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The Troubling Resolution Revolution

Thursday, February 25, 2010

While members of Congress might complain that Goldman Sachs was paid in full during the American International Group bailout, many of them support legislation that authorizes the government to do exactly the same thing in the future.

There is something very odd about the current congressional debate on financial regulation. While everyone in Congress seems to oppose both creditor bailouts and financial firms that are “too big to fail,” many of them continue to support the Obama administration’s legislation that would turn both of these ideas into national policy. A good example of this policy confusion is the recent controversy about whether the Federal Reserve—when it bailed out American International Group (AIG)—should have insisted on discounts from Goldman Sachs and other AIG credit default swap counterparties. Many members of Congress were enraged by the Fed’s failure to seek these discounts, but they don’t seem to realize that creditor and counterparty bailouts are a necessary element of any plan that would authorize the government to take over a failing financial institution.

A resolution authority that would enable the government to assume control of a failing financial institution is a key element of the Obama administration’s regulatory reform plan. Legislation to authorize this has already passed the House. Proponents of the Obama plan argue that resolution authority is necessary to prevent the kind of systemic breakdown that occurred after Lehman Brothers failed in September 2008. Large financial firms are “interconnected,” they say, so that if one of them fails it will drag down others. There is no evidence for this; in fact, the evidence is to the contrary: none of Lehman’s 30 largest counterparties failed after Lehman did.

None of Lehman Brothers’ 30 largest counterparties failed after Lehman did.

But let’s suppose that the proponents of government resolutions are correct, and that the failure of a large nonbank financial institution like AIG would have caused a systemic breakdown. In this case, the entire rationale for the government’s takeover is to prevent this outcome—in other words, to signal to the markets that the obligations of the failed institution will be paid. Otherwise, if the interconnectedness theory is correct, the counterparties and creditors of the failed company will begin dropping like flies, and we will spiral into the systemic collapse we are supposed to fear.

How can the government prevent this from happening? There is only one way, and that is by assuring the markets—the creditors and counterparties—that there will not be any interruption in the payments that the failed company was required to make. Under the typically statist Obama administration solution, the government would be authorized to step in and prevent a large failing financial institution from going into bankruptcy. In other words, large financial institutions will become too big to fail. What about creditor bailouts?

It is an illusion to believe that the government can take over and resolve financial institutions without fully paying off creditors.

Returning to the AIG case: AIG was required under its credit default swap contracts to provide collateral to its counterparties if they had suffered losses on the investments AIG had insured. This condition had been triggered, and now the Fed had stepped in to rescue AIG because—as Treasury Secretary Timothy Geithner said in his recent testimony—that was necessary to prevent a systemic collapse or a second Great Depression or whatever it is that the supporters of the AIG bailout say was going to happen if AIG was allowed to fail.

Having taken control of AIG, is the Fed now supposed to say to AIG’s counterparties that AIG will not be meeting its contractual obligations after all? That would be a truly foolhardy course, since the whole purpose of the takeover was to assure the markets that everything was going to be okay with AIG in the future. It is necessary for all of us, and especially the proponents of a resolution authority, to understand that if the government is given the authority to take over a failing financial institution, its creditors and counterparties will receive 100 percent coverage of their obligations. Hence, a government resolution plan will inevitably mean a creditor bailout just like Goldman’s full payment from the Fed.

Under the typically statist Obama administration solution, the government would be authorized step in and prevent a large failing financial institution from going into bankruptcy. In other words, large financial institutions will become too big to fail.

If these payments are not made, it will be an event of default under the failing firm’s financing arrangements and, in most cases, its obligations will become immediately due and payable. If this happens, the firm’s creditors can take self-help actions like setting off other obligations or even seizing its assets. Bankruptcy law deals with this problem by imposing an immediate stay on almost all payments by the bankrupt firm, and it is precisely to avoid bankruptcy, and these cases of nonpayment, that the proponents of a government resolution authority say that a government takeover is necessary. However, they can’t have it both ways; they can’t insist that the counterparties and creditors take discounts—or, in the popular phrase, “haircuts”—and still claim that the government takeover will prevent a systemic breakdown.

So while members of Congress might complain that all of AIG’s counterparties were paid in full, many of them voted for or support legislation that authorizes the government to do exactly that. It is an illusion to believe that the government can take over and resolve financial institutions without fully paying off creditors. But the problem is bigger than a mere illusion. If the government ever gets this power, creditors and counterparties will immediately recognize that they have a better chance to be paid in full and on time when they lend to big financial firms rather than small ones. The funding advantages thus given to big institutions will be just as destructive to competition as if those companies had been explicitly labeled as too big to fail.

Thus, while everyone in Congress agrees that taxpayers must be protected from future creditor bailouts, and that no company should be considered too big to fail, they don’t seem to realize that a government resolution system will enshrine both these ideas as national policy, and that bailing out creditors creates the real danger to the competitiveness of our financial system.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: Wallison describes the plan to tax AIG bonuses as “New Plan, Old Fears,” and says “The President’s Bank Reforms Don’t Add Up.” In a February Outlook, he also detailed how “The Dead Shall Be Raised: The Future of Fannie and Freddie.”

Image by Darren Wamboldt/Bergman Group.

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