What if Bear, Lehman, and AIG Had Failed Today?

After an incredibly boring and substantively useless day-long hearing yesterday, the Financial Crisis Inquiry Commission (FCIC) was back at it today with a few far more interesting guests. They include Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corporation Chairwoman Sheila Bair. Bernanke was first up, and the question and answer session has been interesting. In particular, FCIC Commissioner Douglas Holtz-Eakin asked a great one: what would have happened to Bear Sterns, Lehman Brothers, and AIG -- the firms that all essentially defaulted, though only Lehman was permitted to fail -- if the financial regulation bill were in place back in 2008?

First, Bernanke considered Bear. He said that Bear's fate may have been the same, though the details different. He imagines that regulators would still have urged an acquisition, but the Fed would not have subsidized it. In 2008, JPMorgan acquired Bear, and the Federal Reserve made it a great deal by taking on a huge chunk of Bear's bad assets. Bernanke believed that regulators would have had more leverage to demand less favorable terms for the acquisition if a resolution authority had been in place.

What if that didn't work, and JPMorgan didn't want Bear, Holtz-Eakin wondered. And what would have happened with AIG and Lehman, neither of which was acquired? In this case, Bernanke said that they would have likely been wound down through the new non-bank resolution authority.

Bernanke's response here was interesting. First, it shows that he really believes that the new resolution authority will work. That's somewhat comforting, as it's easy to imagine that the government taking over and winding down a firm makes sense, but harder to imagine this working in a real crisis. Bernanke appears to believe that it could have worked, even in the very unstable economic climate in 2008.

But I would have like to have seen Holtz-Eakin go a little deeper on this question. Imagine the government takes over Bear, Lehman, and AIG. Is the market really content that the assets that would be liquidated during wind-down would cover all of the firm's obligations? If not, wouldn't that put additional stress on the market, if investors and counterparties are unsure whether the government will demand steep haircuts on the capital they're owed -- or insist that the financial sector pay for any shortfall?

Moreover, what about the other troubled banks? Remember, every large U.S. financial institution received a bailout. Some claim that they didn't want the money, and were essentially coerced to accept it. But certainly some of those big banks needed it. For example, imagine if Citi and Bank of America were resolved as well. How does the market deal with the kind of uncertainty that would be involved in so many significant financial institutions under government resolution at once? Wouldn't you still have a domino-effect where confidence is lost in the whole financial system since no bailouts are provided?

Bernanke's optimism regarding the resolution authority is certainly refreshing. But he left unclear how the new power would actually work in a financial crisis when the industry on a whole is threatened. If this isn't a concern, it would be nice for him to explain why we shouldn't worry.