Let me begin by thanking Bruce Leonard, Chuck Mooney and International Insolvency Institute for inviting me today to speak about Title II of the Dodd Frank Act. Title II is also known as Dodd Frank’s “Orderly Liquidation Authority”, an administrative insolvency provision that is designed for resolving the unresolvable, namely systemically important financial companies that would otherwise be too big to fail (TBTF). I am speaking today in my personal capacity, and the views I express are not necessarily the views of the Federal Reserve Bank of New York, or any other component of the Federal Reserve System.
Let me begin with my bottom line. Title II is a highly consequential piece of financial crisis remedial legislation. Provided the triggers for Title II’s application are satisfied, it authorizes the Federal Deposit Insurance Corporation to execute a plan for resolving a financial company that would otherwise be too big to fail—that is, in a case where the firm’s failure under ordinary insolvency law would have adverse systemic effects on financial stability. The FDIC, through the hard work and creativity of many of its staff, including James Wigand, has developed a plan to resolve the unresolvable that has come to be known as “single point of entry” or SPE. Because we now have a plan to resolve TBTF institutions, and we did not have one before the enactment of Dodd Frank, I consider Title II to be a significant development. It represents a huge contribution to insolvency practice. The reason is simple. If I may quote our last Treasury Secretary, he would say that “plan beats no plan.” SPE—our new plan—has the promise of ending TBTF. Ending TBTF is a cause for celebration, and part of my theme today is we need to embrace Title II and redouble our efforts to see that it works in practice.
Now, in my experience, no plan is perfect. SPE is not perfect. It is dependent on a certain capital structure in the failing holding company. There may be certain challenges in adapting Title II to so-called “universal banks”, although this is not a truly meaningful problem in the United States because we do not have U.S. chartered universal banks along the European model. Further, if the SPE plan is not well executed, it may terminate the life of a TBTF institution but still produce the systemic effects that can give rise to widespread panic and financial instability. With all these things said, I have learned in my career that the perfect can be the enemy of the good. SPE is not perfect but it surely is good.
Between the summer of 2007 and the summer of 2009, the United States endured the worst financial crisis we have seen since the Great Depression. I saw the crisis up close and personally, and I feel privileged to have advised some courageous policymakers. On September 16, 2008, the world’s largest insurance company, AIG, with consolidated assets valued at more than $1 trillion, was prepared to file a Chapter 11 petition. Had AIG filed that petition, our country would be in a terrible economic condition today. AIG, you see, would have filed its petition on the business day immediately after Lehman Brothers filed its Chapter 11 petition. Lehman was roughly one half the size of AIG.
The bankruptcy of Lehman Brothers is widely considered to be the proximate cause of the financial instability that occurred soon after in the United States and around the world. Different people focus on different indicia of financial distress. Some look at the Reserve Primary Fund breaking the buck, and the systemic implications of that action for money market mutual funds. Others look at the commercial paper market, and the systemic disruptions that resulted there. Others focus on the stock market, and the very real effects that investors, pension funds, and ordinary Americans experienced as their Section 401k accounts plummeted in value.
If you think those things were bad post Lehman, and surely they were, just imagine what would have happened if AIG had filed the very next day. AIG contracts touched one out of every three Americans. Joe the Plumber might have been impacted through something as simple as a policy of insurance protecting his plumbing business. Mary the Teacher might have been seen the protection provided by AIG to her stable value fund evaporate, adversely impacting her retirement nest egg. The point is that AIG reached onto Main Street, and it touched nearly everyone on the block, either directly or indirectly. If AIG had failed the day after Lehman—which was largely a Wall Street event—the consequences to the nation’s economy would have been devastating.
So, Federal Reserve officials, with the support of the Treasury Secretary, decided to rescue AIG. I know. I was there. If the Federal Reserve had not stepped in to provide liquidity, then it is a virtual certainty that AIG would have filed for bankruptcy. In that disastrous circumstance created by AIG, the policymakers advised by me faced a stark binary choice. They could have taken a passive position and done nothing, which would have meant the largest bankruptcy filing in history with attendant consequences for the financial system and economy. Alternatively, they had the option to take action in the face of these circumstances and make the affirmative decision to provide rescue financing.
History shows that they made the decision to provide rescue financing. They did so not because they wanted to aid AIG, but because they wanted to avoid adverse consequences to the American people. The failure of AIG, especially given the context where Lehman had failed the day before, would have triggered knock-on failures throughout our financial markets, and ignited a panic that would have produced, almost inevitably, severe financial instability. In a recently published report, the Bipartisan Policy Center said: “If the only choices are between bailout and fire-sale liquidations or value-destroying reorganizations that can result in contagious panic and a collapse of the financial system, responsible policymakers typically choose a bailout as the lesser of two evils.” In the early morning of September 16, 2008, we are fortunate that the people making the decision to rescue AIG were all responsible policymakers.
