Nov 23 2009

Editorial: No Bondholder Left Behind

Wall Street Journal

'We won't have a real market-based financial system until it is safe to let a financial firm fail," Federal Reserve Chairman Ben Bernanke said last week. He's certainly right, though you wouldn't know it from Mr. Bernanke's own actions the last two years. Meanwhile, the politicians are preparing to give the Fed and Treasury more power to bail out all and sundry companies on an unprecedented scale, and so far without any objection from the Fed chairman.

Reading the pending bills to "resolve" failing financial houses from Representative Barney Frank and Senator Chris Dodd, the challenge is to conceive of someone who is not eligible for unlimited taxpayer funds. The list of potential bailout recipients under both bills runs from bank holding companies to hedge funds to auto makers, consumer retail chains and just about anyone else engaging in finance of one kind or another.


While most scholarly investigations of the too-big-to-fail phenomenon start from the premise that it's a problem, Messrs. Dodd and Frank appear to view it as the cornerstone of our financial system. This may not be surprising given their history. Mr. Frank is famous for saying he wanted to "roll the dice" with Fannie Mae and Freddie Mac.

Less well known is how Mr. Dodd has labored to make Wall Street increasingly eligible for the taxpayer safety net. By raising expectations that bailouts will be available, he has, as much as anyone in Congress, encouraged the risk-taking that took the financial system to the brink of ruin.

During consideration of the 1991 Federal Deposit Insurance Corporation Improvement Act, the Connecticut Senator insisted on reducing the quality of collateral Wall Street would need to present when borrowing from the Federal Reserve in times of emergency. Said Mr. Dodd: "My provision allows the Fed more power to provide liquidity, by enabling it to make fully secured loans to securities firms in instances similar to the 1987 stock market crash." He also fought every serious reform of Fannie and Freddie.

In his current bill, Mr. Dodd allows private market participants to receive emergency cash from both the Federal Reserve and the Federal Deposit Insurance Corporation, without the bailout recipient having to enter either bankruptcy or the vaunted "resolution" process we'll describe in a moment.

Under "miscellaneous provisions," Mr. Dodd's bill rewrites a portion of the Federal Deposit Insurance Act and allows cash going to depository institutions -- i.e., commercial banks backed by FDIC's insurance fund -- to also go to nondepositories in an emergency. We see no limit in the bill on what these nonbanks can be.

Similarly, Mr. Dodd rewrites the Federal Reserve Act's section on "unusual and exigent circumstances." Bailouts could now go to "any program or facility with broad-based participation." Mr. Dodd's "resolutions" do not require that firms be liquidated or wound down. Regulators can pump unlimited funds into failing firms and choose to rescue creditors.

Alabama Republican Richard Shelby warns that these multiple paths for large firms to avoid bankruptcy "will undermine incentives for investors and executives to effectively monitor risks. They will likely take even more risks because they know that they will reap the benefits, while taxpayers will have to cover the costs." He adds that the moral hazard created by the bill "could set the stage for an even more severe and more expensive financial crisis in the future." That sounds exactly right.

Over in the House, Mr. Frank gives the FDIC new power to pump cash into both banks and nonbanks that are neither bankrupt nor under government "resolution." As for that "resolution" process, which Mr. Frank has described as "death panels" for nonbanks, shareholders and unsecured creditors could still recover money. In fact, they might recover a great deal, because the FDIC can make loans or buy equity in a failing company or guarantee its debts, among other assistance.

The FDIC may "take such action as necessary to put the covered financial company in a sound and solvent condition." So the government can do more than just prevent a "disorderly failure." It can pump in so much cash that the business becomes an orderly success. This sounds like a mandate to treat even more companies like Citigroup, which has been rescued despite multiple failures and with little discipline for shareholders or executives, much less for creditors.

To fund these bailouts, large financial companies will pay fees until the government has collected $150 billion. Republican Scott Garrett has been warning House colleagues that Mr. Frank's "death panels" really add up to a "permanent bailout authority" that would expand the power of government and taxpayer rescues to historic highs.

Mr. Dodd decided against writing a bipartisan bill with Mr. Shelby, and it shows. For years, Mr. Shelby warned about Fannie and Freddie and the rise of moral hazard, not to mention government-selected credit-ratings agencies and bank capital standards. One might think these warnings would have inspired Mr. Dodd to seek the Alabamian's counsel after the disasters of 2008. But down in the polls and facing re-election, Mr. Dodd wants to pose as a populist reformer even as his bill would entrench moral hazard (and cheaper funding costs for the likes of Goldman Sachs) even deeper into the financial system.

Still, it's not too late to consider a bipartisan approach. This would start with an appreciation that any resolution authority has to include some rules of the road for regulators, rather than let Mr. Bernanke and the Treasury secretary decide who to bail out and when out of their hip pocket.

It must also include the guarantee of punishment for firms that come looking for help. The first step in discouraging excessive risks is that the risk-takers understand they will suffer the consequences of their bad bets. Former SEC Chairman Richard Breeden proposes a special bankruptcy court, like the FISA court for intelligence, where experienced judges with ample resources could handle large financial cases.

This deserves consideration and debate. We think it has potential as a venue if a behemoth like General Electric, with its large finance business, or even a bank holding company like Goldman Sachs, were ever to fail. The FDIC could seize the bank to protect depositors and the rest of the firm could restructure under bankruptcy protection.