Friday, July 23, 2010

Dodd-Frank III: FDIC Bailout Powers

The Dodd-Frank Act gives the FDIC expansive emergency bailout powers.

First, section 1105 of the Act directs the FDIC, in consultation with the Secretary of Treasury, to create a "widely available program to guarantee obligations of solvent insured depository institutions or solvent depository institution holding companies (including any affiliates thereof) during times of severe economic distress." The FDIC must issue regulations governing such guarantees "as soon as practicable." In order for these programs to be triggered both the Board of the FDIC and the Federal Reserve Board of Governors must approve by 2/3 votes.

Second, under the so-called Orderly Liquidation Authority of Title II, section 204(d) authorizes the FDIC to make loans to, guarantee assets or obligations of, or purchase assets of any financial company put into FDIC receivership under the auspices of the Dodd-Frank Act. Under section 206, these expenditures must be for the purpose of financial stability and not for the benefit of any particular company. The Treasury must approve these expenditures under section 210(n)(9). Moreover, if a financial firm enters this orderly liquidation process, the officers and directors are terminated, they are liable for gross negligence, and they are subject to recoupment of their compensation over the past two years. This entire process is triggered only upon a 2/3 vote of both the FDIC and the Fed.

The bottom line to Dodd-Frank is that it permits and formalizes more bailouts not fewer. As former Secretary of Treasury Hank Paulson stated: “We would have loved to have something like this for Lehman Brothers. There’s no doubt about it.” The FDIC and the Fed now have vast powers under law to assure that the failure of a major financial firm does not lead to chain-reaction failures through losses to unsecured creditors. And, because both the Fed and the FDIC are government agencies, the taxpayer is ultimately exposed to losses arising from their efforts to bailout unsecured creditors.

In the absence of vigorous Fed use of the power to order divestitures, the bill can fairly be termed the leave no bondholder behind act, insofar as bailouts are concerned. I argued in Subprime Bailouts and the Predator State that a bailout authority should be profit maximizing, depoliticized and pose serious adverse consequences to management, including severe civil and criminal sanctions. The authority should be accompanied by robust powers to order prudential divestitures. Dodd-Frank fails, particularly due to weakened section 121.

However, the bill also covers much more than bailouts. In my next post I will show that the bill has revolutionary potential in corporate governance, and may help stem the abusive executive compensation issues that were central to the crisis.

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