[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]
BANKRUPTCY CODE AND
FINANCIAL INSTITUTION INSOLVENCIES
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
REGULATORY REFORM,
COMMERCIAL AND ANTITRUST LAW
OF THE
COMMITTEE ON THE JUDICIARY
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRTEENTH CONGRESS
FIRST SESSION
__________
DECEMBER 3, 2013
__________
Serial No. 113-59
__________
Printed for the use of the Committee on the Judiciary
Available via the World Wide Web: http://judiciary.house.gov
----------
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COMMITTEE ON THE JUDICIARY
BOB GOODLATTE, Virginia, Chairman
F. JAMES SENSENBRENNER, Jr., JOHN CONYERS, Jr., Michigan
Wisconsin JERROLD NADLER, New York
HOWARD COBLE, North Carolina ROBERT C. ``BOBBY'' SCOTT,
LAMAR SMITH, Texas Virginia
STEVE CHABOT, Ohio MELVIN L. WATT, North Carolina
SPENCER BACHUS, Alabama ZOE LOFGREN, California
DARRELL E. ISSA, California SHEILA JACKSON LEE, Texas
J. RANDY FORBES, Virginia STEVE COHEN, Tennessee
STEVE KING, Iowa HENRY C. ``HANK'' JOHNSON, Jr.,
TRENT FRANKS, Arizona Georgia
LOUIE GOHMERT, Texas PEDRO R. PIERLUISI, Puerto Rico
JIM JORDAN, Ohio JUDY CHU, California
TED POE, Texas TED DEUTCH, Florida
JASON CHAFFETZ, Utah LUIS V. GUTIERREZ, Illinois
TOM MARINO, Pennsylvania KAREN BASS, California
TREY GOWDY, South Carolina CEDRIC RICHMOND, Louisiana
MARK AMODEI, Nevada SUZAN DelBENE, Washington
RAUL LABRADOR, Idaho JOE GARCIA, Florida
BLAKE FARENTHOLD, Texas HAKEEM JEFFRIES, New York
GEORGE HOLDING, North Carolina
DOUG COLLINS, Georgia
RON DeSANTIS, FLORIDA
JASON T. SMITH, Missouri
Shelley Husband, Chief of Staff & General Counsel
Perry Apelbaum, Minority Staff Director & Chief Counsel
------
Subcommittee on Regulatory Reform, Commercial and Antitrust Law
SPENCER BACHUS, Alabama, Chairman
BLAKE FARENTHOLD, Texas, Vice-Chairman
DARRELL E. ISSA, California STEVE COHEN, Tennessee
TOM MARINO, Pennsylvania HENRY C. ``HANK'' JOHNSON, Jr.,
GEORGE HOLDING, North Carolina Georgia
DOUG COLLINS, Georgia SUZAN DelBENE, Washington
JASON T. SMITH, Missouri JOE GARCIA, Florida
HAKEEM JEFFRIES, New York
Daniel Flores, Chief Counsel
James Park, Minority Counsel
C O N T E N T S
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DECEMBER 3, 2013
Page
OPENING STATEMENTS
The Honorable Spencer Bachus, a Representative in Congress from
the State of Alabama, and Chairman, Subcommittee on Regulatory
Reform, Commercial and Antitrust Law........................... 1
The Honorable Steve Cohen, a Representative in Congress from the
State of Tennessee, and Ranking Member, Subcommittee on
Regulatory Reform, Commercial and Antitrust Law................ 6
The Honorable Bob Goodlatte, a Representative in Congress from
the State of Virginia, and Chairman, Committee on the Judiciary 8
WITNESSES
Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond
Oral Testimony................................................. 10
Prepared Statement............................................. 13
Donald S. Bernstein, Co-Chair, Insolvency and Restructuring
Group, Davis Polk and Wardell L.L.P.
Oral Testimony................................................. 67
Prepared Statement............................................. 72
Mark J. Roe, Professor of Law, Harvard Law School
Oral Testimony................................................. 91
Prepared Statement............................................. 94
LETTERS, STATEMENTS, ETC., SUBMITTED FOR THE HEARING
Material submitted by the Honorable Spencer Bachus, a
Representative in Congress from the State of Alabama, and
Chairman, Subcommittee on Regulatory Reform, Commercial and
Antitrust Law.................................................. 2
APPENDIX
Material Submitted for the Hearing Record
Prepared Statement of the Honorable Spencer Bachus, a
Representative in Congress from the State of Alabama, and
Chairman, Subcommittee on Regulatory Reform, Commercial and
Antitrust Law.................................................. 116
Prepared Statement of the Honorable Steve Cohen, a Representative
in Congress from the State of Tennessee, and Ranking Member,
Subcommittee on Regulatory Reform, Commercial and Antitrust Law 119
Prepared Statement of the Honorable Bob Goodlatte, a
Representative in Congress from the State of Virginia, and
Chairman, Committee on the Judiciary........................... 119
Prepared Statement of the Honorable John Conyers, Jr., a
Representative in Congress from the State of Michigan, and
Ranking Member, Committee on the Judiciary..................... 120
Response to Questions for the Record from Jeffrey M. Lacker,
President, Federal Reserve Bank of Richmond.................... 121
Response to Questions for the Record from Mark J. Roe, Professor
of Law, Harvard Law School..................................... 123
BANKRUPTCY CODE AND FINANCIAL INSTITUTION INSOLVENCIES
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TUESDAY, DECEMBER 3, 2013
House of Representatives,
Subcommittee on Regulatory Reform,
Commercial and Antitrust Law
Committee on the Judiciary,
Washington, DC.
The Subcommittee met, pursuant to call, at 1:54 p.m., in
room 2141, Rayburn Office Building, the Honorable Spencer
Bachus (Chairman of the Subcommittee) presiding.
Present: Representatives Bachus, Goodlatte, Marino,
Holding, Collins, Smith of Missouri, Cohen, DelBene, and
Garcia.
Staff present: (Majority) Anthony Grossi, Counsel; Ashley
Lewis, Clerk; and (Minority) James Park, Minority Counsel.
Mr. Bachus. Well, good afternoon.
The Subcommittee on Regulatory Reform, Commercial and
Antitrust Law hearing will come to order.
Without objection, the Chair is authorized to declare
recesses of the Committee at any time. And, if we have votes,
we will recess for those votes.
Now, I will recognize myself for an opening statement.
I would like to enter into the record the Committee memo
that was prepared for this hearing. In my view, it is an
excellent overview of the issues involved with improving the
Bankruptcy Code in its role as a primary mechanism for dealing
with distressed or insolvent financial institutions.
[The information referred to follows:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
__________
Mr. Bachus. One of our witnesses today is the president of
the Federal Reserve Bank of Richmond, Jeffrey Lacker. And let
me say that there are statistics in an essay prepared by the
Richmond Fed that underscore the importance of what we are
talking about. And let me read from the essay directly.
And I quote, this was I think 2011 essay and it was on
``too big to fail.'' According to--and I quote, ``according to
Richmond Fed estimates, the proportion of total U.S. financial
firms liabilities covered by the Federal financial safety net
has increased by 27 percent during the past 12 years. The
safety net covered $25 trillion in liabilities at the end of
2011 or 57.1 percent of the entire financial sector. Nearly two
thirds of the support is implicit and ambiguous.''
And I think you see that two-thirds portion when we talk
about Lehman and Bear Stearns. Where Bear Stearns received
financial support from the government several months later.
People are thinking, maybe that it is implied, that they will
do the same thing with Lehman. And it didn't happen. And one of
the results was people didn't prepare for it. It surprised
people. And the uncertainty that ensuring--the government, the
taxpayer ensuring that large portion of the financial assets of
our country, the great majority, and then two thirds of that
support being iffy is, I think, is a condition that all of us,
in a bipartisan way, ought to be concerned about.
Those are very significant financial liabilities to place
on the Federal Government and ultimately on taxpayers. It is a
structure that can tilt the field toward government
intervention and bailouts. In my view, statistics like this
strengthen the case for improving the bankruptcy process so
that risks are borne by private parties and cases are handled
in a consistent way, based on established precedent and rule of
law.
And let me say, this hearing is not about Dodd-Frank. But
Dodd-Frank actually set up the mechanism for utilization of
bankruptcy. So this hearing is not an attempt to substitute
something for Dodd-Frank. In fact, Dodd-Frank called for a GAO
hearing and Fed studies on how to improve bankruptcy. So,
nothing we are saying today is an indictment of Dodd-Frank. In
fact, ``living wills'' have been one of the few things that I
think almost everyone, in a bipartisan way, has said that was a
good thing. Although there is a--we discussed earlier
witnesses, you have to be cautious that you don't set up a
corporation structure as if it is going to bankrupt. But you
ought to--there ought to be planning of what you are going to
do in the case there is a bankruptcy.
With that, let me recognize the Ranking Member of the
Subcommittee, Mr. Cohen of Tennessee, for his opening
statement.
Mr. Cohen. Thank you, Mr. Chair.
And I couldn't not start this hearing without
congratulating you on your Auburn victory. What an unbelievable
game. And you were there. I would like to yield to you. Would
you tell us--we heard what the Auburn announcer said, when the
kick was returned. Can you tell us what you said as the kick
was returned? [Laughter.]
Mr. Collins. The Alabama perspective was, ``Oh, God.''
