Stephen Foley: Please let's not pretend that averting the next Lehman will be easy
Saturday 23 April 2011
US Outlook: No crash. No bang. No wallop. If the Dodd-Frank Wall Street reforms, which became law last year, had been in place back in 2008, Lehman Brothers would either not have failed, or would have been wound down by regulators in an orderly fashion. The panic of September 2008 would never have been.
Or at least this is the conclusion of an analysis conducted by the Federal Deposit Insurance Corporation, the regulator that has shored up confidence in America's banks since the Great Depression. It has the ability to seize failing institutions and sell or wind them up so that depositors don't lose money. Under Dodd-Frank, the FDIC will take charge of winding down much bigger and more complex financial institutions if they get into trouble, a power they did not possess when Lehman teetered.
The FDIC's soothing and plausible analysis concludes that its regulators would have gone into Lehman early in 2008, first to put pressure on Dick Fuld, chief executive, and the board to sell the company to a better-capitalised rival, and then – if this failed – to draw up a plan to take over the firm in the event of its collapse. The report says Lehman probably would indeed have sold itself early in these circumstances, but that if it had gone over the precipice in September 2008, the regulator would have had the ability to do what Hank Paulson at the Treasury refused to do, which was to backstop losses on some assets so the bank could be taken over by Barclays without having to go bankrupt.
The purpose of the report is threefold. It tells bank bosses how they can expect to be treated under the new regime and underscores how no institution is now "too big to fail". It is also aimed at bolstering support for Dodd-Frank as it comes under assault from Wall Street lobbyists who, in cahoots with Republican lawmakers, are plotting to gut the key provisions of the law. Finally, it endeavours to burnish the FDIC's own credentials, since the final say about whether to wind up a financial firm will rest not with that regulator but with the Treasury. It is important the FDIC's on-the-ground recommendations are not ignored by politicians more sympathetic to a bank's pleas for survival.
Read the report closely, though, and it is slightly less soothing or plausible. This is not to criticise the Dodd-Frank laws, which are necessary and strong, or the FDIC, which is the only credible agent for intervening when financial firms fail. By keeping banks running under FDIC control and preventing a fire sale of assets, the impact on its trading partners and the losses for creditors, though not eliminated, are minimised.
However, a hard-headed analysis would admit that a lot of things would have had to go right to achieve the rosy outcome that the FDIC paints. Such an analysis would also point out the many things that might still go wrong, even under Dodd-Frank. Here are a few. First, like much discussion of the events leading up to Lehman's demise, the FDIC's report begins with a convenient untruth, namely that Lehman's bosses refused to sell the company because they believed the US government would bail them out.
That isn't what happened. Mr Fuld et al refused to sell because they believed Lehman's share price was driven unfairly low by a market panic, and that it was destined to rebound. Selling out at the prices likely to have been offered by Bank of America or Korea's KDB would have been unfair to shareholders.
In such a context, the FDIC might not so easily have won support for its recommendation to seize the institution. Mr Fuld would certainly have fought back, and any bank boss worth their salt would use their political connections to play off against each other the various actors who must approve the seizure.
Second, the FDIC assumes that its intensive preparation for a wind-down of Lehman, including inviting in wannabe bidders for the firm, could have gone on entirely in secret. It might be able to keep things hush-hush when it is preparing to shut down a Capra-esque Bailey Building and Loan Association, but when the subject is one of the most powerful global banks, whose fate has important systemic consequences, this seems rather less likely. In the leaky real world, a single rumour could trigger a run on the bank, which would dangerously truncate the timeline for the regulator's work.
Third, the international dimension is hugely critical. Every country has different resolution or bankruptcy regimes for failing firms, and the interaction between them would inevitably have unintended legal consequences in a case as complex as Lehman's. All the mechanisms for international co-operation, which have been promised but so far barely sketched, can never change that.
Resources could be an issue too. Would the FDIC really have the staff it needs for such a complex case, especially if it is fighting fires on multiple fronts? Lehman was not alone in tottering towards the brink three years ago, but rather it was one victim of a much wider market meltdown.
And here is the other thing that struck me as I read about the FDIC's alternate-reality victory in saving Lehman and the US taxpayer: Lehman Brothers was the easy one. The regulator should repeat this exercise on AIG, whose spiralling losses turned out to be many times bigger and more intertwined with the rest of the financial system, and which, as predominantly an insurance company, operated with vastly different regulatory regimes and legal structures?
Lehman is always the poster boy of the 2008 financial panic – precisely because it is the easiest case to understand. If the FDIC really wants to persuade us the world is safer, it must venture into the heart of darkness. It must tell us what it could have done with AIG.
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