by Sheila Bair
UST [U.S. Treasury] would vest143 in itself both the power to decide whether to resolve a failing institution using the systemic process and how to resolve that institution. . . . UST’s claim to plenary authority to decide on how to resolve the firm without any clear constraints increases the likelihood of TBTF. . . . There are no provisions in the legislative draft that tie UST’s hands by an obligation to minimize costs compared to a receivership or liquidation process. The white paper simply notes that UST should consider the action’s costs to taxpayers. Second, in a crisis, . . . the uncertainties will likely push for loans, guarantees or other tools that avoid closure [of the institution]—and UST asserts authority to make this decision alone. Nowhere is there any recognition of the troublesome moral hazard or exit strategy issues created by some of these tools or of the stringent conditions that should be, but in practice have not been, placed on institutions receiving such assistance. While there has been much discussion of compensation limits . . . the real tools of restructuring, management changes, or sales of assets have—by and large—not been pushed by UST or other regulators, other than the FDIC.
In other words, instead of ending bailouts, the white paper embraced the status quo. Tellingly, it didn’t even meaningfully address the AIG bonuses that had troubled the president so greatly in March!
It was clear to me at the meeting and subsequent announcement that the president thought he had a proposal to end bailouts, when in fact, it did the opposite. It was also clear to me that Tim and Larry had engineered the meeting to make it look as though all of the regulators supported the white paper, when in fact few of us had had even seen the final version more than twenty-four hours in advance. Feeling blindsided but unprepared to respond to a document I had not yet analyzed, I remained silent, though seething, while the president talked about the importance of financial reform. The private meeting with the regulators took place in the Roosevelt Room, a stately conference room just outside the Oval Office. After that meeting, I, along with the rest of the agency heads, trooped into the East Room for his press announcement. I listened quietly, without expression, as he described what he called “a comprehensive regulatory reform plan144 to modernize and protect the integrity of our financial system.”
Notwithstanding Larry and Tim’s hardball tactics, I tried to keep my public comments constructive while educating members of Congress of our concerns behind the scenes. I also let Rahm know that we had not been given a chance to review the white paper in advance. We didn’t have to do much to discredit the white paper. Without any prodding from us, Hill staff were referring to it as “codifying TARP.”145 A few weeks later, Corker and Warner introduced their bill, which really would have ended bailouts, and on July 27, at Senator Corker’s invitation, I met with a bipartisan group of senators to talk with them about the FDIC resolution process. The meeting went very well.
If anything, we were being too successful from Tim’s standpoint. On Friday, July 31, he summoned all of the major agency heads to his conference room and proceeded to give us an expletive-laced tongue-lashing about talking to people on the Hill. The arrogance and disdain he showed for the agency heads, who also included Ben Bernanke and Mary Schapiro, was astonishing. He ignored the legitimate policy issues that stood at the heart of most of our disagreements, seeking to portray anyone who disagreed with him as interested only in protecting his or her own turf. I believe the tirade was probably mostly aimed at me, though Tim was also upset over the Fed’s continued resistance to the council and the SEC, which, like us, wanted the council to be a more powerful check on the Fed’s power. I patiently listened to his rant and then pointedly told him that the problem was one of his own making as he had failed to adequately brief and consult with the other regulators before going public with a proposal. Tim wanted to have it both ways: he didn’t want to make the changes needed to get other agencies on board, yet he wanted everyone to fall into line and support him.
His meeting accomplished nothing other than the creation of resentment, hard feelings, and a bad press story. (No, we were not the leak, but, as with everything that made its way into the press that Tim didn’t like, he blamed us.) Even if we had wanted to stop separately communicating with the Hill, we couldn’t have. Members of Congress were reaching out to all of us directly. The administration’s white paper had had little traction in Congress, whose members were going to write their own bill. And in the House, things were definitely going our way, with growing support for a tough ban on bank bailouts, strong resolution authority for the FDIC, and assessments on large financial institutions to pay for it.
Unfortunately, things took a bad turn in the Senate. Chris Dodd’s staff started pushing the idea of a single “superregulator” for all banks. Supposedly the idea was to create a completely new bank regulator, stripping authority from the Fed, FDIC, OCC, and OTS. Though I believe that Dodd and his staff were sincere in pushing a single regulator as a way to strengthen bank supervision, in reality, that would have served the interests of the biggest banks by consolidating power in the OCC, their friendliest regulator. The single-regulator concept was exactly what the big banks had been pressing for since the early 2000s. As one commentator put it, “For big banks146 like JPMorgan Chase and Bank of America, a single regulator would be like a dream come true.” They wanted to move toward a single, monolithic regulator patterned after the United Kingdom’s Financial Services Authority (FSA), a model that had been thoroughly discredited during the crisis as weak and a captive of the industry it regulated. The two main lobbying groups for the biggest banks—the Financial Services Roundtable and the Financial Services Forum—were all for it. But the idea quickly ran147 into opposition from Barney Frank, who went out of his way to say that his committee would not support taking regulatory authority away from the FDIC.