Mr. Cohen. And the Auburn perspective was, ``Thank God?''
[Laughter.]
Mr. Bachus. Well, you know, I am--having represented
Tuscaloosa County, the home of the University of Alabama for 20
years, I am not all that vocal sometimes. But, I was thinking
how lucky Auburn had been two games in a row. And I thought
that after that immaculate catch against Georgia that we had
had all the luck we deserved. But, we got some more of it. It
was something to see.
Mr. Cohen. But, what did you say? Did you say anything at
all? I mean----
Mr. Bachus. No. I sort of had that expression, if you seen
number 56, that freshman at Auburn that has been on ESPN
where---- [Laughter.]
He is trying to put this all together. That's what we did.
My wife is a University of Alabama graduate too. So----
Mr. Cohen. That was a smart move on your part.
Mr. Bachus. So, I was telling her how sorry I was. But she
knew I wasn't very sincere. [Laughter.]
Mr. Cohen. You are the kind of the opposite of McKaren and
his girlfriend.
Mr. Bachus. Yeah, she is an Auburn brat.
Mr. Cohen. I know it.
Mr. Bachus. That is how it is going to be. [Laughter.]
All right.
Mr. Cohen. Did you go to Toomer's Corner and throw toilet
paper?
Mr. Bachus. No. You know what, an Alabama fan poisoned
those trees and killed them. That is true, I don't know if you
knew that.
Mr. Cohen. They pled guilty and should have gone to jail
for a long time.
Mr. Bachus. Yeah.
Mr. Cohen. Bad guy.
Mr. Bachus. But the---- [Laughter.]
That is actually--that is true he went--but, you know, he
was responding to Auburn students putting an--after the 2010
victory over Alabama, Cam Newton, they put an Auburn jacket on
Bear Bryant's statute. So, he felt like that was----
Mr. Cohen. That was disrespectful.
Mr. Bachus. Yes.
Mr. Cohen. But, not worthy of killing trees.
Mr. Bachus. No, they didn't kill Bear Bryant's statue.
Mr. Cohen. Innocent there.
Mr. Bachus. All right. I am sorry.
Mr. Cohen. Back to Dodd-Frank---- [Laughter.]
Which I voted for and proudly then, and support to this day
and continue to.
Its passage by Congress in 2010 was an acknowledgment that
insufficient regulation led to the problem of the so-called
``too big to fail'' financial institutions. Those were
institutions that became so big and so interconnected that
their insolvencies threatened to paralyze the entire financial
system and the economy of the world. This situation in turn
resulted in extreme pressure for taxpayer bailouts when those
institutions fell under financial stress. And the bill, I
think, was somewhat bipartisan, pretty bipartisan to save the
country and bail out the banks because we had to.
The bankruptcy filing of Lehman Brothers in 2008, which was
the largest bankruptcy in our history, involved more than $600
billion in assets and illustrates this problem. The bankruptcy
filing greatly exacerbated the financial panic on Wall Street,
leading to a severe crisis in the greatest economic downturn
since the Great Depression, now we call it the Great Recession.
The financial markets' reaction to Lehman Brothers' bankruptcy
highlighted potential limitations of the Bankruptcy Code in
handling the resolution of these financially distressed
institutions and the systemic effect they would have on
financial institutions in general. Dodd-Frank has certain
enhancements in it that are strong ways that we have dealt with
and responded to that problem.
I support legislation to increase the minimum required
amount of capital for covered financial institutions under
Dodd-Frank. We should also consider the potential need for
other enhancements like adding a representative of the
Antitrust Division of the Department of Justice to the
Financial Stability Oversight Council, which was created by
Dodd-Frank to oversee the stability of the financial system.
It is in this spirit that I approach today's hearing, which
will focus on whether current Bankruptcy Code is sufficient to
allow for the early reorganization or liquidation of
systemically important financial institutions under title I of
Dodd-Frank.
Whether one supports or doesn't support Dodd-Frank, we can
agree that today's inquiry is an important one to the extent
that modest revisions to the Bankruptcy Code will help ensure
that we avoid the need for additional future taxpayer bailouts
of financially struggling large financial institutions. We
should be able to work together in crafting such changes.
Just as the Chairman of the full Committee brought us
together on patent reform, I feel confident that the Chairman
of the Subcommittee, that great Auburn war eagle, can bring us
together on something to solve this problem too.
With that, I yield back the balance of my time.
Mr. Bachus. I thank Mr. Cohen for that opening statement.
And, at this time, I recognize Chairman Goodlatte, the full
Committee Chairman.
Mr. Goodlatte. Well, thank you, Mr. Chairman. I appreciate
your holding this hearing.
The Bankruptcy Code has existed in this country for well
over a hundred years. Over this time, our bankruptcy system has
evolved to become one of the most sophisticated regimes in the
world. The bedrock principle embedded in the bankruptcy system
of providing for the efficient resolution and reorganization of
operating firms, has allowed our economy to grow and flourish.
Nevertheless, a periodic evaluation of the Bankruptcy Code to
ensure its adequacy to address the challenges posed by the
changing nature of operating firms, is one of the fundamental
responsibilities of this Committee.
I applaud Chairman Bachus for holding today's hearing to
examine whether the existing Bankruptcy Code is best equipped
to address the insolvency of large and small financial
institutions.
The bankruptcy process confers a number of benefits to all
operating companies, including financial firms. The bankruptcy
court provides transparency and due process to all parties
involved. Furthermore, bankruptcy case law has been developed
over decades providing consistency and predictability.
Additionally, the bankruptcy process has been sufficiently
dynamic to administer the resolution and restructuring of
complex operating companies with billions of dollars in assets,
as well as smaller companies and individuals.
But, despite the bankruptcy system's ability to accommodate
complex operating companies, financial firms may possess unique
characteristics that are not yet optimally accounted for in the
Bankruptcy Code. For example, efficient and orderly resolution
of financial firms can require an unusual level of speed.
Refinements to the code might be considered to provide--to
better provide that speed, while still assuring due process.
Additionally, in some circumstances, the failure of financial
firms can pose unique threats to the broader stability of the
economy. To account for that, title I of the Dodd-Frank Wall
Street Reform and Consumer Protection Act requires certain
firms to prepare ``living wills'' to plan for resolution in
bankruptcy in the event of failure.
The Bankruptcy Code is well crafted to maximize the
recoveries of a debtor's creditors, while providing an
opportunity for the debtor to either reorganize or liquidate in
an orderly fashion. It might, however, bear improvements
designed specifically for the efficient execution of title I
living wills. There are some of the--these are some of the
issues that may need to be examined as part of the broader
evaluation of the existing Bankruptcy Code's adequacy to
address financial institution insolvencies.
I look forward to the testimony from today's excellent
panel of witnesses on these important issues.
And, Mr. Chairman, I thank you and yield back the balance
of my time.
Mr. Bachus. I thank you.
And without objection, other Members' opening statements
will be made a part of the record.
And I do agree with the Chairman when he says that we have
an excellent panel of witnesses, because we do have three of--
really people that, in a bipartisan nature, we consider experts
on bankruptcy and how it can be enhanced to address complex
situations.
I will first begin by introducing our witnesses.
Governor Lacker is the current president of the Federal
Reserve Bank of Richmond, where he began his term on August
1st, 2004. Prior to serving as the president of the Richmond
Federal Reserve, he was a research economist with the bank for
25 years, serving in various capacities including vice
president, senior vice president and director of research. He
is the author of numerous articles and professional journals on
monetary financial and payment economics. And he has presented
his work at universities and central banks worldwide. He
received his BA in economics from Franklin and Marshall
College, and a doctorate in economics from the University of
Wisconsin.
Mr. Bernstein, Donald Bernstein, is a partner of Davis Polk
here in Washington. Is that right or New York? New York, okay.
Where he heads the firm's insolvency and restructuring
practice. During his distinguished 35-year career, he has
represented nearly every major financial institution in
numerous restructuring, as well as leading a number of
operating firms through bankruptcy including Ford, LTV Steel,
and Johns Manville. Mr. Bernstein has earned multiple honors
for his practice including being elected by his peers as the
chair of the National Bankruptcy Conference, the most
prestigious professional organization in the field of
bankruptcy. Mr. Bernstein received his AB cum laude from
Princeton University and his JD from the University of Chicago
Law School. And we welcome you.
Professor Mark Roe is a professor of law at Harvard Law
School where he teaches business bankruptcy and corporations
courses. Professor Roe has authored countless articles and
opinion pieces that have been published across the globe
including in the law reviews and--the law reviews of Penn,
Virginia, Columbia, Michigan, Stanford, Yale, and Harvard. He
also literally wrote the book on corporate restructuring that
is used in law schools across the country. Prior to joining
Harvard's faculty, Professor Roe taught law at Columbia
University, the University of Pennsylvania and Rutgers
University. Prior to joining academia, he worked at the law
firm of Cahill Gordon and at the Federal Reserve. Professor Roe
received his BA from Columbia University summa cum laude, and
his JD from Harvard Law School.
Each of the witnesses' written statements will be entered
into the record in its entirety. I ask that each of the
witnesses summarize his testimony or her testimony. I am not
going to restrict you to 5 minutes, I think it is too
important. If you go over that, that is fine.
And so I am not going to read this about the light and all
that.
So, we--at this time, Governor Lacker, you are recognized
for your opening statement.
