Will the big banks make us pay after death? Jennifer Taub answers

"The bottom line is, when a behemoth bank burns the candle at both ends and then goes belly up, it’s polite to pay our respects, but it’s ridiculous to pay the bill," says Jennifer S. Taub. Here's her take on the so-called bailout fund.

It's not a bailout, it's a funeral
Jennifer S. Taub
Baseline Scenario
June 17, 2010

In poetry and politics, metaphor matters. Expect some fighting figures of speech on Thursday, when the conference committee takes up the topic of the Orderly Liquidation Fund or “OLF.” Under the proposed financial reform legislation, the OLF is the facility that would hold the money needed by the FDIC to shut down a systemically important, insolvent financial institution before its failure can contaminate other firms and the broader economy. In other words, one purpose of the resolution authority and OLF is to avoid repeating the disorder and disruption of either the Lehman bankruptcy or the AIG bailout.

To be clear, many question whether regulators will have the courage to invoke this provision and pull the plug on a dying bank. Accordingly, the “prevention” measures under discussion in the legislation are critical — these included the swaps desk spinoff, hard leverage caps on financial firms, regulatory oversight over shadow banks and inclusion of off-balance sheet transactions in capital standards, among others.

One of the hottest debates concerning funding the OLF is over who should pay into the fund and when should they pay. On the question of “who,” the choices have been framed as either industry or taxpayers. And the “when” options are described as in advance of or after a failure. Many, including the House majority in its bill and FDIC Chairman Sheila Bair, support an up-front assessment on industry. Those who oppose an industry pre-fund have tried to damn the OLF as a “bailout fund” and at times the financial reform legislation as a “bailout bill.”

It’s laughable that big-bank-boosters only characterize it as a “bailout fund” when the banks pay in advance, but not when taxpayers front the money. It’s tragic, though, when we fall for this propaganda, disseminated by some truth-twisting Republican political strategists. But that’s exactly what happened when that fiction effectively killed the industry pre-fund in the Senate bill. As Paul Krugman noted, politicians continue to repeat these twisted talking points because they hope that if they slap the “bailout” label on any provision of the bill that gets tough on big banks, we will be fooled into backing down.

But we cannot be fooled. The proposed legislation is not a bailout. It is a funeral. A bailout involves using money to revive a failing business so that it can continue operations. In contrast, under both the House and Senate versions of the legislation, the FDIC is given the power to dismantle, shut down and liquidate failing firms. Liquidation means the end of the enterprise. Liquidation requires the valuation and sale of eligible assets, including healthy subsidiaries. It’s a funeral.

That’s good. But, unfortunately, under the Senate version of bill, the taxpayers front the funeral expenses. Let me repeat. The taxpayers front the funeral expenses of the failed firm. The FDIC can borrow from Treasury who can then issue debt. It’s true. And it’s very important. The reason is that funding is needed to process a liquidation. Depending upon the number of firms collapsing, this could be in the hundreds of billions of dollars.

The money is needed to avoid a sudden halt of business that causes the financial firm’s viable assets (such as the remaining enterprise value of a healthy subsidiary) to plummet in value. Funds would allow the firm to keep functioning so that an orderly liquidation can occur. The money would be used to put the failing firm into a bridge entity, then manage it and wind it down. The proceeds of the sale of eligible assets and functioning subsidiaries would be used first to replenish the OLF. With the Senate version, any proceeds would be used first toward paying back the loan from Treasury. Of course, not all assets are eligible to be sold. Creditors with security interests (and otherwise given special protection) can pull their assets away from the receivership. To protect against this, the House version allows the FDIC to require these secured creditors to leave behind 10 percent of their collateral. Known as the “secured creditor haircut,” this mechanism does not exist in the Senate version; it should, particularly given that it would be a good resource to pay back the taxpayers.

While the debate has been framed as either a pre-fund or a post-fund, this is a false dichotomy. There will have to be money available when the failing firm is taken into receivership. There will be pre-funding, period. So, the true story is that if the banks do not pay in advance, we will, and then the only questions becomes who will pay us back and when.

Now is the time to address this issue. While taxpayers should support the House industry-pays-in-advance-for-its-own-funerals, version, given the strange power of doublethink, we are in danger that the Senate taxpayer-fronted-funeral process will survive conference committee and make it into the final law.

