Pete Souza / White House
The underlying assumption of the Dodd-Frank Act (DFA) is that the 2008 financial crisis was caused by the disorderly bankruptcy of Lehman Brothers. This is evident in the statements of officials and the principal elements of the act, which would tighten the regulation of large financial institutions to prevent their failing, and establish an "orderly resolution" system outside of bankruptcy if they do. The financial crisis, however, was caused by the mortgage meltdown, a sudden and sharp decline in housing and mortgage values as a massive housing bubble collapsed in 2007. This scenario is known to scholars as a "common shock"—a sudden decline in the value of a widely held asset—which causes instability or insolvency among many financial institutions. In this light, the principal elements of Dodd-Frank turn out to be useless as a defense against a future crisis. Lehman's bankruptcy shows that in the absence of a common shock that weakens all or most financial institutions, the bankruptcy of one or a few firms would not cause a crisis; on the other hand, given a similarly severe common shock in the future, subjecting a few financial institutions to the act's orderly resolution process will not prevent a crisis. Apart from its likely ineffectiveness, moreover, the orderly resolution process in the act impairs the current insolvency system and will raise the cost of credit for all financial institutions.
Key points in this Outlook:
- Congress passed the Dodd-Frank Act under the mistaken assumption that the failure of Lehman Brothers caused the ensuing chaos—hence the Dodd-Frank provision for "orderly resolution" of firms in danger of failing.
- The financial crisis was not caused by one firm's failure, but by a common shock to all firms: the decline in mortgage values after the housing bubble collapsed, exacerbated by mark-to-market accounting.
- The orderly resolution process is unnecessary; in the absence of a common shock, the failure of a single firm would not cause a financial crisis; in the presence of a common shock, the orderly resolution of a single firm, or even a few, would not prevent a financial crisis.
- Orderly resolution, by allowing the Federal Deposit Insurance Corporation to do almost anything it wants with the assets and liabilities of any financial firm, creates uncertainty and raises the cost of credit for all financial institutions.
It is no exaggeration to say that the orderly resolution provisions are the heart of the DFA. Whenever someone in the administration or Congress is called upon to list the benefits of the act, the fact that a large financial institution can purportedly be resolved without triggering another financial crisis is always cited as one of its principal achievements. The orderly resolution process is also treated as a solution to the alleged problem that some institutions may be too big to fail—that is, they are so large that their failure will destabilize the financial system as a whole. With orderly resolution, we are told, all large financial institutions can be safely wound down and thus are not too big to fail.
However, the orderly resolution provisions of the DFA are another example of the misconceptions underlying this troubling legislation. These provisions, together with the special "stringent" regulation mandated for large, "systemically sig-nificant" financial institutions, are based on the assumption that the 2008 financial crisis was caused by the failure of a large financial institution and that future financial crises will stem from the same cause. Presumably, what the administration and congressional framers had in mind was that the failure of a large financial institution has knock-on effects, which drag down other "interconnected" institutions, creating a systemic event. If this were true, then it would be sensible to impose stringent regulation on large financial institutions, and perhaps even to provide for a special form of resolution or wind-down if such an institution failed.
But there is something wrong with this picture. The 2008 financial crisis was not caused by the failure of a single institution, but by a "common shock"—a weakening of all financial institutions because of a general decline in the value of a widely held asset. In this case, the asset was almost $2 trillion in mortgage-backed securities (MBS) held by financial institutions in the United States and around the world. When the unprecedented ten-year housing bubble collapsed in 2007, Bear Stearns, Wachovia, Washington Mutual, AIG, Lehman Brothers, and many other financial firms in the United States and around the world were all severely weakened, particularly because of mark-to-market accounting. Of these large financial firms in the United States, only Lehman was allowed to go into bankruptcy, but that event told us a great deal about what happens when a large financial institution fails. Contrary to the conclusions of the DFA's framers, it demonstrated that the failure of a large financial institution is very unlikely to cause a financial crisis. Even in a financial environment severely weakened by a common shock, Lehman's bankruptcy had virtually no knock-on effects. In other words, the collapse of Lehman showed that almost all financial institutions can survive the failure of a large firm even in the midst of a severe common shock.