TESTIMONY OF JEFFREY M. LACKER, PRESIDENT,
FEDERAL RESERVE BANK OF RICHMOND
Mr. Lacker. Thank you, good morning.
I am honored to speak to the Subcommittee about why I
believe it is important to improve our Bankruptcy Code to make
it easier to resolve failing financial firms in bankruptcy.
At the outset I should say that my comments reflect my own
views and do not necessarily reflect those of the Board of
Governors or my other colleagues at other Federal Reserve
banks.
I think the events of 2008 provide strong evidence of
glaring deficiencies in the way financial institution distress
and insolvency are handled, particularly at large institutions.
The problem, widely known as ``too big to fail,'' consists of
two mutually reinforcing expectations.
First, many financial institution creditors feel protected
by an implicit government commitment of support should the
institution face financial distress. This belief dampens
creditors' attention to risk and it leads to overuse of types
of borrowing such as short-term wholesale funding that are more
fragile, more prone to runs, more prone to volatility.
The second of these two mutually reinforcing expectations
is that if a large financial firm is highly dependent on short-
term funding, policymakers are often unwilling to let it file
for bankruptcy under the U.S. Bankruptcy Code fearing that it
would result in undesirable effects on counterparties. This
fear leads policymakers to intervene in ways that allow short-
term creditors to escape losses such as through central bank
lending or public sector capital injections.
This behavior just reinforces creditors' expectations of
support. That in turn reinforces firms' incentives to grow
large and their incentive to rely on short-term funding which
in turn reinforces policymakers' proclivity for intervening to
support creditors. The result is more financial fragility and
more rescues. The path toward a stable financial system
requires that policymakers have confidence in the unassisted
failure of financial firms under the U.S. Bankruptcy Code and
that investors are thereby convinced that unassisted bankruptcy
is the norm. This is why I believe it is vitally important to
ensure that our bankruptcy laws are well crafted to apply to
large financial institutions.
In response to the experience of 2008, title I of the Dodd-
Frank Act laid out a planning process for the resolution of
failed financial institutions. A resolution plan or ``living
will,'' as they are popularly called, is the description of a
firm's strategy for rapid and orderly resolution under the U.S.
Bankruptcy Code without government assistance. It spells out
the firm's organizational structure, key management information
systems, critical operations, and a mapping of the relationship
between core business lines and legal entities. The heart of
the plan is the specification of the actions the firm would
take to facilitate rapid and orderly resolution and prevent
adverse effects of failure, especially the firm's strategy to
maintain critical operations and funding.
The Federal Reserve and the Federal Deposit Insurance
Corporation can jointly determine that a plan is ``not
credible'' or would not facilitate the orderly resolution--an
orderly resolution under the Bankruptcy Code. And, in that
case, the firm would be required to submit a revised plan to
address deficiencies. If the Fed and the FDIC jointly determine
that the revised plan does not remedy identified deficiencies,
they can require more capital, increase liquidity requirements,
reduce reliance on short-term funding, or restrict the growth,
activities or operations of the firm. In essence, regulators
can order changes in the structure and operations of a firm to
make it resolvable in bankruptcy without government assistance.
Note the implication here that if a firm would require, the
way it is running itself now, an unrealistically large amount
of ``debtor-in-possession'' financing, regulators can require
ex ante, pre-bankruptcy changes in the firm's funding structure
so that plans for funding operations in bankruptcy are
realistic and credible.
Title II of the Dodd-Frank Act gives the FDIC the ability
to take a firm into receivership under its so-called ``Orderly
Liquidation Authority,'' if there is a determination that the
firm's failure under the U.S. Bankruptcy Code would have
serious adverse effects on U.S. financial stability. Title II
receivership differs from the Bankruptcy Code in that the FDIC
would have the ability to borrow funds from the U.S. Treasury
to support creditors, and would have broad discretion to treat
similarly situated creditors differently. This is likely to
replicate the two mutually reinforcing expectations that define
``too big to fail.'' And this is why improving the Bankruptcy
Code to facilitate orderly resolution of large financial firms
is so important. It would position us to wind down the Orderly
Liquidation Authority at an appropriate time and to wind down
other financing mechanisms such as the Federal Reserves'
remaining 13(3) powers to lend in ``unusual and exigent
circumstances.''
Without winding these down, I think that those mutually
reinforcing conditions are likely to arise again. Expectations
of support, in the absence of clear guidance as to when and
where support will be forthcoming, will encourage excessive
risk taking. That risk taking will trap policymakers. It will
put them in a box and force them to respond with rescues and
support, in the event of distress.
The Dodd-Frank Act itself clearly envisions bankruptcy
without government support as the first and most preferable
option in the case of a failing financial institution, and for
good reason, in my view. The expectation of resolution in
bankruptcy without government support would result in a much
better alignment between the incentives of market participants
and our public policy goal of a financial system that
effectively allocates capital and risk.
Thank you very much.
[The prepared statement of Mr. Lacker follows:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
__________
Mr. Bachus. Thank you.
Mr. Bernstein?
TESTIMONY OF DONALD S. BERNSTEIN, CO-CHAIR, INSOLVENCY AND
RESTRUCTURING GROUP, DAVIS POLK AND WARDELL L.L.P.
Mr. Bernstein. Well, thank you for inviting me to testify.
I have spent a lot of my practice life dealing with the
failures of financial institutions, starting with Drexel
Burnham many years ago. And, in recent years, I have done a lot
of work on resolution plans, ``living wills.''
I too am here in my individual capacity, however, and the
views I express are my own. They are not to be attributed to my
firm or clients or organizations with which I am affiliated.
I want to begin with a few observations about the Lehman
Brothers bankruptcy and its implications for the bankruptcy of
other large financial institutions. Then I am going to provide
a bit of an overview of how orderly liquidation authority is
being contemplated to be used, including the single point of
entry resolution strategy that has been developed by the FDIC.
And then, I am going to turn to the Bankruptcy Code and talk a
bit about how resolution planning has interfaced with the
Bankruptcy Code in its current form. And I will end with a few
suggestions as to the way the code might be amended to make it
easier to resolve financial firms.
The unplanned failure of Lehman Brothers as we all know had
an enormously disruptive effect on the U.S. economy. Financial
firms are very vulnerable to a loss of confidence. Even if
their economic fundamentals haven't changed once the confidence
is lost because they are in the business of so-called maturity
transformation. They incur short-term liabilities like deposits
and some of the other short-term liabilities that were just
mentioned and they invest them in long-term assets like
mortgages and corporate loans and the like. And when short-term
creditors lose confidence they run. They take their money and
they run.
And if a run is prolonged and intense, it can force the
firm to sell assets at fire-sale prices and distress markets
and exacerbate any losses that might otherwise exist. And that
also results in depressing market values generally, which has a
follow-on effect to other firms. So, if you have this process
of unwinding of maturity transformation from what it has been
called, ``contagious panic,'' you end up with a very
destabilizing situation. And, in fact, that is how Lehman
Brothers' unplanned failure actually unfolded.
Now, to avoid this disrupt--this abrupt unraveling of
maturity transformation, distressed firms need to be able to
meet sudden liquidity needs without being forced to abruptly
sell their assets. And, over the longer term, they need to be
able to either be recapitalized or wound down in an orderly way
that doesn't create the risk of fire sales of assets. In 2008,
neither the regulators nor the firms had the tools to
accomplish these goals without financial support from
taxpayers. And though the large institutions ended up repaying
those investments, there was wide recognition that more tools
were needed to avoid having taxpayer funds put at risk again.
Many regulators and commentators believe that some of the
tools that are being developed, under title II of Dodd-Frank,
actually accomplish this goal. And I am going to describe the
single point of entry tool, which is the most--the one that is
most frequently discussed. In a single point of entry
resolution, only the holding company for the financial
institution is put into an insolvency or receivership
proceeding. All of the losses are borne by the holding
companies, creditors and shareholders. And the operating
subsidiaries, like the bank or the broker-dealer, wouldn't
fail. They would be recapitalized using assets that are
maintained for that purpose at the holding company and they
would continue in business as a newly created--as subsidiaries
of a newly created holding company which, under orderly
liquidation authority, is called a bridge holding company.
There are a number of reasons why many people think this
approach has some viability. The first is that the holding
company structure used by large financial institutions creates
an additional layer of loss-absorbing debt that is effectively
subordinated to operating liabilities and especially the short-
term liabilities that were just mentioned that are down in the
operating subsidiaries. The firms have also substantially
increased the amount of loss-absorbing capital and debt that
are in the holding companies and new rules are expected to be
forthcoming that require them to maintain sufficient loss-
absorbing debt and assets at their holding companies. So
financially the firms should be in a position to execute the
type of recapitalization that is being contemplated with all of
this additional loss absorbency that they have.
In addition, because the firm's operating subsidiaries keep
in business, single point of entry eliminates the need for
multiple insolvency proceedings for different entities, both
domestically and in foreign countries, which greatly reduces
the complexity of the resolution process. That was one of the
big problems in Lehman Brothers. You had a siloing of each
entity, one from the other, that resulted in the inability to
effectively resolve because you had too many people, too many
parties to consult with and the inability to deal with entities
on a regular-way basis.
