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Dodd Amending Financial Reform Bill To Prevent 'Backdoor Bailouts' After Concerns Raised

First Posted: 05/19/10 06:12 AM ET Updated: 05/25/11 04:55 PM ET

Dodd

In response to concerns that his financial reform bill allows for "backdoor bailouts," Senate Banking Committee Chairman Christopher Dodd will amend his proposal to preclude the possibility of taxpayers spending billions to prop up another flailing firm like AIG.

On Friday morning, Federal Deposit Insurance Corp. Chairman Sheila Bair, who has emerged as a darling of progressives and those wishing to level the playing field between Wall Street megabanks and Main Street community banks, said in a speech in Orlando that she had "serious concerns" about Dodd's bill.

"[It] seem[s] to allow the potential for backdoor bailouts through the Federal Reserve Board's 13(3) authority," she told a conference of community bankers, hosted by the Independent Community Bankers Association.

The Fed used its authority under Section 13 of the Federal Reserve Act to bail out AIG -- a bailout that eventually reached more than $180 billion and included tens of billions funneled to firms like Goldman who were AIG's counterparties on sophisticated derivatives contracts. Members of Congress frequently refer to these payments as "backdoor bailouts."

"We will work closely with the Senate to make sure there are no loopholes around the carefully crafted resolution procedures," Bair said in her prepared remarks. "If the Congress accomplishes anything this year, it should be to clearly and completely end too big to fail.

"Never again should taxpayers be asked to bailout a failing financial firm. It's time that the big players understand that they sink or swim on their own," Bair said.

The relevant section of Dodd's bill appears to begin on page 1,302 of the 1,336-page bill.

In an e-mail to Huffington Post, Dodd's spokeswoman, Kirstin Brost, said: "We informed her office yesterday that the provision Chairman Bair is concerned about will be removed in the manager's amendment."

If Dodd's amendment is accepted, that provision in the Federal Reserve Act will read:

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any any program or facility with broad-based eligibility notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange the Federal reserve bank shall obtain evidence that such participant in any program or facility with broad-based eligibility is unable to secure adequate credit accommodations from other banking institutions. All such discounts any program or facility with broad-based eligibility shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.


Dodd's amendment will prevent targeted bailouts, said Gilbert T. Schwartz, former associate general counsel of the Fed's Board of Governors.

"It has the effect of eliminating the possibility of picking a specific financial institution that's been determined to be targeted as a financially-significant entity, and knocks them out," said Schwartz, a partner at Schwartz & Ballen LLP in Washington. "It... is only going to be available for these general, broad-based programs that the Fed has established... like the TALF program or commercial paper program [which are] open to anybody, so long as they satisfy the criteria."

The Term Asset-Backed Securities Loan Facility, or TALF, gives investors cheap loans to buy securitized debt. It was designed to jump-start the frozen securitization market.

"So the Fed, in theory, wouldn't be able to assist AIG... assuming it had been identified... as worthy of being bailed out," Schwartz said. "It narrows the Fed's options considerably."

"You're not creating Too Big To Fail," he said. "You're not saying we're going to bail out the big institutions.

"In theory, you're saying we'll bail out everybody by having these broad-based programs," Schwartz said. "But you're really not. What you're doing is benefiting the marketplace. It's effectively saying no more AIGs. But on the other hand, you can bail out an industry."

Currently, the Fed's 13(3) authority, which allowed it to bail out AIG, reads (emphasis mine):

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.
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