This conclusion calls into question the need for both the stringent new regulations in the DFA's Title I and the orderly resolution provisions in Title II. If, as seems clear, the financial crisis was caused by the severity of the common shock rather than the Lehman bankruptcy itself, the proper policy response was to take steps to mitigate the likelihood of future common shocks. Given a severe common shock to virtually all financial institutions, the orderly resolution of one or even a few large firms will not mitigate its effects; in the absence of a severe common shock, on the other hand, it is unlikely that the failure of one or a few large financial institutions will cause a systemic breakdown.
Common Shock and the Financial Crisis
Most observers now recognize that the precipitating cause of the financial crisis was a collapse of the huge US housing bubble in 2007. This was not just any bubble. It was almost ten times larger than any previous postwar housing bubble, and almost half of all mortgages in this bubble—27 million loans—were subprime or otherwise weak and risky loans.1
The reason for this was the US government's housing policy, which—in the early 1990s—began to require that government agencies and others regulated or controlled by government reduce their mortgage underwriting standards so borrowers who had not previously had access to mortgage credit would be able to buy homes. The government-sponsored enterprises Fannie Mae and Freddie Mac, the Federal Housing Administration, and banks and savings and loan associations (S&Ls) subject to the Community Reinvestment Act were all required to increase their acquisition of loans to homebuyers at or below the median income in their communities. Often, government policies required Fannie, Freddie, and the others to acquire loans to borrowers at or below 80 percent, and in some cases 60 percent, of median income.
"The 2008 financial crisis was not caused by the failure of a single institution, but by a 'common shock'."
Of course, it was possible to find qualified buyers that met prime lending standards in these areas, but when all these agencies and institutions were trying to meet increasing government quotas for lending to low-income borrowers, mortgage underwriting standards had to -deteriorate. Aggregate government demand, coupled with competition among the agencies trying to meet their ¬quotas, not only built the housing bubble but loaded it up with subprime and other low-quality mortgages.
By 2008, before the financial crisis actually struck, two-thirds of the 27 million low-quality mortgages were on the books of Fannie and Freddie, other government agencies, and insured banks and S&Ls subject to the Community Reinvestment Act.
As bubbles grow, they tend to suppress delinquencies and defaults, since borrowers can easily refinance their homes or sell them for more than they initially paid. So, to banks and other financial institutions, MBS issued against pools of these weak loans looked like good investments. They were paying high rates because the loans were high risk, but they were not showing the high levels of default normally commensurate with these risks. As a result, starting in about 2004, financial institutions around the world began to buy these instruments in large numbers, eventually acquiring MBS backed by pools of about 7.8 million mortgages—somewhat less than one-third of the 27 million low-quality loans outstanding.
But when the bubble began to deflate in 2007, the 27 million subprime and other weak mortgages started to default in unprecedented numbers, driving down housing values. Figure 1 shows the huge run-up and subsequent decline in real house prices during the bubble years 1997–2007.
With housing values falling precipitously, investors fled from MBS, making portfolios of these instruments unmarketable. Figure 2 shows the speed of the collapse in the MBS market. This had a devastating effect on the balance sheets of the large financial institutions in the United States and around the world that were holding these assets—a problem seriously aggravated by mark-to-market accounting, which required the writedown to market value of assets on which losses had not yet been suffered. With the market collapsed and moribund, these values were far lower than the capitalized values of the cash flows the portfolios were generating. As a result, at least in an accounting sense, the institutions holding these securities looked unstable or insolvent, triggering significant declines in their stock prices and general investor and creditor anxiety around the world. Panicky investors, fearful of insolvencies, began to withdraw their funds from financial institutions and place them in safer hands.
The rescue of Bear Stearns in March 2008 temporarily quieted the markets but created substantial moral hazard. Most market participants believed that the US government's policy had been established: it would rescue all large financial institutions. On the evidence, it was not rational to believe otherwise. However, when Lehman was allowed to file for bankruptcy, market participants were shocked. Because of the decline in MBS asset values, it was unclear who was solvent and who was not—and now it really mattered. As a result, major financial institutions stopped lending to one another, creating the financial crisis.
