DealBook: The F.D.I.C.’s Lehman Fantasy

I was in Paris at an international insolvency conference when the Federal Deposit Insurance Corporation came out with a paper on how it would have resolved Lehman Brothers under the new resolution authority in the Dodd-Frank Act.

The response was uniform disbelief: “Ninety-seven percent to the unsecureds? Give me a break.”

And I was equally skeptical, for a return to unsecured creditors that high would be rare even in a nonfinancial Chapter 11 case. And for a failed investment bank, with large holdings of subprime mortgage backed securities, going into an insolvency process during a financial crisis, it seemed to strain credulity.

So upon my return, I spent some time carefully reading, and rereading, the F.D.I.C.’s 19-page document.

Some of the report suggests the F.D.I.C. would have achieved exactly what was achieved in the Chapter 11 case – a quick sale to Barclays – and some of the report seems to rest on pure fantasy. The last bit helps a lot if you want to pay creditors back in full.

And some of the report does highlight real differences between Chapter 11 and the Dodd-Frank resolution authority. But the report does not explain why those differences need persist or consider whether they are really as desirable as the report implies.

Of course, the F.D.I.C. might have no real interest in saying that we could achieve the same result under some modified version of the Bankruptcy Code. The “specialness” of financial institutions is better preserved by pretending the code will be as it always has been.

For example, the F.D.I.C. never really explains why derivatives are treated differently under Dodd-Frank than under Chapter 11. Indeed, the agency seems to justify the special treatment of derivatives in all cases where it causes problems for somebody other than the F.D.I.C.

Similarly, the report makes much of the high professional fees in Lehman, which come out of the bankruptcy estate, compared with an F.D.I.C.-run resolution process, where there presumably would be no such charges. But that facile comparison ignores the simple truth that Chapter 11 cases are self-funding, while the government subsidizes the F.D.I.C. Just because the agency would not charge the estate does not make the process free. Moreover, the true cost is the net cost after considering returns to creditors. If the F.D.I.C. returns substantially less to creditors, it may not really matter that they cost less.

But let’s address the ways in which the report simply restates what happened already in the Chapter 11 case. Many bankruptcy professionals who take the time to read the full report are apt to come away more than a bit annoyed.

The F.D.I.C. would have you believe that it is somehow a unique feature of the new resolution authority that losses are imposed on shareholders and assets are quickly transferred to a new buyer, with new money financing facilitating the whole thing. That sounds a lot like what happens in every big Chapter 11 case.

Indeed, the bits of the report that talk about how the Dodd-Frank resolution authority helps to facilitate the sale of a distressed firm’s “good” assets while allowing for the liquidation of the “bad” assets leaves one wondering if the F.D.I.C. has heard of the General Motors bankruptcy case. Or the Lehman bankruptcy case.

One major difference in the report is that the F.D.I.C. assumes that Barclays would have taken much of more of Lehman than it did. Here we are starting to get into the realm of wishful thinking.

For example, the report assumes that Barclays would have taken Lehman’s entire derivatives business. This is not based on any special provision of Dodd-Frank, but rather the idea that if counterparties knew they had a new, solvent counterparty (Barclays), they would not have any incentive to exercise their right to terminate.

If Barclays had said on Day One of the Chapter 11 cases that it was going to take Lehman’s derivatives business, you could have achieved the same result. But Barclays did not do this, and one has to wonder if it simply did not want Lehman’s derivative business. The F.D.I.C. never really explains how it might get Barclays to buy more of Lehman than it did.

Indeed, much of the F.D.I.C.’s analysis ultimately turns on the belief that “next time will be different.” Particularly, both the regulators and the management of Lehman would plan for Lehman’s insolvency in a way that did not happen in 2008.

Why this would be so is often a bit vague, based on little more than conclusory sentences like:

Lehman’s senior management and board may have been more willing to recommend offers that were below the then-current market price if they knew with certainty that there would be no extraordinary government assistance made available to the company and that Lehman would be put into receivership.

Basically, they’d know that federal regulators are not fooling around this time, because Dodd-Frank says so. But if management was deluded before, shouldn’t we assume they would be deluded again? And if the board failed to live up to its duties by planning for even the possibility of a Chapter 11 filing, why assume it would not make a similar failure in the F.D.I.C.’s alternative reality?

Yes, Dodd-Frank makes it harder to bail out a financial institution. But “harder” does not mean “impossible,” and that’s just the kind of thing that can fuel a lot of terminal optimism by managers of companies in financial distress.

And all this presumed regulatory involvement could have happened in 2008, too. It would not have been the F.D.I.C, but the Securities and Exchange Commission, as regulator of Lehman’s broker-dealer operation, or the Federal Reserve or the Treasury Department, as general overseers of the financial system, could have made some inquiries into Lehman’s planning for the worst-case scenario at some point before Sept. 14, 2008. Indeed, as the F.D.I.C. report notes, the New York Fed and the S.E.C. had been on site at Lehman from March 2008.

And let’s not forget that even if the F.D.I.C. had authority over Lehman at that time, it just might have been a bit distracted by Washington Mutual, Wachovia, Citigroup and the other troubled banks that were its normal focus.

More generally, given all that we’ve been through in the last few years, it seems more than a little odd that regulatory competence should be taken for granted.

And then there is the matter of the 97 percent return to unsecured creditors. How does F.D.I.C. come up with that figure? Well, first we must assume that the only Lehman assets that lose any value in the fall of 2008 are the $50 billion to $70 billion of “suspect” assets.

Everything else remains stable during and despite the resolution, and the suspect assets decline by $40 billion. These suspect assets are ones that several other financial institutions refused to touch – not simply refused to buy at par value, but rather refused to buy at all.

Then Barclays pays 100 percent for Lehman’s assets, apparently despite there being no competing bidder.

So, you see, if you assume very stable asset values during a financial crisis and a buyer that is quite generous, it is quite easy to get to a very high recovery for creditors. Unfortunately, Weil and Alvarez have to deal with a somewhat different reality.

Once a financial firm has become in need of resolution, there has already been a failure of regulation. Why the same regulators should be in charge of cleaning up the mess is something that continues to puzzle me. Certainly they deserve a say, and the special nature of financial institutions will often call for special solutions, but count me among those who remain unconvinced by the very “in house” solution adopted by Dodd-Frank.

Article source: http://feeds.nytimes.com/click.phdo?i=400740607f8f5336e9f481bcdb4f71cd