Perhaps That Guy Was Onto Something…

Yesterday in the Examiner, Joel Gehrke wrote about the horrifying prospect that Senator Sherrod Brown (D-OH) could chair the Senate Banking Committee if Democrats retain control of the Senate after the 2014 elections.

Brown’s views on economics (especially banking and international trade) are decidedly backwards and appeal to the misguided economic populists in Ohio that elect him and keep Ohio in an economic homeostasis that’s not as bad as Detroit, not as good as Pittsburgh, and far behind Texas.

One paragraph that Joel wrote jumped out at me:

Brown is working with Sen. David Vitter, R-La., to craft legislation that would shrink the biggest banks in the country, and they have 10 other Republican allies, according to Business Insider. The Dodd-Frank bill was supposed to solve the problem of some banks being “too big to fail,” but it didn’t.

OccupyWallStreetNYC (which apparently still exists) tweeted this about Gehrke’s story:

Perhaps the folks operating their twitter account aren’t very familiar with the Dodd-Frank law (RAFSA), but Brown already sold them out by voting for it.

When Dodd-Frank was being considered, my former boss — Senator Jon Kyl (R-AZ) — was among the few who claimed that Dodd-Frank didn’t solve “too big to fail” or TBTF as it’s known among banking policy wonks.

Kyl’s view was that Dodd-Frank perpetuated TBTF. (Disclosure: I worked for him at the time and worked on these very issues.)

In May of 2010, Sen. Boxer (D-CA) proposed a 106 word feel-good amendment (#3737) the stated purpose of which was to “prohibit taxpayers from ever having to bail out the financial sector.”

It passed 96 to 1.

Senator Kyl was the only Senator to vote no.

Here are Kyl’s floor remarks before the vote, explaining why, with emphasis and comments added by me, in bold.

Mr. KYL. Mr. President, let me address the amendment which we are going to be taking up first, I gather, on the so-called financial regulatory reform bill, the Boxer amendment.

The Boxer amendment, as I understand it, is a declarative statement that taxpayers will not be responsible for any Wall Street bailouts. My understanding is that it is not a provision that would enforce itself or would in any way be enforceable in the legislation, but it certainly expresses a sentiment I assume every Senator would share. The problem, however, is not just the fact that we are concerned that taxpayers will be responsible for bailouts but the fact that bailouts will exist in any event and how that might affect people who have invested in or lent to an institution, what authority it would give the U.S. Government, and whether such a provision would apply as well to perhaps the biggest miscreants here: Fannie and Freddie, the two government-sponsored enterprises that hold the vast majority of the mortgages that are unsound or on less than strong financial footing–I will put it that way. So the question is not so much whether taxpayers’ dollars will be used–though this amendment, while expressing a good sentiment, doesn’t operatively prevent that–but just as much whether Wall Street will still be bailed out but in a different way. Will the appropriate policies and institutions that should be in place to prevent this be amended into the legislation?

If all we want to do is ensure failing institutions are liquidated, then of course we can have a bankruptcy regime, and many people believe that is the appropriate regime because it is a tradition of law. Everyone knows exactly how it works, where you stand, and it ordinarily has been successful in liquidating firms that cannot pay their obligations.

After the Lehman bankruptcy and the contagion effects which surrounded that, some believe bankruptcy wasn’t really well suited to these kinds of large financial institutions, and it may well be that traditional bankruptcy would have to be modified in some respects in order to easily apply to the liquidation of a financial institution that large.

One of the things, though, we need to do in figuring out exactly what the right process should be is to make sure creditors aren’t receiving special treatment–for example, the way they did when the auto companies were bailed out and when other firms were bailed out. Otherwise, we will actually be increasing moral hazard rather than decreasing it, which is, of course, part of the exercise here.

A government-compelled fund that takes money from successful firms and transfers it to a failed firm, for example, regardless of how you seek to justify it–as an assessment or a recruitment or a tax or whatever you might call it–is still a bailout. Ultimately, the question is not only who will pay for it but also, how does it scramble the obligations and the prioritization of obligations compared to what bankruptcy would do? (Author’s Note: Details on the liquidation fund.)