Thus, the events of 2008 were the result of a sudden, generalized loss in value for a widely held asset—about $2 trillion in privately issued MBS—coupled with the effects of mark-to-market accounting and the moral hazard that flowed from the rescue of Bear Stearns. What happened in 2008, as mortgage asset values began to fall and investors fled from the MBS market, was a classic case of a common shock, described as follows in a 2003 article about bank failures by banking scholars George G. Kaufman and Kenneth E. Scott:
Except for fraud, clustered bank failures in the United States almost always are triggered by adverse conditions in the regional or national macroeconomies or by the bursting of asset-price bubbles, especially in real estate. . . . Banks fail because of exposure to common shock, such as a depression in agriculture, real estate, or oil prices, not because of direct spillover from other banks without themselves being exposed to the shock.2
In other words, bank failures—and by extension, financial institution failures—are generally caused by declines in the values of widely held assets, not by spillovers from the failure of other banks.
The Theory of the DFA's Framers
However, the lesson of this history—that the financial crisis was caused by a common shock—was not absorbed by the framers of Dodd-Frank in the administration and Congress. From all indications, they diagnosed the crisis as the result of losses arising from the bankruptcy of Lehman Brothers, as though Lehman's failure had dragged down other financial institutions. This error is written boldly in their own statements, in their emphasis on the concept of "interconnections" among financial institutions, and in the DFA.
For example, in testimony before the House Financial Services Committee on October 1, 2009, Fed chair Ben Bernanke noted:
In most cases, the federal bankruptcy laws provide an appropriate framework for the resolution of nonbank financial institutions. However, the bankruptcy code does not sufficiently protect the public's strong interest in ensuring the orderly reso-lution of a nonbank financial firm whose failure would pose substantial risks to the financial system and to the economy. Indeed, after Lehman Brothers' and AIG's experiences, there is little doubt that we need a third option between the choices of bankruptcy and bailout for such firms.3
"Sometimes it is argued that the Troubled Asset Relief Program (TARP) prevented more failures. That seems highly unlikely."
This is a point repeated frequently by administration spokesmen—that the financial crisis came about because there was no choice but to allow Lehman to file for bankruptcy, and in effect that the bankruptcy itself caused the crisis.
Interconnections among financial institutions are also emphasized by the act's supporters, again to suggest that when one large financial firm fails it will drag down others. For example, Treasury Secretary Timothy Geithner, in a speech at New York University's Stern School of Business in August 2010, declared that "[t]he largest and most interconnected firms cause more damage when they fail." Although financial institutions are certainly interconnected to some extent, implicit in Geithner's use of the term is the argument that financial institutions are so critically interconnected that the knock-on effects of the failure of one could cause others to fail—in other words, a systemic collapse. A further illustration of this approach appears in a widely read speech in March 2011, by Federal Reserve governor Daniel K. Tarullo. Tarullo focused on the effects of a single firm's distress, outlining four ways in which that might cause general financial instability: a "domino effect" in which the failure of one large institution infects other firms; a "fire sale" effect in which a failing firm dumps assets and thus lowers asset values generally; a "contagion effect" in which market participants conclude from one firm's distress that others are in similar straits; and the discontinuation of a critical function for which there are no substitutes.4 None of these scenarios involves a common shock; it was an idea foreign to the framers of the DFA.
Thus, the DFA authorizes the Financial Stability Oversight Council to identify those financial firms which—if they fail—are likely to cause instability in the US financial system. If it is in fact true that these knock-on effects can result in systemic breakdowns, the 2008 financial crisis would be the acid test; we are unlikely ever to see a case in which a firm as large as Lehman Brothers is allowed to fail when the solvency or stability of other large financial institutions is subject to such doubt among market participants. Yet, as discussed below, there is very little evidence of knock-on effects associated with the Lehman bankruptcy.
Finally, and most importantly, the DFA creates a new orderly resolution system for large nonbank financial institutions of all kinds, administered by the Federal Deposit Insurance Corporation (FDIC). In effect, the DFA extends to all financial institutions the FDIC's authority to resolve insolvent insured banks. Although there are some differences between the FDIC's authorities under the DFA and its authorities under the Federal Deposit Insurance Act, the authorities are essentially the same. It is important to note that these authorities can be extended to all financial institutions, and not just those designated by the Financial Stability Oversight Council as systemically important financial institutions (SIFIs).5 As discussed below, this will have an important effect in creating uncertainty about the enforceability of creditors' rights among firms that are not initially designated as SIFIs and thus will raise the cost of credit to these firms, as well as their consumer and business customers.
