Systemic Options: Too Big to Bail?

[Dover]

Excerpt:

..."What the Treasury has proposed is nothing more than applying bank insolvency to firms that are systemically important," Bliss says. "The detail of how it works is exactly identical to what we've been doing with banks for 20 years."

What is needed is a crash-course on the mechanics of both the bankruptcy-led or receivership/conservatorship remedies. The first lesson, Bliss says, is to understand the unaligned, "markedly different" outcomes for each. "The claim of bank insolvency process is very quick and very efficient, whereas bankruptcy is neither efficient nor quick, but supposed to be fair," Bliss says.

Fair or not to bank creditors or uninsured depositors, the Federal Deposit Insurance Corp.'s legal priority (since 1993, under the "least-cost resolution" doctrine) is to protect insured depositors and the Deposit Insurance Fund. While the FDIC has done a good job of sustaining uninsured depositors and claimants in failures, Bliss said, extending that practice to multi-billion asset, multi-national firms could be at cross-purposes with both alacrity and cost.

Another problem is the systemic institutions' evolved dependence on short-term wholesale funding and derivatives. If a broker/dealer were subject to an FDIC-type takeover, funding would dry up and counterparties would pull contracts without explicit federal guarantees, Bliss said (so much for moral hazard). Any resolution process would likely need a complex apparatus, like a central registry, to continually track positions of contracts. Under receivership procedures today, fulfilling legacy contracts (any contracts) are at the FDIC's discretion. "They have one day to think about - they can either close it out or pass it on," Kaufman says.

The derivatives problem with a systemically important institution is why bankruptcy wouldn't be the magic bullet, either. In the 2005 federal bankruptcy reform act, derivatives were exempted from bankruptcy court stays - under a widespread assumption it was critical to preserving systemic market soundness. With this exemption in place, bankruptcy procedures could do little to stem a run by derivatives counterparties looking for their money.

Bankruptcy law is also unequipped...cont'd

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