To Prepay for a Crisis, or Not

“The legislation is full of holes.”

That assessment of the Senate’s recently approved financial legislation came from Harvey R. Miller, the éminence grise of the bankruptcy bar and a partner at Weil, Gotshal & Manges.

If there is someone who understands the practical realities of our “too big to fail” system and the damage it can wreak, it is Mr. Miller, who, at 77 years old, has handled the largest bankruptcies in history, including the mother of all failures, Lehman Brothers.

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Mr. Miller says he has deep misgivings about how well the legislation — which President Obama declared would mean “no more taxpayer-funded bailouts, period” — will translate into a real-world solution the next time a crisis comes along.

Indeed, a close reading of the Senate’s bill (and its sister version approved by the House) raises big questions about whether it can protect taxpayers from financial institutions deemed too big and too intertwined with the rest of the financial system to be allowed to fail.

Neither version of the legislation seeks to pre-emptively break up any big banks or impose a tax on size in hopes of averting a future disaster. (I’m not sure that would have worked anyway, considering that most of the academic literature suggests size is not the ultimate problem.)

Instead, the bills focus on mitigating the disaster once it happens, through a process called “resolution authority.” The legislation would give the government the power to take over a failing institution and dismantle it in an orderly way, rather than have it file for bankruptcy and let the industry suffer the collateral effects of that (think Lehman).

In theory, resolution authority, which I have long been a proponent of, should be the end of “too big to fail.” But in practice, at least the way it is described in the legislation, it may not be able to deliver on President Obama’s pledge. That is, we may still have taxpayer-led bailouts.

The problem is that resolution authority can be quite expensive. For example, Fannie Mae and Freddie Mac , the mortgage giants that were put through a resolution process that was similar to the proposed one but not quite the same, have already cost taxpayers more than $130 billion. That is more than any of the other rescued companies, and the bill is far from a final one.

(The bill, by the way, does not even try to address the problems created by these firms.)

Under the House version of the bill, the banking industry would create a $150 billion rainy-day fund, financed in advance of the next crisis through fees imposed on financial firms. If another crisis were to hit and that amount proved inadequate, the banks would be asked to pay even more.

That part of the legislation seemed sensible until the Senate got hold of it.

The version the Senate passed — which has the support of the White House and Wall Street and is likely to be the chosen version when the two bills are reconciled in conference — provides for no prepayment by the industry.

Instead, the government, after wiping out shareholders and debtholders, would lay out the remaining money needed to shut down a failing firm in an orderly fashion without risking the market-jarring effect of a formal bankruptcy proceeding. The industry would reimburse the government later.

But, in practice, would the banks really pay up in the midst of a crisis? Would politicians even press them to do so?

“I worry about the politics of trying to extract the costs from the industry if it might have a negative effect on the economy — that could become the problem,” said Stephen Lubben, a bankruptcy professor at Seton Hall Law School.

Some bankers have privately acknowledged that one of the reasons they are against a prepaid fund is they can’t afford it.

“That suggests that they are not in a position to pay ex post,” Mr. Lubben added. “The ex post is an illusion.” Exactly.

Proponents of the pay-later version include Treasury Secretary Timothy F. Geithner. They see a retroactive approach as the only reasonable option, because resolution authority is supposed to be an extraordinary power used infrequently, if ever — and the amount of money will always be unknown until it is needed.

This camp says that setting up an emergency fund would only raise the specter of “moral hazard” — bankers would know they had a safety net, so they would have less reason to limit risk.

But that’s not exactly right.

Here’s why: One of the most important elements in the Senate version of the resolution authority provision is that shareholders, and potentially debtholders, could be completely wiped out in the event that the government took over their institution. Senior managers would lose their jobs. So all parties would still have good reason to minimize risk.

(That point about debtholders is important, because they have always been mostly protected. Under the new rules, they would be at risk too.)

But if there is no money left from shareholders and debtholders to pay back the government — which would be a distinct possibility in an industrywide crisis — it will still be on the banking industry to supply potentially hundreds of billions of dollars that it may not have either.

That’s why the prepay model, as unattractive as it may be for Wall Street, may be the only way to truly protect taxpayers.

Harvey Miller, who likes the pay-later option better, sees another big problem with both bills. Channeling Main Street’s outrage about bailouts, he wonders how the public would be able to monitor the resolution process.

The answer is not much at all. Under the Senate’s proposal, failed banks would not go through a bankruptcy court, whose proceedings are open to the public. Instead the Federal Deposit Insurance Corporation — which is already responsible for taking over failing banks to protect depositors — would take on similar responsibilities with regard to the biggest banks.

If you thought the takeover of A.I.G. lacked adequate disclosure — like the identity of its counterparties — this process may not be much better.

“It’s like a Star Chamber process,” Mr. Miller said. “There is no transparency.”