Tag: Bailouts

Illegality and Hardball in Government’s Nationalization of AIG

Lawrence A. Cunningham is Henry St. George Tucker III Research Professor of Law at George Washington University Law School. This post builds on Professor Cunningham’s recent article published in The National Interest, available here. Professor Cunningham is co-author with Hank Greenberg, former chairman and CEO of American International Group (AIG), of The AIG Story.

Suppose your bank offers to lend you money to buy a home, and even if you repaid the loan, the bank would retain ownership of your home as well. Would you sign up? Would you expect a business organization to accept equivalent loan-plus-forfeiture terms? I don’t think so but that is what the U.S. government’s “bailout” of American International Group (AIG) involved and one reason a federal judge has declared it an illegal exaction in violation of the Constitution of the United States.

In the fall of 2008, Treasury Secretary Henry Paulson and New York Federal Reserve President Timothy Geithner demanded the permanent surrender of nearly an 80% stake in AIG as “security” for a usurious loan. They then fired AIG’s CEO, replaced its board members, took control of all the company’s affairs, and divested nearly half the company’s worldwide assets in a series of fire sales—all while using subterfuge and deception to avoid a shareholder vote the officials agreed was required and promised would be held.


Towards a “Rule of Law” Approach to Restructuring Sovereign Debt

Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University School of Law.

In a landmark vote, the United Nations General Assembly overwhelmingly decided on September 9 to begin work on a multilateral legal framework—effectively a treaty or convention—for sovereign debt restructuring, in order to improve the global financial system. The resolution was introduced by Bolivia on behalf of the “Group of 77” developing nations and China. In part, it was sparked by recent litigation in which the U.S. Supreme Court held that, to comply with a pari passu clause (imposing an equal-and-ratable repayment obligation), Argentina could not pay holders of exchanged bonds without also paying holdouts who retained the original bonds. That decision was all the more dramatic because the holdouts included hedge funds—sometimes characterized as “vulture funds”—that purchased the original bonds at a deep discount, yet sued for full payment.


Cross-Border Recognition of Resolution Actions

The following post comes to us from Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication authored by Mitchell S. Eitel, Andrew R. Gladin, Rebecca J. Simmons, and Jennifer L. Sutton. The complete publication, including footnotes, is available here.

On September 29, 2014, the Financial Stability Board (the “FSB”) published a consultative document concerning cross-border recognition of resolution actions and the removal of impediments to the resolution of globally active, systemically important financial institutions (the “Consultative Document”). The Consultative Document encourages jurisdictions to include in their statutory frameworks seven elements that would enable prompt effect to be given to foreign resolution actions. In addition, due to a recognized gap between the various national legal resolution regimes that are currently in place and those recommended by the FSB, the Consultative Document sets forth two “contractual solutions”—that is, resolution-related arrangements to be implemented as a matter of contract among the private parties involved—to address two underlying substantive issues that the FSB considers critical for orderly cross-border resolution, namely:


After the Deal: Fannie, Freddie and the Financial Crisis Aftermath

The following post comes to us from Steven Davidoff Solomon, Professor of Law at the University of California, Berkeley School of Law, and David T. Zaring, Associate Professor of Legal Studies and Business Ethics at the Wharton School, University of Pennsylvania.

In After the Deal: Fannie, Freddie and the Financial Crisis Aftermath, we offer a solution to the problem of what to do with the profits being made by Fannie Mae and Freddie Mac, the subject of a dispute between the government, which has declared that it will keep those profits, and the shareholders of common and preferred stock left behind after the firms were quasi-nationalized, who have sought, in court, a share of them.


Nationalize the Clearinghouses!

The following post comes to us from Stephen J. Lubben, Harvey Washington Wiley Chair in Corporate Governance & Business Ethic at Seton Hall University School of Law.

A clearinghouse reduces counterparty risks by acting as the hub for trades amongst the largest financial institutions. For this reason, Dodd-Frank’s seventh title, the heart of the law’s regulation of OTC derivatives, requires that most derivatives trade through clearinghouses.

The concentration of trades into a very small number of clearinghouses or CCPs has obvious risks. To maintain the vitality of clearinghouses, Congress thus enacted the eighth title of Dodd-Frank, which allows for the regulation of key “financial system utilities.” In plain English, a financial system utility is either a payment system—like FedWire or CHIPS—or a clearinghouse.

But given the vital place of clearinghouses in Dodd-Frank, it is perhaps surprising that Dodd-Frank makes no provision for the failure of a clearinghouse. Indeed, it is arguable that the United States is not in compliance with its commitment to the G-20 on this point.


Supersize Them? Large Banks, Taxpayers and the Subsidies

The following post comes to us from Nizan Geslevich Packin of the University of Pennsylvania Law School; Zicklin School of Business, Baruch College, City University of New York.

