In 2008, with the American banking system on the brink of collapse, policymakers faced a grim choice: bailout or catastrophe. An attempt to administer tough medicine — by letting Lehman Brothers file for bankruptcy — backfired. Financial panic rapidly accelerated, forcing the government to change tack and stand behind the rest of the financial system.
In the years that followed the crisis, President Obama and Congress put into place safeguards to prevent Washington from again being forced into such a choice by institutions that were “too big to fail.” Today, large financial institutions are subject to much more stringent regulation, and if they get into trouble, the government has important new tools to wind them down without taking down the rest of the financial system. As a result, firms cannot take outsize risks on the assumption that if their bets go wrong, the government will sweep in and prop them up.
Yesterday, the House passed a bill that aims to eviscerate the very reforms that make a repeat of the 2008 scenario less likely. The so-called Financial CHOICE Act — approved by a party-line vote — eliminates two of the key reforms specifically designed to prevent another bailout.
Although the bill is supported by the Trump administration, it would directly undercut an executive order President Trump issued on February 3. One of the “Core Principles for Regulating the United States Financial System” laid out in that order was: “prevent taxpayer-funded bailouts.” The CHOICE act, however, would invite future bailouts.
Republicans have forgotten the lessons of the 2008 crisis
To understand how we’ve gotten here, we need a little history. In the fall of 2008, financial regulators were faced with a series of impossible choices: take extraordinary action to prevent the failure of large, complex financial institutions, or let them fail — and let the country face economic cataclysm. In the case of Lehman Brothers, the government let it file for bankruptcy, with devastating consequences that are all too clear in hindsight.
At the time, Lehman Brothers was the fourth-largest investment bank in the United States. With more than $600 billion in assets, it was also the largest company ever to file for bankruptcy. Lehman’s failure exposed thousands of creditors to hundreds of billions of dollars in losses, and inspired speculation about who might be next. The stock market immediately crashed more than 500 points, the most since 9/11. Market participants of all stripes raced to pull their money out ofother firms perceived to be at risk. This was a classic It’s a Wonderful Life–style bank run, but across the vast capital markets that underpinned a majority of US economic activity.
A day after Lehman’s filing, the Federal Reserve paid $85 billion for 80 percent ownership of American Insurance Group (AIG), which had gotten itself into trouble by gambling massively in esoteric derivatives markets. In essence, AIG had written insurance on billions of dollars of securities backed by subprime mortgages, doing so through an unregulated unit operating out of London. As those mortgages went sour, AIG’s losses mounted, and the purchasers of its “insurance” demanded to be paid. Unable to raise cash in time to make the payments, AIG sought help from the government.
Virtually every major Wall Street player had “insurance” of some sort from AIG, so its failure threatened to set off a chain reaction. Treasury and the Fed eventually provided more than $180 billion of assistance to AIG. Even that was not enough to end the system-wide crisis, and Congress eventually dedicated $700 billion to prop up banks across the country.
Both Lehman and AIG should have been put out of their misery. But while there was clear authority and a well-tested system in place for resolving failing banks — indeed, the Federal Deposit Insurance Corporation (FDIC) had done so hundreds of times — there was no similar authority for investment banks like Lehman Brothers, or for the unregulated AIG Financial Products unit.
Reforms made failure — and system-wide chaos — less likely
The Obama administration and Congress sought to fix those problems in two primary ways: First, the law known as Dodd-Frank created a legal mechanism for financial regulators to dismantle large, complex financial institutions outside of bankruptcy court. This authority is known as orderly liquidation authority (OLA).
As Lehman showed, ordinary bankruptcy is ill-suited to complex financial institutions. Judges lack the detailed knowledge regulators have of firms’ balance sheets and operations, and of the broader financial system, that is necessary to execute an orderly resolution in a timely way. Regulators also prepare in advance for how they would respond to a failure, including by coordinating with overseas regulators unlikely to be available to a judge. Judges are also slow.
Congress’s second reform was to mandate that certain nonbank financial companies (like Lehman and AIG) whose failure might pose a risk to the system should be subject to heightened supervision: more capital, greater liquidity, regular stress tests. A council of regulators called the Financial Stability Oversight Council, or FSOC, would have the power to designate firms for enhanced oversight.
