The U.S. House Financial Services Committee presents an excellent case for why the 2010 Dodd-Frank law has not lessened the possibility that taxpayers will be forced to rescue large financial firms in the event of a crisis. The committee’s new report shows that, in fact, Dodd-Frank appears to have increased the likelihood of future bailouts in several ways.
Financial Markets Were Not Deregulated Leading up to the Crisis.
One myth that seems destined to live forever is that decades of financial market deregulation caused the 2008 crisis. As the report points out, though, the financial sector was increasingly regulated (by several measures) over the decade leading up to the crisis. The report identifies five key pieces of legislation that increased regulations on financial firms.
Many Regulatory Failures Contributed to the Crisis.
It has been very popular to blame “Wall Street” and the “banking industry” for taking excessive risks that caused the meltdown. But too few have acknowledged that regulators watched—and largely did nothing to stop—these activities. In some cases, regulations produced more of the activities that gave us the crisis.
The implementation of the Basel capital requirements in 1988—an attempt to better regulate banks’ capital—was a major failure. The Basel accords induced banks to buy Fannie Mae and Freddie Mac securities to lower their capital, thus having the opposite effect of what was intended. Since 1992, Fannie Mae and Freddie Mac issued these securities under the eye of the Office of Federal Housing Enterprise Oversight, an independent regulator with the Department of Housing and Urban Development (HUD). (Prior to 1992 the companies were regulated by HUD.)
The Federal Reserve is also responsible for key regulatory failures. The Fed, which has been the primary regulator of bank holding companies since 1956, had resident examiners embedded in some of the largest firms that failed or nearly failed during the crisis. Furthermore, the minutes of the Fed’s Open Market Committee meetings in 2008 show that the Fed did not fully understand the magnitude of the crisis as it was happening. These facts are very troubling considering the Fed is a key financial regulator and that one of the main reasons it exists is to maintain financial stability.
Rescuing Firms’ Creditors Creates Moral Hazard and Is Likely to Continue.
One good example of rescuing creditors came during the Bear Stearns bailout. In March 2008, after extending Bear a $13 billion loan, the Fed provided $29 billion in credit to facilitate a purchase of the firm by J. P. Morgan Chase. Because shareholders were essentially wiped out during this “merger,” critics claim that there was no bailout. Bear’s creditors, however, were bailed out.
The Fed acted in much the same manner regarding the insurance firm American International Group (AIG). The Fed ultimately committed to lend AIG almost $200 billion in exchange for the parent company’s assets. Most of AIG’s troubles stemmed from its London subsidiary, AIG Financial Products (AIGFP). When the Fed stepped in, it paid off AIGFP’s creditors “100 cents on the dollar, all in the name of preserving financial stability,” as the committee report points out.
Not only do these types of bailouts create moral hazard by encouraging managers to take more risk, but they encourage more risky debt because lenders expect to be protected against losses.
Title II of Dodd-Frank Replaces Bankruptcy with a Mechanism That Makes Future Bailouts More Likely.
Title II of Dodd-Frank established the “Orderly Liquidation Authority,” a misguided policy that keeps certain financial institutions from going through bankruptcy. Specifically, Title II gives the Federal Deposit Insurance Corporation (FDIC) the authority to seize a firm and “wind it down” in the name of maintaining financial stability.
Dodd-Frank’s proponents argued that Title II would prevent taxpayers from being forced to bail out shareholders and creditors of failing institutions. In practice, though, there is little hope that Title II will end bailouts.
In an orderly liquidation under Title II, the FDIC acts as the receiver of the firm’s parent holding company. The FDIC transfers the parent’s assets, derivatives, and short-term obligations to a newly created “bridge” company, and the bridge is exempt from paying all federal, state, and local taxes. The bridge company will recapitalize the subsidiaries if the FDIC deems it necessary.
Theoretically, these actions could be supported through private borrowing, but a firm can be forced into a Title II proceeding only after the FDIC and the Fed certify that, in the words of the committee report, “no viable private sector alternative is available to prevent the company’s default.” Alternatively, the bridge company can be supported by the “Orderly Liquidation Fund.” The fund is analogous to the FDIC deposit insurance fund in that it contains the proceeds of obligations issued by the FDIC and purchased by the Treasury Secretary. In other words, taxpayers are ultimately responsible for the fund.
This entire process is specifically designed to allow the firm’s operating subsidiaries to continue functioning. As a result, the mangers of the subsidiaries—as well as the firm’s creditors—will know they have a federal backstop for their activities. This backstop prevents the market from disciplining private actors and effectively ensures that there will be even more risky lending.
There is clearly a need to fix this process, and there appears to be some momentum in Congress to do so. Senators John Cornyn (R–TX) and Pat Toomey (R–PA) have introduced the Taxpayer Protection and Responsible Resolution Act, and the House Judiciary Committee has introduced a discussion draft of their own bankruptcy reform bill. Both bills are an excellent starting point for eliminating what Title II of Dodd-Frank created: a new opportunity for unrestrained government intervention in financial markets.