Death of 'Bailout Fund' Renders Resolution Authority Toothless

So much for the non-bank resolution authority. Senate Republicans may have squashed any hope that the new mechanism could help solve future financial crises by finally getting their wish to remove the $50 billion "bailout" fund from the reform bill. Now, the FDIC would wind down troubled large financial institutions by obtaining a loan from the Treasury to pay out creditors and counterparties. Those firms would then pay back the FDIC, and ultimately Treasury, after formal bankruptcy proceeds occur. While this sounds just fine in theory, it would preempt the ability of the non-bank resolution authority from providing market confidence.

The Problem

The financial crisis wasn't really caused by bad subprime mortgages, derivatives, or failing banks. It was caused by uncertainty and panic that led to a massive credit crunch. Banks, investors, and businesses freaked out due to the complexity in the system and fear of the unknown regarding what assets were worth. No one would loan to anyone else; firms couldn't cover their short term liabilities; and bad things began to happen.

Ultimately, the government was forced to step in and back up the entire economy. It took $700 billion, a slew of liquidity programs at the Federal Reserve, and a set of stress tests to finally calm the markets and get credit flowing again. Once the market regained confidence, business resumed.

The Original Solution

So let's rewind. Imagine that there was a non-bank resolution authority in place with a giant fund behind it that would be used to make creditors and counterparties whole, or nearly whole, if a big firm failed. That would immediately reduce uncertainty and panic. If a firm failed, the other companies that were dependent on what they were owed from this company would have a pretty strong understanding of their fate. Even if the assets of a failing firm couldn't cover all of its obligations, there was a fund in place to bail out those it did business with.

The New "Solution"

Under the new plan, that all changes. Now, there is no money set aside to cover costs. Creditors and counterparties will get whatever the assets are worth in conjunction with what a bankruptcy judge rules. Sure, the FDIC will make sure they get some money sooner, instead of having to wait a few years until the court distributes those assets, but those parties won't know how many pennies on a dollar they will get until values are determined and the court eventually decides on distribution.

That means uncertainty returns. Panic will follow. When companies don't know how much money they'll ultimately get, they'll freak out again, and avoid loaning out money to firms that own assets with unclear values. And we're back where we started.

More Bailouts?

To make matters worse, this new plan may actually reintroduce bailouts instead of preventing them. The resolution fund would have been created by assessments on the very large financial institutions that it would ultimately wind down. But now the FDIC will use Treasury funding to temporarily loan money to companies. Yet, what happens if one of those companies runs into trouble of its own, and can't pay the government back? The FDIC will be handed a loss. Who pays for that loss? Probably taxpayers.

Imagine, for example, that it's March 2008 again, but the newly proposed framework was in place. Bear Sterns collapses, so the FDIC resolves it. Consequently, it gets a loan from the Treasury to pay out what Bear owes to its creditors and counterparties. One of those firms would almost certainly have been Lehman. But wait! It fails several months later. Will the government get back the money Lehman owes it?

If the government declares that its debt is senior to any other, then that might protect taxpayers, but it would also harm stability. If Lehman obtains a large loan from the FDIC to cover its Bear exposure, then its creditors would be even more scared that they'll get less money back if Lehman fails -- since the government will be paid first. You can probably quickly see how a domino effect would again result in a credit crunch.

A Better Solution?

This isn't to say the $50 billion resolution fund was a perfect answer. Indeed, it was flawed, as its creation would almost certainly have resulted in big firms obtaining cheaper funding and a competitive advantage over smaller ones.

Instead, some sort of plan needs to be devised to insure short-term debt in the event of a panic. Just like depository insurance protects against bank runs, another kind of mechanism needs to be in place to avoid runs on financial instruments like repos, commercial paper, and lines of credit. Otherwise, the economy will continue to be susceptible to another financial crisis the next time widespread asset value uncertainty hits and the market begins to panic.

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