N. Roubini: « It is time for a special insolvency regime for systemically important financial institutions »

March 25th, 2009

« Finally after a year of delays Geithner and Bernanke have come to agree about the need for a new insolvency regime for systemically important financial institutions (bank holding companies and non bank financial institutions). This new insolvency regime will allow to take over in orderly way – rather than a disorderly bankruptcy like in the case of Lehman – insolvent systemically important financial institutions.   Let me explain next why we need this special insolvency regime in order to orderly nationalize/takeover insolvent financial institutions and banks…

This new conservatorship/receivership regime of insolvency could be similar to the one used to manage the orderly takeover of Fannie and Freddie. While banks have a receivership regime based on the FDIC taking over insolvent banks and working them out in a orderly way bank holding companies and non bank financial institutions do not have such conservatorship/receivership regime outside of Chapter 11 or Chapter 7  bankruptcy.

That is why the government had to bail out the creditors of Bear Stearns and AIG and that is why the collapse of Lehman was disorderly; we need an orderly system to wind down systemically important financial institutions and bank holding companies as many assets and CDS and bonds of banks are at the holding company level rather than the bank level.  Suppose the government were planning to nationalize a large bank  -say for the sake of example Citigroup – that was to be deemed insolvent after the appropriate stress test. While the FDIC could then take over the bank the relevant bank holding company would not be under the FDIC receivership; it will instead go into a Chapter 11 or Chapter 7 bankruptcy;  and the other non bank components of such large financial institutions – its broker dealer, insurance companies, etc. – would also end up into Chapter 11 bankruptcy.

As we know Chapter 11 or 7 bankruptcy for systemically important non-banks and bank holding companies would be a mess: many of the assets and liabilities of a bank – say its CDS and unsecured debt – may be at the bank holding company level or in its non-bank broker dealer or insurance arm or other non-bank arms. And a Chapter 11 or 7 bankruptcy solution for the bank holding companies and the non-bank financial arms of the bank holding company would be a disorderly mess like the one experienced by Lehman. So in order to orderly take over large systemically important banks the FDIC receivership model works only for the bank leg of the bank; it does not work for the bank holding company or for its non-bank financial arms.

And certainly FDIC receivership does not apply to independent broker dealers and other non-bank financial institutions for which a disorderly in court bankruptcy is the only option. An orderly wind-down of Bears Stearns or Lehman or AIG would have required a special receivership/conservatorship as Chapter 11 or 7 would have pushed into automatic default unsecured debt of these institutions and triggered a mess with the CDS of these institutions.

That is why – to avoid a disorderly in court bankruptcy – the government decided to bail out  – at  a huge cost to the taxpayers – the creditors/counterparties Bear Stearns and AIG; and when it decided not to bail out the creditors of Lehman a global financial meltdown followed the bankruptcy of Lehman. This is also the reason why the government has been so far wary of nationalizing large systemically important banks: the bank arm of a large complex banking institution could be orderly worked out in a FDIC receivership but its bank holding company and its non-bank financial arms would end up into formal Chapter 7 or 11 bankruptcy and would cause – like in the Lehman case – a disorderly workout where all the unsecured debt ends up into automatic default and the ability to work out orderly CDS and other derivative instruments held by the bank holding company and the non-bank financial arms of the bank holding companies  is compromised. A special insolvency regime – instead – allows to have the time to figure out whether the unsecured debt of the institutions should be worked out and how it should be worked out; it also allows a more orderly workout of CDS and other credit derivatives issued by the financial institution.

Thus, the signal given yesterday by Bernanke and Geithner – of support of a special insolvency regime for systemically important non-bank financial institutions – is very important as it will allow the orderly takeover/nationalization of large banks and the same orderly takeover of non-bank financial institutions.  Thus it is high time to pass legislation allowing this special insolvency regime to allow an orderly nationalization of large insolvent banks and the orderly wind-down of insolvent financial institution. If such insolvency regime had been in place a year ago the expensive bailout of the creditors/counterparties of Bear Stearns and AIG could have been avoided and the disorderly collapse of Lehman would have also been prevented. Similarly today – as soon as the stress test are done – some large and systemically important banks (and their holding companies and non-bank financial arms) will have to be taken over. To do it orderly we absolutely need a special insolvency regime like the one we have for the bank arms of bank holding companies and like the one we had for Fannie and Freddie. So to orderly nationalize/takeover large insolvent banks and minimize the fiscal costs and financial collateral damage and systemic risk of this takeover we need to pass such legislation now. The time for Congress to act is now. « 

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