I have no doubt that Chairman Dodd was well intentioned in pushing for that. I think he truly felt that he would be getting rid of the OCC in favor of a stronger regulator. But I firmly believe that the opposite would have happened, with the captive OCC becoming the dominant core of the new regulator. Moreover, Dodd’s premise was wrong; he viewed the crisis as having been caused by FDIC-insured banks “shopping” for the weakest regulator. To be sure, the OTS had not provided sufficient oversight of insured thrift mortgage lenders, and there was general agreement that the agency needed to be abolished. However, for the most part, regulatory “shopping” had occurred between banks and nonbanks, with unregulated mortgage brokers originating high-risk mortgages with funds provided by the big securities firms, most of which operated outside of the tougher prudential standards we had for insured banks. Our three biggest problem institutions among insured banks—Citigroup, Wachovia, and WaMu—had not shopped for charters; they had been with the same regulator for decades. The problem was that their regulators did not have enough independence from them. Consolidating all of the power with the OCC, the weakest regulator along with the OTS, would make things worse, not better.
We had seen some sporadic instances of smaller banks trying to change charters to escape supervisory actions. However, earlier in the year148, as the chairman of an interagency group of bank regulators, I had successfully pushed for an agreement binding us all to one another’s CAMELS ratings and enforcement actions so that banks could have no hope of derailing supervisory actions by converting charters. If a bank wanted to change charters, any pending supervisory actions would now follow them to its new regulator.
Moreover, a single regulator would have meant the end of smaller, state-chartered banks that compete with the big banks for loans in their local communities. As I wrote in an op-ed149 in The New York Times in August, a single regulator would inevitably be biased toward the largest banks, hurting the ability of smaller institutions to compete and leading to even more industry consolidation. And putting all of our regulatory eggs into one basket would be a disaster if that regulator were weak and a captive of the largest institutions. Indeed, if it hadn’t been for the FDIC blocking the
Basel II capital standards, FDIC-insured banks would have been able to take on excessive levels of leverage, as had the securities firms, which had only one regulator to convince, the SEC.
That was a prime example of how influential industry lobbyists can contort reform efforts to achieve policy results that will weaken, not strengthen, regulation. Creating a single regulator made for a good sound bite. But in truth, the result would have been to take the FDIC—a strong voice for prudence, given its trillions of dollars’ worth of insured bank deposits—out of decisions governing the conduct of the banks we insured.
Eventually, we were able to convince Senator Dodd not to pursue the single-regulator idea, and in that effort we allied with both the Fed and the nation’s community banks. However, fending off the proposal divided our time and resources. We had to fight a rear-guard action at the same time we were pushing hard for real resolution authority to end too big to fail.
Then we ran into another obstacle on resolution authority: House Republicans, armed with the permissive language in the white paper, tried to paint the effort to create new resolution tools as a codification of bailouts. And notwithstanding our successful efforts to help Chairman Frank write legislation that really would end bailouts, the stigma of the white paper stuck. Bankruptcy attorneys seized on the controversy to argue that the failure of large financial institutions should be dealt with through only bankruptcy and began lobbying against our efforts, trying to convince members of the House Judiciary Committee—which had jurisdiction over bankruptcy law—to weigh in. The lobbying effort was led by Harvey Miller, the lead attorney in the Lehman Brothers bankruptcy. Mr. Miller, a highly influential member of the New York bankruptcy bar, was vigorously arguing the self-interest of his profession. As of this writing, legal and other fees associated with the still unresolved Lehman bankruptcy have topped $1.5 billion. In addition to the massive economic disruptions it caused, it has served Lehman’s creditors poorly. The company’s assets150—which stood at $639 billion in the fall of 2008—dissipated to $65 billion by the end of 2011. As of the end of 2011, its creditors had still not been paid, and when they are finally paid, the senior creditors are expected to recover only about 21 cents on the dollar.
Why has the Lehman bankruptcy proven to be so costly? There are three reasons. As previously discussed, one problem is the preferential way the bankruptcy code treats derivatives trading partners. They are given the ability to cancel their contracts immediately and take ownership of the collateral the bankrupt firm has posted with them. In practice, what happens is that as a firm becomes weaker, derivatives trading partners will demand more and higher-quality assets as collateral. When the firm finally fails, many of the good assets have already been transferred to those trading partners and thus are no longer available to pay the claims of other creditors. The second problem is that there is no way in bankruptcy to ensure continuous funding of operations. Unlike a commercial entity that has plant, equipment, and physical inventory that maintains value even in bankruptcy, a financial firm’s assets have to be funded continuously or their value is severely impaired. With bankruptcy, funding comes to a full stop as creditors cease lending to the institution. Finally, bankruptcy is a highly litigated process, meaning that fighting over what little value is left in a financial institution is protracted. It can take years for creditors to finally be paid. In contrast, the FDIC process is grounded in the public interest. It ensures continuity of credit availability to support economic activity and protect the public purse. For that reason, we put a high priority in getting banking assets back into the private sector as quickly as possible.
