Sunday, April 25, 2010

Gretchen Morgenson echoes Mitch McConnell

Gretchen Morgenson is a well-informed reporter, but her attack in today's Times on the new resolution authority created in the FinReg bill has me scratching my head.

Without referencing Mitch McConnell, Morgenson echoes his claim that the bill's creation of a resolution authority for the orderly liquidation of systemically important financial institutions would enable bailouts rather than prevent them and grant special privileges to the largest financial institutions. Morgenson writes:
Here’s an example of this special treatment: Both bills would establish a specific process to resolve big-bank failures. Smaller institutions, by contrast, would be allowed to go bankrupt without a new resolution scheme.

This special resolution system is not only unfair; it also sends a pernicious signal to the market about large and intertwined institutions. The message is this: Subject as they will be to a newly codified “resolution authority,” these institutions and their investors and lenders can expect to be rescued if they get into trouble.

This perception delivers lucrative advantages to these institutions. The main perquisite is lower borrowing costs, a result of lenders’ assumptions that the giants are less risky because they will be in line for government assistance if they become imperiled.
My understanding is that the proposed new resolution authority's powers to liquidate systemically important nonbank financial institutions are modeled on the FDIC's powers to liquidate FDIC-insured deposit-taking banks.  So claims a statement on the FDIC website under Sheila Bair's name, last updated 4/7/10:

Never again should taxpayers be asked to bail out large, failing financial firms. Unfortunately, we still lack a viable way to close financial behemoths without risking market collapse.

The good news is that the FDIC has a well-established process that works for failing banks. Going forward, this model should be available to close large, failing firms. This means banning government assistance to individual companies and forcing them into orderly liquidation....

Both the already passed House bill, as well as the bill approved by the Senate Banking Committee, draw on the FDIC model to create a resolution authority that specifically applies to large, complex nonbank financial firms. Under both bills, bankruptcy would be the normal process. But under extraordinary procedures, the government would have the option to put the very largest firms into an FDIC-style liquidation process if necessary to avert a broader systemic collapse.
Under the pending Financial Stability Act, insolvent "giants" are not "in line for government assistance" -- they are in line for genuine liquidation, per Section 204 (a) (link on Senate home page; click on S. 3217 in right column):
    (a) Purpose of Orderly Liquidation Authority- It is the purpose of this title to provide the necessary authority to liquidate failing financial companies that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard. The authority provided in this title shall be exercised in the manner that best fulfills such purpose, with the strong presumption that--
      (1) creditors and shareholders will bear the losses of the financial company;
      (2) management responsible for the condition of the financial company will not be retained; and
      (3) the Corporation and other appropriate agencies will take all steps necessary and appropriate to assure that all parties, including management and third parties, having responsibility for the condition of the financial company bear losses consistent with their responsibility, including actions for damages, restitution, and recoupment of compensation and other gains not compatible with such responsibility.

Some have claimed that the resolution authority would be empowered to give creditors a sweetheart deal, citing as example of the way the authority might be used Treasury's buyback at par from AIG's creditors of the assets underlying their credit default swaps . But according to Treasury's initial proposal of legislation creating the new resolution authority, the purpose is precisely the opposite:
In the case of AIG, the government has provided financial assistance in order to avert the risks to the global financial system of the rapid and disorderly failure of such a large, complex entity in a fragile market environment. Had the government possessed the authorities contained in the proposed legislation, it could have resolved AIG in an orderly manner that shared losses among equity and debt holders in a way that maintained confidence in the institution's ability to fulfill its obligations to insurance policyholders and other systemically important customers.

The legislation gives the resolution authority expedited ability to resolve creditors' claims in a standard order of precedence, per below, granting creditors a limited right to appeal in court. 
    (b) Priority of Expenses and Unsecured Claims-
      (1) IN GENERAL- Unsecured claims against a covered financial company, or the Corporation as receiver for such covered financial company under this section, that are proven to the satisfaction of the receiver shall have priority in the following order:
        (A) Administrative expenses of the receiver.
        (B) Any amounts owed to the United States, unless the United States agrees or consents otherwise.
        (C) Any other general or senior liability of the covered financial company (which is not a liability described under subparagraph (D) or (E)).
        (D) Any obligation subordinated to general creditors (which is not an obligation described under subparagraph (E)).
        (E) Any obligation to shareholders, members, general partners, limited partners, or other persons, with interests in the equity of the covered financial company arising as a result of their status as shareholders, members, general partners, limited partners, or other persons with interests in the equity of the covered financial company.
Admittedly, the devil is in the details of how the new authority would resolve the competing claims of the myriad parties engaged in dizzyingly complex contracts with the enormous octopus of an entity large enough to be deemed a systemic risk by two thirds of the board of governors of the created authority. But if Morgenson sees any provisions enabling the resolution authority to go soft on the failed institution's creditors, she doesn't say so.

So what gives, Gretchen? Where's the special privilege accorded to "giants" subject to this resolution authority?

Update 4/26:  In a 4/20 Times article, Gary H. Stern, the co-author of Too Big to Fail: The Hazards of Bank Bailouts, suggests that the bill allows the new resolution authority wiggle room in the treatment of a seized bank's creditors:

Mr. Stern, who retired last year as president of the Minneapolis Fed, is lukewarm about the bill. “It tries to address the problem but it’s half a loaf at best,” he said. “It doesn’t address the incentives that gave rise to the problems in the first place.”

In Mr. Stern’s view, ending “Too Big to Fail” should subject uninsured creditors — bondholders — to losses if the bank fails. Without that fear, he said, unsecured creditors will not exert discipline on the banks by monitoring their risk-taking and pricing their loans appropriately. Mr. Stern said the bill in the Senate is vague about how such creditors would be treated if the government were to seize and dismantle a failing bank.

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