November 16, 2009

“We are trying on every front to increase the role of government.”
–Rep. Barney Frank (D-MA), October 26, 2009

Background

On October 29, 2009, the Financial Services Committee began consideration of Rep. Barney Frank's (D-MA) Financial Stability Improvement Act.  The plan proposes to make the Federal Reserve the authority on systemic risk and financial stability and give the Federal Deposit Insurance Corporation (FDIC) the authority to resolve economically troubled institutions.  The proposal would codify the government policies invoked to bailout AIG, GM, Fannie Mae and others by creating a permanent bailout fund and enabling the FDIC to extend federal guarantees and loans to "systemically significant" (i.e., politically significant) institutions for the sake of "financial stability."  Additionally, the Democrat plan would not only increase the role of government, it would also delegate a tremendous amount of authority to unelected government bureaucrats.  The natural tendency of unaccountable bureaucrats would be to bailout and prop up large politically significant institutions to avoid having an embarrassing failure on "their watch."  Such decisions would leave the taxpayers holding the bag.

Issues of Concern

Mandates More Taxpayer Funded Bailouts:  Since the institutions that would be considered as too big ("politically significant"), interconnected and likely to cause a threat to financial stability would not be allowed to fail or be placed into bankruptcy, taxpayer funded bailouts are inevitable.  AIG is a perfect example of the government picking winners and losers in the market place.  AIG was thought to be too big to be placed into bankruptcy.  As a result, the taxpayers, through the Federal Reserve and Treasury, have spent approximately $135.7 billion propping up the failed insurance company.  While the Democrat proposal would require bailouts by the FDIC to be approved by a vote of 2/3 of both the Fed and FDIC boards and would require the approval of the Treasury Secretary, the FDIC would still have the authority to act as a conservator and determine the amount of bailout funds and the level of taxpayer supported guarantees.  The FDIC guarantees, credit extensions, and asset purchases would create additional exposure for taxpayers, including the use of the FDIC's $300 billion dollar line of credit with the Department of Treasury.  In addition, Secretary Geithner, in recent testimony, refused to commit to limiting the amount of taxpayer dollars that would be available to bail out large firms.

Mandates More Taxpayer Loses:  Like the current bailout programs, the Democrat proposal would expose taxpayers to tremendous risk in the form of loans, the purchase of assets and the provision of guarantees.  For example, according to a November 2, 2009 article in Fortune, "CIT filed for Chapter 11 bankruptcy protection Sunday.  The New York based small business lender said all its common and preferred shares will be canceled, which will wipe out the $2.3 billion Troubled Asset Relief Program investment the Treasury Department made last December.  Though the government is also highly unlikely to recoup all the money it plowed into AIG, Citigroup, Fannie Mae and General Motors, CIT is the first bailout to go to zero-in just 11 months, no less."  A November 2, 2009 report released by the Government Accountability Office stated, "Treasury is unlikely to recover the entirety of its investment [$81 billion] in Chrysler and GM."

Distracts the Fed from Monetary Policy:  The Fed was created to be a politically independent body with control over monetary policy.  The Fed's role, among other factors, in creating the housing bubble during the real estate boom cycle is an indication that it has not focused squarely on monetary policy over the last decade and should not be given more responsibilities.  Instead, the Fed would be given the responsibility to monitor systemic risk.  An October 31, 2009 New York Times editorial on the Democrat proposal stated, "Not only did the Fed fail in its responsibility to identify and stop several of the threats that led to the crisis, it has further damaged its credibility by failing to fully account for how and why those catastrophic lapses occurred." 

Increases the Fed's Authority:  The proposal would increase the risk of catastrophic failure by centralizing and concentrating responsibility for overseeing "systemically significantly" firms in the Fed, despite its historically poor performance in identifying and addressing systemic risks before they become crises.  Also, the proposal makes the Fed the dominant financial regulator by drastically expanding its regulatory portfolio and market intervention authority.  It would be given broad new authorities to overrule the judgments of other regulators; regulate hedge funds, insurance companies, and a wide range of other financial institutions that currently fall outside its jurisdictional purview; and even to break up firms that it decides have grown too large.  For example, the Fed would recommend prudential standards applicable to functionally regulated subsidiaries and banks.  The primary regulator would have 60 days to adopt or say why not.  If standards are not adopted, then the Fed may impose (and examine for compliance with and enforce) the higher standards.

Gives An Overwhelmed FDIC More Responsibilities:  The FDIC has experience in resolving failed depository institutions and has overseen the resolution of a tremendous number of failed institutions this year with more expected.  On October 24, 2009, The Washington Post reported, "The cascade of bank failures this year surpassed 100 on Friday, the most in nearly two decades.  And the trouble in the banking system from bad loans and the recession goes even deeper than the number suggests.  Dozens, perhaps hundreds, of other banks remain open even though they are as weak as many that have been shuttered.  Regulators are seizing banks slowly and selectively-partly to avoid inciting panic and partly because buyers for bad banks are hard to find."

