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The FDIC Could Not Have 'Resolved' Lehman

Lehman Brothers
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Lehman Brothers

The FDIC recently released a report claiming that the new resolution powers it has under Dodd-Frank would have prevented the disorderly and costly collapse of Lehman Brothers—by effecting an “orderly” resolution.

Unfortunately, the report is not very persuasive. Much of it reads, in the words of Penn law professor David Skeel, as “magical thinking.”

The entire report assumes that at each step the FDIC would act with perfect prudence and independence. No lawmakers or lobbyists with hidden agendas make appearances. No regulators make missteps along the way. Everything proceeds smoothly.

The problem is that a report attempting to prove that a resolution would be orderly cannot start with the assumption that it will be orderly. This is just question-begging.

The report also fails, at each and every point, to take into account the reaction of other market participants to the FDIC’s actions.

It imagines, for example, that if the senior management of Lehman Brothers had not quickly arrived at an early private sector solution to their troubles in the wake of the collapse of Bear Stearns, the FDIC would “establish an on-site presence to begin due diligence and to plan for a potential Title II resolution.”

Of course, the moment this happened, Lehman would have seen its access to funding collapse, its counter-parties immediately demanding collateral, and its customers closing off accounts. In short, Lehman would immediately collapse because the FDIC's establishing an on-site presence would trigger a run on the bank.

Perhaps more interesting than the problems with the report is the question of why it was issued at all? Why is the FDIC going through this hypothetical historical exercise?

Here’s Skeel’s answer:

Two possible reasons come to mind. First, the FDIC made these kinds of claims throughout the debates that led to Dodd-Frank, and somehow they worked. The FDIC was given extraordinary new powers under the new resolution rules, even though the FDIC’s track record in handling large cases is not good. Second, the FDIC has been floundering in its efforts to implement Dodd-Frank’s new requirements. It may be that the report is designed to distract attention away from growing fear that the living will requirement will not be effectively implemented, and that the resolution rules are a disaster.

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