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Magical Thinking at the FDIC--Skeel

The FDIC has just released a report speculating about how Lehman’s crisis would have been handled if the Dodd-Frank Act had been in place in 2008. As the report imagines it, the FDIC would have intervened early in the crisis, and guided Lehman to a soft landing that got the utmost value for the business. The FDIC “could have participated in a meeting in the spring of 2008, together with [other regulators], to outline the circumstances that would lead to the appointment of the FDIC as receiver.” The FDIC could have parachuted in and conducted on-site oversight on Lehman’s premises from that point forward.   The FDIC could have prodded Lehman to sell itself or, if “Lehman were unable to sell itself, the FDIC would have commenced with marketing Lehman.” Once Lehman was taken over pursuant to the new resolution rules, the FDIC “would have minimized losses and maximized recoveries,” assuring that Lehman’s general creditors recovered roughly 97% of what they are owed—as compared to the roughly 20% they are likely to get in the actual bankruptcy case.

Heroic assumptions abound, such as an assumption that the counterparties to Lehman’s derivatives would have been fully collateralized. Most heroic of all is the suggestion that the FDIC would have deftly nudged Lehman to plan for its demise, and that the FDIC would be able to handle a resolution on this scale.   The Dodd-Frank Act does include provisions that could improve regulators’ oversight in the future, such as its requirement that systemically important institutions prepare a “living will” (or “rapid resolution plan,” in Dodd-Frank terminology) that explains how the institution would respond to a crisis. But the claims that regulators will intervene early in a future crisis rather than delaying the inevitable (that “next time will be different,” to paraphrase the title of a recent book on financial crises), and that they’ll foreswear future bailouts because Dodd-Frank says they aren’t supposed to do them, are wildly implausible.
 
Perhaps the most interesting question is why the FDIC would write a report that could prompt guffaws from financial experts. Two possible reasons come to mind. First, the FDIC made these kinds of claims throughout the debates that led to Dodd-Frank, and somehow they worked. The FDIC was given extraordinary new powers under the new resolution rules, even though the FDIC’s track record in handling large cases is not good. Second, the FDIC has been floundering in its efforts to implement Dodd-Frank’s new requirements. It may be that the report is designed to distract attention away from growing fear that the living will requirement will not be effectively implemented, and that the resolution rules are a disaster.

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Comments ( 2 )

I have just discovered this blog. I cannot believe it took me this long. I have a lot of catching up to do. I am sorry for the loss of your dear friend, and wished that I could have tracked with him during his time here with us on this blog. I look forward to getting to know both of you!

A statement that the FDIC would insure investment banks, and offer the creditors of Lehman a 97% return, is ***inaccurate and unethical***. The government should be very clear when it uses the word "guarantee". What if someone purchases Lehman debt because they misunderstood the statement and really thinks the FDIC will pay off the debt?

Lehman failed because of careless management, and poor board oversight over management. The company financed its assets with $33 dollars of debt for every $1 of equity. This means that a 3% drop in assets would effectively dissolve the company, triggering bond default covenants and probably preventing the company from accessing capital. Lehman's management should have been more careful and considered the expected losses of their assets (especially when those assets were filled with subprime mortgages, during a time when the Bush Administration repeatedly warned the public of the impending mortgage meltdown).

Lehman's board should have nominated qualified and effective executive managers who could better control the company's financial and business risks. In addition, shareholder rights plans like cumulative voting would have given activist investors the power to nominate experienced board members by allowing them to pool all of their votes for a single candidate.

I am appalled by the company's lack of leadership during a period of financial instability.