Congress is considering legislation that would give the Treasury and FDIC broad new legal powers to resolve failed banks, broker-dealers and insurance underwriters, as well as the companies that own them. While most observers agree that we need a better way to resolve insolvent financial firms, the current proposals do not really address the core public policy concern.

The entire concept of "too big to fail" is based on the belief that unwinding large multinational financial firms via a traditional bankruptcy is operationally impractical and politically disruptive. The market shock caused by the failures of Lehman Brothers, American International Group and Washington Mutual is pointed to as evidence of the veracity of the "too big to fail" doctrine. While reasonable people can differ on this point, let's assume that from a public policy perspective, sudden liquidation of a complex firm is the least desirable option.

The response from the Obama administration and Congress to these events has been to propose giving the Treasury and FDIC power to manage the orderly windup of these firms to protect public confidence and prevent a complete meltdown of the global capital markets, the effects of which are still being felt today. The various proposals would essentially give the Treasury and FDIC the right to take over an entire financial conglomerate and impose haircuts on equity and debtholders, thereby avoiding a repeat of the systemic shock of a Lehman-type failure event.

FDIC Chairman Sheila Bair told a group of international bankers in Istanbul that officials might want to consider "the very strong medicine" of limiting secured claims by bondholders — for example, to 80% — in the event of the failure of a large financial firm. She said limiting claims would encourage secured creditors, who are senior to equity holders when a bank fails, to monitor more closely the risks a bank is taking and could speed up the process when an institution needs to be wound down.

But why should the haircut on debt and other secured claims in the event of an insolvency of a "too big to fail" bank be limited to just 20% face value?

While it may be entirely correct to provide the Treasury and FDIC with powers to reorganize financial firms and impose haircuts on bondholders, the Congress should consider that these extraordinary powers should be used only as a last resort, and that prior to such exercise the various debt and equity holders of the financial firm should first be forced to put all their funds on the line to support the enterprise before the Treasury and FDIC are forced to impose what is effectively a receivership.

Specifically, as part of any new powers granted for resolving complex financial firms, Congress should require that all the secured creditor claims against a complex financial firm be convertible into equity to provide the funding to help support and possibly save the firm from liquidation and/or a public bailout. This proposal, in theory, would go even further than Chairman Bair's 80% "cap" on secured claims, but it might also avoid the need to actually reorganize the financial institution using the new powers under consideration.

The unspoken truth of the past year is that the Treasury, the Fed and Congress have kowtowed to powerful political interests that represent the bondholders and swap counterparties of the largest global financial firms, including buy-side managers like PIMCO and BlackRock, over-the-counter derivatives dealers such as Goldman Sachs and Deutsche Bank, public and private pension funds and global banks and sovereign investors that are the predominant holders of the claims on financial firms.

The U.S. government and the Federal Reserve have been subsidizing the bondholders and counterparties of AIG, Citigroup and other large financial firms, when they should be calling for the secured creditors to recapitalize the enterprise via debt conversion — as in the case of GM, Chrysler and just about every other Chapter 11 reorganization.

By requiring that the claims on complex financial firms be convertible into equity in the event that the firm starts to experience a capital deficit, the Treasury and FDIC could better manage these situations both financially and in terms of market expectations. If you recall that the definition made by the Corrigan Group of "systemic risk" is when markets are surprised, putting the investors in the debt of complex financial firms and bank counterparties on notice that they may be required to convert some or all of their claims into equity makes the rules clear.

Indeed, the credit spreads on large complex financial firms that contain this embedded call option would bolster the safety and soundness of large banks and provide regulators with a daily indicator of safety and soundness. The financial markets will know that, in times of stress, these "too big to fail" institutions will be able to quickly augment capital and reduce expenses, thereby maximizing the private capital buffer to prevent another public bailout. Only when the institution burned through all the available resources from conversion of claims would the Treasury and FDIC need to invoke their resolution powers.

Congress has to reject subsidies for holders of debt and other claims on "too big to fail" institutions and remind the creditors of these complex institutions that when the equity is wiped out by losses, the creditors become the new owners of the enterprise. This course would not only restore discipline to the financial markets, it would end the need for public bailouts.

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