Ending Too Big to Fail

Finally, the two parties have agreed on legislation that largely ends “too big to fail.”  The latest amendment to the financial reform legislation, sponsored by Senators Dodd and Shelby, is described by Dodd here.  My view is that this amendment does end too big to fail and dramatically reduces taxpayer exposure to large failing financial firms. The legislation allows large financial institutions to be taken over and run and liquidated in an orderly fashion by the government when they become insolvent. All shareholders and creditors will take losses in proportion to what they would have taken had the firm been allowed to fail.  It limits section 13(c) of the Federal Reserve Act so that the Fed can only use its emergency lending to lend to solvent institutions (My understanding was that this was pretty much the Federal Reserve’s interpretation of their authority during the initial phases of the crisis and that this interpretation is why Lehman was allowed to go under.  However, as the crisis evolved post-Lehman, the Fed relaxed its interpretation because the size of the “emergency” made the strict interpretation of “lending” as opposed to bailing out less relevant – see Maiden Lanes I through III.)

My two concerns? The legislation seems to be a field day for lawyers in the wake of any such failure.  I would prefer legislation that requires such institutions to have covenants in place ex ante that specify relative losses across debt classes when an institution fails. Second, I fear the complete stripping of an institution before it goes under, which would leave all creditors and equity with nothing but potentially leave the government either needing to cover some of those losses which “somehow” appear to be held in systemically important places or having to cover some commitments of the defunct firm to maintain faith in the financial system. This is related to my view that derivatives contracts allow firms to make new debt senior to existing debt and to pledge value out of firms ‘expropriating’ long-term debt holders and now potentially the taxpayer. Your thoughts are welcome . . .