REPORT TO THE CONGRESS ON SECURED CREDITOR HAIRCUTS
FINANCIAL STABILITY OVERSIGHT COUNCIL
Completed pursuant to Section 215 of the Dodd-Frank Wall Street Reform and Consumer Protection Act
Contents of the Financial Stability Oversight Council Secured Creditor Haircuts Study
I. Introduction and Executive Summary
II. Key Questions
III. Secured Creditor Haircuts
A. Mechanics of Secured Creditor Haircuts
B. Assessing the Impact of Secured Creditor Haircuts
IV. Comparison of Treatment of Secured Creditors under Different Resolution Mechanisms
B. Bankruptcy Code
C. Federal Deposit Insurance Act
D. Orderly Liquidation Authority
E. Summary of Comparison of Resolution Mechanisms
V. Other Reforms that Protect Taxpayers from Loss and Promote Market Discipline.....29 A. Title I of the Dodd-Frank Act
B. Basel III
C. Increased Transparency of Funding Arrangements
Appendix A: Overview of Certain Forms of Secured Lending
I. Repurchase Agreements
II. Stock Loan and Stock Borrow
III. Sell-Buyback Arrangements
I. Introduction and Executive Summary On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).1 Two of the goals of the Dodd-Frank Act are to promote market discipline and taxpayer protection. Section 215 of the Dodd-Frank Act calls on the Financial Stability Oversight Council (“Council”) to study whether allowing regulators in a resolution proceeding to treat a portion of fully secured creditors’ claims as unsecured (“secured creditor haircuts”) would promote these objectives.2 While section 215 contemplates evaluating secured creditor haircuts in the utilization of the orderly liquidation authority (“Orderly Liquidation Authority” or “OLA”) authorized by Title II of the Dodd-Frank Act, OLA provides no authority to impose secured creditor haircuts.3 Proponents of secured creditor haircuts believe secured creditor haircuts would be an effective means of promoting market discipline and taxpayer protection. They argue that secured creditor haircuts would: (a) cause secured creditors to engage in more extensive credit analysis and monitoring, thereby limiting the ability of the largest, most interconnected financial firms to pose a risk to U.S. financial stability; (b) promote taxpayer protection by giving the United States priority over a portion of the secured claims of other creditors; and (c) reduce collateral demands on distressed firms and discourage secured creditors from taking value-destroying actions that would force borrowers into failure.
Others have questioned the efficacy of secured creditor haircuts in promoting market discipline and taxpayer protection, and have argued that secured creditor haircuts may have significant drawbacks. They believe that secured creditor haircuts would: (1) reduce financial stability, including by limiting the availability of secured lending in a crisis; (2) have a negative impact on borrowers’ cost of funds, increasing the cost of funds for financial firms directly and for other 1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
Section 215 of the Dodd-Frank Act requires the Council to:
[C]onduct a study evaluating the importance of maximizing United States taxpayer protections and promoting market discipline with respect to the treatment of fully secured creditors in the utilization of the orderly liquidation authority authorized by this Act. In carrying out such study, the Council shall— (1) not be prejudicial to current or past laws or regulations with respect to secured creditor treatment in a resolution process; (2) study the similarities and differences between the resolution mechanisms authorized by the Bankruptcy Code, the Federal Deposit Insurance Corporation Improvement Act of 1991, and the orderly liquidation authority authorized by this Act; (3) determine how various secured creditors are treated in such resolution mechanisms and examine how a haircut (of various degrees) on secured creditors could improve market discipline and protect taxpayers; (4) compare the benefits and dynamics of prudent lending practices by depository institutions in secured loans for consumers and small businesses to the lending practices of secured creditors to large, interconnected financial firms; (5) consider whether credit differs according to different types of collateral and different terms and timing of the extension of credit; and (6) include an examination of stakeholders who were unsecured or under-collateralized and seek collateral when a firm is failing, and the impact that such behavior has on financial stability and an orderly resolution that protects taxpayers if the firm fails.
3 See 12 U.S.C. §§ 5390(a)(3)(D), (b)(5).
1 firms indirectly; and (3) lead financial firms to rely more heavily on other forms of financing, which could reduce funds available for resolution should such firms fail.
This report evaluates these and related topics. Section II (“Key Questions”) summarizes the Council’s evaluation of each of the issues the Council is required to assess under section 215(a)(2)-(6) of the Dodd-Frank Act. Section III (“Secured Creditor Haircuts”) describes the mechanics of secured creditor haircuts, and evaluates their intended benefits and potential drawbacks. Section IV (“Comparison of Treatment of Secured Creditors under Different Resolution Mechanisms”) sets out aspects of the Bankruptcy Code, the Federal Deposit Insurance Act, and the Orderly Liquidation Authority that bear on the issue of secured creditor haircuts. Finally, Section V (“Other Reforms that Protect Taxpayers from Loss and Promote Market Discipline”) reviews other reforms that would help to achieve the same goals of market discipline and taxpayer protection as secured creditor haircuts would be intended to achieve.
The report supports the view that the combination of the Orderly Liquidation Authority and the new supervisory framework provided by Title I of the Dodd-Frank Act4 can be used to achieve the goals of market discipline and taxpayer protection effectively in the absence of secured creditor haircuts.
II. Key Questions Consistent with its statutory mandate, the Council evaluated each of the questions posed below in preparing this report on secured creditor haircuts.
What are the similarities and differences between the resolution mechanisms authorized by the Bankruptcy Code, the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) and the Orderly Liquidation Authority?
