Dodd-Frank’s Liquidation Plan Is Worse Than Bankruptcy

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Some of the key provisions of the Dodd-Frank Act of 2010, advertised as crucial to preventing a new financial crisis, won’t live up to the claims of its sponsors.

We have a nice example of this in the plan that the Federal Deposit Insurance Corp. revealed last month for how it expects to deal with troubled financial institutions under the Orderly Liquidation Authority outlined in the new law.

Under the plan, the agency would create a bridge institution to assume the assets and liabilities of a failed firm and could force some creditors to take equity in place of their debt holdings. The firm’s subsidiaries would continue operating with funds the FDIC is permitted to borrow from the U.S. Treasury. Whatever costs the FDIC incurs would be assessed against the largest members of the financial community.

As with most things in Dodd-Frank, the public knows little about the liquidation authority, although it has been touted by the Obama administration and others as solving the problem of bailouts for firms seen as too big to fail. But it does nothing of the kind; instead it makes the problem worse.

The powers granted by the liquidation authority to the secretary of the Treasury are unprecedented. With the concurrence of the Federal Reserve and the FDIC, the secretary can seize any financial firm — not just the largest ones — if he believes its failure would cause instability in the U.S. financial system.

One Day

If the firm’s directors object to the seizure, the secretary can apply to a U.S. district court for an order authorizing him to appoint the FDIC as receiver. The court has one day — yes, one day — to decide whether the secretary’s judgment was correct. If the court takes no action within this window, the firm is turned over to the FDIC. It’s a felony to disclose that the secretary has applied for the court order. The constitutional issues here are obvious and breathtaking.

Essentially, there’s no appeal. The secretary’s seizure isn’t subject to a stay or injunction, and once the firm has been delivered into the arms of the FDIC, it’s as good as dead.

It is true that the agency has a well-deserved reputation for taking control of small insolvent banks over a weekend and opening them under new ownership the following Monday. But the FDIC has never closed anything other than a small bank. With the larger and more complicated lenders, it simply sells one to another, as it did with Washington Mutual Inc. (to JPMorgan Chase & Co.) and Wachovia Corp. (to Wells Fargo & Co.). There is nothing in the FDIC’s history to suggest that the agency would be able to liquidate an investment bank on the scale of Lehman Brothers Holdings Inc., which had $600 billion in assets; or a major bank-holding company; or a large insurer or hedge fund.

The Dodd-Frank Act also creates a crucial too-big-to-fail problem by authorizing a group of regulators to designate certain nonbank firms as systemically important because their collapse “may cause instability in the U.S. financial system.” The liquidation authority is supposed to cure this problem, but how so?

The concern is that large firms get bailed out because regulators — fearful of the disruptions caused by a major bankruptcy — won’t let them fail. As Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke have said again and again, when Lehman Brothers was about to collapse, the government only had a choice between a bailout and bankruptcy; the liquidation authority, they say, provides a middle course — an opportunity to wind down an important financial institution without the disruption that a bankruptcy would cause.

Advance Notice

But this idea doesn’t stand up to scrutiny. A bankruptcy is disruptive because the firm’s creditors know in most cases they won’t be fully repaid. Accordingly, as the firm nears bankruptcy its creditors refuse to extend new credit or withdraw the funds they can. By the time the company files for bankruptcy, shareholders usually have been wiped out and the remaining creditors suffer losses.

A large bankruptcy can also be disruptive if investors and creditors run from other firms that they fear might have similar financial troubles. This happened in 2008 when Lehman’s bankruptcy sparked a panic because investors were concerned that almost all financial institutions were weakened by the mortgage meltdown.

How is a liquidation-authority seizure any different? Instead of bankruptcy, the Treasury secretary assumes control of the firm and hands it over to the FDIC. Will that be any less of a market shock? In both cases, creditors will run if they suspect a bankruptcy or a government takeover is near, and after the seizure — again as in the Lehman case — they will run from other firms if conditions in the market are the same as those in 2008. So the liquidation authority is no better than bankruptcy in preventing chaos after a large firm fails.

But it is worse than bankruptcy because it has no rules subject to legal oversight. Secured creditors don’t know in advance whether they will be repaid and, in contrast to bankruptcy, the creditors have no say in whether the firm is liquidated or recapitalized by turning their debt into equity. Under the FDIC plan, the government makes this decision, picking winners and losers. Politics will hover in the background. The uncertainties inherent in the liquidation authority will make credit more expensive for all financial firms of any size.

No wonder the House Financial Services Committee voted in April to repeal this part of Dodd-Frank even before the FDIC unveiled how it would manage the liquidation authority. It was a bankrupt idea from the start.
(Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. The opinions expressed are his own.)

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