Further Politicization of Financial Sector Bankruptcies

Last Friday's Wall Street Journal carried an article about the FDIC and bank dissolutions with this chilling subtitle- FDIC Expected to Use Discretion to Rank the Creditors; That Can Be Tricky.

Among the more ludicrous parts of the article was the report that current FDIC chair Sheila Bair,

"said at a board meeting last week that the authority to differentiate among creditors "will be used rarely" and only in instances where additional payments to certain creditors are "essential" to maximizing the value of a firm or to conduct its operations."

There is so much subjective judgment loaded into Bair's statement as to make it meaningless.

Essentially, recent new regulations have made financial sector bankruptcy a completely subjective, politically-determined process.

Whoever heads the FDIC has the power to effectively choose which firms will be propped up, which will be chosen to 'fail,' and, for the latter, which counterparties will be rewarded with better repayment terms than others.

Bair can talk until she's blue in the face, but it won't change two realities.

One, Bair can't bind subsequent FDIC chairpersons to her allegedly-limited intended use of the newly-granted powers to favor some creditors over others, with no basis in law.

Two, the simple existence of these powers means that all counterparties to financial institutions now realize they may lose their capital at risk at the whim of an FDIC chair. Whether their debtor is declared insolvent and, if so, what treatment the lender/counterparty receives, will potentially be totally a function of the subjective feelings that the sitting FDIC head has for that firm.

Nothing else has to matter.

The article continues,

"John Douglas, a partner at Davis Polk LLP and a former general counsel at the FDIC, said such differentiation could foster instability by driving more Wall Street financing to the short-term. The problems of both Bear Stearns and Lehman Brothers were exacerbated by short-term creditors, who pulled out amid concerns about the firms' health.

"You're giving the FDIC the authority to differentiate and....people are going to try to game the system in a way to minimize the possibility of getting hurt," he said, "If you're a short-term creditor...you've got a chance every night to decide whether to fund or not."

In another astute observation, the article quotes Kenneth Scott, a Stanford law and business professor, as saying,

"Discretion breeds uncertainty; it creates additional risk. Despite what your intent might be, it may lead creditors to cut off funding sooner and accelerate the process, not in any sense ameliorate it."

Any way you slice it, informed observers of this new regulatory power resident at the FDIC think it will drive more funding to shorter terms, so that such funding may be curtailed faster than the FDIC can freeze it.

Once again proving how often legislation causes unintended consequences.

By ignoring prudent, risk-averse behavior of capital-providing financial institutions, Congress has, in its idiocy, written laws injecting more uncertainty and subjectivity into the bankruptcy process for large banks, thus driving their funding counterparties to take steps in the future to limit their risks to such subjective, unpredictable processes for repaying counterparties to a seized institution.