Bull by the Horns

by Sheila Bair

  In March, Dodd released a draft that kept the resolution fund, albeit at a reduced level of $50 billion. But at the behest of the Fed and Treasury, he had included a provision giving the Fed the authority to provide support to failing “financial market utilities” under the Fed’s so-called 13(3) authority.165 The term “financial market utility”166 was broad enough to essentially encompass all of the megabanks in the country.

  The provision completely negated other provisions we had worked hard for to ban bailouts of individual failing firms. We tried to convince the Dodd staff to take the language out, but they refused, given the pressure from the Fed and Treasury to keep it in. So I reluctantly went public with my concern that it was a backdoor bailout. In a March 19 speech to the Independent Community Bankers of America in Orlando, I criticized the provision, stating, “If the Congress accomplishes167 anything this year, it should be to clearly and completely end too big to fail. Never again should taxpayers be asked to bail out a failing financial firm. It’s time that the big players understand that they sink or swim on their own.”

  That same day, Dodd announced168 that he was taking the provision out of the bill.

  Dodd had tried hard to produce a bipartisan bill, going so far as to divide the committee membership into teams of two—one Democrat and one Republican—to give him recommendations in all of the key areas, such as resolution authority, derivatives regulation, and governance issues. He drew from those recommendations in devising his bill. (Fortunately for us, Warner and Corker had been assigned to resolution authority.) But in the end, he could not convince committee Republicans to vote for his proposal. So he reported his bill out of committee on March 22 on a strict party-line vote. Under Senate rules, he had to get 60 votes to end debate and bring his bill to a final vote on the Senate floor. He likely had 56 Democratic votes, meaning he needed at least 4 Republicans. He hoped to get many more.

  The ranking Republican on the committee, Richard Shelby, was really the key to a bipartisan bill and, at least on resolution authority, he was ready to make a deal. On the positive side, he was in sync with the FDIC in closing off loopholes for individual bank bailouts, including restrictions on the Fed’s ability to lend to entities other than solvent banks. In responding to Dodd’s draft, he wanted language tightened further on any suggestion that the FDIC would use our new authority to favor particular counterparties or groups of creditors, as had been done with AIG. We were only too happy to oblige.

  Senator Shelby also wanted to tighten restrictions on the FDIC’s and Fed’s ability to use its emergency lending programs to provide generally available assistance to solvent institutions in the event of a systemic crisis. We also agreed with him there, but his staff did not follow through. Instead, they drafted language that allowed the Fed to provide such assistance with the approval of only the Treasury secretary. In contrast, they required congressional approval for the FDIC to offer such programs. So they tied the hands of the FDIC, the one regulator that had resisted the bailouts, while imposing minimal constraints on the Fed.

  But the really bad news was that Shelby decided to make elimination of our resolution fund a make-it-or-break-it issue. He wrote Tim on March 25169, calling the resolution fund a “slush fund.” He charged that “the mere existence of this fund will make it all too easy to choose a bailout over bankruptcy. This can only reinforce the expectation that the government stands ready to intervene on behalf of all large and politically connected financial institutions at the expense of Main Street firms and the American taxpayer.”

  It was interesting that the letter was addressed to Tim, not to Dodd. Indeed, Shelby’s arguments against the resolution fund echoed the same arguments that I had heard in private meetings from both Larry Summers and Geithner. Larry, known for his ties with big hedge funds that would have had to pay into this fund, liked calling it a “bailout fund.” I suspected that Tim and Larry were behind the letter, even though that would have been in violation of Rahm’s statement to me that the administration would not work against the fund. It was also interesting that the letter had come from Shelby alone. Senate GOP Leader Mitch McConnell was also publicly opposed to the fund and attacked it on the Senate floor. However, Senator Corker strongly countered McConnell, pointing out that the fund helped protect taxpayers, not the other way around. In a subsequent letter170 in which McConnell spearheaded some forty Senate Republicans expressing opposition to the Dodd bill, the prepaid fund was not mentioned.

  On April 13171, my suspicions were somewhat allayed when Tim’s top deputy, Neal Wolin, defended the fund in a conference call with reporters. But apparently Neal didn’t get the memo from Tim, because on April 16, the Associated Press reported that “Obama administration officials172 want Senate Democrats to purge a $50 billion fund for dismantling ‘too big to fail’ banks from legislation that aims to protect against a new financial crisis.” Dodd’s staff alerted us to the story and told us that Treasury was behind it but that Dodd was going to stick with the fund. I forwarded the story173 to Rahm and asked for confirmation that the administration was not working against the fund. He reconfirmed that that was the administration’s view.

  But in apparent defiance of the White House, Tim was behind the Republican opposition to the fund, as became patently clear. On April 18, during the Sunday-morning talk shows, CNN reporter Candy Crowley tried to pin McConnell down on how an industry paid fund could be a “bailout fund.” McConnell testily told her that Obama should go talk to his Treasury secretary, who agreed with McConnell. Similarly, Senator Susan Collins said on the Senate floor that Geithner had told her that he supported elimination of the fund.

