Shocks to the Systemic: Geithner Proposal Would Rewrite More than Resolution Rules

Executive Summary

We know the Geithner systemic-risk bill (see FSM Report SYSTEMIC4) is a
placeholder. However, it’s also a top Administration priority and one to which
Congress may quickly turn after the recess. Several public critiques of it to date
are incorrect – for example, with regard to the degree of protection provided for
systemic-risk counterparties. Here, the draft bill makes a profound policy shift
with far-reaching implications for the overall derivatives market. The bill also
makes policy by essentially giving Treasury a blank check with which to provide,
through the FDIC, any type of assistance to any living or dead systemic-risk firm –
essentially TARP 2.0 without compensation, warrant or other constraints. Based
on our prior analyses of the overall legislation, we here provide a policy and
market-focused assessment of the systemic-risk resolution framework. In our
view, the measure falls short of the Treasury and FRB goal – a way to shut down
systemic-risk firms – because big companies could stay open as long as policy-
makers allow with as little shareholder and counterparty discipline as the firms
can get away with. In this report, we also assess the impact of the Treasury plan
on insurance companies, which we think would find themselves under de facto
federal regulation that bypasses state guarantee funds for the biggest insurance
parent companies. As with other aspects of the proposal, this could have
significant competitive impact and, perhaps, lead to consolidation despite
Treasury’s avowed goal of limiting the number of firms deemed too big and/or
too interconnected to fail.

Analysis

1. Counterparty Risk

In our 2009 strategic forecasts, we anticipated a rewrite of the treatment for
qualified financial contracts (QFCs, see Client Report REFORM3). That is in fact
the thrust of the Treasury systemic-risk proposal: in sharp contrast to QFC risk in
bank failures or bankruptcy, QFC and securities-agreement counterparties would
not get automatic protection that gives them the most immediate and super-senior
lien over all other claimants. This is not to say that the bill would always put QFC
and similar counterparties at greater risk than in an FDIC resolution or
bankruptcy; the key fact is that the bill would permit this should the FDIC
determine this would lead to a least-cost resolution. Bankruptcy trustees have no
comparable flexibility, nor does the FDIC have this flexibility when tackling a bank
failure.

What would this mean in practice? As we read the bill, it would put the FDIC,
likely in consultation with Treasury, in charge of determining how to handle QFCs
on a case-by-case basis for each very big firm. Under all circumstances,
counterparties would get what they would be entitled to in a liquidation, as well
as to netted claims. However, going beyond that to full exercise of QFC rights
ahead of those delegated to the FDIC as conservator or receiver is not guaranteed.
Should the FDIC wish to do so, it could limit QFC and securities-agreement
counterparty rights regardless of contractual obligations that would otherwise
apply in default events (however defined in the applicable contractual agreement).
It would almost certainly transfer the QFCs to a private entity which would then –
presumably with assistance as discussed below – become the new counterparty for
the original obligation, regardless of whether or not the claimant wishes this to
occur.

If this regime is finalized for systemic-risk institutions – but not for other
entities – then we would expect a QFC flight to certainty. This would apply, for
example, at bank subsidiaries of big bank holding companies or in subsidiary
insurance companies (governed by bankruptcy) despite the risks inherent at the
holding-company level. This could significantly increase resolution cost for these
subsidiaries. Even more problematic is the fact that, at least so far, hedge funds
and other private pools of capital fall outside the Treasury systemic-risk regime.
Thus, their counterparties would fare better than those of a big BHC, possibly
creating opportunities for regulatory arbitrage and, over time, still more systemic
risk unless these big firms are brought under the Treasury systemic-risk regulatory
framework that is still on the drawing board.

Our conclusion here is that the unique treatment proposed in the draft for
QFCs housed at systemic-risk counterparties cannot hold. The legislation’s
approach will either need to be expanded to all QFC and similar counterparties or
dropped. Which occurs will of course have profound impact on the OTC market
and the future of its regulation, especially with regard to pending capital
requirements for credit-default swaps and similar instruments.

2. Tarp 2.0

We know this isn’t a flattering reference, at least to many on the Hill. Still,
that’s the way we read a key section in the Treasury draft.
It would allow the FDIC to provide “direct and indirect” aid in any number of
ways – capital injections, loans, asset purchases, guarantees, etc. Note the
“indirect” reference. This would, for example, permit the FDIC to subsidize an
acquisition of a systemic-risk firm and/or any of its parts to favored third parties.
This builds on the FDIC’s approach to transactions like the abortive Wachovia
takeover by Citigroup (see Client Report DEPOSITINSURANCE49), and may
raise as many questions as that transaction. It will also lead to increased industry
consolidation since the most likely acquirers of a systemic-risk firm’s obligations
would be another big entity that, if it didn’t pose systemic risk at the beginning of
the transaction, likely would do so at its close.