All of this raises the question of whether Lehman's bankruptcy—the kind of failure the orderly resolution provisions were designed to prevent—caused the financial crisis, either through the disorderliness of its bankruptcy or the knock-on effects of its failure to meet its financial obligations.
Did Lehman's Failure Cause the Financial Crisis?
Contrary to the underlying assumptions of the DFA, the events that followed the failure of Lehman demonstrate the weakness of the interconnectedness and knock-on theories in explaining the financial crisis. With the single exception of the Reserve Fund, a money market mutual fund, there is no evidence whatever that any significant firm was caused to fail through the knock-on effects of Lehman's bankruptcy. Indeed, the case of the Reserve Fund is itself an example of the ill effects of the moral hazard created by the rescue of Bear. The fund could have rid itself of its Lehman holdings as Lehman was perceived to be weakening, but it likely held on to a large portfolio of the firm's commercial paper in the belief that Lehman, like Bear Stearns, would eventually be rescued and its creditors fully paid. AIG, one of the other high-profile failures around the time of Lehman, had virtually no exposure to Lehman. Nor is there any indication that the problems at Wachovia or Washington Mutual—the other institutions resolved in some way during the financial crisis—had any significant exposure to Lehman. In reality, all were victims of the same common shock that caused Lehman's failure. So in the absence of any evidence of knock-on effects from Lehman's failure, it is necessary to conclude that interconnectedness among financial institutions—as a theory for preventing a future financial crisis through tighter regulation—is invalid.
In the absence of any other examples, supporters of the interconnectedness theory have pointed to credit default swaps (CDSs) as a mechanism through which the failure of one financial institution could be transmitted to others. This is perhaps true in theory, but even in one of the greatest financial meltdowns ever, there is no evidence that the failure of Lehman or AIG—both of which were major players in the CDS market—caused any other financial institution to fail. Indeed, the CDS market continued to function effectively after Lehman and AIG (and through the entire financial ¬crisis); losses on CDSs written on Lehman were resolved five weeks after its bankruptcy by the exchange of approximately $6 billion among hundreds of counter-parties.6 The CDSs on which Lehman was a counterparty were either terminated by its counterparties (who presumably bought replacement coverage) or continued in force by Lehman's trustee if they were favorable to the bankrupt estate. In other words, no great crisis developed in the CDS market as a result of Lehman's failure.
A particularly good summary of the outcome thus far with respect to Lehman's CDS portfolio is the following:
While derivatives certainly lived up to their famous moniker as weapons of mass destruction in the view of the media and many policymakers, the fact remains that derivative transactions were ¬terminated quickly and efficiently, although obviously settlement of claims and the ensuing fiduciary requirements of administration certainly slow the process, no major counterparties slid into bankruptcy, parties were eventually able to ¬re-hedge their positions and quality collateral was fairly ubiquitous both before and after the meltdown in 2008.7
AIG, of course, was devastated by its participation in the CDS market, but this was because it had made the gross error of taking only one side of CDS transactions. It had sold protection against others' losses, but unlike other market participants it never hedged its bets by buying protection for itself. To use AIG's experience as a reason to condemn CDS activity as too risky to be carried on without regulation—the basis for the DFA's regulation of the CDS market—is like regulating all lending because one lender made imprudent loans.
Sometimes it is argued that the Troubled Asset Relief Program (TARP) prevented more failures. That seems highly unlikely. The first funds were made available under TARP on October 28, 2008, about six weeks after the panic following Lehman's failure. By that time, any firm that had been mortally wounded by Lehman's collapse would have collapsed itself. Moreover, most of the TARP funds were quickly repaid by the largest institutions, and many of the smaller ones, only eight months later, in mid-June 2009. This is strong ¬evidence that the funds were not needed to cover losses coming from the Lehman bankruptcy. If there were such losses, they would still have been embedded in the balance sheets of those institutions. If the funds were needed at all—and many of the institutions took them reluctantly and under government pressure—it was to restore investor confidence that the recipients were not so badly affected by the common shock of the decline in housing and mortgage values that they could not fund orderly withdrawals, if necessary. However, even if we assume that TARP funds prevented the failure of some large financial institutions, it seems clear that the underlying cause of each firm's weakness was the decline in the value of its MBS holdings, and not any losses suffered as a result of Lehman's bankruptcy.