To supplement this, there have been initiatives on a
multinational level including those at the Financial Stability
Board and crisis management groups that have been organized by
key regulators of individual firms that are creating increased
alignment among the national regulatory authorities regarding
the benefits of what are called single point of entry and bail-
in approaches to the failure of financial firms. And this is
evidenced by joint work that has been done by the FDIC and the
Bank of England on the subject.
Finally and importantly, orderly liquidation authority does
include certain special tools that are not currently available
under the Bankruptcy Code. And that is going to lead me into my
discussion of bankruptcy. But, those tools really are not
that--there aren't that many of them. There are three very
important ones.
One is the clear path that orderly liquidation authority
provides to creating a bridge holding company and transferring
the stock of recapitalized subsidiaries to the bridge holding
company. That separates them from the debt and the equity of
the old holding company and effectively creates a recapitalized
entity.
The second important feature is the orderly liquidation
fund which is underwritten by the private sector and provides
fully secured interim liquidity, if needed, to stabilize the
recapitalized firm.
And the third is the preservation of financial contracts by
briefly staying closeouts and having provisions that override
cross-defaults and bankruptcy defaults so the contracts can be
assumed by the ongoing entities. Again, a problem that was
faced in Lehman Brothers because of the safe harbors in the
Bankruptcy Code.
Recognizing that progress is being made in developing the
single point of entry strategy, just a couple of weeks ago,
Moody's Investor Service announced that it was removing the two
notch uplift provided to ratings of debt of the largest bank
holding companies to account for the possibility of government
support. Effectively, they have reached the conclusion that
that government support is going to be unnecessary because of
the progress that is being made on resolution.
So, let us turn to the Bankruptcy Code now. I agree
completely that traditional bankruptcy proceedings do provide a
path that, despite the Lehman Brothers' experience, can be
utilized to resolve financial firms provided that there is
appropriate preplanning. The Bankruptcy Code provides
transparency. It provides the opportunity for effected parties
to receive notice and be heard in court and ex ante judicial
review prior to major actions. All of which serve to inspire
market confidence. And, if you talk to people who are
investors, all of them like--uniformly like the Bankruptcy
Code. They like the transparency.
In my view, these are clear benefits of the bankruptcy
process. However, the absence of the special tools available
under orderly liquidation authority makes it harder for
financial firms in bankruptcy to utilize a single point of
entry strategy. As a result, the title resolution--title I
resolution plans typically adopt a hybrid approach in which
some operating businesses are contemplated to be sold or
recapitalized, while others are allowed to wind down in an
orderly way. First, the resolution plans identify the material
operating entities that, because of their capital structure or
the nature of their business, are unlikely either to suffer
losses or that can be recapitalized as they would be under
orderly liquidation authority.
And then, there are tools, such as Section 363 of the
Bankruptcy Code that can be used to accomplish a speedy sale or
transfer of the stock of those entities that are not going to
fail to a debt-free holding company or to a third party. And
the debt-free holding company might be owned by a trust for the
creditors of the bankruptcy estate so that the creditors in
fact are not losing value, but they are actually preserving the
going concern value and it is being held for their benefit by a
fiduciary. The new holding company can then be sold in private
transactions or public transactions, pieces of it can be sold
or its shares can be distributed to the left-behind creditors
in a conventional Chapter 11 plan of reorganization.
This is all possible under the current code. Now, entities
that can't be sold or recapitalized need to be wound down in an
orderly way. And the wind downs need to be carefully planned
taking into account the impact of the different insolvency
regimes; the reactions of regulators, customers,
counterparties, financial market utilities, and others that
need to be anticipated in the resolution plan. Liquidity needs,
through the wind down, need to be conservatively anticipated
and the maintenance of shared services and technology, and the
transition of critical operations to other firms, and the
distribution of customer assets and property need to be
provided for.
Today, liquidity levels at the firms allow them to sustain
in addition a pre-failure runoff of some of their balance
sheet. You may recall that in 2008 one of the problems that
faced Lehman Brothers was----
Mr. Bachus. Let me----
Mr. Bernstein. Sorry.
Mr. Bachus. We have a pending vote series----
Mr. Bernstein. Okay.
Mr. Bachus [continuing]. On the House floor. So, we are
going to stand in recess. We will come back and I will allow
Mr. Bernstein to complete that very good opening statement.
And the Committee stands in recess, subject to the call of
the Chair.
And we ask Members to return immediately so we may resume
the hearing as soon as possible. And we anticipate doing that
fairly soon, but the staff will keep you abreast.
Thank you.
[Recess.]
Mr. Bachus. We will go ahead and commence the hearing so
that the Committee is called to order.
And, Mr. Bernstein, you are recognized for your----
Mr. Bernstein. Thank you, Mr. Chair.
So, I was just describing how the resolution plans seem to
be evolving into hybrid strategies involving continuation of
some entities and wind down of others. And I was giving an
example of how today, with the liquidity levels that the firms
have, some of that wind down can actually happen prior to
failure because they have got the ability to address
liabilities that are running for a period of time because of
the liquidity on their balance sheets. And I was mentioning the
example of prime brokerage accounts, which were one of the
precipitating liquidity factors in Lehman's bankruptcy. And
that is something that can be planned for. And it can actually
make the resolution process less complex and less systemically
disruptive.
And I also note in my written statement a number of other
ways that the plans contemplate taking steps, either well in
advance or immediately prior to the failure of the firm, to
reduce the complexity of the wind downs of entities that are
not being recapitalized or sold.
So, to summarize, the title I plans rely on a combination
of approaches to orderly resolution under the code. They adjust
some current operating practices to simplify resolution. They
plan for client-driven reductions in the firm's balance sheet,
prior to resolution. They preplan the marketing and sale of
some of the firm's businesses. They contemplate
recapitalization and continuation of others and the wind down
of still others. Those hybrid approaches can actually be quite
robust with appropriately detailed planning. And I can't
emphasize that enough. The plans are extremely detailed and
they need to be.
So, part of making these things work is not only the
planning process, but also appropriate consultation with
regulators in advance and education of both regulators, market
participants and those who administer the bankruptcy process so
they understand how these plans work and are in a better
position to implement them.
Now all of that being said, I think the hybrid approaches
do entail complexity and more risk than the single point of
entry approach. So, I believe that reforms to the Bankruptcy
Code that add tools to facilitate the single point of entry
approach, perhaps in the form of a modified Chapter 14, which I
know people have been talking about, should be considered.
These changes would include, among other things, clarifying
that bank holding companies can indeed recapitalize their
operating subsidiaries prior to commencement of bankruptcy
proceedings; clarifying that Section 363 of the Bankruptcy Code
can be used to create a new bridge holding company, in the
manner that I described; briefly staying closeouts and allowing
the assumption and preservation of financial contracts,
including overriding bankruptcy defaults or cross defaults to
facilitate resolution; and providing a fully secured resource,
like the OLF, to be available if DIP financing, debtor-in-
possession financing, is not available in the market.
Expanding resolution options in bankruptcy will minimize
systemic risk and better avoid putting taxpayer money at risk.
But, importantly, even if the Bankruptcy Code is amended, I
think it is important that we retain all of our options. That
single point of entry in bankruptcy is not the only option, but
that the orderly liquidation authority be retained as a backup
option; not necessarily the first choice, but just to have it
there in case it is needed.
We can't know what the contours of the next crisis will be.
And we should want regulators to have the greatest variety of
tools in their toolkit. In addition, host country regulators,
regulators in other countries who are less familiar with our
bankruptcy system, will take comfort from the fact that, if all
else fails, U.S. regulators have the power to act.
I want to thank you for allowing me this opportunity to
present my views.
[The prepared statement of Mr. Bernstein follows:]
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__________
Mr. Bachus. Thank you very much.
And, Professor Roe?
Now, let me say this, I think that the testimony so far has
been very substantial and very helpful. And it--a lot of good
discussion on policy. So, thank you.
TESTIMONY OF MARK J. ROE, PROFESSOR OF LAW,
HARVARD LAW SCHOOL
Mr. Roe. I will do my best to maintain that.
So, Chairman Bachus, thank you for the gracious
introduction earlier.
I am Mark Roe. I am a law professor who focuses on
corporate law, business law, business bankruptcy issues. And I
do appreciate the opportunity to be here to provide you with my
views on the Bankruptcy Code's adequacy in dealing with
failing, failed financial institutions.
I am going to focus my testimony on the exemptions from
bankruptcy for derivatives and short-term financing, the so-
called ``bankruptcy safe harbors.'' Simply put, the Bankruptcy
Code, as it is set up now, cannot effectively deal with most
large failing financial institutions. And a core reason for
that is that the safe harbors are far too wide. They exempt too
much short-term financing and risky investments from the normal
operation of American bankruptcy law. They thereby make an
effective resolution in bankruptcy without regulatory support
harder than it needs to be, quite possibly impossible. They
undermine market discipline in the prebankruptcy market making
the financial system riskier and more prone to suffer major
failures. They subsidize short-term lending over stronger, more
stable longer-term financing for financial institutions. We get
more subsidized short-term debt and less stable, but
unsubsidized, longer-term debt. They also make it harder for
financial upstarts and regional banks to compete with the big
money center banks.