Reduces Competition:  Some economically troubled firms placed on a "systemically significant" list would be able to raise funds at a lower cost than their competitors because the market would perceive those firms as having the implicit backing of the government.  While the proposal would require the list to remain confidential, SEC disclosures and changes in the identified firms' behaviors or strategies would make it relatively easy for market watchers to discern which firms are listed.  Such a designation would foster favoritism and reduce competition in the market place, providing an advantage to the firms with the special designation.  For example, for years the Treasury Department stated that the government would not stand behind Fannie and Freddie's debt.  However, the market had a different perception, and Fannie Mae and Freddie Mac were able to use their government granted competitive advantages (implicit guarantee, line of credit with the U.S. Treasury, lack of SEC disclosures, etc.) to dominate the secondary mortgage market.  While the executives of the two housing GSEs received millions in bonuses due to the institutions' dominance, the taxpayers were increasingly exposed and left with two failed companies at a potential cost of over $5 trillion.

Increases Moral Hazard:  Moral hazard occurs when an institution is protected from exposure to certain market risks and behaves without discipline as a result.  Bailing out troubled institutions increases the likelihood of such risky behavior.  In an October 21, 2009 interview with CNN Money, SIGTARP's Barofsky stated, "With the potential of moral hazard and 'too big to fail,' the government could be setting itself up for an even more dangerous crisis in the future..."  Under the Democrat plan, the bailout fund and the new FDIC bailout authorities would act as an insurance policy, rather than a deterrent of risky behavior like bankruptcy.  In fact, a November 3, 2009 Wall Street Journal editorial regarding the CIT's bankruptcy stated, "Just as the Treasury Department is urging Congress to junk the bankruptcy process and hand over virtually unlimited bailout authority to the executive branch, CIT is proving two things: Bankruptcy works-even for financial firms-and the U.S. Treasury judges systemic risk out of its political hip pocket."  Bankruptcy would eliminate any moral hazard.

 

Republican Solution

House Republicans introduced the Consumer Protection and Financial Regulatory Enhancement Act (H.R. 3310) to bring a new era of responsibility to the federal government and Wall Street.  The Republican solution is premised on three key principles: ending the bailouts once and for all; restoring market discipline; and protecting taxpayers.  This means smarter regulation, rather than more regulation.  It also means ending the misguided government policies that helped cause and worsen the current financial crisis, while propping up failed financial institutions. 

Enhanced Bankruptcy:  H.R. 3310 would provide for the resolution of insolvent non-bank institutions-no matter how large or systemically important-by creating a new chapter of the bankruptcy code to make it more efficient and better suited for resolving large non-bank financial institutions.  This new chapter would facilitate coordination between regulators and the courts to ensure technical and specialized expertise would be applied when dealing with complex institutions.  Bankruptcy judges would also have the power to stay claims by creditors and counterparties to prevent runs on troubled institutions.

Market Stability and Capital Adequacy Board:  Under the Republican plan, a Marker Stability and Capital Adequacy Board would be tasked with monitoring the interactions of various sectors of the financial system and identifying risks that could endanger the stability and soundness of the system.  In order to address current regulatory gaps, each functional regulator would be required to assess the effects of their regulated entities' activities on macroeconomic stability and review how entities under their regulatory purview interact with entities outside their purview.  The Board would be chaired by the Secretary of the Treasury and comprised of outside experts, as well as representatives from the financial regulatory agencies responsible for supervising large, complex firms.

Regulatory Restructuring:  H.R. 3310 would ensure consistent enforcement, accountability and transparency by modernizing the current framework of overlapping and redundant federal financial regulatory agencies and streamlining supervision of deposit-taking entities in one agency while preserving charter choice and the dual banking system.  The bill would combine the Office of the Comptroller of the Currency (OCC) and Office of Thrift Supervision (OTS) into one agency and shift the supervisory functions of the Fed and FDIC to that agency, including the responsibility for overseeing bank and financial holding companies. 

Fundamental Reform of the Federal Reserve:  The Republican proposal would bring transparency and accountability by directing the Government Accountability Office to conduct extensive audits of the Federal Reserve.  The plan would refocus the Fed on its core mission of conducting monetary policy, relieving it of its current regulatory and supervisory responsibilities by reassigning them to other agencies, and require an explicit inflation target.  These changes would eliminate the Fed's current incentive to prop up the economy through an accommodative monetary policy to prevent firms from failing. The bill would impose limitations on the Fed's use of its authority under section 13(3) of the Federal Reserve Act to respond to "unusual and exigent" circumstances by subjecting actions under 13(3) to Treasury approval and giving Congress the ability to disapprove, placing 13(3) transactions on Treasury's balance sheet, and eliminating the use of this authority on behalf of specific institutions.

Government Sponsored Enterprise (GSE) Reform:  H.R. 3310 would phase out taxpayer subsidies of Fannie Mae and Freddie Mac over a number of years and end the current model of privatized profits and socialized losses.  It would sunset the current GSE conservatorship by a date certain and place Fannie and Freddie in receivership if they are not financially viable at that time.  If they are viable, once the housing market has stabilized, the plan would initiate the process of cutting their ties to the government by winding down the federal subsidies granted through their charters and transitioning Fannie and Freddie into non-government backed entities that compete on a level playing field with other private firms.  In making such reforms, Republicans would address reducing Fannie and Freddie's portfolios, re-focusing Fannie and Freddie on promoting housing affordability, and requiring SEC registration and the payment of taxes.