03/18/2010 05:12 am ET | Updated May 25, 2011

New "Too Big To Fail" Bill Gives Feds Power To Freeze Derivatives Contracts

The "Too Big To Fail" legislation currently being debated by a House committee has been widely criticized as toothless. But one provision gives the federal government a powerful mechanism to prevent another implosion like the one that launched the current financial crisis.

The bill, which would give the Federal Deposit Insurance Corporation the power to take over failing firms that pose a risk to the entire financial system, gives the FDIC the authority to repudiate the firm's derivatives contracts, pay the parties less than what they're owed, or transfer the contracts to another, healthy financial firm.

Perhaps most importantly, the FDIC would have the authority to delay the parties from closing out their contracts and taking their money with them. That's part of the reason why the Lehman Brothers bankruptcy announcement caused the financial markets to crash, and it's what helped bring about the demise of the 158-year-old investment firm -- everyone wanted to get their money out before it was too late.

The FDIC already has this power when it comes to failed banks. But its authority is strictly limited to insured depositories. So the FDIC can take over a Citibank, for example, but not all the operations of a Citigroup. It's an important difference, and part of the reason why the administration and House Financial Services Committee Chairman Barney Frank are proposing to give the FDIC this expanded authority.

Here's how it works:

These days, when the FDIC takes control of a bank, it can liquidate it (receivership) or take it over in preparation for a sale (conservatorship). Receivership is the most common approach. In those cases, the FDIC will sell off a bank's assets, or it can open a temporary bank in order to minimize the disruption that would come from immediately selling off all of a bank's assets.

In derivatives contracts, a firm's failure or bankruptcy often triggers a clause that calls for the contract to be immediately closed out.

From Michael Krimminger, special advisor for policy at the FDIC, before a House committee in October:

Under both the Bankruptcy Code and bank insolvency law, the counterparties to insolvent firms can terminate and net out derivatives and sell any pledged collateral to pay off the resulting net claim. During periods of market instability -- such as during the fall of 2008 -- the exercise of these netting and collateral rights can increase systemic risks. At such times, the resulting fire sale of collateral can depress prices, freeze market liquidity as investors pull back, and create risks of collapse for many other firms.

In effect, financial firms are more prone to sudden market runs because of the cycle of increasing collateral demands before a firm fails and collateral dumping after it fails. Their counterparties have every interest to demand more collateral and sell it as quickly as possible before market prices decline. This can become a self-fulfilling prophecy -- and mimics the depositor runs of the past.

This is what happened to Lehman Brothers and another Wall Street firm no longer standing, Bear Stearns.

"Rumors about Lehman's liquidity problems, and the subsequent bankruptcy filing, triggered asset fire sales and destroyed the liquidity of a large numbers of claims held by Lehman's direct counterparties as well as of claims held by counterparties several steps removed from those having claims directly against Lehman itself," Krimminger said. "This led to an abrupt collapse of liquidity as the ability of parties throughout the market to complete settlements was placed into doubt."

While the FDIC can now stem the tide for banks, it can't for investment firms such as Goldman Sachs or Morgan Stanley. The draft of the Financial Stability Improvement Act of 2009 -- first proposed by the administration and introduced in the House Financial Services Committee last week -- would give the agency that ability.

It's not going to be easy, though. With derivatives, under both its current and proposed authority, the FDIC only has until 5 p.m. on the business day following its appointment as a receiver to dispose of the problems. The rationale behind the one-business day turnaround is that the value of derivatives is tied closely to a company's relationship with others in the market and its need for immediate and continuous access to liquidity.

According to a summary of the administration's regularly reform framework by the international law firm Gibson, Dunn & Crutcher, which represents banks and other financial firms, the FDIC would have the "power to repudiate 'burdensome' contracts and leases and is liable only for 'actual direct compensatory damages' and no damages for profits or lost opportunity or pain and suffering or punitive damages...[and it would be able to] enforce contracts despite default, termination, or acceleration clauses."

The proposal has its critics. The International Swaps and Derivatives Association, a global trade group representing the over-the-counter derivatives industry, is concerned that the bill wouldn't allow firms to immediately net-out and end their contracts.

"In general, our main concern about any wind-down authority would be to ensure that potential legislation recognizes the importance of the enforceability of close-out netting to the derivatives markets and the counterparty risk management benefits this brings," the group said in a statement.

To put the provision into context, let's imagine that AIG had been taken over by the FDIC. Rather than the troubled insurer paying Goldman Sachs $12.9 billion for its disastrous credit-default swaps (a type of derivative contract) -- a sum paid in full per the contracts -- the FDIC could have mandated a lesser payment. In the real world, however, the New York Fed chose to make AIG pay all of its debts in full. Per Jonathan Weil of Bloomberg:

AIG wound up paying $32.5 billion to retire the swaps, $13 billion more than if it had paid, say, 60 cents on the dollar. The New York Fed also arranged to pay the banks $29.6 billion for collateralized-debt obligations backed by subprime mortgages and other loans, a tad less than half their face value. (The swaps were side bets by the banks that rose in value as the CDOs fell.)

It probably made sense for the counterparties to reject AIG's initial settlement offers. They had their own investors to look after. And once the government took control of AIG, it couldn't credibly threaten to force the company into bankruptcy proceedings. The premise of the government's seizure, after all, was that AIG was too big to fail.

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