Bankruptcy

Proposals for Haircuts at the FDIC

By Bob Lawless

FDIC-sponsored haircuts have become a hot item in the blogosphere. My wife used to work for the FDIC, and I smile every time I hear the term as I think about the building on F Street with a big barber pole in front of it. Here, the term is not being used in its hirsuted sense but as part of the colorful vernacular that surrounds insolvency work. A "haircut" describes a situation where a creditor is paid less than that to which they are entitled.

The FDIC proposal comes from Representatives Brad Miller and Dennis Moore and would limit the recovery of secured creditors to 80% of the value of their collateral in FDIC takeovers of failed banks. (I can't seem to locate the original text of the proposal on the Internet, but it has been widely reported.) Academic types will remember a similar proposal from Professor Elizabeth Warren back in the 1990s that would have limited recovery to 80% of the collateral's value. While Warren's proposal would have applied to many types of secured lending (at that covered by Article 9 of the Uniform Commercial Code, the current proposal is limited to failed financial institutions taken over by the FDIC.

The usual criticism has arisen in the usual places, namely that the latest proposal will discourage capital formation in banks. In turn, it is said that banks will lend less. Growth will be deterred. And we'll see even more gruesome scenarios involving the cross-breeding of dogs and cats. All of that might be true--well the dogs-and-cats part is less likely--but these criticisms miss the point. The question is not whether we like capital formation and economic growth but whether the costs are worth the benefits. The costs here come from the moral hazard that is created by asset partitioning.

Suppose I am thinking about starting a fireworks business. That's great for me and great for the community because I'll employ lots of people. The only problem is that when my factory blows up, the victims are going to sue and get judgments against me. They'll use the judgments to take my home, my car, my boat, and my kids' toys. That's not so great so maybe I don't start the business. These are exactly the reasons why we have incorporation, which is a form of asset partitioning. I can divide up assets available to my business creditors--those in the corporation--and those available to my personal creditors.

Of course, the asset partitioning will create moral hazard. Because I won't bear the full consequences of my business's risk, I won't have full incentives to minimize those risks. These are some of the reasons we require things like licenses, insurance, and compliance with safety regulations. Generally speaking, we especially have these sorts of requirements when asset partitioning leads to especially bad moral hazard.

Secured lending is a form of asset partitioning as it commits some or all of the firm's assets to a particular creditor or group of creditors. In a manufacturing context, secured credit can remove assets that otherwise would be available perhaps to pay victims of defective products (or any other creditors unable to fully adjust to the increased risk created by the asset partitioning). In the context of the current proposal, secured credit removes value that otherwise would be available to pay the FDIC.

On the merits, the wisdom of the Miller-Moore proposal depends on whether we think the benefits to capital formation that comes from the particular form of asset partitioning at work with secured lending to banks exceeds the costs created by its risks. Maybe this is one issue we can move beyond the usual screeds about the end of capitalism from the business lobbies. One answer is for the FDIC to do a better job and use its regulatory powers to stop banks from using secured lending to engage in overly risky behavior. That answer rests on a false premise that the FDIC can do a better job given the practical and political obstacles that stand in the way of identifying and then acting on situations where banks should be taking fewer risks.

What we do have is a few years of financial crisis that provides evidence that banks were overinvested in risky assets. In addition to the many losses that have fallen all over society, it is clear losses have fallen on the FDIC; its insurance fund has taken a huge hit. Concededly, the Miller-Moore proposal will slow capital formation in the banking industry, but it might also avoid these sorts of losses in the future. Any intelligent discussion of the issue has to recognize not just the benefits that come from asset partitioning by secured lending but also its costs.

Full post as published by Credit Slips on November 25, 2009 (boomark / email).