Thursday, July 22, 2010

Dodd-Frank II: Revisioning Section 13(3) of the Federal Reserve Act

President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, in the above signing ceremony. Overall, the President's speech constitutes an outstanding analysis of the causes of the financial crisis and broad overview of the Act. However, I take issue with his statement (at the 11:00 minute point) that under the bill: "there will be no more tax funded bailouts. Period." This statement is highly problematic, if not outright false.

First, because section 121 is so deeply flawed, we will continue to be burdened by very large megabanks, larger now than ever before. So the question posed is whether these firms would be permitted to fail by future Congresses at the risk of a general economic crash. Think of the risks posed in late September 2008 and double them. There is little reason to think that Congress would behave any differently than it did when it passed the TARP legislation in 2008.

Second, section 1101 of the Dodd-Frank Act amends section 13(3) of the Federal Reserve Act in a way that paves the way for the Fed to bailout large banks so long as it does so pursuant to a program or facility that features "broad-based eligibility." Indeed, the Act directs the Fed and the Treasury to create emergency lending programs and facilities "as soon as practicable." The only limitations the Act imposes on this emergency lending power is that borrowers cannot already be in bankruptcy or receivership and the loan cannot be made with the "purpose of" assisting a "single and specific company." The Act specifically contemplates that the Fed may become an unsecured or at least undersecured creditor.

The bottom line here then is that while high profile bailouts of specific companies like AIG and Bear Stearns are out, regulations that would authorize bailouts of many companies in the same straits as AIG and Bear Stearns are in, and so those kinds of bailouts now have formal legal authorization.

In my next post, I will address the emergency powers of the FDIC under the Act.

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