April 20, 2010

"It is hard to imagine a more dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong."  --Thomas Sowell

BACKGROUND:

Democrats recently charged the Republicans with leading a "misinformation" campaign regarding the Senate financial services "reform" bill, also know as TARP II.  While the Republicans have pointed out many protections for politically connected Wall Street firms in both the House and Senate TARP II bills, Senator Dodd and Rep. Barney Frank continue to insist that such protections are not in their bills.  Despite their claims, both TARP II bills would provide for taxpayer funded bailouts, institutionalize "too big to fail," and increase taxes on families and small businesses.

ISSUES OF CONCERN:

Taxpayer Funded Bailouts:  Title II of the bill provides the FDIC the authority to wipe out shareholders and management of firms placed in receivership, but the bill also provides the FDIC with significant latitude to make creditors whole.  Such discretion given to government regulators, with a mandate to prevent systemic failure, and access to taxpayer funds, including either a pre or post funded bailout fund, FDIC debt guarantee authority, and a Treasury line of credit, provide opportunities for unlimited bailouts similar to the $62 billion of taxpayer funds received by Goldman Sachs, Merrill Lynch and many foreign banks through the Fed's decision to pay AIG's counter-parties in full. 

Under the House TARP II bill, the FDIC, without Congressional approval, would be authorized to extend endless federal guarantees and loans to financially troubled firms.  The Frank bill would create a $150 billion bailout fund.  Both bills place the federal government solidly in a position to determine which firms fail or succeed and make permanent the policies used to bailout AIG, Citigroup, Fannie Mae and others.

On April 14, 2010, Bloomberg reported that Jeffrey Lacker, president of the Federal Reserve Bank of Richmond stated, "[The legislation] just perpetuates the dynamic that gave us ‘too big to fail' to begin with...I think it would be a mistake."  According to the article, "Lacker argued that the financial-overhaul proposals in the House and Senate, which aim to give the government a way to wind down failing financial firms and avoid bailouts, may instead give regulators too much discretion to rescue companies with taxpayer money.  ‘They aren't required to make creditors bear all the losses.'"

Institutionalizes "Too Big to Fail":  In a House Financial Services Committee hearing in October 2009, Secretary Tim Geithner argued that large firms should be assessed the cost of liquidation after the FDIC liquidates a firm.  Secretary Geithner stated, "Such an ex-posting funding mechanism has several advantages over an ex-ante fund.  Most notably, it would generate less moral hazard because a standing fund would create expectations that the government would step in to protect shareholders and creditors from losses.  In essence, a standing fund would be viewed as a form of insurance for those stakeholders."  (Ex post is "after the event."  Ex ante is "before the event.")

Additionally, both bills set up special regulatory regimes for the largest firms; thus, institutionalizing "too big to fail."  According the AEI's Peter Wallison, "The bill authorizes the Fed to regulate all non-bank financial institutions that are ‘systemically important' or might cause instability in the U.S. financial system if they failed.  These words mean something-that the companies designated for Fed regulation are too big to fail...Since these firms will be too big to fail, they will be seen in the market-as Fannie and Freddie were seen-as ultimately backed by the government and thus safer firms to lend to than small firms that are not government backed.  This will permanently distort the financial market, favoring large companies over small ones, and eventually force a consolidation of each market where these firms exist into a few large competitors operating under the benign supervision of the government."

Increases Taxes:  Both bailout funds in the Democrats' bills would increase taxes on consumers at a time when they can least afford it.  The House bill would impose a $150 billion tax on consumers.  The Senate bill would impose a $50 billion tax on consumers.  As the CBO recently noted regarding the Democrats' proposed $90 billion so-called Financial Crisis Responsibility Fee, another tax may be included in the Democrats' reform plan, "[T]he ultimate cost of a tax or fee is not necessarily borne by the entity that writes the check to the government.  The cost of the proposed fee would ultimately be borne to varying degrees by an institution's customers, employees, and investors..."  In other words, thanks to the Democrats' TARP II bills, families on Main Street would still pay to bailout firms on Wall Street.

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:  The Republican solution 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 Market 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:  The Republican plan 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:  The Republican solution 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.