The House model requires financial institutions to pay $150 billion in advance into the OLF (called the Systemic Dissolution fund in the House version). An industry pre-funded facility has precedent. The FDIC relies upon bank assessments to fill the deposit insurance fund (the “DIF”). The DIF is most well known for insuring the money bank account holders have on deposit. It also, however, is used to pay the various expenses associated with the liquidation of covered banks. Another precedent is the Pension Benefit Guarantee Corporation. Pension plan sponsors provide funding through an assessment. The resulting fund is used to pay certain employee pension benefits in the event the employer firm goes into bankruptcy.

The Senate bill requires taxpayers to front the costs of liquidating failing firms. The amount FDIC can borrow from treasury is capped by a “Maximum Obligation Limit” calculation. This is in two parts. In the first 30 days of receivership, the FDIC can borrow from Treasury up to 10% of the “total consolidated assets” of the failing firm based upon the most recent financial statement available. So, for a bank with about $800 billion in assets, the FDIC could borrow from Treasury $80 billion in that 30 day window.

Then, in part two, after examining the firm and better determining the value of its assets (and what funding will be needed for orderly liquidation), the FDIC can borrow from Treasury up to 90% of the fair market value of total consolidated assets “available for repayment.” It’s important to note that there may be very few assets if any available for repayment — if, as noted above, secured creditors pull their collateral — so these will not be eligible.

The FDIC is required to pay back the Treasury within 60 months (five years), using the proceeds of the sale of assets, if there are enough. If the firm is so broke that the assets are not sufficient to pay back the FDIC, then the FDIC is supposed to claw back extra amounts paid to certain creditors, and if that doesn’t work out, an ex-post industry assessment on “eligible financial institutions” is permitted.

Thus the taxpayers may be “out-of-pocket” for up to five years or beyond. Given that one of the greatest objections to the Bush Bailout of 2008 was the burden on taxpayers, how did this happen? Opponents of the bank pre-fund claim that the existence of a fund would encourage banks to take high risks because they know that they will be bailed out. This ignores the fact that both the House and Senate bills would impose stricter standards on these institutions, requiring them to have more capital cushions in the event that the assets they own decline in value (a common part of the business cycle). Thus, the risk-taking will be monitored and minimized. In addition, given that firms will be liquidated not rescued, this argument is silly.

Perhaps there’s a third option, an industry paid “Just-in-Time” mechanism. Just-in-Time mean would mean assessing “eligible financial institutions” at the moment of FDIC receivership. And, instead of leaving the allocation formula as a mystery until some future date, the legislation could require the new council of regulators (the Financial Stability Oversight Council) to come up with a methodology that would be transparent to each firm.

Of course, there are plenty of arguments against this approach. One argument is that it is unworkable because the assessments come too late. I agree that it is better to collect “rainy day” resources on a sunny day. And, I support the House’s $150 billion pre-fund approach. Representative Luis Gutierrez, from Illinois’s 4th District, is going to lead this charge on the House side during conference on Thursday. If we can convince the Congress to do that, terrific. But, that is not the message some conference committee members are signaling.

Some might also worry that such a Just-in-Time assessment on industry would be difficult to collect if there were a massive failure a la September 2008. Implicit in this argument is that the liquidation of one firm means a full blown financial crisis has hit. This is not necessarily the case. An FDIC-run liquidation could be a Bear Stearns (March 2008) moment, not a Lehman (September 2008) moment, or even a single, stand alone troubled firm. And, even if it is the Lehman moment, recall that the weekend before Lehman filed for bankruptcy, industry rivals were assembled together ready to buy up its bad assets so that Barclays might buy the good ones. While this transaction fell apart when the UK regulators reasonably insisted that shareholders at Barclays get to vote on the deal, the point is that the top financial institutions were prepared to help.

However, the Just-in-Time language could be drafted in such a way that a firm’s condition could be considered before deciding upon the amount of the up-front assessment. If a firm is too unhealthy to pay in, it could be granted a deferred assessment. In the case of a “one-off” failure, with a fairly isolated insolvency and many healthy firms, it would be a good time to avoid moral hazard and show industry that they, instead of the taxpayers must front the costs of the liquidation. In other words, suggesting the firms won’t have the money when a firm goes into receivership is only a hypothesis. Another hypothesis is that many will. Congress should prepare for both so that passing the hat around to industry happens before we are asked to pinch our pennies and pitch in.