In the paper Supersize Them? Large Banks, Taxpayers and the Subsidies that Lay Between, I provide an in-depth study of the substantial, non-transparent governmental subsidies received by the biggest banks. Though some continue to deny the existence of these subsidies, I conclude that the subsidies exist and negatively impact the financial markets. The most significant implicit subsidy stems from market perception that the government will not allow the biggest banks to fail—i.e., that they are “too-big-to-fail” (TBTF)—enabling them to borrow at lower interest rates. I outline the solutions that have been proposed and/or implemented as an attempt to solve the TBTF problem, and I suggest a new user-fees framework that can be used in conjunction with other approaches to mitigate the consequences of the TBTF subsidies.


Financing as a Supply Chain

The following post comes to us from Will Gornall and Ilya Strebulaev, both of the Finance Area at Stanford University.

In our recent NBER working paper, Financing as a Supply Chain: The Capital Structure of Banks and Borrowers, we propose a novel framework to model joint debt decisions of banks and borrowers. Our framework combines the models used by bank regulators with the models used to explain capital structure in corporate finance. This structure can be used to explore the quantitative impact of government interventions such as deposit insurance, bailouts, and capital regulation.


SIFIs and States

The following post comes to us from Jay Lawrence Westbrook, Benno C. Schmidt Chair of Business Law at The University of Texas School of Law.

Today an enormous global civilization rests upon a jury-rigged financial frame rife with moral hazards, perverse incentives, and unintended consequences. This article, SIFIs and States, forthcoming in the Texas International Law Journal, addresses one aspect of that fragile structure. It argues for basic reform in the international management of financial institutions in distress, with a special emphasis on SIFIs (Systemically Important Financial Institutions). The goal is to examine public institutional arrangements for resolution of financial institutions in the midst of a crisis, rather than the substantive rules governing the resolution process. The proposition central to this article is that the resolution of major financial institutions in serious distress will generally require substantial infusions of public money, at least temporarily. The home jurisdiction for a given financial institution must furnish the bulk of the public funds necessary for the successful resolution of its financial distress. The positive effect is that other jurisdictions may be likely to acquiesce in the leadership of the funding jurisdiction in exchange for acceptance of that financial responsibility. On the other hand, acceptance of the funding obligation would have profound consequences for the state as well as the institution, because the default of a SIFI may threaten the financial stability of that state. Until the crisis of 2007-2008, all that was implicit and unexamined in the political process; to a large extent it remains so.


Shareholder Empowerment and Bank Bailouts

The following post comes to us from Daniel Ferreira, Professor of Finance at London School of Economics, David Kershaw, Professor of Law at London School of Economics, Tom Kirchmaier, Lecturer in Business Economics and Strategy at University of Manchester, and Edmund-Philipp Schuster, Lecturer in Law at London School of Economics.

One, of several, regulatory responses to the financial crisis has been to consider the extent to which bank failure can be explained by flaws in banks’ corporate governance arrangements.

In many jurisdictions this diagnosis has generated calls upon shareholders to act as effective owners and hold boards of banks to account, as well as calls to empower shareholders to enable them to do so. But what do we know about the relationship between shareholder power and bank failure? To date scholarly attention has been paid to the relationship between board independence and bank failure, but limited attention has been given to the relationship between bank failure and the core corporate governance rules that determine the ease with which shareholders can remove and replace management. In our paper, Shareholder Empowerment and Bank Bailouts, we examine the relationship between shareholder power — and, thus, managerial accountability — and the probability of bank bailouts.


The Future of Bailouts and Dodd-Frank

Editor’s Note: Peter J. Wallison is a senior fellow at the American Enterprise Institute. This post is based on an article by Mr. Wallison; the full article, including footnotes, is available here.

In the first presidential debate, Mitt Romney identified the Dodd-Frank Act as the “biggest kiss” to Wall Street, opening a topic that has received too little attention in this election season. Supporters of the act argue that it ends bailouts, but this is true only if bailouts are defined narrowly as the use of taxpayer funds to rescue a failing financial institution. However, the source of funds for a bailout is not the real issue. The possibility of a creditor bailout creates moral hazard, no matter where the bailout funds originate, and it is moral hazard that provides the largest banks or other large financial firms with competitive advantages. The same is true of the special “stringent” regulation required by the act for banks and other firms deemed systemically important. These provisions create moral hazard by reassuring creditors that there is less risk in lending to these large firms than to small ones, and thus provide the biggest firms with a continuing competitive advantage in the form of lower funding costs. Romney is correct to see this as a subsidy to big banks and other large financial institutions. Title I invokes stringent regulation for systemically important firms, Title II provides a mechanism for bailing out creditors if a systemically important firm should fail, and Title VIII authorizes Federal Reserve funding for an unlimited number of additional financial institutions. If President Obama is re-elected, Dodd-Frank is likely to continue in its current form, adding materially to the problem of moral hazard and TBTF in the US financial system.

At its enactment, the Dodd-Frank Act (DFA) was advertised as legislation that would end financial bailouts. When signing the legislation on July 21, 2010, President Obama said, “There will be no more tax-funded bailouts—period.” But this is an accurate depiction of the act only because the president and the act’s other proponents define bailouts as the use of public funds for rescuing failing financial institutions.


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