Five years ago Lehman Brothers propelled forward the
financial crisis, when it filed for bankruptcy. The Lehman
bankruptcy proved to be chaotic and the country suffered a
major economic setback from which it is still recovering. Yet,
if a Lehman-class bankruptcy occurred today, the Bankruptcy
Code and the bankruptcy system really couldn't do any better
than it did in 2008. So, if a major financial failure gets by
the regulators for whatever reason, we still really can't count
on bankruptcy to catch the ball.
Complex systems, and our financial world is one very
complex system, need redundancy in dealing with failure. If one
stabilizer fails in a complex system, we want another mechanism
to take over to avoid a catastrophic failure. Engineers know
that and we should start to make bankruptcy a more viable
option than it is today.
Second reason for acting on this is that bankruptcy is the
first line of defense by statute and regulatory preference.
Financial regulators say that they will play the Dodd-Frank
title II card only if bankruptcy fails. But, regulators cannot
allow a bankruptcy for even a day to see if it works, if we
have a major, systemically important financial institution with
significant safe harbored securities, because, under today's
bankruptcy rules, as soon as the financial institution with
major safe harbored financing files for bankruptcy, the
exemption for bankruptcy for much of its short-term debt and
for its derivatives portfolio will lead its counterparties to
rip apart the bankrupts portfolio. There will be no chance to
put Humpty Dumpty back together.
The third reason to work on bankruptcy as a viable
alternative: it is possible that title II may not work. It
hasn't been tried. And we should be wary of untested systems.
What are the kinds of things we should be thinking about
doing for the Bankruptcy Code?
First, the kind of collateral that is allowed for short-
term lending safe harbors that are exempt from normal
bankruptcy should be narrowed. Yes, for United States Treasury
securities. No, for mortgage-backed securities.
Second, the broad exemption from bankruptcy for safe
harbored counterparties should be curtailed. They should be
required to stay in bankruptcy for long enough so that the
court can sell off bundles of the failed firm's derivatives
book intact. The chaotic closeouts in Lehman Brothers are said
to have cost Lehman about $50 billion in value. We could do
better with a better Bankruptcy Code.
Third, the blanket preference safe harbor needs to be
better targeted. Preference law has long reduced creditor's
incentives to grab collateral and force repayment on the eve of
bankruptcy, driving a weak but possibly survivable firm into
bankruptcy. Preference law reduces the incentives to grab and
demand repayment on the eve of bankruptcy.
So, if John owes Jane $1 billion in normal debt and if she
holds a gun to John's head and says, ``Repay me,'' when he is
on the verge of bankruptcy, she would go to jail for extortion
and the $1 billion will be recovered from Jane as a preference
in John's bankruptcy for the benefit of all of John's
creditors. And the $1 billion preference forced out of John
prior to his bankruptcy, will be recoverable even if Jane
exerts much less pressure than with a gun. But, if John owes $1
billion to Jane in derivatives debt and she holds a gun to his
head to collect, then she will also go to jail for extortion,
but she won't have to return the $1 billion as a preference.
The derivative safe harbors will fully protect her from the
operation of preference law.
I would submit that this exempting of blatant grabs from
basic preference law is one of the several overly wide aspects
of the safe harbors that need correction and narrowing to fit
markets better. And there is reason to believe that the
collateral grabs that AIG suffered, as it sank in 2008, would
have been preferential had the safe harbors not existed. AIG
might have failed, would probably have failed and quite
plausibly would have been bailed out anyway, but maybe it
wouldn't have been done in such dire circumstances and there
would have been more regulatory options available, if so much
of AIG's obligations were not safe harbored.
So, overall, bankruptcy should support financial safety
better than it does now. Bankruptcy should be capable of
resolving a non-bank, systemically important financial
institution with major positions in safe-harbored financing.
But, as of today, it cannot. Because it cannot, bailouts are
more likely than otherwise and, perhaps even more importantly,
system-wide costs to the economy are more likely than they
would be otherwise. Bankruptcy should not subsidize the
riskiest forms of financing and investment, the shortest-term
debts in our financial system. And they shouldn't be
facilitating riskier, weaker, systemically important financial
institutions. Today, bankruptcy subsidizes this extra risk and
short-term finance.
Bankruptcy should promote market discipline. Today it tends
to undermine that market discipline via the safe harbors,
making our financial institutions weaker than they otherwise
would be. Several of these problems can be fixed. They are not
that hard to fix. And we should fix them.
Thank you.
[The prepared statement of Mr. Roe follows:]
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__________
Mr. Bachus. Thank you very much.
Mr. Smith, do you have any questions or do you want me to?
I can go first and then you can. All right thank you.
Hearing your testimony, I think we are all thinking back to
2008 in our mind. And we are talking about the failures of what
is now called SIFIs and there was obviously almost a ``domino
effect.'' I mean, everyday there was a Merrill Lynch or there
was a Lehman. For a while there AIG was just--you pick up the
paper and what is next?
I do think, as we consider what we are going to do, you
mentioned redundancy. I think that was your testimony Professor
Roe, which I think is tremendously important in a case like
that, because I--when you said, you know, title II might work,
but it might not work. Or enhanced bankruptcy may work, but it
may not. But you have two tracts. And I have told people that
2008 was almost like the economy had a stroke or a heart
attack. And it was--you know, as with a stroke or heart attack,
you need to get to the patient, time is of the essence.
And knowing that, we also add the political theater of
what, you know, as these companies either begin to--they become
insolvent--there is probably only going to be maybe two or
three--it would be unusual to have one, because I think some of
the regulations we have now on short-term financing and over
leveraging, hopefully we won't have that. But it may be almost
a systemic event. And you wonder whether you have to also
factor in, is Congress going to try to intervene which even
complicates that.
I think it is important for us to address this now, not do
it in the middle of a crisis where we are being pushed around
by changing sentiment. And I think you have all given us a
roadmap.
One thing that I am struck by, that I did not know at the
time, AIG was credit default swaps. I mean this was all pretty
risky stuff. It was their insurance business, which was their
core business, was totally reserved, there was no--but it was
one of their subsidiaries. And I am just wondering, and I--my
first question, Mr. Bernstein, in that case you had a
subsidiary where the liability was overwhelming the whole
company. That single point of entry, does that work in that
situation?
Mr. Bernstein. I am going to answer this one in the
abstract because we had a major involvement in AIG, so I would
prefer to keep it to the general.
I think if you have significant liabilities in one
subsidiary, first of all, if you made some of the changes that
permitted you to assume the credit default swaps and other
types of instruments rather than having them terminate on
bankruptcy, you would have many more options. You could put
that subsidiary into bankruptcy and you could preserve those
contracts as a book which had value. Or you could recapitalize
that entity or do other things. Whereas, you know, currently,
with the way bankruptcy works, bankruptcy wasn't an option.
Mr. Bachus. Right. And, you know, from your testimony, I
think both of you mentioned that the safe harbor includes
derivatives. So, it probably included credit default swaps. So,
which took, in the case of AIG, almost all their liabilities
were outside of bankruptcy or were in the safe harbor. You
know, one--there was a lot of discussion back then about good
bank, bad bank. Though that is not what you are proposing, is
it?
Mr. Bernstein. No. It is the single point of entry approach
is not really so much good bank, bad bank. It is really taking
a group of stakeholders that are subordinated and imposing the
losses on them in the private sector, rather than having the
public sector support the institution.
Mr. Bachus. Yeah.
You know, there is. I think Senator Vitter has a bill to
basically do away with our largest financial institutions. I
know this isn't the subject of this hearing and there is a lot
of discussion on that. But, I want to say this, I don't think
that is the best alternative because we have to compete on a
global marketplace. And I think one of our strengths is we do
have some very large companies and financial institutions they
are, of course, and I know I am not going to ask you all, at
this point, you know, unless you want to discuss that. Does
anyone want to volunteer?
Mr. Lacker?
Mr. Lacker. I will just comment that there is a relevance.
There is a connection between bankruptcy reform and strategies
like Vitter's or my colleague--former colleague Tom Hoenig, who
have advocated dividing up the institutions either by size or
activities. You know, what you want to achieve. What those
strategies are designed to achieve is a situation in which
those firms are resolvable in bankruptcy without government
support. I think that is their general objective. And the
planning work, that Mr. Bernstein described so eloquently and
in detail, that is the way you would deduce, that is the way to
figure out exactly what they have to look like now in order for
us to feel confident in the future, in extremis, that you could
take them through bankruptcy with a fair amount of confidence
that it would be orderly enough to be workable.
At this point in the process of those ``living wills'' we
have just been through, we have just had a second round of
submissions, I don't think we know enough now to know exactly
what changes we need to make. Whether it is--I am not sure size
is the right criteria and I am not sure activities are. I think
it is likely to be more--it is more likely to be things like
what Mr. Bernstein pointed to, having clear plans, having
detailed plans; organizing your legal entities in conformance
to your operating activities in a way that makes them
severable, if need be, in bankruptcy, if you ever feel the need
to spinoff a foreign subsidiary, for example, or handle a
foreign subsidiary differently than domestic subsidiaries.
So I think all those things are well motivated. But, I
think the ``living will'' and the planning process centered
around a bankruptcy filing and the fine details of what that
looks like, I think that is going to be more informative and
more reliably get us to the right kind of solution.
Mr. Bachus. You know, AIG, in all of this, is a great
example to look at because for--on several different angles.
But you did have a foreign subsidiary in London that really was
making bets it couldn't afford to lose and in staggering
percentages.
