Fed paper backs Wall Street reform under GOP attack

WASHINGTON (Reuters) - Federal Reserve economists endorsed on Wednesday one of the crown jewels of 2010's Wall Street reform laws -- orderly liquidation of troubled financial firms -- which a top Republican has targeted for repeal.

The Cleveland Federal Reserve Bank researchers, in a report that could foreshadow congressional testimony, said the orderly liquidation provision of the Dodd-Frank laws "is an important step toward addressing the too-big-to-fail problem."

The provision is one of several interlocking measures in Dodd-Frank, approved in July, meant to prevent a repeat of the 2007-2009 financial crisis that deeply wounded the economy and led to huge taxpayer bailouts.

It sets up a new way for the U.S. government to dismantle large non-bank financial firms on the brink of collapse. The new process is supposed to avert future bailouts while being less jarring to markets than bankruptcy, with policy-makers in Europe eyeing similar reforms.

Representative Spencer Bachus, the new chairman of the House Financial Services Committee since Republicans took control of the House of Representatives, told Reuters in September that his top priority as chairman would be to kill parts of Dodd-Frank, specifically orderly liquidation.

Some Republicans have argued that the provision institutionalizes bailouts, rather than avert them.

Orderly liquidation was strongly supported last year by the Obama administration, along with the rest of the sprawling Dodd-Frank bill, named after co-authors Representative Barney Frank and former Senator Christopher Dodd, both Democrats.

Bachus, along with other House Republicans, fought unsuccessfully to block Dodd-Frank, as did an army of lobbyists from Wall Street and the big banks.

FED ECONOMISTS REVIEW CRISIS

Cleveland Fed economists Thomas Fitzpatrick and James Thomson in their paper reviewed the shocking late-2008 bankruptcy of Lehman Brothers, the bailout of AIG, and the deathbed acquisition of Merrill Lynch by Bank of America.

"The market turbulence in the days immediately after Lehman's failure confirmed the fears of policymakers that bankruptcy was unlikely to produce an orderly resolution of a large non-bank financial firm, at least not during a period of financial market stress," the economists said.

As a result, lawmakers looked for another way, and came up with orderly liquidation after much debate.

Under the provision, if the government fears that the collapse of a large non-bank financial firm threatens economic stability, that firm can be seized by the government and put into receivership by the Federal Deposit Insurance Corp.

The FDIC for decades has followed a similar process with failing banks, whose troubles have long been treated differently by the government than those of non-financial firms, which normally go to bankruptcy court when failing.

As early as this month the FDIC is expected to propose more details on its liquidation authority, building on an October proposal that dealt with how creditors would be treated.

Bankruptcy will remain the default process for most non-bank firms that are in trouble, even with Dodd-Frank in place, said Fitzpatrick and Thomson.

"The orderly liquidation authority is meant to be an exceptional power and not the default procedure for winding up the affairs of large distressed non-depository financial firms," they said.

"Yet it recognizes that some non-depository financial firm failures are different from others because of their potential to significantly destabilize the financial system.

"Thus, (Dodd-Frank) provides an important new tool in the regulatory toolkit that allows financial system supervisors to close and resolve such firms appropriately."

(Additional reporting by Dave Clarke, Editing by Chizu Nomiyama)