The same is true of many other extraordinary actions taken by the government after Lehman's bankruptcy, including guaranteeing loans, purchasing commercial paper, and ring-fencing weak assets on the balance sheets of large financial institutions. These actions were made necessary by the effects of the common shock, not by the bankruptcy of Lehman. The fact is that even in their weakened condition, most financial institutions are so highly diversified that any losses suffered because of the failure of another firm are unlikely to leave mortal wounds, and that appears to be the lesson of Lehman.
This analysis leads to the following conclusion. Without a common shock, the failure of a single Lehman-like firm is highly unlikely to cause a financial crisis. This conclusion is buttressed by the fact that in 1990 the securities firm Drexel Burnham Lambert—then, like Lehman, the fourth largest securities firm in the United States—was allowed to declare bankruptcy without any adverse consequences for the market in general. At the time, other financial institutions were generally healthy, and Drexel was not brought down by the failure of a widely held class of assets. On the other hand, in the presence of a common shock, the orderly resolution of one or a few Lehman-like financial institutions will not prevent a financial crisis precipitated by a severe common shock. Resolving one institution, or even a few, will have little or no effect on the weakened condition of those still surviving. This question remains: even if the orderly resolution provisions of the DFA are not effectively designed to prevent a financial crisis, are they an improvement over the bankruptcy system? That issue is addressed in the rest of this Outlook.
Dodd-Frank and Insolvency Law
As long as they remain part of the law applicable to financial institutions, the orderly resolution provisions of the DFA will have important adverse effects on ¬insolvency law. In effect, by giving the government the power to resolve any financial firm it believes to be failing, the act has added a whole new policy objective for the resolution of failing firms. Before Dodd-Frank, insolvency law embodied two basic policies—retain the going concern value of the firm and provide a mechanism by which creditors could realize on the assets of an insolvent firm that cannot be saved. The DFA, based on the view that Lehman's bankruptcy was a cause of the ensuing chaos, added a third objective—preserving the stability of the financial system by giving the federal government a role in any insolvency.
As this Outlook will discuss, there is a real question whether the orderly resolution of the DFA is any better than bankruptcy as a resolution process. But there is little question that orderly resolution leaves creditors' rights in a state of serious uncertainty. This is because the FDIC, which is the statutorily designated receiver for any firm placed into orderly resolution, is given virtually unlimited discretion to determine who among a firm's creditors gets paid and to what extent.
In the interest of preventing instability in the financial system, the FDIC as receiver can do almost anything it wants with the assets and liabilities of a covered firm. As outlined in the DFA, the orderly resolution process is invoked by the Federal Reserve, the FDIC, and the secretary of the treasury, acting separately. Each must decide that a financial firm is in default or "in danger of default" and that its failure might cause "instability" in the US financial system. If they so decide, but the firm itself does not agree, the secretary can go to a federal ¬district court in a secret proceeding for approval to place the firm involuntarily into the orderly resolution process.
Incredibly—I should probably say absurdly—the court has only one day to render its judgment, after hearing both sides. If it cannot decide in a day, then the orderly resolution process is automatically invoked and the FDIC becomes the receiver for the institution. Obviously, a court would have to be considerably outraged by what the government was trying to do before it would intervene. It would be far easier just to let the day pass. The right to a hearing, therefore, is essentially a nullity, and the idea that the government can at any time take over a financial firm it believes to be "in danger of default" is of questionable constitutionality under the "takings" clause.
There are two additional aspects of this process that are noteworthy. First, the DFA seems to assume that the regulators' approach to the firm, the dispute with the board and management, and the court proceeding can all be kept secret. This is wildly naïve. In our financial system, with its 24/7 financial news cycle, nothing can be kept secret. It might even be a violation of securities law for these discussions to be held and not revealed to the markets. Still, the DFA provides for criminal penalties—a fine of $250,000 or a prison term of up to five years—for anyone who "discloses a determination of the [Treasury] Secretary" to seek a takeover of a firm believed to be in danger of default.8 So here, as a demonstration of the mindset and naïveté of the DFA's framers, we have our first Official Secrets Act for a matter not involving national security. It's a good thing for its sponsors that the act has a severance clause. A clearer and more meritless restraint on free speech can hardly be imagined.
