WASHINGTON (Reuters) - The Dodd-Frank Wall Street reforms of 2010 gave the U.S. government a weapon to slay the “too big to fail” monster at the core of 2008’s financial turmoil, but wielding it will take some courage.
The orderly liquidation provision of the Dodd-Frank law empowers regulators to seize a large financial firm that is headed for disaster and dismantle it in a way that is less disruptive than either taxpayer bailouts or bankruptcy.
The trouble is that the markets, and many left- and right-wing critics of Dodd-Frank, just do not believe that orderly liquidation will ever be invoked, and even if it is, its detractors say that it will not work as intended.
As a result, more than two years after they were bailed out by taxpayers, the largest U.S. banking firms are back, spinning profits and once again enjoying a cost-of-capital advantage because they are viewed as too big to fail.
“Most people think that we’ll get a bailout if a Bank of America or a Citigroup runs into trouble,” said David Skeel, a University of Pennsylvania law professor and author of “The New Financial Deal,” a book about the Dodd-Frank reforms.
Yet, orderly liquidation is the law of the land and its proponents insist that if the circumstances arise, it will work, and it will end taxpayer bailouts, and it will show that no financial institution is too big to fail.
“People are saying we won’t have the guts” to invoke orderly liquidation, acknowledged Democratic Representative Barney Frank, co-author of the reforms, in an interview.
“Well, we had the guts with regard to the TARP to get the money back. We got it back,” he said, referring to the $700-billion Troubled Asset Relief Program bailouts that went to Wall Street firms and have been largely repaid.
“I don’t have any question that we’re going to go through with it” Frank said regarding orderly liquidation. “That’s the death panel,” he said, reprising the colorful rhetoric he employed during the intense Dodd-Frank debate.
The issue is about more than the discounted interest rate advantage that benefits giants such as JPMorgan Chase (JPM.N), Bank of America (BAC.N), Citigroup (C.N), Goldman Sachs (GS.N), Wells Fargo (WFC.N) or Morgan Stanley (MS.N).
The “too big to fail” question speaks to what kind of financial system Americans want — one where mega-banks are able to keep their profits and socialize their losses; or one where they succeed and fail, just like any other business, but without devastating the economy in the process.
No one wants to test orderly liquidation, of course, and most of the sprawling Dodd-Frank package is designed to make large financial institutions more accountable, stable and predictable, reducing the likelihood of further trouble.
Financial crises happen, however, and with disturbing regularity through hundreds of years of history, as shown by economists Carmen Reinhart and Kenneth Rogoff in their ground-breaking 2009 book “This Time is Different.”
The next U.S. crisis may not look at all like the last one, but it may be similar and it is likely that Americans’ memories of 2008 will have faded.
“If Citigroup, Bank of America or Goldman failed, we’d be looking at uncharted territory,” said David Min, a policy analyst at the Center for American Progress, a moderate think tank. “It would be a big moment and indicate a lot about the balance of power” between Washington and Wall Street.
If orderly liquidation was invoked and if it did work, the balance of power would be with government. But if the skeptics are right and more bailouts followed, then the triumph of Wall Street over Washington would be complete.
“Look at what’s happening at Europe and you’ll get a sense of it,” said Robert Borosage, president of the Institute for America’s Future, a progressive group, citing recent government bank bailouts like Ireland’s.
Orderly liquidation “authority is written into the law, it just isn’t operable,” Borosage said. “These firms are so huge now that I think it’s pretty unlikely” that the U.S. government would put one of them into orderly liquidation.
Sounding remarkably similar, conservative Republican Representative Spencer Bachus, chairman of the House Financial Services Committee, has said that Dodd-Frank only institutionalized taxpayer bailouts into law.
Keywords: FINANCE SUMMIT/LIQUIDATE
Not so, says the senior officer at the U.S. Federal Deposit Insurance Corp who is in charge of managing the new protocol. Like Frank and some economists, he is convinced of the potential of orderly liquidation.
“If the objective is to have an orderly process without a taxpayer bailout, I certainly think it will work,” said the FDIC’s Jim Wigand in an interview.
Under the new regime, the FDIC can seize control of a large financial firm that is in distress and threatening the economy, sack the managers, wipe out the shareholders, deal equitably and efficiently with the creditors, sell off assets and essentially dismantle the business.
The idea is to preserve economic stability by unwinding troubled firms, but in a way that is less politically explosive than bailouts and less traumatic to the markets than bankruptcy, like the Lehman Brothers collapse of 2008.
The FDIC is still ironing out details on orderly liquidation, but could take over a firm tomorrow if needed.
“Right now, unfortunately, when people think of FDIC’s orderly liquidation authority, they’re thinking in terms of a Chapter 7 liquidation under bankruptcy,” Wigand said.
“They say, well, that can’t work because that’s just too draconian — everything has to stop, contracts are frozen, it can take two years for claimants to receive any type of distributions. That’s not the way the process would work in an FDIC-controlled resolution,” he said.
“Creating a bridge entity, passing certain contracts and creditor classes into the bridge, keeping the continuity of business operations and facilitating the monetization of creditor claims. Nobody has been able to make a convincing argument as to why this will not work.”
Some critics contend that orderly liquidation’s biggest flaw is that it addresses only U.S. law, that there is no international pact on resolving the problems of large financial institutions that are global in scope.
“A major unanswered question is the asymmetry between (orderly liquidation) — by far the most disciplined approach to ‘too big to fail’ to date — and the approach in all other banking centers, where rescue remains de rigeur,” said Karen Shaw-Petrou, managing partner at Federal Financial Analytics, a regulatory policy consulting firm.
Some critics contend that JPMorgan and firms like it are aggressively expanding overseas with the goal of immunizing themselves from orderly liquidation by making it unworkable.
Dodd-Frank calls for international coordination by the FDIC on unwinding troubled firms. But the world is a long way from any kind of uniform orderly liquidation pact.
The European Union is targeting 2013 at the earliest for adoption of new laws on resolving troubled firms, to be phased in possibly by 2015. Officials are still debating basic concepts, some of which resemble Dodd-Frank.
One common feature is requiring large firms to keep “funeral plans” on file that spell out how they could be quickly unwound in an emergency as a guide for regulators.
The absence for now, however, of an international accord on the matter makes Dodd-Frank’s orderly liquidation program “almost impossible” to carry out, Borosage said.
Critics also say the U.S. government’s fiscal constraints are a problem. Orderly liquidation allows the FDIC to borrow money from the U.S. Treasury Department to cover liquidation costs, with an iron-clad repayment plan required. But the cost of unwinding a behemoth like Citigroup, for instance, would be enormous, perhaps more than Treasury could handle.
Some critics also question the ability of the FDIC to administer such a vast project. The agency has a sterling record on seizing and unwinding banks — a job it has handled adroitly since it was established in the 1930s. But it has never tackled a firm as complex as Goldman, for instance.
“Dealing with Citigroup would obviously be a challenge, Hopefully that day won’t come, but I don’t think that means it couldn’t be managed,” said David Moss, a Harvard Business School professor and proponent of orderly liquidation.
The key point, he added, should not be whether the FDIC can manage orderly liquidation without flaw, but that the only other options in a crisis are still the ones faced by the Bush administration in 2008 — bankruptcy or bailouts.