The Corner

Would the Dodd Bill Prevent Bailouts?

Treasury Secretary Tim Geithner said yesterday that the Dodd bill for financial regulatory reform does not institutionalize bailouts. “If a major institution manages itself to the edge of their abyss, we’re able to put them out of their misery, put them through an effective bankruptcy regime, dismember them safely without taxpayers being exposed to a penny of risk of loss,” Geithner told reporters, according to the Times.

Not according to the bill.

Title II, which starts on p. 107, explains how “orderly liquidation authority” would work. When the Treasury and a panel of judges have determined that a financial firm is unsafe for bankruptcy, the FDIC would take over that firm. In “liquidating” the company, the FDIC would figure out who — of the firms’ lenders, other creditors, and shareholders — would get what.

On the repayment list is “any amounts owed to the United States, unless the United States agrees or consents otherwise” (italics mine).

That speaks for itself on whether taxpayers will be “exposed to a penny of risk of loss.”

More important, though, what does it mean to “liquidate” a company?

It’s not just to take out the managers and see shareholders lose. Lenders, too, must take their losses. Otherwise, lenders, including big bondholders, will figure that the government will bail them out again — and they’ll continue to lend too much too freely to financial companies, which got us into this mess in the first place.

The bill does not ensure that lenders will take losses. Instead, it merely directs the FDIC to operate under a “strong presumption” (p. 131) that “creditors and shareholders will bear the losses of the financial company” (p. 132).

A hundred-odd pages later, the bill offers a big loophole for lenders in a crisis. It says that the FDIC, “with the approval of the [Treasury] Secretary, may make additional payments or credit additional amounts to or with respect for the account of any claimant or category of claimants of the covered financial company” — that is, to lenders — “if the [FDIC] determines that such payments or credits are necessary or appropriate to minimize losses” to the FDIC (p. 241).

It wouldn’t be unreasonable for a lender to expect the government and the FDIC to use all of the discretion the bill affords them to guarantee financial firms’ debt in a future systemic financial crisis, just as happened this time around.

This conclusion would help create the next systemic crisis.

Finally, Geithner’s language — he wants to “dismember” failed financial firms “safely” — is interesting.

Three months ago before Congress, Geithner had this to say about the AIG bailout: “We didn’t rescue AIG. We intervened so we could dismember it safely.”

True, that was the government’s intent in the fall of 2008. But AIG is still with us; the stock trades at nearly $40.

The same thing would happen with the government’s “orderly liquidation authority.” The world will see a failed financial firm as, well, a failure — until the government steps in with $183 billion. Then, the formerly failed firm looks pretty healthy — and it’s hard for Washington to kill off a “healthy” company.

Sure, the government is gradually minimizing its financial losses at AIG, just the Dodd bill wants the FDIC to do in possibly guaranteeing lenders in a future crisis. But the bigger loss is to the nation, as arbitrary government power, rather than free-market discipline, continues to govern the financial sector.

– Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of After The Fall: Saving Capitalism From Wall Street — and Washington.


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