A Dagger at the Heart of Business
January 21 2010 by Richard Epstein
This first year of the Obama administration has been marked by its relentless pursuit of major regulatory initiatives on a full range of domestic issues. CEOs who find it difficult to implement one program at a time must wonder how a president unversed in complex business issues can push forward simultaneously on four major fronts: healthcare, global warming, labor law and, last but not least, financial regulation.
The Reform Agenda
Real work is needed in each of these areas. But sound reform should not make matters worse, which is what will happen to the financial sector if Congress passes the misnamed Financial Stability Improvement Act. The FSIA would create a stronger federal presence under a newly created Financial Services Oversight Council, allegedly to cope with any repetition of the financial meltdown of the fall of 2008. The case for the FSIA rests on a single proposition: The government must be equipped to deal with systemic risk.
Systemic risk is, of course, just a fancy term for the positive correlation in the failure of major financial institutions: Once one domino topples, others will quickly follow, bringing a heavily interlinked financial system to its knees. This systemic risk is a modern rendition of yesterday’s “run on the bank.” Old line banks can only work by lending out most of their deposits at higher interest rates than they pay to their depositors. Making these loans necessarily means that banks cannot keep all their assets in cash or cash equivalents even though all depositors have the unfettered right to withdraw their money at any time. In stable times, happy customers deposit and withdraw money independently in accordance with their personal needs, so that the limited amounts of cash in the till can meet all demands on the bank. Tranquility reins.
However, once it is feared, or rumored, that the bank is about to fail, all depositors rush to demand payment at once. The inability of even a solvent bank instantly to convert its long-term loans to cash could create a short-term calamity. Government insurance helps counter that risk in two ways. First, it picks up the financial slack for depositors when the banks fail. Second, by giving depositors confidence it nips any possible bank run in the bud.
This federal insurance is not, however, a free good. The risk, of course, is that banks will make foolish loans because they look more to the government guarantee than the sufficiency of the debtor’s collateral. No private insurer would write coverage unless it could control the behavior of its insureds. All too often the government’s lax oversight of its insureds leads to irresponsible lending practices by banks that hope to keep all of the high side profits, while laying off the extra risk on Uncle Sam.
A Fresh, but Flawed, Start
The new statutory framework is intended to make sure that nonbank institutions cannot imperil the financial system with failures like AIG and Lehman Brothers. The FSIA’s attempt to control systemic risk for these nonbank financial institutions, however, only works if we have a clear sense as to the origins of the meltdown. Unfortunately, the one risk that no financial institution can diversify away is that of bad government regulation.
Indeed, substandard agency oversight was a major culprit last time round. Financial risks were magnified when the Federal Reserve set interest rates so low that homebuyers bid up housing prices to unsustainable levels. Fannie Mae and Freddie Mac fueled the fires by financing or guaranteeing risky loans at ridiculously low rates, so that private bankers lent, and others bought and sold their mortgages, on the strength of the government guarantee, not that of the underlying security. Once these securities were divvied up across the market, the bubble burst in part because of mark-to-market accounting that forced key institutions who held these “toxic” securities-that is, just about everyone-to sell them to meet their margin requirements when the market went into free fall.
CEOs of private financial institutions have pulled in their horns since the debacle. And now the FSIA is likely to become a fresh government source of systemic risk. One fatal design flaw gives the Federal Deposit Insurance Corporation undue power to throw into receivership “covered financial institutions,” which at a minimum include large banks and other cash- rich financial players. The reach of the FDIC’s mandate is not pinned down by the statute, so the CEOs of insurance companies, commercial trading companies and hedge funds won’t always know in advance whether they are in or out. The FDIC tells them their status only after it consults with the President, the Treasury Secretary and key administration officials. Together they must make some shadowy judgment, not about the solvency of the institution, but about its supposed systemic financial risk-assuming that the two can be separated.
