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Academic

: Less than the Least

Endgame in the Financial Reforms--Skeel

By David Skeel and Bill Stuntz

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With the financial reform bill now in the full Senate and all signs pointing toward its passing in the next week or two, a flurry of possible amendments are circulating privately and publicly. Which are most important? Not Senator Boxer's new amendment, which would explicitly state that large financial institutions must be liquidated if they are subject to the proposed resolution procedures for 'systemically important' financial institutions. Senator Boxer's claim that this would prove that the bill doesn't allow future bailouts illustrates an understandable but dangerous confusion about what a bailout is. If all of an institution's creditors are paid in full, it's a bailout even if the institution itself is eventually liquidated. If creditors know they'll be paid—and they can be under the proposed bill—they'll be too willing to lend to the institution and won't monitor as carefully as they would if they would if they weren't protected. They'll act like the creditors of Bear, Stearns, AIG and Lehman Brothers did.

The one amendment that would do most to change this, in my view (and as Tom Jackson and I argued in this recent op-ed), would be to reverse the special treatment that derivatives and other financial contracts are now given under the bankruptcy laws. Parties to a derivatives contract currently can terminate their contract, sell their collateral, and keep even preferential or fraudulent payments they receive prior to a bankruptcy. These special rules, which were insisted on by Goldman Sachs and other major derivatives dealers in the 1980s, 1990s and 2000s, substantially reduce the benefits of bankruptcy for a large, troubled financial institution. Unlike many of the proposals being discussed in DC, which would slap down Wall Street without producing real benefits, this one would punish Wall Street more productively. It would make bankruptcy even more attractive as an alternative to bailouts than it already is, and make future bailouts much less likely.

Full post as published by Less than the Least on April 30, 2010 (boomark / email).