As noted, none of this assistance would come with requisite strings attached.
As a result, a systemic-risk firm or its successors, counterparties or other interested
entities could get untold sums from the FDIC at no immediate cost in terms of
executive-compensation restrictions, governance reform or Treasury upside
warrants. Like Secretary Paulson, Mr. Geithner may well have decided to start the
bargaining here with nothing on the table to limit what Congress might do to
condition the FDIC’s flexibility. Also, the assistance here is funded by the
industry, not taxpayers. The bill requires “financial companies” to pay the costs of
any rescue, although whether funds could be prospectively amassed is unclear, as
is precisely which firms would be required to ante up.

Despite these differences, though, we do not expect Congress to look with
favor on the condition-free assistance possible under the Geithner plan. To say the
least, the mood has turned since Paulson tried this and, even then, he couldn’t get
what he wanted in TARP. We do not expect Congress to enact anything like the
open field proposed in this draft. Indeed, we expect not only mandatory
compensation and similar restrictions, but also far tougher language forcing the
FDIC to close troubled companies, not just help them out.

3. Insurance Regulation

The draft would give Treasury and the FRB unlimited authority to shut down
the parent company of any bank, securities firm or insurer deemed to be in danger
of default. Although this power would not extend to functionally-regulated
subsidiaries, we believe any FDIC takeover and/or support at the parent-company
level would have profound impact on the subsidiaries. It is, for example, difficult
to see how a state-regulated insurer would continue doing business as before
while its parent firm was in an FDIC conservatorship, receivership or bridge
entity. Conversely, the federal government’s unlimited authority to provide the
type of aid outlined above at the parent would of course have significant impact
on the subsidiary, given the parent firm’s ability quickly to downstream federal
dollars to the functionally-regulated subsidiary.

While state-chartered banks would be as affected, the longstanding precedent
of both FRB holding-company regulation and FDIC resolution authority limit the
systemic-risk resolution framework’s impact on the dual-banking system. For
broker-dealers, state regulation has long been of limited impact and resolution,
through SIPC, is a federal affair. In sharp contrast, however, insurance has so far
been exclusively governed and resolved at the state level. With a new federal
authority effectively to preempt any state regulator’s solvency determination
and/or to assist a regulated insurance subsidiary, the state role becomes less clear.
FedFin thus concludes that state insurance regulation would be effectively
applicable only for agents and/or small insurers, with the federal government the
functional prudential regulator at the parent-company level of any global or large
insurer. The resolution regime leads to this result only indirectly because
Treasury, the FRB and FDIC have no express prudential authority over systemic
holding companies. This will, we think, quickly be addressed when Treasury
follows up the resolution legislation with a still-broader proposal to outline a
systemic-risk regulatory framework. This will almost surely house oversight
responsibility at the Federal Reserve and provide a regulatory-capital regime for
any firms found to come under the new standards.

These rules would essentially trump state insurance capital standards even
though not directly applied to regulated subsidiaries much in the manner that
parent-company regulatory capital for banks essentially dictates subsidiary capital.
There are as yet no details on how this capital regime would be structured except
for indications that firms brought under it would need, if banks, to hold more
regulatory capital than would otherwise apply and be subject to still more
stringent risk-management requirements. For insurers, we would expect this
regime to include a capital regime analogous to the Solvency II one adopted by
international insurance regulators, tightened to impose still tougher standards at
the parent level.

Differences between insurance companies in or out of the systemic-risk
framework would create additional regulatory-arbitrage opportunities vis-a?-vis
smaller firms. On the positive side for firms under the systemic-risk umbrella
would come the implicit guarantee from the TARP 2.0 backstop, perhaps making
annuities holders and other customers more willing to do business with a covered
firm. The new regime could also satisfy European Union demands for a parent
regulatory framework, a demand that after 2013 will create barriers to entry in the
EU for state-regulated U.S. insurers. On the negative side, of course, are the direct
capital costs of any federal requirement, costs that would reduce profitability and,
perhaps, lead to adverse pricing of various insurance products offered by
competitive, smaller firms.
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