What if Frank-Dodd Act was enacted before the crisis?

Federal Deposit Insurance Corporation has prepared this interesting what-if paper which looks at what would have happened if Frank-Dodd  Act (FDA) was enacted before the crisis. Would Lehman have been saved? How would the events flow if we had DFA in place?

This paper looks at the evidence and shows how a global meltdown could have been averted if we had acted on these risks earlier. Under FDA, FDIC gets new powers which allows FDIC to act for systemic financial firms like it does for banks.

The paper starts from reviewing how the events transpired after fallout Bear Stearns. Lehman came on to the radar for the next fallout i- bank. Its executives started to talk with market participants and some were willing to place equity in Lehman. But thanks to the overconfidence of Lehman execs who believed firm was worth more than the offerings, the placements did not go through. And then as people became nervous of its shaky assets and liquidity conditions, people withdrew leading to bankruptcy.

Now, the report asks what would have happened if FDIC could resolve Lehman just like it does for banks? It first lists what FDA allows FDIC to do. It then goes back to Mar-2008 to see how FDIC would have done things differently and helped prevent fallout of Lehman. The reports concludes as:

The report concludes that the powers provided to the FDIC under the Dodd-Frank Act to act decisively to preserve asset value and structure a transaction to sell Lehman’s valuable operations to interested buyers — which are drawn from those long used by the FDIC in resolving failing banks — could have promoted systemic stability while recovering substantially more for creditors than the bankruptcy proceedings — and at no cost to taxpayers. The report estimates that given the substantial, though declining, equity and subordinated debt of Lehman in September 2008 and the power for the FDIC to implement a prompt structured sale while providing short-term liquidity to continue value-adding operations, general unsecured creditors could have recovered 97 cents on every $1 of claims, compared to the estimated 21 cents on claims estimated in the most recent bankruptcy plan of reorganization. While there remains no doubt that the orderly liquidation of Lehman would have been incredibly complex and difficult, the report concludes that it would have been vastly superior for creditors and systemic stability in all respects to the bankruptcy process as it was applied.

…..Title II of the Dodd-Frank Act could have been used to resolve Lehman by effectuating a rapid, orderly and transparent sale of the company’s assets. This sale would have been completed through a competitive bidding process and likely would have incorporated either loss-sharing to encourage higher bids or a form of good firm-bad firm structure in which some troubled assets would be left in the receivership for later disposition. Both approaches would have achieved a seamless transfer and continuity of valuable operations under the powers provided in the Dodd-Frank Act to the benefit of market stability and improved recoveries for creditors. As required by the Dodd-Frank Act, there would be no exposure to taxpayers for losses from Lehman’s failure.

What powers are given to FDIC ?

The powers provided under the Dodd-Frank Act are critical to these results. Among the critical powers highlighted in the report are the following:

  • Advance resolution planning: The resolution plans, or living wills, mandated under Title I of the Dodd-Frank Act would have required Lehman to analyze and take action to improve its resolvability and would have permitted the FDIC, working with its fellow regulators, to collect and analyze information for resolution planning purposes in advance of Lehman’s impending failure.
  • Domestic and International Pre-planning: The Lehman resolution plan would have helped the FDIC and other domestic regulators better understand Lehman’s business and how it could be resolved. This would have laid the groundwork for continuing development of improved Lehman-specific cross-border planning with foreign regulators to reduce impediments to crisis coordination.
  • Source of Liquidity: A vital element in preserving continuity of systemically important operations is the availability of funding for those operations. The FDIC could have provided liquidity necessary to fund Lehman’s critical operations to promote stability and preserve valuable assets and operations pending the consummation of a sale. These funds are to be repaid from the receivership estate with the shareholders and creditors bearing any loss. By law, taxpayers will not bear any risk of loss.
  • Speed of Execution: The FDIC would conduct due diligence, identify potential acquirers and troubled assets, determine a transaction structure and conduct sealed bidding — all before Lehman ever failed and was put into receivership under Title II. A suitable acquirer would be ready to complete the acquisition at the time of Lehman’s failure. A critical element in quickly completing a transaction is the power, provided by the Dodd-Frank Act, to require contract parties to continue to perform under contracts with the failed financial company so long as the receiver continues to perform. This is particularly critical to avoid the lost value, as exemplified in the Lehman bankruptcy, when counterparties immediately terminate and net financial contracts and liquidate valuable collateral.
  • Flexible transactions: The FDIC’s bidding structure would provide potential acquirers with the flexibility to bid on troubled assets (e.g., questionable real estate loans) or leave them behind in the receivership. Similarly, creditors could receive advance dividends (i.e., partial payment on their claims) to help move money back out into the market and further promote financial stability. Advance dividends would not be provided if they would expose the receivership to loss.