You also, if you are dealing with a global financial
institution headquartered here or even headquartered somewhere
else, you--and I am sure somewhere in the Bankruptcy Code, I am
not sure how you would--there would have to be some cooperation
globally between regulators or between really the court system
in different countries. And what would you--how would you
address a company that was operating major subsidiaries and
business across the globe?
Mr. Bernstein. This is also an area where resolution
planning is important because, one, you can't assume that local
jurisdictions are going to act outside their own self-
interests. So, you have to assume self-interest will be the
driving force. And you have to design plans that demonstrate
that the self-interest of the local jurisdiction is going to be
fulfilled by cooperating with the resolution.
Many of them do not have a bankruptcy process like we do.
They have got a purely administrative process. Some countries
go in the other direction and have processes which are purely
common law. So, you have to really look at each entity and look
at how you demonstrate it is in the local interest to
cooperate.
Mr. Bachus. All right.
You know, again, derivatives would have, if there was a
derivative, if they weren't in a safe harbor, if there were
some provisions in dealing with those, as opposed to sort of a
fire sale, both Lehman and AIG, I think, you know, would be
some benefit if that had been in the code.
Mr. Roe. Well that--the difficulty with the safe harboring
that causes problems for financial institutions with a major
derivatives portfolio is that the portfolio is put together as
a unit: buy pounds on this side and sell pounds on that side.
And the best way to be able to reposition the portfolio is to
sell it intact or to sell obvious units of the portfolio
intact. The safe harbors make this very difficult because I may
have packaged selling pounds with buying pounds together, but
my counterparty will tend to closeout this part of the
portfolio and my other counterparty might close out that part
of the portfolio on terms that aren't particularly favorable to
me and make it impossible for me to sell the portfolio
somewhere else, if I have a buyer. With some cutback on the
safe harbors, we have the potential to be able to put the
portfolio together and reposition it and sell it presumably
quickly in a bankruptcy. We can't really do that in bankruptcy
now. It is possible to do that under title II, but it is not
really viable for a firm that has significant derivatives that
actually does the filing for bankruptcy.
Mr. Bachus. Would, under the Bankruptcy Code that you
envision, would all safe harbors be--would there be no safe
harbors or would you do it incrementally?
Mr. Roe. Incrementally.
And there are several things in the Bankruptcy Code that
make it difficult or impossible for the good functioning of the
derivatives market to work. So, one example, when somebody buys
or sells a derivative, they are basically trying to protect
themselves against volatility in whatever they are buying or
selling. The Bankruptcy Code gives the debtor a nearly
unlimited right to reject or assume that contract without any
real time limits on that capacity to reject or assume.
So, if we had a derivatives contract and I went bankrupt,
you would be very worried, legitimately worried that I just
might play the market to wait for the moment when the contract
has turned favorable to me. So there ought to be some fairly
sharp limits on the debtors' capacity to reject or assume a
contract. Something along the lines of a few days, a short
period in which the portfolio could be assumed and sold intact
to somebody else.
Mr. Bachus. Okay.
And, of course you know, to a certain extent, the Fed
assumes some of those to do that, I think. I mean, their book.
I mean they assume some of those. I guess they assume some of
them were derivatives and that the Fed took on there.
Mr. Lacker. Are you talking about the AIG case? I am not
familiar with the details of what they assumed----
Mr. Bachus. Yeah. I guess well they mortgaged----
Mr. Lacker [continuing]. How much, I am not sure.
Mr. Bernstein. Yes.
Mr. Bachus. Mr. Bernstein?
Mr. Bernstein. One point to make, which I think was being
made by Professor Roe is that--now I think there are really two
separate issues here. One, is what it takes to do an effective
resolution of a financial institution, in terms of changes to
the safe harbors which might be a limited stay and it might be
the ability to quickly assume and move the contracts. The
separate issue and I think it is, you don't necessarily need to
deal with it in financial institution insolvencies, is the more
general question of the scope of the safe harbors. And there is
a lot of good work being done on that by the National
Bankruptcy Conference, the American Bankruptcy Institute
Commission and I know Professor Roe is involved in that. But I
think it is worth separating those two issues for purposes of
this hearing because it is really the former that we really
need to focus on for financial firms.
Mr. Bachus. All right. I appreciate it.
Now, mortgage-backed security, is that a derivative? Excuse
my ignorance, but I am just trying to----
Mr. Lacker. No.
Mr. Roe. The principal place where mortgage-backed
securities would come into the safe harbors would be as a repo.
So, if I lent to you with a mortgage-backed security as my
collateral, this transaction would be safe harbored under the
Bankruptcy Code. One of the problems in the financial crisis is
that there was a lot of dumping of the mortgage-backed
securities when people realized they weren't worth as much as
they hoped they were going to be worth in 2005 and 2006. They
turned out to be worth less in 2008.
The safe harbors facilitate some of those quick sales in
that, if you have done a repo on a mortgage-backed security
with me and I go bankrupt, you can take the mortgage-backed
security and immediately sell it. In a traditional bankruptcy
you can't immediately get to the mortgage-backed security and
sell it. The judge has to promise that you will be adequately
protected. But, that adequate protection can be realized
sometime later on.
Mr. Bachus. All right.
Mr. Roe. So, that is where----
Mr. Bachus. And I am not----
Mr. Roe [continuing]. The mortgage-backed securities----
Mr. Bachus [continuing]. Thinking that mortgage-backed
security wouldn't be a derivative because it is just a basket
of mortgages. So, it doesn't derive its value from anything
external, I guess, is that correct?
Governor Lacker?
Mr. Lacker. It is not traditionally thought of--mortgage-
backed security is not traditionally thought of as a
derivative.
Mr. Bachus. Right.
Mr. Lacker. There are derivatives that are written to
replicate----
Mr. Bachus. Right.
Mr. Lacker [continuing]. The returns on mortgage-backed----
Mr. Bachus. And that's what----
Mr. Lacker [continuing]. Securities or to reference those
returns.
Mr. Bachus. Well, and I, you know----
Mr. Lacker. So, that happens.
Mr. Bachus. Some of those were--bets were made to do just
that.
Mr. Lacker. Yeah. There is a lot of that.
Mr. Bachus. Mr. Jason Smith of Missouri.
Mr. Smith of Missouri. Thank you, Mister----
Mr. Bachus. A Missouri Tiger fan.
Mr. Smith of Missouri. Absolutely. Is there any other?
Thank you, Mr. Chairman.
Mr. Bachus. When there is not a miracle on the Auburn side?
Mr. Smith of Missouri. I hope not. It is a miracle for both
of us right now. [Laughter.]
Mr. Smith of Missouri. My question is to Mr. Lacker.
In your view, what are the benefits of resolving the
financial firms through the bankruptcy process?
Mr. Lacker. So, the alternative are worse, essentially. And
the alternatives that we have utilized involve the
discretionary deployment of public funds to protect creditors.
I think that is an unstable and unsustainable approach. And
that is what concerns me about title II as well.
The dynamic--the expectation, I talked about that creditors
view large financial institutions as ``too big to fail'' and
likely to get government support, arose over several decades
from the early 70's and it was the accretion of--slow accretion
of various precedents that led to the expectation that that is
how we are going to behave. We ended up--those precedents
resulted from situations in which, faced with a choice between
rescuing or not and having the ability to do that, policymakers
erred on the side of caution and protected creditors.
And this came home, this was most vividly illustrated in
the Bear Stearns case. The Bear Stearns had a substantial
amount of RP borrowing that was maturing overnight every day,
every morning actually. And there were--there was a substantial
amount of lending overnight, via purchase agreements, to
several other investment banks. And the fear was that, should
Bear Stearns not get support and should those lenders get
collateral back instead of their cash and have to sell the
collateral for an uncertain value, that that would cause
lenders to pull away from other financial firms as well.
The ambiguity about that was what drove--is what created
this awful dilemma for policymakers. And that is an example of
the kind of dynamic that set up the precedence that led to the
widespread expectation coming into the crisis for this. I think
that providing that discretion to policymakers is likely to
lead to this dynamic replicating itself in the future.
Mr. Smith of Missouri. So, if the Bankruptcy Code was
adequately equipped to handle these insolvencies for the
financial institutions, what is your belief on this ``too big
to fail'' policy?
Mr. Lacker. I think that the combination of good
improvements to the Bankruptcy Code and the ``living will,''
the resolution planning process, can get us to a position where
regulators are comfortable and confident that, should a large
financial institution experience financial distress, they are
willing to take it through bankruptcy without extraordinary
government assistance. And once they are confident about that,
we can convince creditors that that is going to be the norm.
That will shift incentives in financial markets. That should
lead to less short-term funding, less of the fragility that we
see, less of the maturity transformation that creates so many
problems to begin with. So--and that maturity transformation,
that short-term lending like in the Bear case I described, is
what gives rise to these terrible dynamics. And that is, I
think, our best hope for getting out of the ``too big to fail''
box.
Mr. Smith of Missouri. Is the bankruptcy--this question
could be for anyone. But, is the Bankruptcy Code prepared for a
big company, other than just a financial institution but a big
company that may be the largest employer in the United States
let us say, that decided to, you know, be insolvent? I mean, is
that going to be the same type of situation where it comes back
to Congress and we have to bail out this big corporation? Or is
the Bankruptcy Code prepared right now to handle a situation
that has maybe 200,000 employees?