Together, these reforms would make the failure of large, complex firms less likely and would provide a credible alternative to a bailout: an orderly “unwind.”
“Orderly liquidation” is not a bailout. It’s the opposite of a bailout.
In a recent letter to shareholders, JPMorgan Chase chair and CEO Jamie Dimon argued that Lehman Brothers could not take down the financial system today. His confidence, he wrote, rests partly on the fact that America now has “a system to wind firms down in an orderly fashion” — namely OLA. Former Fed Chair Ben Bernanke, who knows firsthand the perils of facing a crisis with a limited toolkit, has called OLA “the best way to reduce the odds” of future bailouts. The always-colorful Barney Frank called the process “death panels” for banks.
The surest way to convince the market that the government will indeed let an institution fail — thereby imposing market discipline on that firm — is to have a credible plan for handling that failure. OLA is untested to date. But the FDIC and other regulators, domestically and abroad, have taken major steps to prepare — including by conducting simulated failures. There is no question that regulators are better prepared to handle the failure of a major institution than they were in 2008.
Nonetheless, the CHOICE Act eliminates OLA, and the White House’s budget proposed to do the same, in the name of preventing bailouts.
How can congressional Republicans and the White House claim that eliminating OLA would prevent bailouts, when expert consensus is that doing so would increase their likelihood? The answer lies in the misleading budget semantics used by supporters of the CHOICE act. OLA authorizes the government to provide limited and temporary liquidity to firms being wound down, to keep viable businesses running during the resolution process. In a typical bankruptcy, this kind of financing is provided by private lenders, but in the midst of a crisis the private sector may be unwilling to provide that bridge financing.
The full amount of any liquidity support provided by the government is required by law to be recouped — first from the firm itself, and then from the industry. So the taxpayer is not on the hook. Nevertheless, Congress uses a ten-year window to estimate the cost of legislation, and a resolution occurring in year eight or nine may not be fully repaid within that window. Thus, the Congressional Budget Office “scores” OLA as having a budgetary cost.
This allowed Republican opponents of Dodd-Frank to paint OLA as a bailout, when in fact it was the most direct way to ensure there would be no bailouts. By proposing in its budget to “prevent taxpayer bailouts” by eliminating OLA, the administration has now elevated a misleading political talking point to official policy.
One key financial regulation can be repealed with a simple majority in the Senate
The CHOICE Act faces long odds of passing the Senate, but OLA itself can arguably be repealed with only 51 votes. For the complicated reasons described above, repealing OLA scores as “saving” money, so Congress may be able to use so-called budget reconciliation procedures to bypass the filibuster and repeal OLA with a simple majority.
The CHOICE Act also completely eliminates the authority of FSOC to designate institutions deserving of special scrutiny. This administration may well take a different view than the Obama administration regarding the risks posed by firms that have thus far been so designated by FSOC: Prudential, AIG, and MetLife. But such a difference of opinion in itself is no reason to scrap this policy wholesale. All designations are subject to annual reevaluation. Eliminating this authority altogether would leave some of the largest and most highly leveraged and interconnected institutions free from comprehensive oversight.
In his shareholder letter, Dimon also argues that if a situation comparable to Lehman’s arose today, the bank would be required to have twice as much capital as it did prior to the crisis, buffers of highly liquid assets, and more stable funding. It would have a cushion that would make collapse less likely. But that would only be true if the 2017 version of Lehman had been designated as worthy of special scrutiny by FSOC. It would be a grave mistake to willfully eliminate the one tool available to fill a regulatory gap that played such a central role in the last crisis.
Taken together, these two elements of the CHOICE Act would prevent FSOC from bringing firms like Lehman Brothers or AIG — or the US investment banking operations of giant Chinese lenders — under comprehensive oversight. It would eliminate the only tool available to unwind any such firms safely in a crisis.
If enacted, the CHOICE Act and the policies advocated by the administration make it more likely that when the next crisis comes, Congress will again be forced to choose between the AIG and Lehman paths, between bailout and catastrophe.
During the campaign, President Trump appealed to many voters’ nostalgia for a greater past. I doubt even his supporters yearn for a return to the days of September 2008, when the whole country picked up the tab for Wall Street’s bad bets.
Jonah Crane is a former deputy assistant secretary at the US Treasury Department, and former policy aide to Sen. Charles Schumer (D-NY).