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The Administration’s “Bailout Authority”: Assume We Have a Can-Opener?

As we mark the second anniversary of the Lehman bankruptcy and the AIG bailout, I am reminded of a joke that economists tell about themselves that goes something like this:

Sen. Spencer Bachus (R)
Scott J. Ferrell | CQ-Roll Call Group | Getty Images
Sen. Spencer Bachus (R)

A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, “Let’s smash the can open with a rock.” The chemist says, “Let’s build a fire and heat the can first.” The economist says, “Let’s assume that we have a can-opener.”

Two years after Lehman’s catastrophic failure and the improvised rescue of AIG, the Administration has provided the American people with its own version of the “assume a can-opener” joke that goes something like this: To resolve a failing firm in an orderly manner, we need a resolution authority. How would the resolution authority work? By resolving a failing firm in an orderly manner.

Rather than accept this circular logic, I’ve written the Secretary of the Treasury — twice— to ask him to answer the question: how would this “bailout” authority have worked two years ago to “resolve” Bear Stearns, Lehman, AIG, and Citigroup? Would anything have been different? Or would taxpayers still have found themselves backstopping Wall Street’s biggest firms against the consequences of their mistakes?

The question is not simply hypothetical: if one cannot, with the benefit of hindsight, explain exactly how the “resolution authority” would have worked, there is every reason to expect that one will not be able to explain how “resolution authority” will work the next time a “too big to fail” firm finds itself in trouble.

When Secretary Geithner finally got around to responding to my letters last month, he again circumvented the issue without explaining how the Administration’s “resolution authority” is not a bailout by another name.

The “resolution authority” effectively permits the FDIC to borrow up to the book value of a failing institution. For the largest institutions, that figure is more than $2 trillion; for the six largest firms that figure is as an eye-popping $9.4 trillion. The “resolution authority” then permits the FDIC to use that money to pay off creditors — up to 100 cents on the dollar — and make loans to the failing institution and to buy its assets.

Two years after Lehman and AIG, we still don’t know — and the Administration hasn’t explained – how the “resolution authority” would work. Is it deposit insurance for the largest, most-sophisticated financial institutions, protecting them against loss the same way we protect small retail depositors?

That seems a recipe for disaster, inviting big Wall Street firms to gamble again on toxic assets, knowing that the upside is all theirs while the American taxpayer stands ready to protect them against loss.

Is it a dumping ground for toxic assets, like the original TARP was supposed to be? Is it a source of debtor-in-possession financing for insolvent institutions, the same way the Fed was for AIG when AIG’s counterparties were paid off 100 cents on the dollar?

Or is it a war chest to aid Wall Street firms to buy up insolvent firms, just like JPMorgan Chase was enticed to acquire Bear Stearns through generous government subsidies?

We still do not have those answers from the Administration, however, they have told us not to worry: Wall Street will have to pay back the difference between whatever the FDIC doles out and what the creditors of a failed firm would have gotten in bankruptcy. But the “resolution authority” is silent on how this is supposed to happen.

We are being asked to assume we have another can opener. Theoretically, Wall Street firms could be compelled to pay back excess payments.

Theoretically, Goldman Sachs and all of AIG’s counterparties could have been compelled to pay back the difference between the 100 cents on the dollar that Secretary Geithner — then President of the New York Fed — agreed to pay them and what they would have gotten had AIG filed for bankruptcy.

Theoretically, the taxpayer will not be on the hook for bailing out Wall Street. But as the AIG bailout demonstrates, just because something works in theory does not mean it will work in practice.

Any way you theorize it, the Democrats’ “resolution authority” is the institutionalization of bailouts in which taxpayers will be left to pay off the creditors of failed institutions.

House Republicans have consistently made the case that the only way regulatory reform legislation could permanently end bailouts is to ensure objective bankruptcy proceedings in which creditors are paid from the assets of the bankrupt company, not the pockets of the taxpayers.

Bankruptcy, not bailouts, also vindicates the rule of law, rather than giving government bureaucrats virtually unbridled discretion to seize troubled corporations and pay off some creditors rather than others. It is not surprising — but no less disappointing — that the House and Senate Republican bankruptcy amendments were rejected on party-line votes.

For that reason, I am again asking the Administration to explain — in detail — how the “resolution authority” would work. In theory, and in practice, how would “resolution authority” have actually resolved the difficult cases of 2008?

The anniversary of Lehman’s failure is as good a time as any. Using Lehman’s balance sheet and what we know about Lehman — a large part of which we learned not from the Fed or from the SEC but from the tireless efforts of the bankruptcy examiner — show us exactly what would have been done.

In other words, show us the can-opener.

  • Jeff Cox is finance editor for CNBC.com.

  • Lawrence Develingne

    Lawrence Delevingne is the ‘Big Money’ enterprise reporter for CNBC.com and NetNet.

  • Stephanie Landsman is one of the producers of "Fast Money."

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