Mr. Roe. I think I could address that. I believe that the
bankruptcy system now is capable of handling the bankruptcy of
a very large industrial firm. And you could put some of this
in, not historical perspective, but perspective over the
decades, something I was mentioning while we were offline. When
the Bankruptcy Code was passed in 1978, the general thinking
was that a large industrial firm, such as the kind of firm you
are describing, could not survive Chapter 11.
And, in fact, we bailed out Chrysler right after the
Bankruptcy Code was passed. And Lee Iacocca, the president and
chairman of Chrysler, persisted and was very convincing with
the argument that, if Chrysler entered Chapter 11, it would not
exit Chapter 11 intact, that consumers would simply not buy
cars from a bankrupt Chrysler.
Over the subsequent decades, the system has learned how to
reorganize very large industrial firms effectively. You know,
in the last few weeks I flew American Airlines in bankruptcy
and US Air outside of bankruptcy. And I might have been the
only one on the plane who just noted that when I got on I was
flying a bankrupt airline. It has just become a normal part of
business. It will be very good for the economy of the United
States if, over the next couple of decades, we could routinize
the bankruptcy of financial institutions so that it just
happens in the background and works effectively.
So, one additional cost of--one additional advantage of
bankruptcy over alternatives is, for example, that to use title
II, somebody has to be saying this is a systemically important
financial institution whose failure would be very detrimental
to the American economy. That is the kind of thing that could
help propel more panic than we really need to have. If this
entity could go right into bankruptcy and be handled by the
bankruptcy institutions, which I believe an amended Bankruptcy
Code could do, the waters would be calmer and bankruptcy would
do better for us.
Mr. Bernstein. I would like to comment on that question
also.
First of all, the Bankruptcy Code was designed for the
biggest companies. In fact, it really was designed to follow
the pattern of equity receiverships in the 19th century which
took the railroads, which were the biggest companies that
existed at that time, and reorganized them.
But there are two issues that it is very hard for the
Bankruptcy Code to deal with. One is, will the company be able
to continue in business? And I think what Mark is saying is
that, in a lot of instances where people thought companies
couldn't continue in business, they have actually been able to
sell their product in bankruptcy. Now, whether that would have
been true, had the auto manufacturers stayed in bankruptcy for
more than 6 weeks, would somebody buy a car with a 5-year
warranty and the like? The answer may be that they would, as
long as somebody stood behind the warranty other than the
debtor.
And that gets to the second question, which is somebody has
to be willing to finance these entities in order for them to
reorganize. And one of the problems in a downturn that goes
beyond just the individual company and effects the whole
economy is the money may not be available to finance you until
you can reorganize. You know, the Tribune Company went into
bankruptcy about 4 or 5 years ago. And, at the beginning of
that bankruptcy case everyone thought its value was one-third
what it turned out to be when it emerged from bankruptcy.
And, because of the degradation of value in a depressed
market, it may be difficult to find private financing. And
there has to be some form of bridge financing, probably other
than DIP financing, in that kind of market that is available.
And that is why it may be difficult without that sort of
liquidity backup for the largest company in America to fail.
And that was the experience with the auto companies recently.
Mr. Bachus. Thank you.
I have got some prepared questions that I would like to go
through. There are two for Governor Lacker. These are from
staff members or the Chairman.
Can you explain why you believe that shifting away from
short-term financing for financial firms will increase the
probability that they may be orderly resolved through the
bankruptcy process?
Mr. Lacker. So, Mr. Roe has argued this eloquently in his
statement.
Mr. Bachus. Right.
Mr. Lacker. There is a great deal of maturity
transformation that goes on outside the banking system, outside
of deposit taking. And it is the type of financial arrangement
that is most likely to pin down a policymaker, put him in a box
and make him feel as if he needs to rescue creditors rather
than let bankruptcy proceed.
I think setting the criteria for these large financial
institutions that they ought to structure themselves so that
they can be resolved in bankruptcy without government-provided
``debtor-in-possession'' financing, with just the debtor-in-
possession financing they have planned for is a good criteria.
If that means they do less maturity transformation, if that
means that they do less borrowing short and holding longer in
liquid assets, then I think so be it. I think that the system
we have now is--artificially favors the maturity transformation
that goes on in qualified financial contracts, particularly in
RP lending. And I think reforms to the Bankruptcy Code and the
kind of planning, the kind of resolution planning that Mr.
Bernstein described, can help us get to a situation where we
have a more socially appropriate quantity of maturity
transformation going on.
Mr. Bachus. You know, look Bear Stearns--in Bear Stearns I
have had knowledgeable people that have said to me, ``You
should have been able to look at the balance sheet and told
they were insolvent.'' So, I think maybe a more clear
accounting or examination of their balance sheet. But also they
were going through some, what I call, some financial
shenanigans of shifting things back and forth. But I am just--
you know there are ways in bankruptcy, there are ways to go
back and capture some of that, I think. So that would probably
be another advantage of bankruptcy.
But anyway, I will get back to it. One of the questions I
think sort of tracks on the question I have just asked Governor
Lacker, for you Professor Roe. If the safe harbor exemptions
create incentives for short-term financing, in your view, how
does that make the financial system more difficult to resolve
through bankruptcy?
Mr. Roe. This will parallel Jeffrey Lacker's comments, in
this way, if we have safe harbors for short-term debt but don't
have it for long-term debt, we will tend to get more short-term
debt that can run off very quickly in a bankruptcy or during a
financial failure. So we have rules that facilitate the runoff
when we should either want the rules to be neutral or maybe to
slow down that sort of runoff. And this actually feeds into the
point that Donald Bernstein was making. One of the big problems
in a large financial institution bankruptcy would be financing.
And this--the remark that I am going to make now is not
going to make the problem go away. But, the safe harbors
increase the difficulty of financing because some significant
portion of the financial structure of a failed financial
institution, if they are in safe harbored repo, will runoff
immediately and then, in the extreme case, will have to be
replaced. If it couldn't runoff immediately the financial
pressure would be less on the firm.
So, one example, when Bear Stearns filed--when Bear Stearns
failed and was taken over by JP Morgan Chase, it had about a
quarter of its liabilities in repo. Only a couple decades
before its repo level was only about 6 percent of its total
liability. When it failed in 19---in 2007, 2008, it is much
more difficult for it to go through a bankruptcy because so
large a portion of its structure is going to be immediately
withdrawn.
Mr. Bachus. And I think, just from reading you all's
testimony and sort of coming into this, it is just clear that
the safe harbors does create some big problems. And the one you
have described is pretty clear. I don't know that--Mr.
Bernstein, that is to you----
Mr. Bernstein. I definitely agree that----
Mr. Bachus. Yeah.
Mr. Bernstein [continuing]. In order to resolve financial
institutions you have got to give them the ability to preserve
the book of financial contracts and move it on to the
continuing entity.
Mr. Bachus. And, you know, that seems to be a point if we
are going to do something. If we don't do something
comprehensive incrementally that would be a good first step
that I think would beat a little dissension.
This is for Governor Lacker. Do you think there should be
any regulatory involvement in the resolution of a financial
firm through the bankruptcy process? I guess if we ask 12
different Fed governors, we would get 12 different answers to
that question.
Mr. Lacker. I don't know.
Mr. Bachus. I think that the answer you----
Mr. Lacker. I think it makes--I have seen proposals that
give regulators some standing. I think some standing makes
sense. But I think you have to be careful about this. I think
having a regulator initiate insolvency proceedings seems
useful. I think you would want to carefully prescribe through
the principles that they ought to be adhering to in making that
decision. I think you would want to give them that right, but
preserve as much clarity as you can for market participants as
to when it is going to be exercised. So, try and do it in a way
that provides some bounds around it that provides clarity about
when it is going to be exercised.
Mr. Bachus. I was just thinking the word boundaries. And,
you know, statutorily there ought to be some, with some
marginal, I mean, you know, some discretion. But, you would
need to define the boundaries of that participation. Whether it
was to advise, just to offer advice or to assist, as opposed to
not to dictate to them.
Mr. Lacker. Yeah. So, the reason I think that is important,
is it is important to, in a situation in which there is the
potential for creditors to expect government rescues, you want
the regulator to be able to force action and force bankruptcy
before things unwind, before actions are taken that just make
the matters dramatically worse and force the regulator's hand
later. So, now, there is other aspects of standing that I don't
have a--I really don't have a view on. You know, pleadings and
I guess things that these guys are an experts in.
Mr. Bachus. Okay.
Mr. Bernstein?
Mr. Bernstein. Yeah. I generally agree with what has just
been said. The--you know, if in fact you retain orderly
liquidation authority as a backup, it will be less likely to be
used if the regulator has the option of using bankruptcy. So, I
think that is probably, on balance, a good thing. The--as to
other matters, I mean, there may be other issues such as, you
know, if you did this single point of entry approach in
bankruptcy that the regulator would want to be heard on. So,
there may be other standing issues the regulator wants to be
involved in.
Mr. Bachus. Well, and I think you could provide for a
regulator to actually sit, if not part of the panel, in some
position because you would have to assemble people that had the
expertise.
Mr. Bernstein. Or at least give the regulator the
opportunity to be heard on any issue.
Mr. Bachus. Okay.
And I think the last question is for you, Mr. Bernstein.
