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Sunday, October 3, 2010

FDIC to decide who might still get a bailout...wait a minute, Obama stated 'There will be no more tax-funded bailouts—period,"

The Wall Street Journal

Read my lips
"There will be no more tax-funded bailouts—period," said President Obama on July 21, the day he signed the Dodd-Frank financial reform into law. This week, the board of the Federal Deposit Insurance Corporation will use the new powers it received under Dodd-Frank to decide which bank creditors will receive . . . tax-funded bailouts.

On July 21, Mr. Obama said that "there will be new rules to make clear that no firm is somehow protected because it is 'too big to fail,' so we don't have another AIG." But under the new law, firms deemed too big to fail by the new Financial Stability Oversight Council can be protected from bankruptcy, if regulators so desire, and instead put into an alternative process managed by the FDIC. The idea is to provide the firm with taxpayer cash that would not be available in a bankruptcy, and then try to recover the taxpayer's money over time from sales of the company's assets.

If the taxpayers don't come out whole, Plan B is to seek money from the firm's other creditors after the crisis has passed. Failing that, the government will assess fees across the financial industry, including firms that had nothing to do with the failure. Regulators and the bill's authors have unanimously agreed not to call this a bailout program.

Let's see...whom do I choose?
The issue for the FDIC board this week is the pecking order for creditors of companies undergoing FDIC resolution. During the Congressional debate on Dodd-Frank, we warned about the discretion afforded the FDIC to discriminate among such creditors, offering bailouts to some while punishing others.

Last week, FDIC Chairman Sheila Bair confirmed that the problem exists, though she still won't use the word "bailout." Ms. Bair said, "The authority to differentiate among creditors will be used rarely and only where such additional payments are 'essential to the implementation of the receivership or any bridge financial company.'"

She was quoting the Dodd-Frank law, and the question is which creditors to a failing firm will be considered "essential" and therefore eligible for a bailout. Backers of the FDIC process have promoted the idea that taxpayer money flowing into the failed business will be used to pay the electric company to keep the lights on or vendors of basic office supplies. But who else will enjoy the coveted "essential" status? The opportunities for political favoritism are enormous.

Ms. Bair promised last week that "long-term bondholders, subordinated debt holders, and shareholders of a financial company" will never be considered "essential." That's nice, and from her we even believe it. But why not simply say that "all financial counterparties" will never be considered essential? Is the FDIC Chairman saying that short-term bondholders, however defined, may get a rescue?

We eagerly await the public release of information from the FDIC. But leaving the door open for a rescue of, for example, lenders due to be repaid within six months or a year would only encourage the short-term funding model that helped destroy Bear Stearns and so many other firms in 2008. Rather than eliminating moral hazard, it will simply concentrate it in a particular category of financial instruments.

We don't mean to pick on Ms. Bair, who deserves credit for at least trying to rule out certain bailouts. We suspect she is facing the usual pressure from the Treasury Department to keep all options open when it comes to rescuing unwise lenders from the consequences of their decisions.

Whether Washington calls firms "essential," or "systemic," or "nationally recognized" as in the case of credit-ratings agencies, the government always goes wrong when it anoints particular firms for special favors they can't secure in the market or before a judge. Repealing ObamaCare has captured the public imagination for obvious reasons, but the next Congress should also repeal the new system of bailouts enabled by Dodd-Frank.

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