In a paper published in early 2011, the FDIC argued that its examination of a prospective target would not attract the attention of the markets.9 Such an examination, it said, would be regarded as "routine." That is a statement one would expect from an agency that has earned its stripes taking over small banks on Friday afternoon and reopening them under new ownership on Monday morning; it is a bit alarming that the FDIC thinks markets will not watch it closely as it goes about its business with firms that have billions of dollars in assets spread throughout the world. Once the rumors start, the markets and counterparties will react. There is a huge premium for those who can get out first. A firm that was stable one day will be unstable the next. Moreover, as its current creditors and counterparties desert it, no new creditors will be willing to come in—even as secured creditors—because the DFA leaves the ultimate discretion on ¬payment of creditors with the FDIC. In the DFA's orderly resolution process, there is no stay and no debtor in possession financing. The assumption is that the government will provide the financing, recovering any losses from other large financial institutions—assuming they are not themselves in financial difficulty at the time—after the fact.
Second, to make the FDIC the statutorily designated receiver for any financial institution was—to put it plainly—a bizarre idea. During the few congressional hearings about the DFA, administration witnesses praised the FDIC as a highly successful agency in resolving insolvent banks. These statements were of questionable accuracy and clearly misleading. The FDIC is required by law to close down banks when their capital falls below 2 percent. If this process works, the agency should not suffer any losses because of bank failures, since the bank should have more assets than liabilities when it is closed. However, the FDIC has suffered losses averaging 25 percent on two-thirds of the banks it has closed in the last three years, and is itself currently underwater. With very few exceptions, the banks the FDIC closes are quite small, operating locally and not internationally, and the closure is done over a weekend, with accounts transferred to a healthy institution by the following Monday. The agency has no experience at all resolving nonbanks, or even bank holding companies. How it would resolve a trillion-dollar insurance holding company like AIG or a $600 billion securities firm like Lehman Brothers is anybody's guess. The only thing sure is that it would not happen over a weekend. It seems likely that the FDIC was selected and put forward as a qualified receiver because no one in the administration or Congress had any better idea.
Once the FDIC is appointed as receiver, it will have many of the extraordinary powers it already has under the Federal Deposit Insurance Act, but with very little of the judicial review available to creditors and others under bankruptcy laws. The agency's authorities as a receiver under the DFA include the power to:
- Transfer all or any portion of the assets and liabilities of a firm in receivership to any person—or merge the institution with any person— without any approvals.10 Presumably, this would be for the agency's estimate of fair value, but even that would not be subject to judicial review.
- Cherry-pick assets and liabilities without creditors' consent or court review, even if it differentiates between creditors in the same class or treats junior creditors more favorably than senior creditors.11
- Set up a bridge institution and transfer to that institution any portion of the assets and liabilities of the firm in resolution.12 If there is any doubt that the act allows the FDIC to protect creditors—which is really the meaning of a bailout—this provision should resolve it. Liabilities transferred to the bridge bank will be fully protected against loss. The DFA, despite the hoopla, has authorized bailouts instead of preventing them.
The net effect of these powers, and others, is to leave creditors' rights in a state of uncertainty. The FDIC has proposed a regulation that purports to limit its discretion in certain respects, but the statutory language can override that regulation in special circumstances the FDIC declares.
Uncertainty about the insolvency law applicable to a particular financial firm will continue to affect the US economy as long as the orderly resolution provisions of the DFA remain on the statute books. This is because all financial firms—not just the largest ones that have been designated for special regulation by the Fed—are potentially subject to this procedure. Section 202 of the act specifically confers authority on the secretary and the other officials noted above to cover any financial institution under the orderly resolution provisions. Accordingly, it will be difficult to tell in advance whether a financial firm in danger of failing will be resolved in bankruptcy—where one set of rules applies—or by the FDIC under the DFA's orderly resolution provisions.