  That was hardly a fair fight. The irony was that Tim was obviously teaming up with Senate Republican partisans, who were overtly using the bailout-fund rhetoric to criticize his boss, President Obama. Why? The fund was going to be paid for through an assessment on large financial institutions. Polls showed174 that the public was cutting through the bailout-fund rhetoric and supporting the fund. Congressional Democrats in both the House and the Senate strongly supported it.

  So why were Tim and Larry siding with some in the GOP who wanted to use the fund as a partisan issue? Indeed, there were press reports175 that the GOP was using the issue for fund-raising.

  I think there were several reasons.

  First, I think they were trying to protect the big institutions from having to pay assessments. In January 2010, after the House had passed the $150 billion resolution fund, the administration had proposed a new “TARP tax” to raise about $90 billion over a ten-year period. Supposedly, the tax was designed to cover the projected costs of TARP. The TARP tax was dead on arrival, and Tim never seriously pushed it. My assumption was that it was a tactical ploy to divert support from the resolution fund. Indeed, more recently, Tim has worked against proposals in Europe and the United States to impose a transactions tax on financial firms. In doing so, he has revived his going-nowhere TARP tax as an alternative—this time at a reduced $30 billion over ten years. He pulls it out as an alternative whenever momentum builds for a meaningful assessment on high-risk financial firms.

  Second, I think it was petty. They didn’t like the influence we were exerting on the new resolution authority and wanted to beat it back just because it would be beating us back.

  But finally, and perhaps most important, Tim wanted leverage against us. That is because he and some of the Republicans, while calling the resolution fund a “bailout fund,” were proposing that the fund be replaced by a line of credit with the Treasury Department. That’s right: they were arguing that our proposed resolution fund, which would be built from assessments on big hedge funds, investment banks, nonbank mortgage lenders, and others, would be a “bailout fund,” but that giving the FDIC a line of credit from taxpayers to support resolution activities would be fine. Got that? It was an argument straight out of George Orwell’s 1984. Big Brother couldn’t have said it better.

  It was nonsense. The resolution fund was designed to
provide a barrier between failing institutions and taxpayers. As Andrew Sorkin observed in a May 25, 2010, column supporting the fund, “the prepay model176, as unattractive as it may be for Wall Street, may be the only way to truly protect taxpayers.”

  But protecting taxpayers wasn’t Tim’s priority. Having control over the resolution process was. And of course, under the Shelby proposal, Treasury would control the line of credit. By forcing the FDIC to have to come to Treasury for money to conduct the resolution, Tim’s ability to influence the FDIC would increase.

  All sides agreed that to achieve an orderly resolution of a large financial institution, some temporary funding had to be provided to continue operations. Even Harvey Miller and the bankruptcy advocates were arguing that the Federal Reserve Board should provide funding to bankrupt financial entities to preserve the franchise. (And I can’t think of anything more dangerous than to have the Fed or any other government entity lending money into a bankruptcy proceeding, as private litigants spend years squabbling over who gets what.) The question was always where the money would come from.

  As I stated in a letter to the editor in The Washington Post on April 29:

  The real question is177 not whether some liquidity funding is necessary, but where it comes from: pre-funding from the industry, Fed lending (which would impose no burden on the industry) or a Treasury line of credit that would be repaid by the industry after the fact. The FDIC feels strongly that large institutions should be required to pay risk-based assessments up front to make large firms internalize the costs of resolutions and make sure that the riskiest institutions pay the most.

  That was another important facet of a prepaid fund: our ability to assess institutions on the basis of risk. And we were planning to base the assessments on exactly the type of activities that fueled the crisis. Firms that funded themselves with short-term debt, took on maximum leverage, made high-risk loans, and invested in complex, hard-to-value securities would have paid the most. Financial firms that used stable, longer-term funding and made prudent loans and investments would pay less. In addition, by adding to the funding costs of large financial institutions, the assessment would have helped level the playing field between large and small banks. As a result of the bailouts, banks perceived as being too big to fail were having to pay much lower rates on their deposits and other borrowings than were community banks. Depositors and other creditors demanded higher rates of return from the smaller banks because they knew their money was at risk. With the larger banks, the assumption was that the government would protect them.

  Dodd stuck with us in support of the fund, notwithstanding Tim’s shenanigans. McConnell also backed off somewhat. But Shelby wouldn’t budge. He essentially told Dodd that if Dodd agreed to drop the fund and incorporate his other changes (which we mostly supported), he would endorse the resolution section of the bill and acknowledge that it would provide the means to end bailouts. Recognizing the importance of Shelby’s support to achieving financial reform, Senator Dodd finally relented. We had no choice but to go along. As Dodd pointed out, we could claim victory in that our language banning bank bailouts was in and in fact had been strengthened by Senator Shelby. I agreed to support the Dodd-Shelby compromise, while preserving our right to push for the prepaid fund again when the House and Senate met in conference to reconcile their bills.

  Dodd and Shelby offered their amendment on the Senate floor on May 5, and it was approved by an overwhelming margin of 93 to 5. At least the support for resolution authority was bipartisan, another goal of mine.