The people who bear the cost of propping up a failed firm, for example, have nothing to do with the fact that firm failed or with the poor decisions of that firm. So if, instead of the American people, you are going to make other entities in its area–for example, a bank begins to fail, so you are going to make the other banks prop that bank back up. How is that fair to the shareholders or investors in the bank that has to do the propping up, or the groups of banks? They didn’t have anything to do with the poor decisions made by the management of the failed firm, whereas you can argue that the lenders to the failed firm, the people who invested in the failed firm, and certainly the managers of the failed firm all had something to do with the direction the failed firm took. Because of that fact, the bankruptcy laws have set out priorities as to who ends up bearing the risk of the failure of that firm. The lenders and the investors in failing companies lose control of the money they invested, and whatever resources remain are channeled by the bankruptcy court into productive endeavors or to pay the people who have lent the money to the firm. That is exactly the opposite of what a government-sponsored fund does in transferring resources from a productive to unproductive purpose. Here, if it is not the taxpayers who fund it, then it is fellow banks, let’s say, or fellow financial institutions–again, people who had nothing to do with the failure of the entity that is being acted upon.

Fortunately, there is a process that can address the problem of failing firms, that does move resources into more productive areas and at the same time holds those directly responsible for the mistakes accountable. There are different names for this and it can take different forms. One of them is called speed bankruptcy–in other words, a form of bankruptcy that recognizes that in certain institutions you are going to need to quickly take hold of them and, in order to prevent contagion in the market, shore up their financial situation so they cannot infect others and therefore cause a larger failure than just relates to that particular company.

We should describe bankruptcy, first of all, to appreciate what this does. A firm becomes insolvent when its liabilities–which could be payments to bondholders, it could be payments to suppliers, it could be repaying loans–are worth more than the assets the company has, assets such as land, capital, accounts, the value of intangibles, and even things like reputation.

Over the last couple of years, we have seen the collapse or near collapse of several well-known firms–for example, the GM and Chrysler auto companies, as I mentioned, Bear Stearns, AIG, the big insurance companies. We have also seen Fannie Mae and Freddie Mac, which are projected to be dependent on government assistance for the foreseeable future–and by government assistance, of course, ultimately we mean the taxpayers of this country. In the examples I cited above, the government response was in effect to prop up the failed firm with taxpayer funds.

This so-called speed bankruptcy and iterations of the idea would instead convert a portion of the existing longer term debt of the company into equity. There are a lot of benefits, as you can see, to
such a proposal. For example, with a large, complex firm that is in financial trouble, a lengthy process could create the kind of uncertainty that would otherwise undermine the ability of the company to continue once it exits the resolution process and, as I said, could also infect others in these areas. A speed bankruptcy, on the other hand, would permit the firm to remain in operation, to keep running.

There is a paper that has been written on this that I think is very interesting. Garret Jones at the George Mason University Mercatus Center writes that this kind of proposal actually leaves bondholders with something of value so they are not entirely wiped out and retain the potential to make up for some of their losses if the equity shares they receive in lieu of their bonds once again gain value. Here is what he writes in this recent paper:

Friday’s bondholders become Monday’s new shareholders, and the banking conglomerate can continue borrowing and lending much as before, with little possibility of a short-run crisis.

It is a little bit like debtor-in-possession financing in a bankruptcy, but it matters where you get the financing, and in this case creditors of one kind become creditors of a different kind, trading, in this case, bond for equity in the firm.

Second, unlike government-sponsored bailouts, investors directly tied to the troubled firm bear the financial costs of the restructuring of the firm.

Third, since many of the bonds are publicly traded and are therefore liquid, the process would be entirely transparent, and the reason the process could occur so quickly is because of that conversion.

Fourth, a debt-to-equity conversion leaves deposits untouched, avoiding a potential run on the bank in the case of banks and financial institutions.

What steps and operations would be necessary to make this work?

First, an insolvent firm would be able to convert an amount of its long-term debt specified in advance into stock in order to recapitalize and strengthen the institution. Under such a proposal, regulators would first need to declare that the institution is the risk.

Second, the firm would need to breach a certain specified capital level to actually trigger the conversion. Once this process occurred, the restructured firm would emerge healthier, with less debt, with more equity, without any taxpayer money being used and without any money being used from other banks or other financial institutions.

For example, Pershing Square Capital Management released a proposal to convert $75 billion of Fannie Mae’s $750 billion senior unsecured debt into equity. For every dollar of senior unsecured debt, the bondholder would receive 90 cents in new senior unsecured debt and 10 cents in value of new, common equity. As a result, the new Fannie could take advantage of its new capital. It has a dollar to expand its underwriting. It can utilize increased cash flow to absorb expected losses and, in the future, once conditions improve, to reduce its balance sheet by gradually selling some of the mortgage assets on its books.

John B. Taylor writes today in the Wall Street Journal how to avoid a bailout bill:

You do not prevent bailouts by giving the government more power to intervene in a discretionary manner. You prevent bailouts by . . . making it possible for failing firms to go through bankruptcy without causing disruption to the financial system and the economy.

