The Battle Over Bailout

Sitting in his office, Rep. Brad Sherman does not look like an angry man. Leaning back and rubbing his stomach, the Californian calmly explains his concerns about the Treasury Department's plan to regulate the financial industry, currently moving through Congress. Put him at a hearing, though, and he'll subject witnesses to scathing questioning on the subject; at a recent closed-doors meeting between White House Chief of Staff Rahm Emanuel and congressional Democrats, he launched into a short tirade.

Sherman thinks the administration's proposal -- the Financial Stability Improvement Act -- amounts to institutionalizing the expensive and controversial bailouts the government used to deal with the crash of 2008. Not surprisingly, the administration disagrees.

"In a credibility contest, you've got some bald guy you've never heard of versus [Treasury Secretary Tim] Geithner, Wall Street, the administration, and [Federal Reserve Chairman Ben] Bernanke," Sherman says. "Why not just believe the establishment?"

It's a bit more complicated than that. Sherman's hair (or lack thereof) aside, the plan currently before Congress could have prevented the worst of the financial crisis, but it does not represent the fundamental rethinking of the financial industry many progressives advocate. The argument between Sherman and the "establishment" -- including House Financial Services Committee Chairman Barney Frank, a liberal himself -- is indicative of the broader divide among Democrats, between populists like Sherman and pragmatists like Frank and the Obama White House.

Sherman is deeply concerned about allowing the Federal Deposit Insurance Corporation (FDIC), with the approval of a council of federal regulators and the Treasury Department, to make loans to solvent financial institutions if they are facing runs from a panicked market. But none of the institutions that got loans from the Fed last fall, like American International Group (AIG), were solvent -- they would have gone out of business without government help. The new statute would also forbid equity investments in banks, which is where the bulk of the Troubled Asset Relief Program money went, and prevent the Fed, which is more deeply intertwined with the financial industry than the FDIC, from giving loans to individual institutions.

Nonetheless, Sherman worries the availability of loans will give too much of an advantage to banks. Banks can access capital more cheaply if lenders believe that they are more likely to be repaid with government help during a crisis, and the federal safety net could inculcate "moral hazard" among bankers who might feel free to take big risks, expecting the government will back them up. Moreover, with no cap on the funds and no need for congressional approval, Sherman fears taxpayers could be put on the hook if the loans aren't repaid. Treasury had proposed that any losses on the loans be paid for with fees from big banks after the fact -- essentially, having them pay for the excesses of the system.

At a hearing of the House Financial Services Committee Thursday, Sherman's concern about taxpayers footing the bill was echoed by FDIC Chair Sheila Bair and Rep. Luis Gutierrez, who both advocated creating an insurance fund with fees assessed from banks during good times. This seems to have had an effect -- the next day, Frank told me he intended to support an up-front fund to pay for emergency loans and having any additional funds approved by Congress. Sherman, told of this statement, said via a spokesman that "it sounds like [Frank's] moving in the right direction."

But Sherman remains concerned the proposed regulation will promote moral hazard and worse, do little about the problems posed by large banks -- he advocates that no bank be allowed to have assets worth more than 1 percent of U.S. gross domestic product. "The idea that you need to be over $100 billion to compete globally is absurd," he says, arguing that banks that are smaller won't need to be rescued if they fail. "When you've allowed everybody to build a house of cards, I don't have a plan for when the wind blows."

Frank finds these criticisms of the legislation's approach "very unfair," observing that the reform legislation also regulates derivatives, restricts sub-prime loans, increases bank capital standards, limits leverage, and would allow regulators to impose a Glass-Steagall-like separation of investment and commercial banking on financial institutions.

All of this, Frank says, will start to shrink the banks. But what if some new and terrible financial innovation comes along? Frank says this is the job of the proposed council of regulators. "The council decides that either a particular institution or a particular activity is threatening stability," Frank says. "If it's an activity like sub-prime loans, they order either a cessation or a severe restriction. If it's an institution, they say, 'You may not sell any more CDSs or whatever the future thing is. 'You have to double your capital; you have to divest yourself, like AIG just did, of this or that entity.' And if that doesn't work, and you are failing, fine; then, you are out of business. The CEO is fired, the board of directors is fired, the shareholders are wiped out."

Another insurance fund, paid for by banks, will cover initial costs of this liquidation process, which might include running the bank while unwinding its bad assets, according to Frank. This "dissolution authority," which many progressives hoped to apply to weakened banks last winter,  has already been the subject of complaints from Wall Street, which doesn't like the idea of being subject to the FDIC. Timothy Ryan, a securities-industry lobbyist, told Frank's committee that the FDIC system has "creditor-unfriendly rules."

"I said, yes, thank you, we want to be creditor unfriendly," Frank told the Prospect. "The more creditor friendly it is, the more [of a] moral hazard it is. We want creditors to be very nervous."

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