Wednesday, July 20, 2011

FSOC Study Eschews Secured Creditor Haircuts for Dodd-Frank Liquidation Authority Regime

In a Dodd-Frank mandated study, the Financial Stability Oversight Council concluded that the Orderly Liquidation Authority provided in Title II of the Act and the heightened supervisory framework provided by Title I can be used to achieve the goals of market discipline and taxpayer protection effectively in the absence of secured creditor haircuts. The study, conducted pursuant to Section 215 of Dodd-Frank, noted that Title II provides no authority to impose secured creditor haircuts. The FSOC is composed of the primary financial regulators, including the SEC and the CFTC.

The stud said that the Orderly Liquidation Authority, together with the new heightened prudential standards to be imposed on the largest, most interconnected financial firms, will promote market discipline by helping to force such firms to internalize the full cost that their failure would impose on the financial system. Working in tandem, the Orderly Liquidation Authority and the supervisory framework for the largest, most interconnected firms set out in Title I, may already provide a significant new measure of taxpayer protection. These reforms are designed to reduce the probability that a large, interconnected firm would fail, and in the event that such a firm does fail, allow regulators to wind it down, break it apart, and liquidate it without forcing taxpayers to bear any of the costs.

If the proceeds from an orderly liquidation are insufficient to repay amounts owed to the U.S. Government, the FDIC ultimately has the authority to assess large financial companies to repay those amounts. Thus, these reforms lessen the need for the potential taxpayer protection that the addition of the secured creditor haircuts might arguably afford.

More granularly, the study posited that secured creditor haircuts that applied only in the context of the Orderly Liquidation Authority could increase the cost of borrowed funds for large, interconnected financial firms because lenders would demand higher rates of interest to compensate for the potential impact of secured creditor haircuts. These effects could be significant, noted the study, since secured lending provides a major source of funding for financial firms.

While the impact of secured creditor haircuts that applied only in the context of the Orderly Liquidation Authority would be somewhat reduced to the extent that those haircuts would only apply if further conditions were met, noted FSOC, significant uncertainty about whether these conditions would be met in the case of any particular covered financial company could increase funding costs more broadly. Such uncertainties might not be easy to address given the importance of preserving the discretion of the FDIC-Receiver to administer the receivership of a covered financial company as effectively as possible in light of the particular facts and circumstances of each case.

In addition, secured creditor haircuts could increase the cost of borrowed funds by making it more difficult for money market mutual funds, as well as other lenders, to participate in the repo market. Money market mutual funds are currently a major lender in the repo market, extending approximately $440 billion in credit through repo transactions in Q1 2011. However, Rule 2a-7 under the Investment Company Act limits money market mutual funds’ ability to participate in repo transactions unless they are collateralized fully. To the extent that secured creditor haircuts would prevent repo transactions from meeting the definition of collateralized fully, said the study, they could prevent institutions such as money market funds from participating in the repo market.

While secured creditor haircut provisions that apply only in the context of the Orderly Liquidation Authority would affect large, interconnected financial firms’ borrowing costs directly, such provisions might also affect borrowings costs for other firms indirectly. Securities prices reflect the cost of credit used to fund securities purchases. To the extent that credit becomes more expensive, securities prices will fall and securities issuers’ cost of capital will increase.