ple a lot of com­fort.”

The Fi­nan­cial Choice Act would cre­ate a new sec­tion of the fed­eral bank­ruptcy law to deal with fi­nan­cial in­sti­tu­tions with more than $50 bil­lion in as­sets. Spe­cial judges with the ex­pe­ri­ence to han­dle such bank­rupt­cies would han­dle the cases un­der ex­pe­dited pro­ce­dure.

“Judges sit­ting in open court in­stead of un-elected bu­reau­crats sit­ting be­hind closed doors will make con­sis­tent, pre­dictable de­ci­sions based on decades of case law,” said Rep. Dave Trott (RMich.).

“More im­por­tantly, bank­ruptcy puts the risk of fail­ure on the bank’s share­hold­ers and cred­i­tors, not the tax­pay­ers,” he said.

But af­ter the TARP res­cues, which left bank share­hold­ers largely in­tact, the liq­ui­da­tion au­thor­ity was de­signed to pre­vent that. Dodd-Frank specif­i­cally says “cred­i­tors and share­hold­ers will bear the losses.”

A pos­si­ble com­pro­mise?

The de­bate over end­ing bailouts largely comes down to whether you be­lieve reg­u­la­tors would re­cover the money from an or­derly liq­ui­da­tion from the fi­nan­cial in­dus­try, Ver­ret said. If not, “it’s bailout.”

Fred­er­ick Can­non, direc­tor of re­search at bro­ker­age and in­vest­ment bank Keefe, Bruyette & Woods, said that given how TARP turned a profit, he has a dif­fi­cult time with the con­cerns about tax­pay­ers re­cov­er­ing money used for a liq­ui­da­tion.

Be­yond that, he said, nei­ther the Demo­cratic nor the Repub­li­can strat­egy for deal­ing with a fail­ing fi­nan­cial gi­ant is fool­proof.

“Both of them have a good chance of not suc­ceed­ing, es­pe­cially in a sys­temic cri­sis,” Can­non said. But the liq­ui­da­tion au­thor­ity “has a bet­ter chance of suc­ceed­ing ” than bank­ruptcy.

“If you’re a de­pos­i­tor at a bank, whether a big com­pany or an in­di­vid­ual, and sud­denly the bank where your money is sit­ting is in bank­ruptcy in a new bank­ruptcy code and the judge says, ‘Don’t worry, your de­posits are good,’ are you go­ing to feel bet­ter about that?” he said. “Or will you feel bet­ter about the FDIC tak­ing over the bank and say­ing, ‘We’re the guar­an­tor of your de­posits.’ ”

The best chance of suc­cess, he said, is to do both — en­hance the bank­ruptcy code so it’s more able to han­dle a large fi­nan­cial firm’s col­lapse and leave the liq­ui­da­tion au­thor­ity as a fail-safe.

“It may sound like belt and sus­penders, but if the bank­ruptcy ap­proach does not sta­bi­lize the in­sti­tu­tion you sure as heck bet­ter have a backup,” Can­non said.

Chip Somodevilla Getty Im­ages

A DEMON­STRA­TOR holds up a sign be­hind Trea­sury Sec­re­tary Henry Paul­son, left, and Fed Chair­man Ben Ber­nanke dur­ing a Se­nate panel hear­ing in 2008.

Manuel Balce Ceneta As­so­ci­ated Press

REP. JEB HEN­SAR­LING wrote the Fi­nan­cial Choice Act and op­posed the pro­gram that helped prop up the bank­ing in­dus­try.

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