President Obama and his financial reform sidekick, Senate Banking Committee Chairman Chris Dodd, want you to believe that the financial reform bill they hope to pass in the Senate soon not only contains no bailout mechanism for large financial firms, but forbids bailouts from ever happening again. Alas, it isn’t so.
Virtually everyone agrees that bailouts are driven by the notion that some firms are “too big to fail.” As long as some institutions are so big that their failure would drag down the entire economy, Washington politicians will always feel compelled to act in some way to halt their collapse. Simply letting them go bankrupt, as the Bush administration did with Lehmann Brothers, is both economically and politically risky, and politicians famously want to avoid risk.
The trouble with the Dodd bill is that it does not decree that the government must stay back and watch firms fail, but instead creates a new legal framework with which Washington heavily regulates financial institutions in such a way as to encourage them to grow, not shrink.
In addition to a new regulatory regime, the bill creates rules that allow the Federal Reserve to takeover and liquidate huge firms on the verge of collapse. But in liquidating them, the Fed will have the authority to borrow from the U.S. Treasury to pay off the failing firm’s bad debts. The whole idea is to protect the system from collapse. The question is: why is that not a bailout?
Treasury Secretary Timothy Geithner, adamantly denying that the bill allows bailouts, characterizes its liquidation authority like this: “If a major institution manages itself to the edge of their abyss, we’re able to put them out of their misery … dismember them safely without taxpayers being exposed to a penny of risk of loss.”
Geithner, Obama and Dodd are claiming that because the Fed will dismantle the firm, the process cannot be called a bailout. They are trying to change the definition of a bailout to exclude any taxpayer-funded intervention that does not keep a firm intact.
But when Washington bailed out AIG in September of 2008, the Bush administration didn’t keep AIG intact. The top managers were fired, and huge chunks of the company were sold off. The bailout was not to save AIG, but to pay people whose money AIG had lost. That is exactly what the Dodd bill allows. Under its provisions, the Fed will take over a firm, fire its top executives, use taxpayer money to pay its bad debts, and fold the company.
Because that authority would be used only on firms so large that their bankruptcy would cause huge losses throughout the economy, possibly triggering another crisis, the Dodd bill provides investors with powerful incentives to avoid small banks and put their money in large ones. A small bank won’t be rescued. If it dies, your money is gone. But under the Dodd bill, the larger the bank, the safer your money.
Instead of ending “too big to fail,” the Dodd bill could make it much worse. Instead of ending bailouts, it creates a legal framework that authorizes them in perpetuity.
Financial reform is definitely needed. But this bill does not provide the kind of reform most Americans want – regulations that make large financial transactions more transparent and that discourage large firms from getting larger and taking dangerous risks. It actually encourages the flow of money to larger and larger institutions and puts taxpayers on the hook should they fail, which is exactly the opposite of what it should do.
Andrew Cline is editorial page editor of the New Hampshire Union Leader.