The U.S. Bankruptcy Code, the Federal Deposit Insurance Act (as amended by FDICIA, “FDIA”), and OLA have different goals. The primary goal of the bankruptcy process is to maximize the value of a debtor’s assets for the benefit of its stakeholders and, if justified, provide the debtor with the ability to reorganize.5 The Federal Deposit Insurance Corporation’s (“FDIC”) process for resolving and liquidating a failed insured depository institution (“IDI”) under the FDIA is driven by the FDIC’s mandate to maintain confidence in the banking system, including through the protection of insured depositors from losses, and to liquidate a failed IDI in the manner least costly to the Deposit Insurance Fund (“DIF”). The objective of OLA is to prevent serious adverse effects on U.S. financial stability, while prioritizing the goals of protecting taxpayers and maintaining market discipline above the goals of preserving the going-concern value of the debtor’s estate solely for the benefit of the failed firm’s stakeholders. The differing goals of the Bankruptcy Code, FDIA, and OLA give rise to other key distinctions, including the types of institutions subject 4 As discussed in Section V, the new supervisory framework provided by Title I of the Dodd-Frank Act is complemented by other recent reforms, including new “Basel III” capital, leverage and liquidity requirements.
5 THOMAS JACKSON, THE LOGIC AND LIMITS OF BANKRUPTCY LAW, 10-17, 20 (Beard Books 2001).
How are secured creditors treated in such resolution mechanisms, and how might a haircut (of various degrees) on secured creditors improve market discipline and protect taxpayers?
The U.S. bankruptcy process generally allows a secured creditor to retain the benefit of its superior non-bankruptcy rights by granting the creditor’s secured claim full priority over other claims up to the value of its security interest, by providing the secured creditor “adequate protection” against a loss during the debtor’s retention of collateral, and by providing for judicial involvement at the time creditors’ rights are determined. The FDIC IDI resolution process under the FDIA is an administrative process designed to help the FDIC carry out its responsibility to maintain confidence in the banking system.6 The FDIC as receiver has many of the same authorities under the FDIA that a bankruptcy trustee has under the Bankruptcy Code for recovery of the debtor’s property that was transferred prior to the point of bankruptcy or receivership to both secured and unsecured creditors (e.g., avoidance of preferential transfer and fraudulent conveyance in cases of actual fraud). As compared to the bankruptcy process, administrative processes by design have less contemporaneous judicial involvement. OLA continues to protect the contractual rights of secured creditors in many of the same ways as the Bankruptcy Code, while adopting many of the expanded authorities available to the FDIC for resolving IDIs.7 As discussed in more detail below, proponents of secured creditor haircuts argue that secured creditor haircuts would promote market discipline and strengthen taxpayer protection by creating incentives for secured creditors to engage in more extensive credit analysis and monitoring, giving the United States priority over a portion of the secured claims of other creditors, and reducing collateral demands on distressed firms. However, others believe secured creditor haircuts could reduce financial stability by severely limiting the availability of credit in a crisis, raise the cost of funds for financial firms and other borrowers throughout the economy, and increase the use of other forms of financing that could reduce funds available for resolution.
How do the benefits and dynamics of prudent lending practices by depository institutions in secured loans for consumers and small businesses compare to the lending practices of secured creditors to large, interconnected financial firms?
Prudent lending practices by depository institutions generally involve extensive credit analysis for each loan extended to a consumer or small business. Such loan-by-loan credit analysis is an important means of limiting risk when lenders do not already have substantial knowledge of borrowers, particularly when loans are long-duration, secured by illiquid collateral or would be subject to the automatic stay and avoidance provisions of the 6 The FDIC’s powers include: (1) the ability to transfer assets or liabilities quickly without counterparty or judicial consent to a bridge depository institution; (2) the ability to place failing IDIs into receivership prior to actual default, subject to ex post court review and other safeguards; and (3) the ability to place a temporary limitations on creditors’ rights to unwind financial contracts of the failed firm.
7 See 12 C.F.R. pt. 380 (2011).
3 Bankruptcy Code if the borrower were to enter a bankruptcy proceeding. Lenders to large, interconnected financial firms may have less need to engage in this type of credit analysis because, for example, they may have an understanding of the firms’ credit profile from repeated dealings and from publicly available sources, such as audited financial statements, material event disclosures, and market analyst reports. Further, secured lenders to major financial firms may manage risk by adjusting the duration of loans, obtaining high quality collateral, and entering into lending agreements that would allow them to obtain their collateral immediately if the borrower becomes insolvent or files for bankruptcy.
Differences in the form of credit analysis do not necessarily indicate a lack of market discipline.
Does credit differ according to different types of collateral and different terms and timing of the extension of credit?
Extensions of credit differ along many dimensions, including loan duration, the nature of collateral, and the applicable legal structure. In the context of secured lending to consumers and small businesses, credit is often long-duration, secured by relatively illiquid collateral, and could be subject to the automatic stay, and to avoidance provisions of the Bankruptcy Code if the lender sought to obtain its collateral shortly before the borrower filed for bankruptcy. A significant portion of secured lending to large, interconnected financial firms is short-term, secured by highly liquid collateral, and qualifies for the “safe harbor” provisions of the Bankruptcy Code for “qualified financial contracts” (“QFCs” and “QFC Safe Harbors”).8 What was the impact, on both financial stability and on an orderly liquidation that protects taxpayers, of stakeholders who were unsecured or under-collateralized and sought collateral when a firm was failing?