Now that the financial regulatory reform bills are progressing in both houses of Congress, it means that to really be on top of things, you not only have to read the bills, you have to read the amendments. One example is the Miller-Moore amendment (full text here), which passed the committee 34-32, only to run into criticism from Andrew Ross Sorkin and Yves Smith, among others, as well as defenses by Felix Salmon.
The amendment applies to cases where (a) a systemically important (TBTF) financial institution is taken over by the government and (b) the government has to take a loss on the transaction (that is, the assets cannot be liquidated for enough to cover the secured creditors and the insured depositors). In those cases, it says that the receiver can choose to treat up to 20% of a secured debt as unsecured. (A mortgage is an example of secured debt; if you can’t pay off your mortgage, the bank gets the house instead. For financial institutions, we are largely talking about repos — transactions where Bank A sells securities to Bank B and promises to buy them back later, which is effectively a secured loan from Bank B to Bank A — and collateral held provided by Bank A to Bank B when derivatives trades move against Bank A.)
Why? One reason is to recover some money for the taxpayer. In the last round of bailouts, the imperative of keeping creditors whole meant that gaps had to be filled by taxpayer money. But there are two forward-looking reasons as well. One cited by Representative Brad Miller himself (in a comment on Smith’s first post) is to deter counterparties from seizing more and more collateral in the last days of a financial institution’s death spiral. A related reason that Salmon discusses is to generally deter financial institutions from relying on repos for their funding needs, since repo funding can evaporate overnight; that’s part of what killed Bear Stearns and Lehman Brothers last year.
The concern that some people have, including Smith, is that the fear of a 20% haircut will cause repo funding to dry up sooner and faster than it otherwise would, possibly making banks more susceptible to runs. Miller addressed this fear in another comment. His first point is that the amendment might not even apply to repos, since repos are (on paper at least) sales with an agreement to repurchase, not debt. Even if it does apply, he argues that the amendment will only kick in “even after all shareholders, bondholders and general unsecured creditors lose everything.” The language of the amendment is “amounts realized from the resolution are insufficient to satisfy completely any amounts owed to the United States or to the Fund.” Since secured creditors’ claims can only be reduced after unsecured debt and uninsured deposits are written down to zero, it seems like we could only get to this point if a bank (a) were overwhelmingly funded by repos to begin with or (b) pledged all of its assets as collateral in a desperate attempt to raise cash right at the end. Furthermore, Miller says the haircuts would be discretionary, meaning that the receiver could choose not to impose them on creditors who had secured debt long before the crash (say, old-fashioned commercial mortgages).
I’m going to stop here, but I would like to give props to Miller for not only reading the blogs but bothering to weigh in on them multiple times. It makes you feel like we actually live in a participatory democracy.
By James Kwak