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Financial Reform Newsletter: Better Markets Bites Dog Again

Better Markets Bites Dog Again, Agreeing with The Clearing House, JP Morgan Chase CEO Jamie Dimon and the Trump Administration’s Treasury Department That the OLA Failsafe is Necessary

Better Markets, Jamie Dimon, The Clearing House and Trump’s Treasury Department all agree that the government must have a last resort, failsafe mechanism to resolve gigantic, complex, interconnected global banks when all else has failed to prevent a disorderly collapse that threatens the country’s financial system.  The Orderly Liquidation Authority (OLA) in the Dodd Frank financial reform law is that mechanism and the Treasury Department’s latest report endorsed it.

Filing bankruptcy like every other company in the country is preferable to all of us (other than the too-big-to-fail firms) and, as the Treasury said, must remain the first option:

“We conclude unequivocally that bankruptcy should be the resolution method of first resort. Our reason is simple: market discipline is the surest check on excessive risk-taking, and the bankruptcy process reinforces market discipline through a rules-based, predictable, judicially administered allocation of losses from a firm’s failure.”

However, bankruptcy is simply unlikely to be sufficient to resolve the financial collapse of the largest, most complex and interconnected global financial firms (unless and until they are forced to significantly increase their equity buffers or are reduced in size, complexity, etc.).  Unlike most companies in bankruptcy, these too-big-to-fail firms simply don’t have the cash flow to provide sufficient readily available liquidity to survive immediate collapse. Rather than having receivables, such banks have run-ables, which will quickly result in a disorderly bankruptcy like Lehman Brothers in 2008, risking contagion and disaster.  Changing the bankruptcy code (and ensuring robust, market-tested living wills) are necessary and must be done, but they will not be sufficient.  Without OLA as a failsafe, the only choice policymakers will face in the future is the one they faced in 2008:  risk a horrific second Great Depression or use taxpayer money to bail out the biggest banks on an ad hoc basis.  OLA is the way out of that Hobson’s choice.

Importantly, used correctly, OLA will nevertheless result in liquidation, but an orderly liquidation rather than a damaging disorderly liquidation. However, there must be no doubt that OLA will wipe out shareholders, convert certain debt to equity, extinguish claims, fire the Board of Directors and management, claw back compensation, and otherwise make the process as painful as possible for those who ran the company into ruin, particularly its most senior executives. Unlike 2008, OLA must not be an unaccountable bailout for underserving bankers. It must be an exacting penalty, where the CEO and other executives and directors must be ejected in disgrace and, ideally, penurious. 

This is exactly what JP Morgan Chase CEO Jaime Dimon testified previously:

“I would have claw backs. I would fire the management. I would fire the board. I would wipe out the equity and the unsecured [creditors] should only recover whatever they recover like in a normal bankruptcy. . . . I think the bank should be dismantled after that and the name should be buried in disgrace.”

That’s what OLA is intended to achieve and it will remain a necessary tool for the government to combat future financial crises until there are limits on the size of gigantic financial firms and/or capital and liquidity levels are significantly raised to enable bankruptcy to work as a first and only option necessary.  As the editors at BloombergView put it:

“The effort [of the Treasury Department] illustrates, once again, the crucial point: There’s no good way to let a systemically important financial institution fail. That’s why it’s vital to make such failures as unlikely as possible, by requiring institutions to have enough equity capital to absorb even severe losses. In this, despite improvements since the crash, the U.S. still falls short. The Federal Reserve Bank of Minneapolis estimates that capital requirements would need to more than double to lower the risk of failure adequately.

Unfortunately, Wall Street’s lobbyists and Washington allies are seeking to deregulate the biggest, most systemically significant too-big-to-fail firms, including by irresponsibly reducing equity capital, liquidity and ending the designation of systemically significant nonbanks.  This all will only and inevitably make another financial crash and taxpayer bailouts more likely.  That makes the availability and robust work-ability of OLA authority all the more important.


Another Seed of the Next Financial Crisis Planted as Court Limits Scope of “Skin in the Game” Risk Retention Requirement

A trifecta of risk is emerging as court decisions join legislators and regulators in limiting or reducing the financial protection rules put in place to prevent another financial crash. 

One of the leading causes of the 2008 crash was the proliferation of the mindless, get-rich-quick “originate to distribute” business model.  For example, mortgage brokers often eliminated all underwriting standards and would give mortgages to anyone because they were paid a fee upfront for each one regardless of whether or not a single payment was made on the mortgage.  Making matters worse, they were awarded irresistible bonuses based on “volume” regardless of creditworthiness.  That’s how we ended up with so-called “NINJA” loans: no income, no job, no assets…..no problem.  The same was true for the assembly, packaging, slicing and sale of mortgages (and derivatives) in the securitization (or structured product) process:  huge fees collected up front while the risk of worthless paper was passed on to other unsuspecting and often defrauded investors. 

One part of the solution to that problem was to require originators, sellers, packagers, etc., of financial products to retain some of the risk and, thereby, have some “skin in the game.”  Creating this financial self-interest was intended to incentivize them to ensure that the financial product was reasonably sound and was likely to pay off.

Unfortunately, the D.C. Circuit court recently issued an opinion striking down the application of the “risk retention” rule to certain complex securities sold to millions of unsuspecting investors.  In The Loan Syndications and Trading Ass’n v. SEC and Board of Govs., a three-judge panel reversed the district court and held that companies that manage or assemble open-market “collateralized loan obligations” (CLOs) cannot be regarded as “securitizers” under the Dodd-Frank Act.  As a result, the court ruled they do not have to retain any portion of the products created when they bundle the high-risk loans into securities for sale to investors.  In other words, the managers don’t have to keep any “skin in the game.”

The Court latched on to narrow dictionary definitions of the statutory terms used to define a “securitizer” and concluded that CLO managers could not fit within that category and therefore could not be subject to the risk retention requirement.  The Court refused to defer to the agencies in their rulemaking. 

The decision is marked by a number of flaws.  First, the Court discounted other definitions of the statutory terms that clearly support the agencies’ interpretation.  Those plausible, alternative readings of the statute provided ample basis to warrant judicial deference to the agencies’ expert judgment in this case.  Second, the Court seemed to apply a double standard when it comes to the policy implications of the rule.  The Court gave credence to the classic industry fear-mongering about the supposedly adverse market impact of the agencies’ rule.  At the same time, however, the Court swept aside the agencies’ serious concern that exempting CLOs from the risk retention rule would create a huge loophole.  Regrettably, this ruling will have the effect of supplying a blueprint for financial engineers to use in structuring all kinds of products and business arrangements so that they fit into the court-created loophole and evade the risk retention requirement.


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