When the FDIC chairman, Sheila Bair, gave a speech in Istanbul on October 5 floating a proposal to limit the claims of secured creditors of failed banks, we commented that the change would "make it harder and more expensive for banks to raise capital." When we checked if her proposed 20% haircut would apply just to newly issued debt or retroactively to existing secured creditors, her spokesman replied, "The chairman simply raised the issue as a possible approach. No details were provided." Well, the details are in, and the proposal has gone from trial balloon stage to actual legislation, in the form of an amendment passed this week to the House financial services "reform" bill.
The amendment, offered by Rep. Brad Miller of North Carolina and Dennis Moore of Kansas (where Ms. Bair has roots), is as follows: "Payments to Fully Secured Creditors: Notwithstanding any other provision of law, in any receivership of a covered financial company in which amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United States or to the Fund, as determined in the receiver's sole discretion, an allowed claim under a legally enforceable or perfected security interest (that became a legally enforceable or perfected security interest after the date of the enactment of this clause), other than a legally enforceable or perfected security interest of the Federal Government, in any of the assets of the covered financial company in receivership may be treated as an unsecured claim in the amount of up to 20 percent as necessary to satisfy any amounts owed to the United States or to the Fund. Any balance of such claim that is treated as an unsecured claim under this subparagraph shall be paid as a general liability of the covered financial company."
By applying the provision only to claims that become enforceable "after the date of the enactment of this clause," the amendment avoids some of the ex-post facto and rule of law problems that I had warned about, but that just makes it a really, really bad idea as opposed to a totally and absolutely horrible idea. Even applied prospectively rather than retrospectively, the provision make it harder and more expensive for banks to raise capital, and therefore, harder to get credit flowing again into the economy. The banks will just pass their increased costs of funding onto their customers in the form of higher fees and higher interest rates on loans.
As a Barclays research report put it: "It would likely make secured funding to large institutions much more 'flighty' – that it, much more volatile and prone to leave quickly. In any situation where it appears that a large firm is about to fail, secured lenders will rapidly head for the exit and terminate as many of their repo transactions as possible. No secured lender will want to be left in a trade with a bank in receivership where the regulators have converted the transaction into an unsecured loan at 80% of the original amount (net of the original haircut). We believe the proposed legislation will also make secured lending far more pro-cyclical – with lenders stepping away from a systemically important institution immediately upon hearing anything that might raise the odds of a FDIC takeover. In our opinion, the combination of flight-prone money and pro-cyclicality would ultimately defeat the intent of this legislation, which is to reduce systemic risk. Instead, large systemically important firms would become more vulnerable to liquidity runs – of the sort seen last fall. In addition, the Miller and Moore amendment would raise funding costs for large institutions, pushing them into the unsecured market and removing an important source of liquidity to the repo market – at precisely when unsecured money is not available."
No word on whether the Senate will go for a similar approach, or whether the amendment will make it into any final law, but this one is worth watching as an example of potential unintended consequences. The rights of secured creditors took a beating in the Chrysler bankruptcy, and now that the precedent has been set, it seems to be open season. First Chrysler, now this. To be fair to Ms. Bair, Miller, and Moore, their argument is that exposing the secured creditors to loss will make them keep a closer eye on risks taken by the institution they are providing capital to. Sounds nice in theory, but my sources tend to agree with Barclays that this would do more harm than good. If there's been any coverage of this yet in the major papers, we haven't seen it.
Update: Welcome Felix Salmon readers. Please check out the rest of the site, sign up for the email list using the box toward the upper righthand side of the page, bookmark this Web site, or subscribe to the FutureOfCapitalism.com RSS feed using the button on the righthand side of the page.