What Five Hours From Last Thursday Can Tell Us About Dodd-Frank And JP Morgan

In the course of an afternoon, we saw the problems Dodd-Frank is trying to solve, the solutions on the table, and the efforts to roll them back — not in that order.

Let’s take a quick look at a time frame lasting less than five hours from last Thursday, May 10th, 2012.

At 12:10 p.m., Martin J. Gruenberg, Acting Chairman of the Federal Deposit Insurance Corporation (FDIC), gave the keynote at the 48th Annual Conference on Bank Structure and Competition held by the Federal Reserve Bank of Chicago. In the long-awaited speech, he outlined the overall vision, as well as the problems and pitfalls, of the FDIC using “resolution authority” to oversee the failure and unwinding of a Too Big To Fail financial firm. These powers were granted to the FDIC in the Dodd-Frank financial reform bill in order to achieve both accountability and stability while avoiding the panic and contagion that occured in the fall of 2008.

At 2:15 p.m., House Republicans passed H.R. 5652, Paul Ryan’s Sequester Replacement Reconciliation Act of 2012, by a vote of 218 to 199. This reconciliation act does many things; one is that it takes lots of money from poverty relief programs and gives it to the military, and another is that it renegs on automatic cuts that were agreed to as a result of the Super Committee’s failure, which will almost certainly trigger a crisis on the next debt ceiling fight. But for our purposes, one specific thing it does is revoke Title II of Dodd-Frank, which is the resolution authority powers Gruenberg was presenting. It replaces them with nothing.

At 5 p.m., the large, systemically risky firm JP Morgan had a surprise conference call where it announced, following what was disclosed on its 10-Q, that it had a giant loss of $2 billion in the last quarter. This suprised the market and sent analysts running to their phones and computers.

There are two ways to look at the relationship between the Dodd-Frank financial reform framework and JP Morgan’s loss disclosure. One is that it shows the need for a strong implementation of Dodd-Frank broadly and the Volcker Rule specifically, which is designed to separate prop trading from large, risky financial firms. Marcus Stanley of Americans for Financial Reform has a great post up discussing what happened, how the principle of the Volcker Rule should work in this situation, and the threats it faces. Dodd-Frank is designed to make the financial markets more transparent and robust to shocks through such mechanisms as expanding clearing requirements for derivatives and reducing interconnectedness between large financial firms. It is also designed to make it less likely that any individual firm will collapse by having stronger capital requirements for larger financial firms and eliminating certain business lines they can participate in through the Volcker Rule. This is crucial for a Too Big To Fail firm like JP Morgan.

But the second is to acknowledge that businesses run profits and they run losses. There is something to a conservative like Kevin Williamson’s remark that “The odd thing about this is that it is now considered somehow scandalous when a business loses money. It’s a scandal when banks make profits, and it’s a scandal when they make losses.” On a long enough timeline, the survival rate for everyone drops to zero. Though it was clear quickly at 5 p.m. Thursday that JP Morgan wasn’t in danger of collapsing, if things had been different it could have failed.

This illustrates the need for a mechanism to allow firms to fail in a way that fairly allocates losses to the right parties. The way corporations fail in this country is a series of legal choices we’ve made, and we found in the fall of 2008 that the mechanism we have for a shadow-bank financial firm failing — Chapter 11 bankruptcy — dragged down the entire system with it. Hence the move to bring in the FDIC to make sure a financial firm fails in a way compatible with fairness. The FDIC has special powers — advance planning and living wills, debtor-in-possession financing and liquidity, making payments to creditors based on expected recoveries, keeping operations running, the ability to transfer qualified financial contracts without termination, and the ability to turn up or down regulations going into a potential resolution based on prompt corrective action — appropriate to what our 21st century financial system needs.

Now what did Gruenberg present? The whole speech is recommended, but these goals are worth highlighting:

The second step will be the conversion of the debt holders’ claims to equity. The old debt holders of the failed parent will become the owners of the new company and thus be responsible for electing a new board of directors. The new board will in turn appoint a CEO of the fully privatized new company. For a variety of reasons, we would like this to be a rapid transition.

In summary, what we envision is a resolution strategy under which the FDIC takes control of the failed firm at the parent holding company level and establishes a bridge holding company as an interim step in the conversion of the failed firm into a new well-capitalized private sector entity. We believe this strategy holds the best possibility of achieving our key goals of maintaining financial stability, holding investors in the failed firm accountable for the losses of the company, and producing a new, viable private sector company out of the process.

Shareholders are wiped out, the bank is recapitalized through previous debt holders, and the old board is fired. Stability and accountability are both emphasized. This is not simple, and this is where Dodd-Frank hangs together or it falls apart. It is a system of deterrence and detection alongside FDIC resolution. The Volcker Rule is meant to prevent having hedge fund-like gigantic losses out of nowhere, which would allow the FDIC to have some lead time to try to steer a firm back to solvency through prompt corrective action before resolution. Well-capitalized and transparent derivative markets will help with issues of contagion and panic that come with a major financial firm approaching collapse.

This isn’t perfected yet. The big problems are given special attention in the speech: the international component of these firms, their size and complex corporate structure, their liquidity needs, and the lack of available or appropriate acquisition firms. These are not simple problems to solve, though it is clear that the FDIC wants to solve them. Now is the worst time to pull the plug and replace it with nothing, though that is the course House Republicans are on. Because no matter how many regulations are put in place, firms fail. We need a system that allows that.

Mike Konczal is a Fellow at the Roosevelt Institute.

Cross-Posted From The Roosevelt Institute’s Next New Deal Blog

The Roosevelt Institute is a non-profit organization devoted to carrying forward the legacy and values of Franklin and Eleanor Roosevelt.