These powers would enable the FDIC to act to preserve the financial stability of the United States and to maximize value for creditors by preserving franchise value and by rapidly moving proceeds into creditors’ hands.

The very availability of a comprehensive resolution system, which sets forth in advance the rules under which the government will act following the appointment of a receiver, could have helped to prevent a “run on the bank” and the resulting financial instability.

FDIC chief says this helps take the discussion forward:

FDIC Chairman Sheila C. Bair said, “This new report is an important step in ensuring that the public and market participants understand how the FDIC’s new resolution authority for large systemic firms works. The powers to implement an FDIC liquidation of a systemic financial company during a future crisis give us the tools to end Too Big to Fail and eliminate future bailouts. Much work remains to be done, and we look forward to working with key stakeholders to ensure that this process is effective in achieving its goals. The Lehman failure provides an excellent model to contrast the tools available to the FDIC to effectuate an orderly resolution of a large financial institution against the process used in bankruptcy which, unlike our process, is not specifically designed to deal with the failure of a financial entity. I commend the professional staff for completing this comprehensive and rigorous analysis. It will add tremendous value to the public understanding of the FDIC’s resolution process under Dodd-Frank.

Though the report points there are limitations with such an exercise as it is based on many assumptions.

This paper has focused on how the government could have structured a resolution of Lehman under Title II of  the Dodd-Frank Act following the failure of such firm.   In so doing, we have made a number of assumptions  and caveats to provide a framework for the analysis and  to maintain consistency with the historical record.   That is, while we have assumed that the Dodd-Frank  Act had been enacted pre-failure, and that the FDIC  would have been able to avail itself of the pre-planning powers available under Title I, including having access  to key data of subject institutions through resolution  plans and on-site monitoring, we have not assumedaway the failure of Lehman.

The orderly liquidation authority of Title II would be a  remedy of last resort, to be used only after the remedies  available under Title I—including the increased informa tional and supervisory powers—are unable to stave  off a failure.  In particular, it is expected that the mere  knowledge of the consequences of a Title II resolution,  including the understanding that financial assistance is  no longer an option, would encourage a troubled institution to find an acquirer or strategic partner on its own  well in advance of failure.  Likewise, on-site monitoring  and access to real-time data provided under Title I is   expected to provide an early-warning system to the  FDIC and other regulators well in advance of a subject  institution’s imminent failure.

The paper is interesting as it takes you through the events carefully and is a nice primer on the events. But having a FDA before Lehman was something which would have never really happened. Even if it had, it would have been much weaker, a risk the paper takes into account.

Having said this, most economists are not happy with FDA and think it is still weak and does not do justice to TBTF issues. One should first focus into solving the TBTF problem and make banks etc smaller. And then only things like resolution should be looked into. By having something like this, TBTF problems only grows worse as firms now know they would be saved.

Overall, the paper is a nice one to understand Lehman crisis and new powers of FDIC. Though we must not really expect that TBTF problem is any better now.

Addendum:

BTW, FDIC has been one of the most unsung stories of this crisis. FDIC list shows 363 banks have failed since Aug-07 but none have really been a concern. True most are small banks with few branches but given the linkages with others, it could have easily led to system wide concerns. But thanks to FDIC efforts, we have hardly seen any. The

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