Here is the summary of what I am saying. Most of us here do not want to see taxpayer bailouts of these firms that have made poor management decisions, have invested poorly, and have made mistakes for which taxpayers should not be responsible.

That is the genesis of the Boxer amendment. But for the Boxer amendment to be effective, two things will have to be done, and perhaps we will have suggestions on how to change it. It would have to be operational and enforceable. As I said, the amendment is oratory language–taxpayer funds should not be used for bailouts. We know that a sense-of-the-Senate resolution is nothing more than that, a sense of the Senate. It needs to have operational and enforcement language to have meaning. It is my understanding that this language doesn’t. (Author’s Note: The Boxer amendment was 106 words long.)

Second, the real question is whether instead of a bailout, where government–I don’t want to use the word bureaucrats–officials representing the U.S. Government in one, two, or three different entities could, on their own, with little direction in congressional legislation, determine that a firm now needs to be taken over or bailed out, and without very much legislative criteria to direct them as to how to do it, or the circumstances under which it should be done, could begin to unwind that firm, using taxpayer money that is later recouped or perhaps funding from a tax or an assessment on other banks, for example, to infuse capital to keep it from going out of business. This is a way in which bankruptcy would ordinarily work, except that bankruptcy works according to a set of rules and traditions that have been developed over a couple hundred years that everybody is familiar with, and which people took into account before they made investments in or lent money to a company in the first place. If they became a bondholder, they knew where the bondholders would be in the order of priority in the case of a bankruptcy. If it is secured, they would have one level of security, and if it is unsecured, they are going to be at the bottom of the totem pole when it comes to distributing the assets of the bankruptcy. Lending is predicated upon their understanding of these well-known rules and principles.

Moreover, they understand that a judge will be in charge, and he will put people under oath and cause them to testify so that you know exactly what the assets are, and you can understand what it would take to keep the company running or, in the event it does have to be liquidated, how the funds would be disbursed. A trustee is appointed, who has a fiduciary responsibility, under the court rules, to manage how the company comes out of bankruptcy, or to ensure that the rules of bankruptcy and the judgment are carried out. That is the way a bankruptcy works. It is a proper way to unwind or liquidate most businesses in this country.

I think those who say these financial institutions are different, we need a different set of rules, first, have an obligation to tell us why. What is different about these entities that the bankruptcy laws simply don’t work? What would cause them to have a different set of treatments? If there are some things–and I can think of a couple things that distinguish them–then how can we modify the bankruptcy rules in effect to take into account those differences? One deficit, one could posit, is the fact that a large financial firm could easily have an effect on others invested in or who they invest in and, therefore, in effect cause a domino effect in markets. That could happen very quickly. Therefore, when you see signs of a problem, you need to deal with that very quickly. That is where this idea of bankruptcy comes from. It doesn’t take a government bureaucrat or a government entity set up for this purpose to figure out that is what needs to be done and how to do it. It can be done within the context of bankruptcy today or with relatively modest modifications in the Bankruptcy Code, we could make those changes.

The fear a lot of us have is that the people who are not elected or constrained by any particular power, except the limitations Congress imposes upon them–and in this bill those limitations are very general–those people could make decisions and put somebody into this process to decide who gets paid how much, without any reference necessarily, for example, to the Bankruptcy Code, who gets privileged and who isn’t, and with whose money.

If you look at the example of the two auto companies, you find that labor unions were substantially privileged to the exclusion of other investors. A lot of people thought this was wrong. It was contrary to the way it would have evolved had they been in bankruptcy court. So what most folks would like to see is a process you can count on, that you have rules of law established over time in the bankruptcy law that enable you to rely upon them, and not some unspecified, unclear process
that is run by some agency of the U.S. Government. While it is certainly a step forward to say that taxpayers should not be on the hook for this, it is not enough to say that, A, because that is not operational or enforced, but, B, because there are other ways to do it that represent a closer adherence to the rule of law that would be better at promoting investment or lending in the first instance, because of the clarity and predictability of the way the situation would be treated in the event of a bankruptcy; and finally, that people who are not responsible for the bad management decisions would not have any liability when that company is liquidated or comes out of bankruptcy operating again. Rather, the people who had been involved in the company in the first instance would bear that obligation.

This is just one idea–one of many–as an alternative to the specific provisions in the legislation. It is my hope that as we continue debate about this portion of the bill, we can come together on a set of principles that would adhere more closely to the rule of law established in the Bankruptcy Code to the concept that those responsible should be the ones who end up bearing the burden and that, in any event, as it appears most of us would agree, taxpayers should not be responsible for the decisions made by the management of a failing firm.

Call me crazy, but perhaps Kyl was onto something.

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