The key will be whether the Federal Reserve, the FDIC, and the secretary of the treasury determine that the failure of a particular firm at a particular point in the future is likely to cause instability in the financial system.
That decision, however, will be strongly influenced by the conditions when it is made and is unknowable when credit is advanced. If the financial system is stable when such a firm is in danger of failing, it will likely be allowed to go into bankruptcy. On the other hand, the same firm might seem to be a candidate for the orderly resolution process if the financial system is weak and investors are nervous.
The uncertainty about a firm's status will increase the cost of credit for any financial institution that might reasonably be subject to the DFA's orderly resolution rules. Ironically, this might not be true of the very largest firms that are eventually designated as SIFIs. These firms will in effect have been declared too big to fail, and their creditors are likely to believe that they will be better protected in lending to such a firm in the event of the firm's failure. After all, if a firm is designated as systemically important, it is because its distress could—at least in the view of the government officials then in office—cause instability in the financial system. Thus, its creditors could be reasonably confident that regulators will not allow such a firm to fail. In effect, then, the systemically important firms designated by the Financial Stability Oversight Council will have additional advantages over smaller competitors because the uncertainty about their status is much lower.
Finally, one of the key policies of bankruptcy laws is the preservation of the going concern value of a bankrupt institution; for this reason, bankruptcy laws allow the management of a failed firm to reorganize it and maintain it as a going concern. Liquidation is an option in bankruptcy, of course, but usually only when the management cannot persuade creditors that the firm has prospects for a return to profitability. Preserving the going concern value of a firm is especially difficult for financial institutions, because they are uniquely depend-ent on client relationships and the trust and confidence of their counterparties. But this possibility is cut short by the DFA, which requires the liquidation of any financial firm put into the orderly resolution process. Workout and reorganization are not an option.
The reason for this provision, which can only be described as punitive, seems to flow from the mistaken idea that unless a firm is liquidated its shareholders will be bailed out. Certainly this is not true of bankruptcy, where shareholders are generally wiped out and creditors work with the management to reorganize the firm. In contrast, under the DFA, the management of a firm taken over by the FDIC as receiver has to be immediately dismissed. So when the FDIC walks in, it does not know anything about how the firm really operates—who the key people are, where they are located, and how they carry out the successful and essential functions of the business.
To summarize, then, the orderly resolution provisions of the DFA will create uncertainty about which financial firms will actually be covered in the future, raise the financing costs of all financial firms that might be ¬covered, destroy the value of going concerns by requiring liquidation and firing management, and turn over the resolution process for the largest nonbank financial firms to an agency—the FDIC—that has never resolved a nonbank and has not been particularly successful in resolving small banks.
Will It Work?
From the discussion above, it should be clear that the orderly resolution provisions of the DFA will have an adverse effect on the financial system and the economy generally. It is possible that this effect is already being felt in credit restrictions and the unwillingness of businesses to expand and hire new employees. More-over, these provisions are not likely to help prevent a financial crisis: orderly resolution will not prevent or ameliorate the effects of a common shock, and is likely unnecessary in the absence of a common shock. Nevertheless, it is a legitimate question whether—simply by giving the FDIC the authority to replace the bankruptcy system under -certain circumstances—the DFA reduced the ¬likelihood of a financial crisis. In other words, if Lehman had been placed into the orderly resolution process of the DFA, rather than into bankruptcy, would that have reduced the chaos that followed Lehman's bankruptcy?
The answer to this question is fairly obviously no. As noted earlier, Lehman's bankruptcy filing was not itself the cause of the financial crisis; it was the fact that its filing upset the market's expectations—after the rescue of Bear Stearns—about the US government's willingness to rescue all large financial institutions. The context is also important: at the time, because of the common shock associated with the mortgage meltdown and the collapse of the MBS market, virtually all large financial institutions were seen as unstable and possibly insolvent. The CDS market on Lehman's debt shows this confidence; it held steady for almost six months after Bear, blowing out only just before the last weekend when it became apparent that the government had run out of other options and was still refusing to support a Lehman rescue. When Lehman ultimately filed for bankruptcy, all market participants had to reevaluate their counterparties and hoard their cash, bringing lending—even among the largest banks—to a halt. Placing Lehman into the DFA's orderly resolution process would not have changed the fact that the government was not willing to do for Lehman what it did for Bear. The financial crisis would have proceeded exactly the same way as it did in 2008, and been just as severe.