  Though the fight over the resolution fund was disappointing, we preserved the ban on bailouts and were winning key battles on other fronts. Most important, we were successful in our support for an amendment sponsored by Senator Collins to require that minimum capital levels set by regulators for large banks could not be lower than the minimums generally applicable to smaller banks. That was a knife in the heart of the Basel II standards, and it came none too soon.

  On April 22, 2010, Senator Collins invited me to join her for breakfast in the Senate Dining Room to talk about the financial reform bill and ways it could be strengthened. Prior to her election to the U.S. Senate, Senator Collins had served in the Maine cabinet and had overseen state banking supervision, among other responsibilities. As a consequence, she understood the essential importance of strong capital standards in a stable financial system.

  At that breakfast, I shared with her our Basel II woes and suggested that she sponsor an amendment mandating that large-bank capital requirements stay at least as high as the requirements generally applicable to smaller community banks, the kind she had overseen when in state government. I further suggested that it would help protect the FDIC from losses if her amendment required that bank holding company capital standards be at least as strong as those applicable to insured banks. I thought that was the only way to make sure that bank holding companies were truly a source of strength for the insured banks they owned. During the crisis, we had in fact found the opposite to be true: due in part to the weaker capital standards the Fed had in place for bank holding companies, FDIC-insured banks had ended up supporting the holding companies, not the other way around. At one point in the breakfast, Senator Harry Reid, the Senate majority leader, came by our table to encourage us to work together to help build bipartisan support for the financial reform legislation. Like Senator Dodd, Reid understood the critical importance of locking in Republican support.

  Collins agreed that mandating higher capital requirements was paramount to financial reform, and Paul Nash and her legislative director, Mark LeDuc (both of whom were at the breakfast) formed a partnership that helped drive the Collins Amendment through to enactment. Our capital expert George French provided technical assistance to the Collins staff, and several days later, Collins sent the amendment to Dodd and Shelby, asking for their support. However, as soon as he got wind of the amendment, Tim visited Collins and pushed back against the amendment, saying that it would hurt smaller banks! Tim’s strategy, also backed by the Fed, was to keep capital standards out of the legislation. The Fed wanted flexibility to write capital standards as it saw fit, working with the Basel process. Given our past experience with Basel II, we wanted some statutory constraints on it.

  The amendment was anathema to the large financial institutions, which were still hoping they could take on more leverage under Basel II after memories of the crisis started to fade. Big foreign banks that owned U.S. bank holding companies were also opposed to the amendment. The Fed routinely granted holding companies owned by foreign banks exceptions from capital requirements. As a consequence, foreign-owned bank holding companies held very little capital. Indeed, one actually had178 negative capital, according to our staff analysis.

  The Fed’s rationale for granting the exceptions was that foreign banks could infuse additional capital into their U.S. banks if needed, so it was not necessary to require their U.S. holding companies to be well capitalized. We were skeptical of that argument, given the high level of leverage of European banks and the likelihood that if one of them got into trouble, their foreign regulators would want it to keep any excess capital at home, not send it to the United States. Our concerns about foreign-owned holding companies proved to be prophetic, as the European sovereign debt crisis has more recently caused widespread distress in that banking sector, creating questions about the financial strength of European banks.

  The big banks and the Treasury Department, as well as the Fed, were all working to oppose or water down the Collins Amendment. However, a number of market analysts and commentators spoke well of it, as they had seen firsthand how lax capital regulation at the holding company level had failed during the crisis. As The Wall Street Journal’s David Reilly put it, “Sen. Collins’ amendment179 was right to end this charade. Neither she nor the Senate should backtrack on it.”

  Most important, Senator Collins stood up to all of the naysayers, recognizing that her job was to protect the public from financial inst
ability, not cater to industry special interests. Given her background overseeing bank regulation, she understood the role of excess leverage in causing the crisis and the need to put some basic statutory capital standards into place. She knew her vote would be key to whether the financial reform bill passed in the Senate. She had her own “leverage,” and she masterfully used it in sponsoring this amendment.

  But we ran into an unexpected snag from community banks. Keeping large-bank capital minimums at the same level as community banks’ would help the smaller institutions, not hurt them. But the part of the Collins Amendment that required bank holding capital standards to be as high as those for the insured banks did have some impact on smaller institutions. Many community banks had holding companies that had issued hybrid debt instruments to raise capital. Those instruments were not recognized as good capital at the insured-bank level, so they would be disallowed under the Collins Amendment, and for good reason: we had extensive research showing that holding companies, both large and small, that used hybrid debt as capital were more likely to fail, and when they did fail, they generated more losses for us.

  Given that the amendment was targeted primarily at large institutions, we agreed to support a change to Senator Collins’s proposal to let community bank holding companies continue counting hybrid debt that they had already issued as good capital—known as a “grandfather provision”—though, going forward, any new securities that they issued would have to be pure equity to count as capital. With that change, Dodd and Shelby agreed to accept the amendment, and on May 13, it was approved on the Senate floor by a voice vote, without opposition.