How a GOP bill could cause the next financial crisis – Bruce Grohsgal and Simon Johnson

MIT Sloan Professor Simon Johnson

From Politico

Wall Street’s gambles and risky borrowing directly led to the financial crisis, causing the collapse and near-collapse of megabanks and greatly harming millions of Americans. But thanks to government bailouts, those megabanks recovered quickly and top executives lost little.

In response, Congress passed the Dodd-Frank regulatory law to ensure thatno failing bank ever receive such special treatment again. But legislation that favors very large banks

Professor Bruce Grohsgal

and undermines those reforms is in the works again. The bill is called the Financial Institution Bankruptcy Act, or FIBA. The measure already has been passed by the House, and the Senate may take it up soon.

In theory, the bill attempts to solve a major issue in the Bankruptcy Code that prevents failing megabanks from restructuring through traditional Chapter 11 bankruptcy protection. In effect, though, FIBA offers banks an escape route, creating a subchapter in the Bankruptcy Code through which the Wall Street players who enter into these risky transactions will get paid in full while ordinary investors are on the hook for billions of losses. Not only is that deeply unfair, but it will encourage Wall Street to gamble on the very same risky financial instruments that caused the recent crisis.

Under Chapter 11, a failing company can get a reorganization plan approved to keep its business operating while paying its creditors over time. It then can emerge from bankruptcy as a viable business. During Chapter 11 bankruptcy protection, creditors are prohibited from suing the debtor to collect on their debt, a key provision that ensures all creditors are treated fairly and enables the business to reorganize. This is known as an “automatic stay.”

But Chapter 11 bankruptcy protection has never worked well for large banks. One reason is that, thanks to a series of special laws that Congress passed prior to the financial crisis, the automatic stay does not apply to specific financial instruments — technically called derivatives and repurchase agreements, or “repo” — which are largely held by Wall Street banks. In other words, while most creditors must wait out the Chapter 11 process to receive payment, financial institutions holding these specific financial instruments can sue immediately. Ordinary creditors must sit idly by, restrained by the stay, while the other financial institutions drain the assets and value of the failing bank.

Congress tried to address this problem in Dodd-Frank in two main ways. First, it required megabanks to have “living wills” under which they would limit their derivatives and repo exposure in advance so that they would be able to resolve themselves in Chapter 11 without putting the financial system at risk. Second, if the megabank is failing and its collapse in Chapter 11 would put the financial system at risk, the government can put it into an FDIC receivership, which allows the FDIC to wind down a failing megabank outside a bankruptcy court.

Republicans on Capitol Hill consider these changes unworkable and have proposed the new bill. The theory behind FIBA is that, if we can just tune up Chapter 11 bankruptcy law by enacting a new subchapter V to the Bankruptcy Code, then a large, failing financial institution will be better able to resolve itself in bankruptcy just like any other company. But in fact, FIBA’s subchapter V doesn’t do this. It just stacks the deck even more thoroughly in favor of Wall Street.

Here’s how it would work: Under the legislation, within 48 hours of a failing megabank declaring bankruptcy, a court would hold a hearing to allow the bank to transfer selected contracts and liabilities, consisting mostly of its derivatives and repo agreements, to a newly formed company. This so-called bridge company’s sole purpose is to take on the liabilities owed under these financial contracts and loans. The bridge company will be required to pay 100 percent of those liabilities, without any writedown, even if the property transferred to the bridge company is worth only a fraction of the debt. Once the transfers are made, the bridge company is outside of the jurisdiction and supervision of the bankruptcy court.

Read the full post at Politico.

Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at the MIT Sloan School of Management, where he is also head of the Global Economics and Management group and chair of the Sloan Fellows MBA Program Committee.

Bruce Grohsgal is the Helen S. Balick Visiting Professor in Business Bankruptcy and Law at Widener University Delaware Law School. 

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