Ten years ago this March, the Bush administration engineered a bailout of the failing investment firm Bear Stearns, ushering in a year of financial-industry rescues that eventually totaled in the trillions of dollars. Donald Trump is president today in part because the 2008 financial crisis exposed the failures of both political parties. Trump and a Republican Congress now have the opportunity to end the “too big to fail” phenomenon that still distorts our supposedly free-market economic system. A Treasury Department report on this issue, released last week, offers some useful fixes—but then promptly contradicts itself, making those fixes less likely to work.
Weeks after taking office, Trump set out seven core principles for the financial system and directed federal officials to ensure that current laws and regulations conform to them. The second such principle was to “prevent taxpayer-funded bailouts.” That Trump is pursuing this goal concedes that the Obama administration’s 2010 Dodd-Frank Act did not accomplish it. Indeed, Dodd-Frank only enshrined into permanent law the main mechanism behind the ad hoc 2008 rescues—some approved by Congress on the fly and some carried out unilaterally by the Federal Reserve.
Dodd-Frank created something called the “orderly liquidation authority” (OLA) to address the shortcomings of the traditional bankruptcy code when it comes to large financial firms. Bankruptcy, in the rest of the economy, is a critical tool of capitalism. When a firm has made catastrophic mistakes that render it unable to pay on its obligations, it petitions for court protection from creditors. It can ask to liquidate itself, essentially giving up and selling off its assets piecemeal to other companies to pay off creditors, or it can seek to reorganize itself. Either way, if the firm’s assets prove insufficient to cover its debt, creditors lose money.
Yet the system is inadequate for big financial companies. An airline or a casino can go bankrupt without taking the rest of the economy down with it—because airlines and casinos don’t load their balance sheets with their competitors’ debts. The financial world is different. A large firm can have hundreds of billions of dollars’ worth of short-term derivatives and overnight lending contracts. These agreements are made with other global financial firms, which, in turn, have made similar deals with yet more global financial firms; in bankruptcy, “counterparties” on these contracts can yank their money out immediately, potentially destabilizing all parties involved. Thus, the global financial system is like a house of cards balanced on top of a giant game of pick-up sticks.
OLA is supposed to address these shortcomings, but Congress didn’t reform the bankruptcy code to achieve this end; instead, lawmakers bypassed bankruptcy altogether. Under OLA, regulators have the authority to take over a large financial institution in a crisis, funding it and managing it for up to five years with taxpayer money. The Federal Reserve can recommend that the Treasury appoint the Federal Deposit Insurance Corporation, a government-charted entity whose traditional function has been to protect small-scale depositors from bank failure, to take over a large financial institution, rather than allow it to enter bankruptcy. In this instance, the FDIC could replenish a failing firm’s coffers with public money and use those funds to protect derivatives counterparties, short-term lenders, and other creditors at the failing firm from losses, thus discouraging them from pulling all their funding over the years-long unwinding process. And rather than follow the bankruptcy court’s system for allocating losses, with junior lenders taking bigger losses than senior lenders, for example, the Treasury could discriminate among such creditors. Finally, the Treasury could recoup any taxpayer losses from such activity by assessing a fee on other large financial firms—the ones that didn’t fail.
This strategy has lots of problems, starting with the idea of the executive branch of the government controlling—for years—a company that can lend billions of dollars to the private sector. Also, allowing the FDIC to decide which creditors get paid first would create uncertainty in lending and raise obvious questions of favoritism or cronyism. Creditors making risky loans demand a higher interest rate in return, but if OLA leaves uncertain who will be the favored creditors, then it is harder for investors to “price” such risk. Further, why should successful, well-managed banks have to pay for the failure of banks that were managed poorly? The shareholders, creditors, and management of the failed firm should bear that burden. As the Treasury report notes, in summing up these flaws, OLA “confers far too much unchecked administrative discretion, could be misused to bail out creditors, and runs the risk of weakening market discipline.”
The Treasury report offers a sound solution. It proposes that Congress change the bankruptcy process so that large financial firms could go through this court process without putting the global economy at risk. A Chapter 14 section of the bankruptcy code, as opposed to the usual Chapter 7 (liquidation) and Chapter 13 (reorganization) fillings, would address the main problems of letting a financial firm go bankrupt. Chapter 14 would create a temporary restriction on cash calls by counterparties in the event of default, and allow the distressed company to remain solvent through the bankruptcy. The process would be quicker, too. A judge would oversee a bankrupt firm transferring its critical operating units to a new “bridge company” within 48 hours. Shareholders, management, and creditors to the failed financial firm would be “left behind,” with a judge and lawyers to determine the extent of their losses later, after the bridge company, under court supervision, determines the diminished value of its assets.
This approach is better for free markets. “Shareholders, management and specified creditors would bear all losses,” the Treasury document says, “just as they do under the ordinary bankruptcy process.” And, “most important,” the report concludes, “not a single dollar of taxpayer support would be used to capitalize the new bridge company.” Instead, such money would come from new creditors and shareholders, who would have priority over the old ones. This way, “the bridge company would remain in private hands,” without the need for the government to run a huge bank for five years. The new owners—that is, the investors willing to put up the new capital—would determine its management, rather than the government doing so. So far, so good.
But then, the Treasury undermines its own report. With a reformed bankruptcy code able to handle the failure of a large financial firm, it follows that the Trump administration would recommend that Congress abolish OLA. Yet Treasury wants to keep it “as an emergency tool for use under only extraordinary circumstances.” But this solution restates the original problem. Any failure of a complex financial institution—like a JPMorgan Chase, with trillions of dollars in assets and liabilities—is going to be “extraordinary,” and likely the result of some extraordinary event: a bond-market crash, say, or a mass-scale fraud. Treasury worries, too, about cases in which “there is insufficient private financing” to recapitalize a bankrupt company. But if that’s the case, the government could provide such financing within its new Chapter 14 process.
The Treasury is concerned that without OLA, foreign regulators would require foreign branches of U.S. banks to put up more capital to cushion losses, “harming their ability to compete internationally.” Yet a system under which foreign banks are lenient on American institutions’ operations in expectation of a government rescue when needed, and vice versa, is not a system of free-market capitalism.
It’s especially important for America to lead here in light of recent global events. China recently seized the Chinese-headquartered insurer Anbang, which owns Park Avenue’s Waldorf-Astoria hotel and several other key commercial assets in the West. Beijing most likely wants to unwind the heavily indebted insurers’ assets without causing a meltdown in global asset prices in a fire sale—the same motivation that would cause the U.S. government, someday, to invoke OLA for one of our strategic financial companies. This type of planning, though, is characteristic of centrally planned economies, not liberal Western ones.
Treasury does propose some reforms to OLA that would make moderate improvements—eliminating OLA’s ability to discriminate among creditors, for example, which would force it to follow prescribed bankruptcy process, and requiring that a court, not FDIC administrators, adjudicate claims. Yet these reforms only add perplexity. If it’s so important to rein in the executive branch’s discretion here, why not do it by using the Chapter 14 bankruptcy process, which would accomplish exactly that?
Treasury’s goal is admirable: a “more robust, effective” bankruptcy process, it says, would make the use of OLA less likely. But as long as OLA is written into the law as an escape hatch for “extraordinary” situations, we can bet that it will be used eventually.