November 10, 2011
Imagine that it’s 2013, and the world has entered a deep recession in the wake of a renewed sovereign debt crisis in Europe and another wave of mortgage bond defaults. “New Jefferson Bank,” with over $1 trillion of assets, is nearing collapse after its secured creditors, recognizing the bank is highly exposed to failing assets, yank their short-term deposits.
The Treasury Secretary calls an emergency weekend meeting of the Financial Stability Oversight Council, which brings together the heads of the government’s financial regulatory agencies. By Sunday night, they must decide what will be done to avert a wider panic on Monday morning. A failure to act could bring down the entire financial system, and lead to a global depression.
How will those bank regulators respond to that future crisis under the Dodd-Frank financial services law passed in 2010? Some of the nation’s leading economists, regulators and financial experts – including former Treasury Secretary Lawrence Summers -- gathered in a room in New York recently for a full blown simulation to find out whether the law would achieve its stated goal of preventing a full-blown financial crisis.
In 2008, there appeared to be only one option for government officials and regulators faced with a similar situation. Either let the banks fail – as officials did with Lehman Brothers – or run to Congress for a bailout. Then-Treasury Secretary Henry Paulson eventually did both. While it took Congress two votes to finally pass it, the $700 billion Toxic Assets Relief Program (TARP) successfully halted the panic. It did so by guaranteeing the loans of the unsecured creditors at institutions that had frittered the money away on sub-prime mortgage bonds and failed derivatives trades.
At its heart, the Dodd-Frank financial overhaul legislation, named after its chief sponsors former Sen. Chris Dodd, D-Conn., and Rep. Barney Frank, D-Mass., gave federal regulators new powers to deal with similar situations in the future.
While prohibiting bailouts, the government now has the power to seize large financial holding companies that are on the verge of bankruptcy. The hypothetical “New Jefferson,” for example, is about half the size of Bank of America. Those “resolution” powers, which the Federal Deposit Insurance Corporation has held over individual deposit-taking banks since the 1930s, didn’t exist when Bear Stearns, Lehman Brothers and AIG collapsed, which led to widespread market panic and the freezing up of virtually all credit markets.
For many critics, like former International Monetary Fund chief economist Simon Johnson of the Massachusetts Institute of Technology, allowing behemoth financial institutions to continue to exist, even if there are rules for restructuring those that fail, is the central flaw in the Dodd-Frank bill. “The resolution powers won’t work for the largest cross-border banks,” Johnson wrote recently on Bloomberg View. “And bankruptcy for financial institutions would seriously undermine confidence, as happened with Lehman.”
Can FDIC-style restructurings work for huge financial services companies with large cross-border operations? Their complex financial dealings usually include exotic derivatives, off-balance-sheet two-party transactions and large inventories of questionable bonds produced by their investment banking arms. The Bipartisan Policy Center, at a forum sponsored by The Economist magazine, recently brought together an all-star cast of former government officials and leading lawyers and consultants to play out how they would deal with the failing New Jefferson under Dodd-Frank’s rules.
Summers, the Harvard economics professor, assumed his former role as Treasury Secretary. The Brookings Institution’s Donald Kohn, who spent 40 years at the Federal Reserve, played the chief of the central bank. BlackRock’s Peter Fisher, who spent 15 years at the New York Fed and was an undersecretary of Treasury in the early 2000s, took on the New York Fed chief’s role. Diana Farrell of McKinsey & Co., who previously worked for Goldman Sachs, advised the president. Rodgin Cohen, the managing partner of Sullivan & Cromwell and one of the nation’s top banking lawyers, advised the Treasury Secretary. And Covington & Burling’s John Dugan, former Comptroller of the Currency, spoke on behalf of the Federal Deposit Insurance Corporation.
The first option on the table was throwing New Jefferson into bankruptcy, which is the option usually favored by market fundamentalists. “There’s the 'Lehman was really fun so let’s repeat that' strategy,” Summers offered in a tone that suggested the answer was obvious. The panelists agreed and unanimously rejected that option.
They also rejected arranging a sale to another big bank, with shareholders and junior creditors in New Jefferson taking the losses. “The combined institution would control about 15 percent of all financial assets in the U.S., beyond the 10 percent limit set in Dodd-Frank,” Dugan, acting as head of FDIC, pointed out. “This could be waived by the Fed, but there are strong policy arguments against forming this mega-mega bank,” not the least of which was the possibility that it would set up the potential for an even larger failure down the road.
Rather, given all the information that the new rules in Dodd-Frank had provided regulators leading up to the crisis, which included a routine cataloging of banks’ assets and a “living will” for managing the collapse of a financial institutions deemed “systemically important” because of their size, the panel voted to radically restructure the bank.
They wiped out stockholders’ equity; created a “good bank” with the institution’s performing loans and assets, and a “bad bank” with its toxic assets; guaranteed 100 percent of the deposits and bonds of the secured creditors; and gave the unsecured creditors a “haircut” by turning their bonds into stock in the new bank valued at a price that took into account the losses in the toxic assets, which would be determined by the regulators.
“The takeaway was that Dodd-Frank worked,” said Jay Powell, a senior fellow at the Bipartisan Policy Center and a former undersecretary of the Treasury in George H.W. Bush administration. “The law wanted to eliminate the regulator’s ability to bail out individual institutions, and in this case, there was no taxpayer bailout.”
But most of the panelists expressed concern that there would still be a flight to safety by secured creditors at other institutions, which would be feeling the same pressures because of the economic downturn. Given the panicky state of financial markets, they might not understand that only the unsecured creditors had taken a hit in the restructuring of the first financial institution to go down the tubes.
“There will be liquidity issues at those holding companies when they see this coming,” said acting Fed chief Donald Kohn. “If they saw that the subordinated debt would be hit and nothing else, then perhaps the pressures would be alleviated, but until the first resolution goes through and people see how it [Dodd-Frank] works, there will be pressure.”
Cohen and Peter Fisher, whose day jobs put them squarely at the heart of Wall Street’s investment banking industry, also feared the new “good bank” would be unstable. Some of the pension funds, hedge funds and other unsecured creditors given stock would immediately begin dumping those shares on the market. Even if they were required to hold those shares for a time, they would begin dumping other bank shares in their portfolios to lessen their exposure to the banking sector. “The real danger isn’t in getting the recap done, it’s in what comes after,” said Sullivan & Cromwell’s Cohen.
The execution of the plan wouldn’t be easy, either. It might take weeks to get foreign regulators to go along with the plan, since unlike plain vanilla domestic bank restructurings organized by the FDIC, large investment banks and bank holding companies invariably have large portfolios of foreign assets. Valuing failing derivative contracts will also pose a new and time-consuming task for regulators.
Near the end of the session, the panelists agreed that Dodd-Frank’s absolute prohibition on bailouts could wind up putting regulators in a straight jacket where the dismantling of a single bank could wind up fostering the very contagion they were trying to avoid. “A simulation like this can’t fully answer the question of whether the law was appropriate or not appropriate,” Summers said. “I tend to be one that believes that no one can foretell the future with great precision and therefore statements that use the word never are usually mistakes and laws that use the phrase under no circumstances have a problematic aspect.”
In other words, allowing banks to continue to be “too big” means that one can never rule out that there could one day be a circumstance when banks deemed “too big to fail” will require a bailout. But it wouldn’t be done under this law. “Under Dodd-Frank, you’d have to go back to Congress,” Powell said. “That was exactly what Congress intended.”