"Orderly resolution provisions of the DFA will have an adverse effect on the financial system and the economy generally."
But let's go one step further. Let's assume that Bear had not happened and Lehman was the first large financial institution to be threatened with default. Is there anything about the orderly resolution process that would have made the aftermath of the Lehman failure less chaotic? No, again. In fact, it would have been much worse. As Lehman's time began to run out, the FDIC and others would closely monitor the company, leading ¬market observers to believe that the firm would be placed into the orderly resolution process. The DFA specifies that as far as possible the losses in any resolution should be borne by unsecured creditors. Accordingly, the -unsecured creditors would not be hanging about doing nothing; they would be withdrawing whatever funds they possibly could, and the firm would be bleeding liquidity. It would have to be put into the resolution process quickly, before it lost any ability to operate.
What would happen then? Under the DFA, the management would be dismissed and the FDIC would try to run the firm as receiver—without any experience in operating a firm of this type or of this global size. In its 2011 paper,13 the FDIC makes the claim that if it had had the authority conferred by the DFA before Lehman's failure, it would have been able to preserve Lehman's going concern value by transferring its assets and liabil-ities to a bridge bank. Let's consider this for a moment. What assets? What liabilities? Who makes this decision, and how fast could it possibly be made? A decision like this about a $600 billion global enterprise could not be made in days or weeks, or even months. Meanwhile, with no stay, creditors would be declaring defaults and insisting on payment. Congressmen and senators would be calling to make sure their favored constituents were at the top of the list for immediate payment or at least transferred to the bridge bank. Chaos would reign.
Is this any better than a bankruptcy filing, in which there would be a creditor stay, politicians would have no influence, and the Lehman management would get protection from creditors while they worked out a reorganization plan? There is much reason for doubt.
So what has the DFA wrought in this area? It has seriously disrupted the universality of the bankruptcy system for nonbank financial institutions, ensured the same chaotic wind-down that occurred with Lehman, and put an inexperienced political agency in charge of the resolution, all without actually addressing the true causes of the financial crisis.
1. The data supporting these points are contained in Peter J. Wallison, Dissent from the Majority Report of the Financial Crisis Inquiry Commission (Washington, DC: AEI, January 26, 2011), www.aei.org /paper/100190.
2. George G. Kaufman and Kenneth E. Scott, "What Is Systemic Risk and Do Bank Regulators Contribute to It?" The Independent Review VII, no. 3 (Winter 2003): 379.
3. Regulatory Reform, Before the House Financial Services Committee, 111th Cong. 7 (October 1, 2009) (testimony of Ben Bernanke, Chairman of the Federal Reserve).
4. Daniel K. Tarullo, "Regulating Systemic Risk" (remarks, Credit Markets Symposium, Charlotte, NC, March 31, 2011).
5. See §203(a) of the DFA, which authorizes the Financial ¬Stability Oversight Council to make a recommendation to the secretary of the treasury for the orderly resolution of any financial company in danger of default.
6. Peter J. Wallison, "Everything You Wanted to Know about Credit Default Swaps—But Were Never Told," AEI Financial Services Outlook (December 2008), www.aei.org/outlook/29158; see also Peter J. Wallison, "Unnecessary Intervention: The Administration's Effort to Regulate Credit Default Swaps," AEI Financial Services Outlook (August 2009), www.aei.org/outlook/100065.
7. Kimberly Anne Summe, "An Examination of Lehman Brothers' Derivatives Portfolio Post-Bankruptcy and Whether Dodd-Frank Would Have Made Any Difference," in Resolution of Failed Financial Institutions: Orderly Liquidation Authority and a New Chapter 14 (Palo Alto, CA: Stanford University, Hoover Institution Working Group on Economic Policy, Resolution Project, April 24, 2011), 3–28.
8. Wall Street Reform and Consumer Protection Act, HR 4173, 111th Cong. (2010), §202(a)(1)(C).
9. "The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act," FDIC Quarterly 5, no. 2 (2011).
13. "The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act."