Home -> Law Blog Directory -> Legal Commentary Blogs -> Economics of Contempt

Legal Commentary

: Economics of Contempt

KC Fed President Hoenig on Nationalization

By Anonymous

Ezra Klein is right that Kansas City Fed President Thomas Hoenig "can't be dismissed as an idealist unaware of the government's workings or an armchair observer with an insufficient grasp of the complexity of the American banking system." Hoenig has always struck me as an extremely thoughtful observer of the financial system, and he's been an active participant in the "too big to fail" debate for many years.

So what should we make of his claim that "In recent weeks, I have outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis in the United States"? It's tough to say.

"Nationalization" clearly means different things to different people. Most nationalization advocates seem to want to place the major financial institutions (e.g., Citigroup, BofA) in an FDIC-style receivership (or conservatorship). They want to treat the major bank holding companies, which currently aren't subject to the FDIC's insolvency regime, like FDIC-insured banks.

The key is that in receivership, the receiver has the authority to impose haircuts on creditors. Outside of receivership, conservatorship, or bankruptcy, there is no legal mechanism for unilaterally imposing losses on creditors of bank holding companies. This legal authority is the key issue in the nationalization debate. So when Hoenig said that he has "outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis," I expected that his plan would deal with this issue.

But here's the thing: Hoenig glosses over this issue, acknowledging how difficult it is and then moving on. From Hoenig's written statement outlining his argument:

The most difficult part of resolving these large firms without a new resolution process is how to make creditors bear the cost of their positions. Ideally, when a firm fails, all existing obligations would be addressed and dealt with according to the covenants and contractual priorities set up for each type of debt. Insured creditors would have immediate access to their funds, while other creditors would have immediate access to maturing funds with the potential for haircuts, depending on expected recoveries, any collateral protection and likely market impact. However, this is difficult because it would require negotiating with groups of creditors, unless there's a process that allows regulatory authorities to declare a nonbank financial firm insolvent.

Hoenig's argument is that we already have a framework for resolving systematically important nonbank financial firms (i.e., bank holding companies) without the new resolution authority that Treasury has proposed. But what good is a resolution framework without the key legal authority given to receivers and bankruptcy courts in the other resolution frameworks? Without a way to place bank holding companies into receivership or conservatorship, I fail to see how Hoenig's proposal is a workable solution.

I'm also unconvinced by Hoenig's argument regarding the government's ability to resolve extremely complex institutions, for which he cites the resolution of Continental Illinois:

At the time of its failure, Continental Illinois had $40 billion in assets and was the nation's largest commercial and industrial lender. It was the seventh-largest bank in the United States. It had 57 offices in 14 states and 29 foreign countries, a large network of domestic and international relationships, and a separate function for making residential and commercial real estate loans.

Citigroup has over $1.9 trillion in assets, which makes it almost 50 times bigger than Continental Illinois by assets. Citigroup also has 2,070 principal subsidiaries, and roughly 12,000 offices in all 50 states and 107 foreign countries. And it took the government 7 years to fully reprivatize Continental Illinois?hardly the model of a successful nationalization.

Full post as published by Economics of Contempt on May 04, 2009 (boomark / email).