Apr 07 2010

The Dodd Bill: Bailouts Forever

contracts, repurchase agreements, and other complex instruments that no one else is interested in acquiring.

The real choice before the Senate is between the FDIC and the bankruptcy courts. It should be no contest, because bankruptcy courts do have the experience and expertise to handle a large-scale financial failure. This was demonstrated most recently by the Lehman Brothers bankruptcy.

It didn't get a lot of media attention, but an important financial event occurred on March 15, when Lehman Brothers offered a blueprint for its reorganization and exit from Chapter 11 -- 18 months to the day after it filed its bankruptcy petition. In the course of Lehman's resolution, its creditors, shareholders and management all took severe losses.

The firm's principal assets -- its broker-dealer, investment-management and underwriting businesses -- were all sold off to four different buyers within weeks of the filing of its petition. At the time of its failure, the firm had over 900,000 derivatives contracts, more than 700,000 of which were canceled and the rest either enforced or settled, if its creditors agreed, in the blueprint for the firm's reorganization.

The FDIC has no significant experience with broker dealers, investment management, securities underwriting, derivatives contracts, complex collateral arrangements for repos, or the vast number of creditors that had to be included in the Lehman settlement. Is it at all likely the agency could have done any better?

There is another lesson in the Lehman bankruptcy. Mr. Dodd claims his bill cures the too-big-to-fail problem because it requires the liquidation of a failing firm. But Lehman has been liquidated; what is left is a shell that may or may not struggle back to profitability.

The difference between the Lehman bankruptcy and what the Dodd bill proposes is important to understand. The Dodd bill provides for a $50 billion fund, collected in advance from large financial firms, that will be used for the resolution process. In other words, the creditors of any company that is resolved under the Dodd bill have a chance to be bailed out. That's what these outside funds are for. But if the creditors are to take most of the losses -- as they did in Lehman -- a fund isn't necessary.

Which system is more likely to eliminate the moral hazard of too big to fail? In a bankruptcy, as in the Lehman case, the creditors learned that when they lend to weak companies they have to be careful. The Dodd bill would teach the opposite lesson. As Sen. Richard Shelby (R., Ala.) wrote in a March 25 letter to Treasury Secretary Tim Geithner, the Dodd bill "reinforces the expectation that the government stands ready to intervene on behalf of large and politically connected financial institutions at the expense of Main Street firms and the American taxpayer. Therefore, the bill institutionalizes 'too big to fail.'"

Mr. Shelby is right on target. It doesn't matter where the money comes from -- whether it's the taxpayers or a fund collected from the financial industry itself. The question is how the money is used, and if it is used to bail out creditors of large firms -- reducing their lending risks -- it will encourage large firms to grow ever larger.

Like Fannie and Freddie, these large financial firms will be seen as protected by the government and, with lower funding costs, will squeeze out their Main Street competitors. Then, if these financial giants are on their way to failure, they are handed over for resolution to a government agency that has no experience with firms of this size or complexity. Surely the Senate will see the flaws in this idea.