Is Romney's Bailout Stance Supported by Dodd-Frank?

The new non-bank resolution authority might provide the answer that the Republican frontrunner is looking for

600 Romney Debate REUTERS Adam Hunger.jpg

In presidential debates, truly revealing moments are tough to come by. Often, candidates just rely on well-rehearsed responses or deflect questions entirely. That's why I found it so interesting to see Republican frontrunner Mitt Romney deviate from the rest of the pack and support a very unpopular position during Tuesday night's GOP debate: that the Wall Street bailout was necessary.

Many Republicans, particularly those who sympathize with the Tea Party, think the bailout was a tragic mistake. Romney, on the other hand, just says that he wishes the bailouts would have been done differently. What he may not realize, however, is that the more favorable outcome he describes might have already been made possible through last summer's Dodd-Frank financial regulation bill.

What Romney Said

Let's go straight to the transcript. Here Bloomberg TV White House Correspondent Julianna Goldman asks Romney about what he would do if faced with another U.S. banking crisis due to a European financial collapse. (It's just a precious coincidence that someone with the last name "Goldman" is asking about bailouts.) I'll start mid-answer, with Romney's general bailout philosophy:

MR. ROMNEY: . . . But I can tell you this. I'm not interested in bailing out individual institutions that have wealthy people that want to make sure that their shares are worth something. I am interested in making sure that we preserve our financial system, our currency, the banks across the entire country, and I will always put the interest of the American people ahead of the interests of any institution.

MS. GOLDMAN: But -- so would you -- so would you or would you not be open to another Wall Street bailout?

MR. ROMNEY: Well, no one likes the idea of a Wall Street bailout. I certainly don't.

MS. GOLDMAN: But you said in 2008 that it prevented the collapse of the financial --

MR. ROMNEY: There's no question but that the action that President Bush and that Secretary Paulson took was designed to keep not just a collapse of individual banking institutions but to keep the entire currency of the country worth something and to keep all the banks from closing and to make sure we didn't all lose our jobs. My -- my experience tells me that we were on the -- on the precipice and we could have had a complete meltdown of our entire financial system, wiping out all the savings of the American people. So action had to be taken.

Was it perfect? No. Was it well-implemented? No, not particularly. Were there some institutions that should not have been bailed out? Absolutely. Should they have used the funds to bail out General Motors and Chrysler? No, that was the wrong source for that funding.

But this -- but this approach of saying, look, we're going to have to preserve our currency and maintain America and our financial system is -- is essential.

To review, Romney believes that government intervention is sometimes necessary to prevent the financial system from collapse. But he also believes that some institutions should fail in the process.

What Romney Probably Means

Romney never actually provides a policy statement for which firms should or should not be bailed out, but we can probably piece together what he means. If he believes that firms that deserve to fail ought to fail, then he must also believe that bailouts during a financial crisis would rescue firms that do not deserve to fail. What he's may be getting at here is the difference between failures due to solvency problems versus liquidity problems.

Let me provide a quick explanation here for those who are not familiar with these terms. A bank is insolvent if its losses overwhelm its assets. In this case, it fails because it cannot afford to pay all the money it owes, even if it sells everything of value it has. Even in the course of a normal economy, its business would be unsustainable.

Most banks rely on borrowing to fund their activities. If economic conditions prevent a bank from managing to roll over its borrowing, that is getting new loans when its old loans mature, then it will fail. Again, it won't have enough assets to cover all it owes. In this case, losses may have little to do with failure.

That latter scenario describes the pickle that the vast majority of banks found themselves in during the 2008 financial crisis: it was a credit crunch. Had conditions been different, most banks would have continued to roll over their borrowing and the financial system would have chugged along. Although many banks had significant mortgage-related losses, few banks were in real danger of those losses overwhelming all of their assets. That's why we saw most big banks pay back their bailout money rather quickly: once the credit markets reopened, they no longer needed the government's money.

So what does this have to do with what Romney said? I would suspect that if you asked Romney to clarify his stance, he would probably say that the government needs to keep the financial system going when a credit crunch hits. Firms that are suffering liquidity problems shouldn't be forced to fail. But firms that would be genuinely insolvent irrespective of credit conditions ought to fail.

Really, there isn't much other way to make sense of Romney's statement. You need some systematic way to determine which firms should survive and which should fail in a bailout scenario, and determining whether problems stem from solvency or liquidity is the only way to do so.

Where Dodd-Frank Comes In

So how does the government determine which firms to wind down and which to rescue? Presumably it would need some regulatory mechanism with which to determine which firms were having those genuine solvency issues. And they could call it the "non-bank resolution authority." Of course, last summer's Dodd-Frank regulation bill created such an authority to scoop up and wind down large failing financial firms. You would just need to tweak its mission a bit during financial crises.

Many are skeptical of the new non-bank resolution authority's ability to prevent a financial crisis. If a credit crunch takes hold, then no firm is safe from failure from a liquidity standpoint. At that time, a bailout would likely be necessary. But what the resolution authority could do during these periods is to identify which firms should be wound down due to solvency issues.

Obviously, Romney hasn't said anything like this. But I wonder whether this resolution mechanism could provide the more preferable outcome he calls for. If you want a bailout where firms that deserve to fail do fail while rescuing the others, it seems like the new resolution authority might be a good tool to use to make that happen.

Image Credit: REUTERS/Adam Hunger