Once designated, the FDIC receiver can decide without legal constraint which assets to put under his or her control and which to leave behind to the ordinary bankruptcy court. The FSIA shies away from forcing the receiver to make a single all- or-nothing judgment. The consequent sorting out of claims and liabilities in a two-front war has to invite huge amounts of political intrigue, for even the expedited procedures under the act will take weeks, instead of the 48 hours or so it took for the Federal Reserve to engineer JP Morgan’s takeover of what remained of Bear Stearns. These vast reserves of discretionary political power are proof positive that nothing in the FSIA limits the greatest source of systemic risk-the U.S. government.
The Miller/Moore Haircut
One risk of dividing assets under the FSIA is that the holders of claims against the “left behind” assets could experience a systematic shortfall relative to what they would have received if the covered institution had been liquidated under ordinary bankruptcy rules. To supply a transfusion of cash into that pool, the House version of FSIA contains a revised version of the Miller/Moore Amendment-the brainchild of Democratic congressmen Brad Miller and Dennis Moore. In its original form, that amendment gave the FDIC receiver unprecedented powers to cut down, in its sole discretion, secured claims that all outside lenders held against covered financial institutions by 20 percent. The power would have allowed the receiver to trim all such loans regardless of their length, amount or type of security. Most critical, Miller/Moore covered all “repos” by which a secured loan looks like a sale by the economic borrower subject to an option to repurchase by the economic lender. That borrower “sells” securities to the economic lender for a needed cash infusion. When the seller of the securities exercises its “option to repurchase,” the price increment represents interest on the underlying loan.
The case for the FSIA rests on a single proposition: The government must be equipped to deal with systemic risk.
The current version that has passed the House cuts back on the original amendment in three ways. First, the haircut is now only 10 percent. Second, it only applies to short-term transactions done at or before the risk of bankruptcy. And third, government sponsored securities are out from under the haircut. The second and third provisions are only likely to make matters worse. There is, in all cases, a huge difficulty with respect to transactions done on the eve of bankruptcy. If unsecured creditors scramble for additional security, they are rightly required to return their “preferences” to the pot, for otherwise there would be a mad scramble for assets at the worst possible time. But when these lenders advance new value to the teetering firm, they should receive a clear priority; faced with a possible haircut, they won’t lend at all. The standard bankruptcy rules understand this vital point that the FSIA seems to miss.
Second, the preference for Treasurys shows that all this matters, not only in the repo market, but in the original issue market. The Treasury understands that it will have to pay higher interest rates if its bonds cannot be used as collateral. There is no reason to force that burden on the issuers of private debt and securities. The upshot is that the Miller/Moore Amendment distorts both the original-issue market and the short-term repo market by altering the relative rates of interest.
The attack on secured credit is, moreover, without justification. One reason why sophisticated CEOs prefer this type of secured credit is that it allows a company to make loans to financial institutions without having to monitor exhaustively its overall condition, which could be exceedingly difficult to do for major institutions with far-flung operations subject to all sorts of government regulation and market shocks. On the other side, borrowers may not want to share inside information with multiple lenders. Besides, global monitoring is what the federal government is supposed to do on its own, without conscripting a group of lenders for the job. Pass this amendment and the threat of FDIC haircuts will reduce credit lines that CEOs will be prepared to authorize to distressed banks.
Miller/Moore seeks to soften its blow by covering only repos made after its passage. Protecting existing liens, however, does nothing to ease the confusion that arises when the parties modify or refinance an existing loan. And going forward it makes it hardest to extend credit to the borrowers that need it most. I am working as a consultant with lawyers for key financial institutions on the potential constitutional challenges to so ill-conceived a piece of legislation. There seems to be little support for Miller/Moore in the Senate, which should bury the amendment so as to avoid years of legal wrangling over the dubious departure from established bankruptcy principles.
Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law, The University of Chicago, the Peter and Kirsten Bedford Senior Fellow, The Hoover Institution, and a visiting professor at New York University Law School.