Treasury’s report earlier this week on what the U.S. would do if a big financial institution falters is its most important yet. Prior financial-reform recommendations are of course meaningful, but investors price risk every day based on whether or not they expect a direct or indirect taxpayer backstop behind a giant bank or other systemically-important financial institution. Because Treasury pushes for losses in an orderly liquidation, its report has immediate market impact, as well as considerable near-term bearing on what the Administration will do to Fannie Mae and Freddie Mac in the absence of Congressional action later this year.
One lesson from the crisis is that investors who pick up a failed bank on the cheap make an awesome profit. Mr. Mnuchin knows this better than most since that’s how he made a lot of money following his acquisition of the largest bank put in an FDIC conservatorship in the midst of the financial crisis. For that matter, Commerce Secretary Ross knows this too – his private-equity group also made a killing on a big failed thrift.
That the Administration policy is designed to prevent these get-even richer-even faster schemes may well be no coincidence. Treasury can’t change the law governing systemic resolutions, but it sure can change how it handles all its options under that law. In its Wednesday report, it did just that – telling creditors and counterparties that it and an amenable FDIC will go along with Dodd-Frank’s bridge-company construct, but only to the extent that creditors and counterparties take far more of a hit than many now anticipate. For good measure, it wants to yank the tax-exempt status Congress confers on these corporate halfway houses. Taken together with the other reforms, this change would not only cost creditors, but also limit the lucre a bridge-company acquirer can reasonably expect at taxpayer expense.
In addition to personal experience, Treasury’s hard-nosed stand – with which I strongly agree – is also born of the challenges it confronts handling the Fannie/Freddie conservatorships. In 2008, the FHFA used authority on which the ink was barely dry to put the GSEs into the conservatorships that have lasted over the succeeding ten years.
Why has it proved so difficult to end the conservatorships, which are essentially the bridge companies intended for SIFIs without a mandate for a precursor receivership or eventual transfer into private hands? The reason lies in part in how dependent the U.S. became on the GSEs in all of the years in which their implicit guarantee made them not only TBTF, but their lax regulation and free-wheeling ways also eliminated private competition for prudent loans.
When the GSEs failed in 2008, the entire U.S. residential-finance system would have gone with them had not the taxpayers bailed both companies out and created the ever-lasting conservatorships. These are still with us a decade later not only because the market relies on them, but also because the conservatorships were established with so little cost to anyone other than the taxpayer that a powerful confluence of private and public interest groups likes things just as they are.
Treasury, though, wants a change. In concert with many who have grown tired of competing with conservatorships that crowd out private capital, Treasury wants to re-introduce risk into U.S. mortgage finance. A prior FedFin report lays out how this could be done. Key to this is the establishment of bridge companies that would finally put an end to indefinite, “effective” taxpayer support. These “limited-life regulated entities” are complex and come under law and rule different than those applicable to giant banks and other SIFIs in extremis. It is, though, clear that taking the conservatorships and turning them into these bridge entities would have been considerably easier a lot earlier if market reliance on the GSEs and taxpayer indifference to risk had been tempered by resolution that paved the painful way to real reform.