Dodd financial reform bill goes too far

Senator Dodd's financial reform gives regulators too much leeway to crack down on the financial industry.

There is one new regulation that is truly needed—a way to wind down, without major disruption to markets, failing broker-dealers and other financial companies. The new financial industry bill introduced by Senator Christopher Dodd claims to do this and solve the “too-big-to-fail” problem.

Reading the particulars of the bill, however, makes one queasy. To use a metaphor, what’s needed is a commitment to defensive war when necessary. What this and a related bill sneak under the radar is authority for pre-emptive war—with all the wide-open discretion that implies.

Lehman Brothers’ bankruptcy in September 2008 had a big impact on markets largely because the assets of its clients got tied up in courts, not just in the US but in the UK. With their capital frozen in years-long litigation, the clients – in particular hedge funds – sold securities to raise money. This selling put downward pressure on markets.

So, instituting a process by which large financial companies can be shut down without a lengthy bankruptcy case would reduce the impact of failures and get rid of the notion that investment banks need to be bailed out—expeditious and orderly winding down of a failed firm is the obvious solution.

While this process may be similar to established procedure for dealing with insolvent commercial banks, broker-dealers don’t have Federal Deposit Insurance Corp.-insured deposits. Their customers get only limited aid from the Securities Investor Protection Corp.—as the Bernard Madoff investors discovered.

The bill would establish a liquidation fund financed by the industry and authorize the appointment of FDIC as receiver for insolvent companies, with SIPC acting as trustee for broker-dealers. All that sounds reasonable. You don’t notice the danger until you’re deep into the 1,336 page bill.

The government is to take over not only defaulting financial companies but those “in danger of default”. Five conditions are listed to define default and in-danger-of-default. Two are straightforward—the company will be filing for bankruptcy shortly or its board or shareholders agree to a government takeover.

The other three conditions allow the government to take over even when a company is not filing for bankruptcy and its board/shareholders do not consent. What it means is that the secretary of the Treasury can decide that a company is about to collapse even if it does not look that way to other people.

Notice that this is different from the Lehman Brothers situation, where there was no question the bank was going bankrupt once the expected merger with Barclays Capital was nixed by British regulators. (Barclays later bought parts of Lehman in the bankruptcy proceeding.) Arranging an orderly wind-down would have been a defensive move. What the Dodd bill adds is the power to intervene pre-emptively.

Perish the thought, but suppose a secretary of the Treasury has a crony who really wants to buy an investment bank on the cheap—and will provide some future quid pro quo. Pick a time when equities are down and you could make a case that a financial company is wobbly. Voila, it gets liquidated in a fire sale.

Maybe this sounds far fetched—a politician would not do something just for his own interest, would he? In any event the Dodd bill provides what looks like oversight mechanisms. The Treasury has to get the OK of a panel consisting of several bankruptcy judges.

But consider these judges’ incentive. If they say no to the Treasury and then the company runs into trouble, it will be on their heads. If they say yes, there’s little risk to them. Almost certainly the panel will agree to such requests. The FDIC and the Federal Reserve also have a say. But in 2008-2009, these agencies acted together with the Treasury and likely will do so in future stress situations. Therefore they do not provide checks and balances.

Moreover, consider that if there is any public suspicion of what’s going on, the company is dead. Once the Treasury decides a company is doing down, this decision will become self-fulfilling. That company will go down. The way the bill is written, it vastly expands government power to make arbitrary choices—like liquidate bank x but let bank y stand. A preview of this happened in 2008, when the Treasury and Fed decided to backstop Bear Stearns but not Lehman Brothers.

The useful part of this regulation is to quickly unwind companies that have defaulted. Not could, might or may default. Have defaulted. To allow the government to make a determination of what could or might happen is to create a whole new arena for political corruption.

Peter Klein recently pointed out that an agency created in the 1930s to fight the Great Depression now helps raise money for a politically well-connected company —an instance of the Higgs effect, aptly named after economic historian Robert Higgs, of temporary crises being used to permanently ratchet up government interventionism and the cronyism that goes with it.

While we don’t know how exactly the new powers contained in Dodd’s monster bill would be used, the past provides no assurance that the discretion it gives government agents will be deployed wisely or even as expected.

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