Under the Orderly Liquidation Authority mandated by the 2010 Dodd-Frank Act, the Federal Deposit Insurance Corp. would create a bridge institution to take over a failed financial firm, forcing some creditors to assume equity in place of debt holdings. Subsidiaries of the failed institution would be allowed continued operation with borrowed funds from the U.S. Treasury, according to Bloomberg.
“As with most things in Dodd-Frank, the public knows little about the liquidation authority, although it has been touted by the Obama administration and others as solving the problem of bailouts for firms seen as too big to fail,” Wallison said, Bloomberg reports. “But, it does nothing of the kind; instead it makes the problem worse.”
With cooperation from the FDIC and the Federal Reserve, the treasury secretary can take over any financial firm that he or she believes could cause instability in the U.S. financial system. Should the firm’s directors object to a takeover, the secretary may then appeal to a U.S. district court for authorization to appoint the FDIC as receiver. The court, which would be legally unable to disclose the secretary’s appeal, would then have one day to respond to the secretary’s request.
“The constitutional issues here are obvious and breathtaking,” Wallison said, according to Bloomberg.
Wallison said that since the FDIC has never taken over any institution other than a small bank, there is no evidence to suggest that the agency could handle a liquidation as large as some of America’s biggest financial institutions would require.
Additionally, Wallison said that while the liquidation authority was designed to prevent the disruptions of a bankruptcy, the concept is flawed.
“Will [a seizure] be any less of a market shock?” Wallison said, Bloomberg reports. “In both cases, creditors will run if they suspect a bankruptcy or a government takeover is near, and after the seizure—again as in the Lehman case—they will run from other firms if conditions in the market are the same as those in 2008. So the liquidation authority is no better than bankruptcy in preventing chaos after a large firm fails.”
Wallison said that, on the contrary, the liquidation authority is a worse idea than bankruptcy.
“Secured creditors don’t know in advance whether they will be repaid, and, in contrast to bankruptcy, the creditors have no say in whether the firm is liquidated or recapitalized by turning their debt into equity,” Wallison said, according to Bloomberg. “Under the FDIC plan, the government makes this decision, picking winners and losers. Politics will hover in the background. The uncertainties inherent in the liquidation authority will make credit more expensive for all financial firms of any size.”