In 2011, the FDIC staff151 did an analysis of how Lehman Brothers could have been resolved using our standard resolution tools. The analysis indicated that Lehman’s senior creditors would likely have recovered 97 cents on the dollar. What’s more, given our ability to plan in advance and auction a failing institution quickly, the healthy parts of Lehman’s operations would have continued uninterrupted and creditors would have been paid much more quickly. Another contrast between the FDIC process and the bankruptcy process is provided by the WaMu failure. We were able to auction and sell WaMu’s insured thrift immediately. There was no disruption to WaMu’s customers, depositors, and borrowers. General creditors also suffered no losses. But WaMu’s holding company, WaMu Inc. (WMI), is still mired in bankruptcy proceedings. For three years, billions of dollars in cash and tax benefits have sat at the holding company. As with Lehman Brothers, these billions are just sitting in litigation instead of being deployed to support economic activity. That is not the fault of the bankruptcy courts; they do an amazing job, given all the legal avenues available to claimants to litigate. It is a problem with the adversarial nature of the judicial process and the way litigants are able to exploit it to their own advantage. Bankruptcy courts exist to protect creditors. The FDIC process exists to protect the public interest.
Fortunately, through the exceptional work of my chief legal adviser, Mike Krimminger, and Paul Nash, a seasoned Washington pro whom I had hired to head our External Affairs office, which included our legislative operations, we were able to beat back the assault on resolution authority. We convinced House Judiciary Committee members that the government needed the new resolution tools if we were to end bailouts. The irony was that continued reliance on the bankruptcy code to resolve large financial institutions would be an affirmation of the bailout status quo. After contending with the severe disruptions caused by Lehman’s failure, no government official in his or her right mind would allow a large, interconnected firm to enter that process again. The government would do another bailout before allowing the system to seize up as it did following Lehman’s bankruptcy filing.
Chairman Frank and his staff continued their discussions with us and the other regulators. I tried desperately to engage House Republicans to support our version of resolution authority. If promarket Republicans should be about anything, they should be about letting the market work to punish mismanaged, inefficient institutions. I reached out to Spencer Bachus (R–Ala.), the committee’s ranking Republican, and Jeb Hensarling (R–Tex.), one of the committee’s more influential conservative members, and met with them over the summer to try to convince them that, with our revisions, the new authority really could end bailouts. But they had it in their minds that it was all about ratifying bailouts, and in truth I think they wanted to keep the issue alive to bang over the administration’s head. Tim had made a terrible mistake with the white paper. Given his perceived close association with Bob Rubin and the too-big-to-fail institutions, the GOP smelled an issue, and it wasn’t going to give it up.
Unfortunately, Tim, and his financial reform point person, Michael Barr, continued to press Frank for flexibility to do future bailouts, as did members of the Fed staff. We were fighting for the souls of Barney Frank and his staff. Draft legislation that Frank floated in October still did not ban bailouts, nor did it give us the power to assess large institutions to build up a resolution fund. On October 29, I testified forcefully before Frank’s committee:
Congress should also152 prohibit open company assistance that benefits shareholders and creditors of individual institutions. The ban should apply to any assistance provided by the government including lending programs provided by the Federal Reserve Board. . . . The government should not be in the position of picking winners and losers among poorly managed firms that can no longer function without government assistance. Those institutions should be placed into receivership, and their shareholders and creditors, not the government, should be required to absorb losses from the institution’s failure.
I also insisted that the resolution mechanism be funded in advance through assessments on the big industry players:
To be credible153, a resolution process . . . must have the funds necessary to accomplish the resolution. It is important that funding for this resolution process be provided by the set of potentially systemically significant financial firms, rather than by the taxpa
yer. To that end, Congress should establish a Financial Company Resolution Fund (FCRF) that is pre-funded by levies on larger financial firms. . . . We believe that a pre-funded FCRF has significant advantages over an ex post funded system. It allows all large firms to pay risk-based assessments into the FCRF, not just the survivors after any resolution, and it avoids the pro-cyclical nature of requiring repayment after a systemic crisis.
In other words, collecting money from the industry in advance, as we did with our deposit insurance, would make sure that all potentially impacted firms, including the one that failed, paid into the fund. Collecting the money in advance would also mean that the government would have it when it was needed and was not put into the position of trying to collect money from the industry in the midst of a crisis. Most important, it would provide an added measure of protection for taxpayers: going forward, I didn’t want to see a penny of taxpayer money used to clean up big financial institution messes if I could help it. We acknowledged that some temporary borrowing authority from the Treasury was needed as a backstop, as was the case with the FDIC’s Deposit Insurance Fund. But Treasury borrowing should be available only as a last resort; the first line of defense should be a prepaid industry fund.
The hearing was a huge success for us. Paul Nash immediately received154 inquiries from committee members wanting help to draft amendments to ban bailouts and set up a resolution fund. On November 3, Frank told reporters that he planned to revise his legislation to include a resolution fund. It would apply to nonbank financial institutions with $10 billion or more in assets. (Insured banks would continue to pay into the FDIC fund.) When asked about the size of the fund, he responded that he hoped it “gets enormous.”155 Subsequently, his staff156 gave us his new draft bill, which also included our long-sought ban on bank bailouts, mandatory receivership for insolvent institutions, and FDIC backup authority for large systemic institutions.