In September of 2008, AIG was an institution that was too big to fail. When AIG was at the edge of a bankruptcy filing, the Federal Reserve extended a rescue loan that enabled it to survive and the unacceptable systemic consequences to be avoided. Today, AIG has fully repaid the government assistance that it received in troubled times. As our country emerged from crisis, the Congress turned its attention to remedial legislation. Some looked at the AIG case, and asked whether there should be a solution that allows the TBTF firm to fail without risking a collapse of the financial system or, alternatively, a governmental rescue. On this point, in testimony to the Congressional Oversight Panel in 2010, I said that policymakers “did not have the necessary tools, such as legal authority for a special resolution regime, with which to limit the damage of an AIG collapse.” Without such a regime, policymakers in the future would face the same nasty binary choice. Could this Hobson’s choice be avoided?
Title II adds a third option to the binary choice. In my view, the new option—SPE under Title II—will enable future policymakers to avoid the Hobson’s choice. It is to be used with respect to a financial company whose failure “would have serious adverse effects on financial stability in the United States” and where the use of OLA “would avoid or mitigate such adverse effects.” Title II is designed to avoid the use of taxpayer resources to execute a rescue. It establishes an orderly liquidation fund that empowers the FDIC to borrow from the Treasury and make the loan proceeds available to the failing institution in resolution, with provisions to help ensure repayment from that institution. Title II further provides that, if such funds are for any reason not ultimately repaid from the assets of the failed firm, any residual loss is recouped through assessments on a specified pool of large financial institutions.
The architecture of a Title II resolution under the SPE plan is relatively simple to describe. First, the failing financial holding company would be put into an FDIC receivership. Second, instead of marshaling all of the assets for the purpose of paying creditors, as would be done in typical liquidation, the FDIC would transfer to a bridge holding company all of the holding company’s assets, including its ownership interests in all of the operating subsidiaries. This would include for a prototypical financial firm, its bank, its broker dealer, its insurance company (if any), and its asset or wealth management company. The FDIC would take these actions over a weekend or overnight.
Here is what would result from these two steps. The equity of the holding company and its long-term unsecured debt obligations would be left behind in the receivership. The holding company that would have been viewed as TBTF during the crisis now may fail. In this context, failure is a good thing so long as great hardship is not inflicted on the innocent. The beauty of SPE is that it can achieve this salutary result. One key element to achieving this with the SPE plan is that the systemic portions of the failed company now become operating subsidiaries of the bridge holding company, with access to the liquidity provided by the orderly liquidation fund. Systemic consequences generally would result only if those systemically important subsidiaries were to fail as well. Under the SPE plan, they do not fail. For those creditors who might think the failure of the legacy holding company provides them with a reason to terminate their contracts with the operating subsidiaries of the bridge, the OLA contains a provision that overrides such termination rights if those rights arise only by reason of the failure of the legacy company, provided that any holding company guarantees of those contracts are transferred to the bridge holding company within one business day of the legacy company’s failure and the operating subsidiaries continue to perform on the contracts.
Under the SPE plan, the shareholders of the legacy company will be wiped out in the receivership, teaching a powerful lesson to shareholders of other TBTF institutions that they better ensure that their boards of directors exercise effective oversight. The “left behind” long-term unsecured debt holders will also likely sustain losses, teaching these creditors a hard lesson about credit risk. These helpful features of Title II address moral hazard. During the crisis, banks became the object of popular anger because people saw cases in which top-level executives at banks allowed their firms to assume outsized risks without being held accountable when those risks turned into disastrous losses. Here, too, Title II is helpful. The FDIC is required to remove any directors or senior management responsible for the legacy firm’s failure, and has discretion to insert new management and a new board of directors in the bridge company.
Once conditions in the bridge holding company and its operating subsidiaries return to normal, or what we might consider a “new normal”, the FDIC as receiver can decide to initiate the next step in a Title II resolution—the exit. The Title II exit will involve the bridge company’s re-emergence into private ownership through what the FDIC calls the “NewCo”—a new bank holding company with a sound capital structure that will enable the NewCo and its subsidiaries to fully return to private funding markets. In connection with the bridge company’s re-emergence into private ownership, the common shares of the NewCo will be distributed to the holders of the failed holding company’s long-term unsecured debt—giving these creditors a haircut and furnishing a ready-made capital base for the new enterprise. In connection with this emergence from resolution, the bridge holding company may raise additional outside equity, or restructure or sell certain businesses.
What about systemic risk? The beauty of a Title II resolution using the SPE plan is that you have a failure of the institution that would otherwise have been too big, but without the systemic consequence and the handmaiden of systemic risk, financial instability. For example, the insurance subsidiary would continue as a going concern, and policy holders would have their insurance contracts honored. The broker-dealer would not default on its trades—it would continue to settle and, if it needed liquidity, it could obtain liquidity from private sector sources or indirectly through the OLF. The bank subsidiary would also presumably function unimpeded; if there were a need for capital, its well capitalized bridge could recapitalize the bank subsidiary.
Let us return to a point that I made at the outset—the SPE plan clearly beats having no plan at all. But, is the SPE plan executable? In my view, the SPE plan is executable. With that said, I acknowledge that much more work remains to be done. I am concerned that we will stop with the theoretically “neat and tidy” solution of SPE, and not continue to address the many and varied practical problems that need to be solved for an effective execution. I also worry that, instead of spending time working through the many details that need attention for an effective execution, we will become distracted. What kinds of distraction do I worry over?
