Saving too-big-to-fail banks: Here comes a new government takeover strategy

The federal government could soon have the right to seize control of troubled financials institutions that are deemed "too big to fail," fire their top executives, wipe out shareholders and rewrite the institution's loan agreements. These are among the provisions in a new bill that Representative Barney Frank is likely to introduce this week, according to a report in Monday's New York Times. If Frank's bill makes it though the legislative process, bankruptcy court would no longer be the ultimate decision maker for giant financial institutions whose collapse could jeopardize the financial system. Instead, the government would take that role.

The federal government has been trying to figure out how to deal with such major financial institutions for almost 30 years. In 1980, First Pennsylvania was the first bank that the FDIC bailed out because the Federal Reserve and the U.S. Treasury deemed it was too big to fail. This doctrine has continued up to now, with rescues of AIG (AIG), Bear Stearns, Fannie Mae and Freddie Mac, as well as bailout funds for many huge financial institutions including Citigroup (C) and Bank of America (BAC), both of which are still on government life support.

Clearly, the current handling of banks that are too big to fail isn't the way to go. But is wiping out the traditions of bankruptcy court and the rights of bondholders the best answer to the problem? According to the Times report, Treasury Secretary Timothy Geithner will support Frank's bill in testimony before the House Financial Services Committee on Thursday.

The Times reports that the White House sees the plan as "the equivalent to setting up living wills for corporations." These systemically important institutions would be required to come up with their own procedure to be disentangled in the event of a crisis. The Obama administration wants these plans to be laid out for the public in advance.

This proposal sounds like a trial balloon that's going to quickly burst. Opposition will rapidly grow to such a dramatic change in the handling of failed financial institutions. But the plan just might succeed in getting the the financial industry in the mood to negotiate something less drastic. Bondholders also won't like to see the government take control from them, so they may be ready to come to the table with more creative ideas.

Of course, some experts want to go further and are calling for breaking up the too-big-to-fail institutions. Among those are former Federal Reserve Chairman Paul Volcker and Bank of England Governor Mervyn King. They'd like to see commercial banking and investment banking split into two separate institutions. Volcker is pressing for some form of a Glass-Steagall-like bill to reconstruct the wall between commercial banking and investment banking. Glass-Steagall, passed after the Great Depression, was repealed in 1999.

The administration doesn't want to split up the giant institutions, so instead it's looking for a different way to rein them in. It seems clear that the White House knows the public won't accept any more bailouts.

The banks continue to ignore the administration's attempts to gain some control over their financial health. And the banks have gone back to their plans for large bonuses and executive pay packages, despite great opposition from the administration and the public. So, obviously a bigger stick is needed. The question is: Will the threat of a government takeover help get these financial institutions back in line?

Lita Epstein has written more than 25 books including Reading Financial Reports for Dummies and The Complete Idiot's Guide to the Federal Reserve.


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