Politics makes strange bedfellows, and never stranger than when the far-right and far-left join together to punish Wall Street. This month, Senator David Vitter (R-LA), himself no stranger to strange bedfellows (metaphorical and otherwise), allied himself with Senator Elizabeth Warren (D-MA) and introduced a co-sponsored bill innocuously called the “Bailout Prevention Act of 2015.”
Vitter is consistently ranked among the most conservative Republican senators; Warren has become the Carrie Nation of the “Occupy Wall Street” flank of the Democratic Party. This bipartisan alliance of extremes has set the agenda for public debate on financial regulation with an unchallenged assertion that bailouts are bad and ought to be made as difficult as possible, if not prohibited outright.
This is a dangerous and false assertion. Indeed, the opposite is true: Fed bailouts are inevitable and necessary and ought to be subject to as few restrictions as possible, save those that give life to the policy articulated in 1873 by English economist Walter Bagehot that in times of panic, central banks must lend freely, at a penalty rate, against good collateral.
The Warren-Vitter bill would add two material restrictions on the ability of the Federal Reserve to provide emergency financial assistance to liquidity-challenged financial firms during a crisis. First, it would redefine the 2010 Dodd-Frank Act requirement that any assistance be part of a “broad based” program to mean that at least five firms are eligible to participate. Second, it would require that the Fed (or another responsible regulator) certify that each firm that receives assistance is solvent and that the analyses supporting the finding of solvency be immediately made public.
A third provision of the bill would require that all such Fed loans bear interest at a rate no less the 5 percent in excess of the relevant Treasury rate. While inane, this mandate is unlikely to be dangerous since the Fed could simply accept less collateral to lower any excessive penalty embedded in the rate.
Still, none of the Warren/Vitter rules comport with reality. The simple reason why bailouts are inevitable is that banks accept demand deposits (and, in modern times, short-term borrowings from institutional lenders) and loan those funds long-term. This mismatch means that in times of panic—when too many want their money back all at once—banks will not have sufficient cash resources to pay them all, even if every loan the bank has made is money-good. The bank will fail unless someone—a lender of last resort—steps up and loans it money until the panic subsides.
Prior to 1914, there was no lender of last resort in the United States. This absence caused and exacerbated financial panics, and solvent but cash-strapped banks regularly failed when private sources of capital (often with sinister motives) refused to lend to them. After the Panic of 1907, when J.P. Morgan effectively determined which banks would live and die, the federal government decided that it must form and control a reserve-rich lender of last resort. And in 1914 the Federal Reserve System was born.
The Great Depression demonstrated that even with a lender of last resort, panics and bailouts would still exist. The Fed’s bailout powers were expanded in the Emergency Banking Act of 1933, while the Glass-Stegall Act created the FDIC, providing a government guarantee of bank deposits. But curiously, the aftermath of the 2008 financial crisis has turned out differently. Instead of giving the Fed more flexibility to provide assistance in times of panic, Washington has tied the Fed’s hands.
Under the Warren-Vitter legislation, no firm could receive assistance from the Fed until at least five were eligible to participate. In 2008, this would have meant that both Bear Stearns and AIG—solvent but failing firms whose bailouts the American taxpayers would ultimately make a substantial profit on—would have been forced into receivership and their operations wound down. Lehman Brothers too would be forced into receivership, as it was in 2008 with disastrous results, perhaps the worst policy decision the Fed has ever made.
Only if, say, Goldman Sachs and Morgan Stanley were also failing at the same time would the Fed meet its Warren-Vitter magic number. The market, knowing that a panic will need to become widespread before the Fed may intervene, will act accordingly with runs on all at-risk institutions, self-fulfilling a widespread panic.
And when the panic is widespread and the Fed is able to act, Warren-Vitter would have it engage in a time-consuming solvency certification process that, done according to the letter of the law, would take weeks before funds could flow to besieged firms. And Warren-Vitter would require that banks taking assistance would have that fact publicly disclosed, which itself might cause a run—and those in need of liquidity would be hesitant to take a bailout when offered.
Rest assured, all of this is well known to Janet Yellen and the rest of the Fed Board of Governors. They certainly won’t watch with folded arms during the next crisis, slavishly adhering to letter and spirit of Warren-Vitter. The Fed will jerry-rig a bailout plan that will, on its face, comply with the law, but will nip the panic in the bud. Think TARP, writ large.
All firms in trouble will be forced to take bailout money—need it or not, like it or not—with healthy firms fully camouflaging ailing ones. The result will be bailouts much larger than if the Fed was simply left alone to do its job. As for the solvency certifications? They will be fudged, just as FDR did during the bank reopenings under the 1933 Emergency Banking Act. (His Treasury secretary, William Woodin, browbeat California’s banking superintendent into certifying that Bank of America, the state’s largest bank, was solvent so that it could promptly reopen and inspire confidence in the banking system.)
While bailouts are necessary and inevitable, they need not be excessive and dishonest as the Warren-Vitter bill would require them to be. There are many hazards in a financial system, not all of them moral. Let’s not ignore those being peddled by strange bedfellows and their boosters on the fringe left and right: the toxic stew of stupidity, ideological purity, and populist pandering.
Richard Farley is a partner in the Leveraged Finance Group of the law firm Paul Hastings LLP. His book, Wall Street Wars; The Epic Battles With Washington that Created the Modern Financial System, was released this month by Regan Arts.