FINREG's Bailout Provisions Explained

The recently-stalled Senate financial regulation bill, designed, badly, by retiring Senator Chris Dodd, has a particular weakness about which either lies have been told by various Democratic Senators and administration officials, or those people grossly misunderstand what the provisions actually will do.

As Peter Wallison and others have written in the Wall Street Journal editorial pages numerous times over the past several weeks, the Dodd proposal creates a dangerous process, rather than clear law, which may, at the whim of an administration, supersede bankruptcy.

The "resolution authority," as it is named, is to be the FDIC. But, under the terms of the bill, the FDIC may use this authority arbitrarily, which is one major weakness.

But the authority has been defended in the past week by both Austin Goolsbee, the administration's chief economic adviser, and newly-elected Democratic Senator Mark Warner, from Virginia, in interviews on CNBC.

Goolsbee blathered on at length about how there was "no bailout" provision in the bill, because any firm which was seized by the resolution authority would have its managers fired and its shareholders' equity eliminated.

This morning, on CNBC, Warner portrayed the resolution authority as being so distasteful that no firm would willingly prefer it to bankruptcy.

Ah, but Warner omitted the key point. The firm couldn't choose which option, because, under Dodd's absurdly-flawed proposal, the FDIC would do the choosing. Thus, it becomes arbitrary, ripe for occasions of bribery and influence, and the very antithesis of a clear-cut law.

As to Goolsbee, he either lied, or is just so naive as to not understand what Wallison and others, including me, realize about the resolution authority process.

As Wallison wrote in yesterday's Wall Street Journal,

"The Dodd bill has one answer. It says that the FDIC "may make additional payments," over and above what a claimant would be entitled to in bankruptcy, if these payments are necessary "to minimize losses" to the FDIC "from the orderly liquidation" of the failing firm.

This practice is a straightforward bailout of all creditors, and it has been criticized by Congress over the years. Yet here it is, back again, in the guise of an innocuous power to make additional payments to some creditors, coupled with virtually unlimited authority to borrow from the Treasury."

Either Goolsbee is really inept, and unable to understand this provision, or he's lying about it, in order to claim that there is 'no bailout' in the bill.

Nobody who claims there can be a 'bailout' ever meant shareholders.

No, we all refer to the bailout of creditors who were counterparties to debts of the failing firm.

We need look no further than tax-filing-challenged Treasury Secretary Tim Geithner's misguided payments of AIG's debts, in full, to all creditors, especially Goldman Sachs and a large french bank, when bankruptcy proceedings would have treated them much more harshly.

This is the genesis of the charge that those banks viewed by investors as "too big to fail" will be perceived as likely to be handled by the FDIC's proposed "resolution authority" and, thus, be eligible for its counterparties being repaid in full for their debt instruments. Thus, those banks will naturally enjoy lower interest rates, because their lenders will assume they have no principal risk from the transaction.

It's a backdoor GSE clause. The large bank is presumed to have Treasury backing, via the FDIC, in the event of the failure of the very large bank.

That's the bailout. Not of the firm's owners or managers, but its creditors.

And this is, of course, for a financial firm, a much larger amount of capital than its equity. If anything, we should wish the Dodd bill rescued the owners, rather than the counterparties. It would be, though totally illogical, much cheaper for the taxpayer.

Anyway, don't be fooled by any pundits or politicians you hear babbling about the Dodd bill being misrepresented, misunderstood, and/or containing absolutely no "bailout" provisions.

It's just a variant of that old magician's trick where your eyes are drawn to something other than where the real action is happening.

In the case of the Dodd bill, its defenders dwell on the draconian treatment of managers and owners of failed- well, actually, not necessarily failed, but merely firms an administration wishes to close, for any reason- firms, in order to draw your attention away from its overly-generous guarantees of repayment to such a firm's creditors.

If those defenders really don't understand this, they are foolish and inept. If they do, they're lying to the public.

Which do you think it is?