Based on your experience working with and developing ``living
wills,'' setting aside the question of how a financial firm
will be financed through a restructuring, what are the major
impediments to efficient resolution of a financial firm through
the bankruptcy process as the Bankruptcy Code is currently
drafted? And actually, you have covered an awful lot of this.
Mr. Bernstein. Yeah, I did. Well, I strongly believe that
the ability to separate the--first of all, I believe the
ability to recapitalize rather than liquidate is extremely
important. And I think the tools that are there today will
permit it for some entities but not for all entities in the
group. And it would be good if the tools were there to have
that happen for all entities. I do think liquidity is an
important issue and I distinguish that very importantly from
capital. The capital losses are going to be suffered in the
private sector, but if the liquidity is not there to stabilize
the firm through a lender of last resort that is problematic.
Banks have the discount window, they can do that; but, broker-
dealers don't. So, I think that is an important aspect.
And so, I think really focusing on the good work that has
been done by the FDIC on single point of entry. And taking that
and saying, ``How can we do that in a procedurally appropriate
way, under the Bankruptcy Code,'' would be an excellent step.
Mr. Bachus. Thank you.
Let me--and I am going to conclude with a question that--
and more maybe not a question but to sort of try to encourage
some action and that is--you know, National Bankruptcy
Conference, the American Bankruptcy Institute, the American Bar
Association, the regulators. It would be extremely helpful to
the Judiciary Committee and I know the Senate is also looking
at this, so this is not something that is--in fact they have
had ongoing discussions and we have had discussions with them.
So there is a willingness and a desire to make changes in the
Bankruptcy Code. But, we--it would be so much easier if, as in
the case of some other things, we had a model act or we had a
something brought to us. And I know the Senate actually has
some draft language, but that would be extremely helpful. It
would give us quite a bit of comfort because it would be very
hard for us to do that. And so, I would encourage the
different--the Conference, the Institute, the regulators to
continue discussion and give the Congress some guidance. And,
if not, a draft.
So, thank you.
This concludes the hearing. Thanks to all our witnesses for
attending. This is a very--we, in this case, both the democrats
and republican agreed that you were as qualified witnesses as
any.
And without objections all our Members of the Committee
will have 5 legislative days to submit additional written
questions for the witnesses or additional materials for the
record.
And this hearing is adjourned.
[Whereupon, at 3:50 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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Material Submitted for the Hearing Record
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Prepared Statement of the Honorable Steve Cohen, a Representative in
Congress from the State of Tennessee, and Ranking Member, Subcommittee
on Regulatory Reform, Commercial and Antitrust Law
I voted for the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 and remain a supporter of the law.
The Dodd-Frank Act's passage by Congress was an acknowledgment of
the fact that insufficient regulation led to the problem of so-called
``Too Big to Fail'' financial institutions--that is, financial
institutions that were allowed to become so big and so interconnected
that their insolvencies threatened to paralyze the Nation's financial
system and its broader economy. This situation, in turn, resulted in
extreme pressure for a taxpayer bailout when those institutions fell
under financial distress.
The bankruptcy filing of Lehman Brothers in 2008--the largest
bankruptcy in U.S. history, involving more than $600 billion in
assets--vividly illustrated aspects of the ``Too Big to Fail'' problem.
Lehman's bankruptcy filing greatly exacerbated a financial panic on
Wall Street, leading to a severe financial crisis and the greatest
economic downturn since the Great Depression, the effects of which we
continue to feel today.
More importantly, the financial markets' reaction to the Lehman
Brothers bankruptcy highlighted the potential limitations of the
Bankruptcy Code in handling the resolution of financially distressed
systemically important financial institutions.
I remain a strong supporter of the Dodd-Frank Act, although I also
support certain enhancements to it. For example, I support legislation
that would increase the minimum required amount of capital for covered
financial institutions under Dodd-Frank.
We should also consider the potential need for other enhancements,
like adding a representative of the Antitrust Division of the
Department of Justice to the Financial Stability Oversight Council,
created by Dodd-Frank to oversee the stability of the financial system.
It is in this spirit that I approach today's hearing, which will
focus on whether the current Bankruptcy Code is sufficient to allow for
the orderly reorganization or liquidation of systemically important
financial institutions under Title I of the Dodd-Frank Act.
Whether one supports or opposes the Dodd-Frank Act, we can agree
that today's inquiry is an important one. To the extent that modest
revisions to the Bankruptcy Code will help ensure that we avoid the
need for any future taxpayer bailouts of financially struggling large
financial institutions, we should be able to work together on crafting
such changes.
Prepared Statement of the Honorable Bob Goodlatte, a Representative in
Congress from the State of Virginia, and Chairman, Committee on the
Judiciary
The Bankruptcy Code has existed in this country for well over a
hundred years. Over this time, our bankruptcy system has evolved to
become one of the most sophisticated regimes in the world. The bedrock
principle embedded in the bankruptcy system of providing for the
efficient resolution and reorganization of operating firms has allowed
our economy to grow and flourish.
Nevertheless, a periodic evaluation of the Bankruptcy Code to
ensure its adequacy to address the challenges posed by the changing
nature of operating firms is one of the fundamental responsibilities of
this Committee.
I applaud Chairman Bachus for holding today's hearing to examine
whether the existing Bankruptcy Code is best equipped to address the
insolvency of large and small financial institutions.
The bankruptcy process confers a number of benefits to all
operating companies, including financial firms. The bankruptcy court
provides transparency and due process to all parties involved.
Furthermore, bankruptcy case law has been developed over decades,
providing consistency and predictability.
Additionally, the bankruptcy process has been sufficiently dynamic
to administer the resolution and restructuring of complex operating
companies with billions of dollars in assets as well as smaller
companies and individuals. But despite the bankruptcy system's ability
to accommodate complex operating companies, financial firms may possess
unique characteristics that are not yet optimally accounted for in the
Bankruptcy Code.
For example, efficient and orderly resolution of financial firms
can require an unusual level of speed. Refinements to the Code might be
considered to better provide that speed while still assuring due
process.
Additionally, in some circumstances the failure of financial firms
can pose unique threats to the broader stability of the economy. To
account for that, title I of the Dodd-Frank Wall Street Reform and
Consumer Protection Act requires certain firms to prepare ``living
wills'' to plan for resolution in bankruptcy in the event of failure.
The Bankruptcy Code is well-crafted to maximize the recoveries of a
debtor's creditors while providing an opportunity for the debtor to
either reorganize or liquidate in an orderly fashion. It might,
however, bear improvements designed specifically for the efficient
execution of title I ``living wills.''
These are some of the issues that may need to be examined as part
of the broader evaluation of the existing Bankruptcy Code's adequacy to
address financial institution insolvencies. I look forward to the
testimony from today's excellent panel of witnesses on these important
issues.
Thank you Mr. Chairman, and I yield back the balance of my time.
Prepared Statement of the Honorable John Conyers, Jr., a Representative
in Congress from the State of Michigan, and Ranking Member, Committee
on the Judiciary
This hearing examines whether current law would adequately address
the insolvency of a significant financial institution given what we
learned from the near collapse of our Nation's economy just five years
ago.
As we consider this issue, it is critical that we keep in mind what
precipitated the Great Recession.
Basically, it was the regulatory equivalent of the Wild West.
In the absence of any meaningful regulation in the mortgage
industry, lenders developed high risk subprime mortgages and used
predatory marketing tactics that targeted the most vulnerable by
promising them that they could finally share in the Great American
Dream of homeownership.
This proliferation of irresponsible lending caused home prices to
soar even higher, ultimately resulting in a housing bubble.
In the absence of any meaningful regulation in the financial
marketplace, these risky mortgages were then bundled and sold as
investment grade securities to unsuspecting investors, including
pension funds and school districts.
Once the housing bubble burst, the ensuing 2008 crash stopped the
flow of credit and trapped millions of Americans in mortgages they
could no longer afford, causing vast waves of foreclosures across the
United States, massive unemployment, and international economic
upheaval.
And, to this day, we are still dealing with the lingering effects
of the Great Recession of 2008 in the form of a sluggish national
economy, neighborhoods blighted by vast swaths of abandoned homes, and
municipalities struggling with reduced revenues.
Fortunately, the Dodd Frank Act reinvigorates a stronger regulatory
system that makes the financial marketplace more accountable and
institutes long-needed consumer protections.
It also establishes a mandatory resolution mechanism to wind down a
systemically significant financial institution that cannot be resolved
under bankruptcy.
The Act also imposes various requirements on financial institutions
that will allow regulators to better assess the risks such institutions
present to Wall Street and, most importantly, Main Street.
A key component of the Dodd Frank Act process requires these
companies and the regulators to assess resolution under current
bankruptcy law.
In recent years, some of the Nation's largest companies have used
the Bankruptcy Code to regain their financial footing, including
General Motors, American Airlines, and Washington Mutual.
Questions have been raised, however, as to whether the Bankruptcy
Code can be improved upon to better accommodate large inter-connected
financial institutions like those subject to the Dodd Frank Act.
Some have even suggested that a new form of bankruptcy relief that
specifically deals with these institutions may be the most expedient.
There may, in fact, potentially be consensus that some changes to
the Bankruptcy Code may be warranted.
In any event, today's hearing should elicit some helpful guidance
and I look forward to the testimony from these experts.
Thank you Mr. Chairman, and I yield back the balance of my time.
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