One distraction could be to spend time and lawyerly energy on developing a new chapter of the Bankruptcy Code. Some have suggested that a judicially supervised bankruptcy proceeding is far superior to an administrative proceeding like Title II. They see advantages in creating a new Chapter 14 of the Bankruptcy Code, and perhaps even developing a specialized cadre of judges to hear all cases involving TBTF institutions.
I believe that we must not let work on a new chapter of the Bankruptcy Code distract us from our foremost priority, making the SPE plan executable in practice. Recall that the SPE plan is the “new” third option with respect to what was the ugly, binary choice. While a fourth or even a fifth option would be a “nice to have”, for me the clear and present priority should be to make SPE executable in the near term. In this connection, I am reminded of Thomas Edison’s wise counsel that “[v]ision without execution is a hallucination.” The SPE plan is, in my view, a visionary breakthrough idea. We must not let it become a hallucination.
What types of things need to be done to make the SPE plan executable? The short answer is there are several, and here I will take time to mention a few of the most critical ones. The first item on my list is to ensure that the SPE plan is acceptable to critical “host” jurisdictions. Most of the largest U.S. bank holding companies have broad, cross-border footprints. This means that their operations are not confined to the United States, and the prototypical large U.S. bank holding company will have financial operations in places like London, Frankfurt, Tokyo, Hong Kong and Singapore. When the legacy holding company in the United States is put into receivership, the financial regulators in offshore jurisdictions will most probably have the authority to take action to protect depositors and creditors of the entities conducting business in their territory. Will they have confidence in the Title II SPE plan that the principal operating subsidiaries remain in operation as components of the new bridge vehicle?
An affirmative answer to this question is essential to an executable plan. To the credit of the FDIC, the recently published joint paper with the Bank of England suggests that United Kingdom authorities are very positively inclined. With that said, favorable mention in a published paper is not the same as legal recognition, and we may need to go further in providing more certainty and specifics to host countries and market participants.
Another important detail concerns the capital structure, and having the necessary amount of long term debt outstanding to accomplish the overall mission with respect to the bridge. In the United States, this may require rulemaking by the Board of Governors.
Still another important issue concerns derivative transactions and whether the receivership of the legacy holding company will be an event of default under standard ISDA documentation, triggering widespread close-out of derivatives contracts. While Title II of the Dodd-Frank Act provides a robust solution to the close-out problem under U.S. law, as noted earlier most of our large U.S. bank holding companies have global operations. Not all derivative contracts will be subject to U.S. law, and this cross-default and close-out issue needs to be addressed with respect to these offshore contracts. If cross default and close out are not addressed, the SPE plan may face significant challenges associated with the close-out of derivatives contracts abroad. In view of the significance of this challenge, lawyers need to turn their attention to developing constructive changes to the ISDA documentation to accommodate the SPE strategy, and not get distracted. The changes to ISDA’s contract terms should be to the effect that a Title II receivership of the legacy holding company does not default the operating subsidiaries on their contracts so long as these subsidiaries remain in operation outside of insolvency, and any associated parent company guarantees are transferred to the bridge.
Another potential issue relates to counterparty discipline. By keeping all of the key subsidiaries in operation, there is the potential danger that the SPE plan, if widely viewed as credible, could cause some erosion in counterparty discipline at the subsidiary level. For example, if you are doing business with a broker-dealer subsidiary of a U.S. financial holding company that you believe could ultimately meet the criteria for resolution under Title II, you might take some comfort from the fact that, under the SPE plan the broker-dealer will generally continue in operation and meet its obligations as they come due.
Any such complacency should be tempered, however, by the fact that Title II is a discretionary regime that requires action by two major independent agencies and by the Secretary of the Treasury (in consultation with the President) prior to its application. Overall, Title II and the SPE strategy increase market discipline by placing holding company creditors on notice that even if bankruptcy does not prove to be a tenable option from a systemic standpoint for a particular firm in a particular instance, there is still a credible resolution method that places all losses on private stakeholders. Coupled with significantly enhanced regulatory and supervisory measures to increase the resiliency of our largest firms through heightened capital requirements, liquidity standards and recovery and resolution plans, the Title II SPE strategy is part of a powerful suite of initiatives aimed at eliminating the TBTF problem. With regard to the still outstanding challenges associated with making the Title II SPE plan fully executable that I have described here today, I have great confidence in the power of ideas when they are brought to bear on a particular problem. The key thing is to not get distracted from making the SPE plan executable.
To conclude, I hope that this brief talk has illuminated thinking about Title II’s SPE plan. I think SPE is a huge breakthrough, and I wish that we had it back in September of 2008. Title II has the promise of solving TBTF, which indeed should be a cause for celebration. In looking around this room, I see lots of incredibly talented lawyers. We need you to work on making the SPE plan executable, and I hope that my words this morning will move you to that purpose.
Thanks so much for your kind attention.