Why bankruptcy rules work best when big institutions break down

Reuters

The Bear Stearns name is seen outside their headquarters in New York July 18, 2007.

Article Highlights

  • We're likely to see or hear less about the burdens of the Dodd-Frank financial regulation legislation than Obamacare.

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  • The Bear bailout created expectations that the Fed and the Treasury would bail out every big financial institution.

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  • In his new book, David Skeel argues that small amendments could improve the Dodd-Frank act.

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Over the next year, we will probably see much controversy over the implementation of Obamacare. Health insurance is something that almost every adult is acquainted with, and there seem to be glitches aplenty in the legislation, much delay in issuing regulations and some possible changes resulting from litigation.

We're likely to see or hear less about the burdens of the Dodd-Frank financial regulation legislation, passed four months after Obamacare. Most of us don't work at the banks or financial institutions that will have to grapple with its myriad provisions and resulting regulations, and we tend to toss out disclosure forms sent by our banks.

But Dodd-Frank may produce more problems than it solves. That is the thesis of David Skeel, professor at the University of Pennsylvania Law School, in his new book "The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences. "

Skeel does not find fault in Dodd-Frank's effort to regulate derivatives -- contracts in which one party agrees to pay another in case of changes in interest rates, currency exchange rates, oil prices or just about anything else -- with provisions encouraging them to be conducted through clearinghouses.

They were an obvious target for regulation, because derivatives based on the value of mortgage-backed securities did much to trigger the collapse of Lehman Brothers and AIG in 2008. Skeel calls these Dodd-Frank derivative provisions "an unequivocal advance."

But he sees serious problems in what he describes as the two themes that emerge from the law's 2,319 pages: "(1) government partnership with the largest financial institutions and (2) ad hoc interventions by regulators rather than a more predictable, rule-based response to crises."

The prime mover behind these policies, he argues, was Treasury Secretary Timothy Geithner, who as a junior Treasury official played a role in the bailout packages for the Mexican peso in 1994-95 and the hedge fund Long Term Capital Management in 1998. They're his models for future regulation.

As president of the New York Federal Reserve, he played a key role in fashioning responses to the financial crises of 2008. Dodd-Frank, Skeel argues, was written to give regulators powers they felt they lacked when they allowed Lehman Brothers to go into bankruptcy in September 2008.

Lehman's collapse, followed by the Bush administration's demand for the $700 billion Troubled Asset Relief Program legislation and especially its initial rejection (reversed four days later) in the House, led to staggering losses first in the stock market and then in the economy at large.

Skeel is one of many who argue, persuasively in my view, that the real mistake here was not the failure to bail out Lehman but the apparently successful bailout of a smaller investment bank, Bear Stearns, in March 2008.

The Bear bailout created expectations that the Federal Reserve and the Treasury would bail out every big financial institution -- expectations strengthened when the government took over Fannie Mae and Freddie Mac in August 2008 and AIG in early September.

Lehman could and almost certainly would have sold itself out of trouble, Skeel argues, if its executives had not had such expectations.

Dodd-Frank's provisions requiring special treatment of the very largest financial institutions creates similar expectations, Skeel says. And it enables those "too big to fail" institutions to borrow money at lower rates than smaller banks.

Similarly, Fannie and Freddie, with their implicit government guarantee, were able to borrow cheaply and engage in the practices that brought them down, which has cost taxpayers $140 billion.

Skeel is a specialist in bankruptcy law, and he argues that the relatively fixed rules of bankruptcy could better handle the breakdown of big financial institutions than the discretion Dodd-Frank gives to regulators.

One reason Dodd-Frank is tilted against bankruptcy, he says, is congressional committee jurisdiction lines: Dodd-Frank was the product of the banking committees, and bankruptcy is handled by the judiciary committees.

Solutions? Skeel argues that small amendments could improve the law. Remove the special treatment for derivatives in bankruptcy. Allow investment banks to declare Chapter 11 bankruptcy without liquidation. A special panel of judges could be set up to handle financial firm bankruptcies.

And, based on his criticism of the Chrysler and General Motors bankruptcies, Skeel argues that bankrupt firms should not be able to sell assets without an auction allowing outsiders to bid.

Not everyone will agree with Skeel's analysis and recommendations. But they're worth looking at.

Michael Barone,The Examiner's senior political analyst, can be contacted at [email protected] His column appears Wednesday and Sunday, and his stories and blog posts appear on washingtonexaminer.com.

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