News and Information
Proposed Legislation Undermines Credit Risk, Threatens Capitalism
Nov. 24, 2009
Washington Post photo
In 1991, Senator Dodd insisted on reducing
the quality of collateral Wall Street would
need when borrowing from the Fed.
Massive government bailouts of failed firms such as Citigroup and General Motors have already served to undermine the concept of effective credit risk management, one of the fundamental pillars of capitalism. Now, some in Washington and Wall Street want to go even further.
Two weeks ago, Senator Christopher Dodd, the chairman of the Senate Banking Committee and long-time influential Democratic senator from the state of Connecticut, circulated a 1,100 page bill that would grant more power to the Federal Reserve and FDIC to bail out more companies when they get into trouble.
Dodd's bill would create a new Consumer Financial Protection Agency (CFPA) to regulate consumer finance in areas like credit cards and home mortgages as well as something called an "Agency for Financial Stability" that would identify and address risks to the stability of the financial system, according to The Hill, a publication that covers legislative efforts on Capitol Hill. This agency would supposedly be involved in establishing regulations on capital, leverage and liquidity requirements for banks and possibly any firms involved in the commercial paper and derivatives credit markes.
According to a summary of the legislation from Dodd's office, as written in The Hill, the bill aims for federal regulators to impose, "increasingly strict standards for companies as they grow larger, more complex or more interconnected, including heightened capital, leverage, and liquidity requirements that ensure these companies have greater resources to deal with financial shocks."
But the current credit and banking crisis has provided evidence that companies such as AIG, Citigroup and General Motors are too large, complex and interconnected now, which is why their survival depended on government bailouts. These companies convinced lawmakers that the bailout was necessary by using the argument that they were "too big to fail" -- an argument that has since lost much of its credibility.
The Dodd bill, however, would take "too big to fail" to a whole new level. According to the Wall Street Journal, new agencies created by Dodd's bill would "allow private market participants to receive emergency cash from both the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), without the bailout recipient having to enter bankruptcy. Regulators can pump unlimited funds into failing firms and choose to rescue creditors." Currently, failing firms must choose to either reorganize or liquidate through the bankrupcty process with creditors usually recovering less than 50 cents on the dollar.
The legislation by Dodd represents the latest and perhaps most comprehensive effort by some Washington lawmakers, many of whom have strong financial support from Wall Street's largest firms (see accompanying chart), to provide a safety net to some of the biggest risk-takers on Wall Street thus furthering the notion of "too big to fail."
More importantly, Dodd's legislation ignores the fact that the bailed out firms, most notably AIG, Citigroup and Bank of America, had full knowledge and understanding of the risks they were taking but proceeded anyway. In fact, in two high profile cases involving Merrill Lynch and Countrywide, both firms that were on the brink of insolvency before being acquired by Bank of America, credit risk managers repeatedly warned of excessive risk taking. The chief risk manager at Merrill Lynch, Jeffrey Kronthal, was fired and Countrywide's chief risk manager, John P. McMurray, was ignored.
Not everyone in Washington agrees with Dodd's approach. Senator Richard Shelby of Alabama, the ranking Republican member on the senate finance committee, is steadfastly opposed to Dodd's legislation. Shelby warns that allowing large firms to receive taxpayer money and avoid bankruptcy "will undermine incentives for investors and executives to effectively monitor risks. They will likely take even more risks because they know that they will reap the benefits, while taxpayers will have to cover the costs."
Dodd claims the bill is necessary because "for decades, Washington has failed to deliver the substantial reform we need. If we fail again this time, our economy will be vulnerable to another crisis," Dodd said, according to a quote in The Hill.
Senator Dodd, who was elected to the senate in 1980, has been one of the strongest advocates in Washington for using taxpayer money to bail out financial firms that have taken excessive risks, mismanaged their assets and accumulated high levels of debt. Now, with this new bill, Mr. Dodd apparently wants other companies to be eligible for bailouts no matter how careless the risks or poorly managed the assets.
AIG ($69.8 billion), General Motors ($50.7 billion), Citigroup ($50.0 billion), Bank of America ($45.0 billion) and JP Morgan Chase ($25.0 billion) are the largest recipients of TARP funds as of June 2009, according to a tracking article in the New York Times.
CreditPulse will continue to follow this story that affects the very future of credit risk management and our capitalist system as we know it today.
