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Yes, It's a Bailout Bill

Saturday, April 24, 2010

Markets participants will understand that the Senate financial regulation bill allows for bailouts, and this will give rise to riskier behavior that in turn makes future bailouts more likely.

The debate over financial regulation is now focused squarely on the ability of the government to take over a failing financial institution such as a bank holding company or hedge fund—so-called non-bank resolution authority. This is the linchpin of reform because allowing the government to intervene in a crisis will affect investors’ risk-taking behavior from the start—for better or worse. A resolution regime that provides certainty against bailouts will reduce the riskiness of markets and thus help avoid a future crisis, while a reform that enshrines the possibility of bailouts will foster risky behavior and unwittingly make future bailouts more likely. The key choice is thus whether financial regulatory reform gives the government discretion to bail out creditors or instead ensures that these counterparties take losses.

President Obama’s approach, as embodied in Democratic Senator Chris Dodd’s bill, is for discretion and thus for bailouts. Top administration officials state that they will impose losses on counterparties such as lenders to a failing firm. The reality, however, is that the Senate bill gives the government discretion, without a vote of Congress, to put money into a failing firm to pay off creditors. Shareholders will take losses but creditors can benefit from government-provided funds. Regardless of the administration’s intentions, markets participants will understand that the Senate financial regulation bill allows for bailouts, and this will give rise to riskier behavior that in turn makes future bailouts more likely.

The Dodd bill allows two forms of a bailout, since the government can put cash directly into a failing firm or guarantee its debt. The Dodd proposal is a bailout bill, plain and simple.

A particularly misleading claim from the administration is that the bill is not a bailout because any losses would be recouped through taxes on banks after the fact. The intervention itself is the essence of the bailout, not whether there are losses to the government. Imagine if the Troubled Asset Relief Program was to end up with a profit—not just recouping the money put into firms over the past two years but actually making a return for taxpayers. No one would suggest that the TARP is then somehow not a bailout. Recouping funds after the fact might be a good way to protect taxpayers, but it is preposterous to claim that this makes the Dodd bill anything other than a bailout. The ability of the government to put money into a failing firm and make payments to counterparties at its discretion is what makes the Dodd proposal a permanent bailout authority, not the issue of who pays after the fact.

Moreover, the discretion given to the government in the Senate proposal opens the door to undesirable actions such as allowing the administration to write checks to favored parties. This concern is not theoretical: such mischief took place in the bankruptcies of Chrysler and General Motors, as the two auto companies were used as conduits to transfer billions of dollars from TARP to the president’s political supporters.

There are middle grounds between bankruptcy and bailout that would considerably improve on the current House and Senate bills.

A better approach would be a resolution regime centered on bankruptcy. It would impose substantial constraints on the ability of the government to put money into a failing firm. A judge would divide up a failing firm’s resources among its creditors and leave no possibility of a bailout without a vote of Congress. The Federal Reserve could still use its emergency powers under the so-called Section 13-3 authority to lend against good collateral. Enforcing the requirement for collateralized lending ensures that taxpayers are not propping up a failing firm or providing extra payments—bailouts—to creditors (or auto unions).

In the fall of 2008, the Lehman Brothers bankruptcy was followed by severe negative effects as short-term credit markets shut down. This is sometimes taken as evidence that bankruptcy is not a tenable outcome for a large financial firm. This is wrong. The disruptions that followed Lehman’s collapse were greatly magnified by the idiosyncratic problem that a large money-market mutual fund broke the buck as a result of losses on Lehman debt. This sparked a panicked flight out of money-market mutual funds, which led commercial paper markets to seize up and in turn begat TARP. This situation would have been prevented only by guaranteeing Lehman debt—that is, by a bailout that the administration says would not be allowed to occur under its financial regulatory reform proposals. This means that either the administration intends to allow bailouts or that its approach would not in fact solve the problem of Lehman’s collapse—it cannot be both ways. In fact, the Dodd bill allows two forms of a bailout, since the government can put cash directly into a failing firm or guarantee its debt. The Dodd proposal is a bailout bill, plain and simple.

Ensuring instead that firms will fail and that lenders will take losses is a better way to reduce market participants’ risk-taking behavior and make future crises less likely.

Some problems arising in the wake of Lehman’s failure can be addressed by thoughtful reforms of the bankruptcy code. The United Kingdom’s bankruptcy regime, for example, resulted in the assets of some Lehman clients being frozen, forcing affected firms to sell off other assets and thereby contributing to a downward spiral. It would be useful for regulatory reform to include harmonization of the bankruptcy processes in the United States and other key financial centers.

There are also middle grounds between bankruptcy and bailout that would considerably improve on the current House and Senate bills. Non-bank resolution authority could be constrained to allow the executive branch to provide only well-collateralized lending to a failing firm and not unlimited discretion as in the Dodd proposal. This would shift emergency lending authority for non-bank firms from the Federal Reserve to the Treasury Department. Such emergency lending could be further constrained by having any lending start a 30-day clock for Congress to approve the action. Failing congressional approval, the intervention would be unwound and the federal lending repaid without a loss to taxpayers (because it would be well-collateralized). A further constraint would be a tripwire that government lending in excess of $50 billion requires an immediate vote of Congress. Together these provisions would give considerable certainty that there would not be unlimited bailouts, while providing the Treasury Secretary with the additional tool to address a crisis.

The irony of President Obama’s partisan approach to pushing for financial regulatory reform is that there is a good deal of agreement on other aspects of the issue, including systemic risk regulation and consumer protection (and even on changes to the regulation of derivatives, where the administration’s position appears to be closer to that of the leading Republicans than to the heavy-handed proposal from the Senate Agriculture Committee). The big remaining obstacle is non-bank resolution—what happens in the event of another crisis. Everyone agrees that shareholders of a failing firm will be wiped out. But the unlimited discretion is the essence of a bailout. Ensuring instead that firms will fail and that lenders will take losses is a better way to reduce market participants’ risk-taking behavior and make future crises less likely.

Phillip Swagel is a visiting professor at the McDonough School of Business, Georgetown University, and a non-resident scholar at the American Enterprise Institute. The author was previously assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.

FURTHER READING: Swagel previously coauthored an article discussing “An Uncharitable Proposal” within President Obama’s tax plans. Treasury Secretary Timothy Geithner visited AEI in March to discuss financial regulatory reform, while Peter Wallison offers his scholarly critique of the suggested reforms in “Crisis and Ideology.” Jonah Goldberg discussed “Capitalism vs. Capitalists,” and Alex Pollock just concluded a blog series examining the Dodd bill.

Image by Darren Wamboldt/Bergman Group.

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