On Nov. 18 the House Financial Services Committee narrowly adopted an amendment to pending legislation, the Financial Stability Improvement Act of 2009 (HR 3996), that will greatly increase financial instability if it becomes law.

Under the measure, known as the Miller-Moore amendment, secured creditors of a large, insolvent financial holding company being resolved by the FDIC could suffer as much as a 20% loss under the special receivership provisions created by this legislation.

This 20%-haircut idea was first proposed by FDIC Chairman Sheila Bair and then embraced by Rep. Brad Miller, D-N.C., and Rep. Dennis Moore, D-Kan.

Specifically, the amendment provides that before the federal government or the systemic-resolution fund created by the legislation suffered any loss, secured lenders would lose up to 20% of the amount they are owed, regardless of the value of their collateral.

Put another way, if the insolvency loss in the failed institution completely wipes out stockholders and all unsecured creditors, secured creditors would be next in line to absorb that loss, up to 20% of what they are owed.

The rationale for this amendment is incredibly shortsighted in its aim of penalizing last-minute, short-term secured lenders to failing financial institutions because it ignores the fact that banks and other financial institutions also obtain medium- and long-term secured-debt financing.

A Nov. 18 letter Chairman Bair sent to Rep. Barney Frank, the chairman of the House Financial Services Committee, supporting the amendment reflects this shortsightedness.

She states that "this amendment will ensure that the largest firms are not immunized from their bad decisions by relying on short-term financing so long as they have collateral to pledge" (emphasis added).

Her letter goes on to say that "this amendment will help achieve your goal of enhancing market discipline because it will mean that secured creditors, alike (sic) every other creditor, will need to evaluate the solvency of our largest financial firms."

Chairman Bair and other supporters of this amendment seem to believe that secured lenders ignore the creditworthiness of those to whom they lend, especially for loans that will be outstanding for more than a few years.

In fact, a secured lender's credit evaluation influences the amount of overcollateralization required, the interest rate and loan covenants. Likewise, credit ratings for secured debt reflect the borrower's creditworthiness as well as collateral strength.

However a secured lender, in evaluating a borrower's creditworthiness, cannot see with perfect clarity three, five or 10 years into the future. That is why secured lenders, who by their nature are risk-averse, want adequate collateral protection. Otherwise they would lend on an unsecured basis.

In effect, Bair, Miller, Moore and other supporters of the 20% haircut want long-term secured lenders to risk taking a haircut, even if they have sufficient collateral, should a large, systemically important financial institution fall into insolvency five or 10 years after the secured loan is made.

Long-term secured lenders will respond in a very understandable manner — they simply will not lend to any financial firm whose secured borrowings potentially could be subject to the 20%-haircut rule.

Federal Home Loan Banks will curtail their long-term secured lending to banks and thrifts. At Sept. 30, secured FHLB advances maturing more than three years in the future totaled $200 billion.

The 20%-haircut threat would make it impossible to launch covered-bond financing for home mortgages on the books of financial firms. Covered bonds, long a safe, efficient funding source in Europe, are very much needed in the U.S. as an alternative to mortgage securitization.

The FDIC would have "sole discretion" in determining how large the haircut would be in a specific situation. Conceivably it could fully protect secured creditors who made the loan when the borrower was solvent while imposing a loss on lenders extending a secured short-term loan to a firm on the verge of failure.

Such discretion merely adds to lender uncertainty, especially if there is no recourse in the courts. Absent that recourse, the FDIC could act in a highly arbitrary, capricious manner.

If the Miller-Moore amendment becomes law, even small financial firms would find it difficult to obtain long-term secured financing since potentially they could be acquired by a larger firm that potentially could be subject to the 20%-haircut rule.

Financial firms of all sizes will experience more costly medium- and long-term funding as the cost of secured funding rises, approaching the cost of unsecured funding of the same term.

Consequently, the cost differential between short- and long-term funding will widen, giving financial firms an incentive to engage even more than they do today in maturity mismatching — borrowing short to lend long.

If there is one thing that the current financial crisis has taught, again, it is that maturity mismatching can lead to liquidity crises in financial firms, and hence to a broader financial crisis.

Why Congress would deliberately enact an insolvency rule that increases maturity mismatching and the potential for future financial crises beggars belief. Hopefully, Congress will dump the ill-conceived Miller-Moore amendment before enacting any new resolution mechanism for large, insolvent financial firms.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.