As the Senate moves closer to another cloture vote on Senator Dodd’s legislation, we are again reminded of the several flaws found in the Dodd-Frank approach to financial regulatory reform.
Beginning with the rescue of investment bank Bear Stearns in the spring of 2008, the Federal government has committed trillions of taxpayer dollars to institutions like Fannie Mae, Freddie Mac, AIG, Citigroup and Bank of America, out of fear that the demise of any of these “too big to fail” institutions would trigger a systemic crisis and collapse of the global financial system. With the bailout of creditors domestically and overseas, we have seen an increase in moral hazard and a 78 basis point advantage in lower borrowing costs for those firms receiving government funds.
Instead of learning from the failures of 2008, the legislation put forward will compound the moral hazard problem. Take the House bill that passed last December. Armed with a $150 billion bailout fund backed by the US Treasury, regulators would be authorized to “make loans to, or purchase the debt obligations of a systemically risky company; purchase its assets; assume or guarantee its obligations; take liens on assets or sell or transfer the company’s assets.” This is a huge amount of power left to the discretion of government officials. As my colleague Rep. Brad Sherman (D-CA) accurately described when the bill was first introduced, it amounts to “TARP on steroids.”
Beyond the bailout fund, the House bill provides regulators the authority to “guaranty obligations of solvent” financial institutions; that’s right solvent firms. Essentially, the FDIC will be able to extend $500 billion in taxpayer liabilities to companies that are not currently in financial trouble. While final language remains uncertain, the Senate bill incorporates much of this approach.
This is not the death panel that Chairman Frank so often claims when referring to the fate of failing institutions. Given the ability to arbitrarily reward certain creditors and counterparties, this is not an “enhanced bankruptcy process” or an “expedited bankruptcy” that the Administration wants people to believe. Despite the rhetoric coming from the other side, the Dodd-Frank approach hands over the keys to the Treasury to a group of unelected bureaucrats. If TARP was any indication, regulators will always err on the side of doling out too many (not too few) federal dollars under the guise of preventing a systemic shock.
If the goal of regulatory reform is to prevent failed firms and those that do business with it from receiving taxpayer bailouts, three simple steps should be avoided:
- First, do not give regulators the authority to make loans to or purchase assets of a failed firm.
- Second, do not create a bailout fund which will reward those very parties.
- Third, do not give the FDIC the authority to guaranty $500 billion worth of debt of solvent institutions.
The underlying assertion of the Dodd-Frank approach is that the bureaucrats that missed the last crisis will be there to foresee and prevent the next one. Instead of handing over permanent bailout authority to the bureaucrats that performed so poorly in the past, Congress should focus on expanding the bankruptcy code to liquidate failed financial firms in a timely manner. Today, this type of expedited bankruptcy is routinely used to resolve failed airlines and railroads.
The bankruptcy code is clear, efficient and does not rely on bureaucratic discretion. Firms that take improper risk will fail. Those businesses that choose to deal with such a firm will also face the consequences of their decisions. With the understanding that the federal government is out of the bailout business, better underwriting will be practiced throughout our capital markets and market discipline will return. As a result, credit will be directed to credit-worthy products, rather than to large financial institutions whose only competitive advantage is an implicit government guarantee in the event of failure.
There was strong bipartisan opposition to the Dodd-Frank approach when it sneaked through the House last December. Those that opposed the bill understood the implications for the taxpayers and our capital markets under this plan. Hopefully, Senator Richard Shelby and his colleagues opposing the Dodd-Frank approach in the Senate will not settle until drastic changes are made to this fundamentally flawed bill.
The views expressed by guest bloggers on the Foundry do not necessarily reflect the views of the Heritage Foundation.