How will the FDIC unwind repos?

The Dodd-Frank Act gave the FDIC the job of resolving systemically important financial institutions when they are in financial trouble. 

How will the FDIC handle that company’s repos? An FDIC report April 18 gives the answer.

It will sell them to an acquiring firm or give them to a temporary workout bank set up just to handle some of the failing company’s businesses until the FDIC can unwind them in an orderly way.

Lenders will not be allowed to unilaterally terminate their repo contracts and seize the collateral, as they would normally be able to do when a repo borrower files bankruptcy.

Some analysts claim that the right to terminate repo contracts without fear of getting caught up in a bankruptcy proceeding let lenders ignore risk. It meant they had no skin in the game. It encouraged them to withdraw from the repo market in 2007 and 2008, because they didn’t have to care if their actions forced a company into bankruptcy.

The credit crisis that then developed, when the repo market dried up, was the main reason for the government bailout of the banks in 2008, regulators have said. Some economists are calling it a repo run on the banks, similar to depositor runs on banks 100 years ago.

The FDIC claims its plan could have helped prevent that panic, by giving repo lenders confidence that their deals will be honored.

The very availability of a comprehensive resolution system that sets forth in advance the rules under which the government will act following the appointment of a receiver could have helped to prevent a “run on the bank” and the resulting financial instability.

The FDIC has been successfully unwinding insolvent commercial banks and thrifts for many years. But a systemically important financial institution, by definition, is going to be much bigger, far more complicated, international in scope and interwoven with others through thousands of transactions.

The largest institution the FDIC has ever taken over was Seattle-based Washington Mutual Bank, which the FDIC seized Sept. 25, 2008. It had $310 billion in assets. The largest banks likely to be deemed “systemically important financial institutions” by the Financial Stability Oversight Council have $2 trillion in assets: Bank of America, JP Morgan Chase and Citigroup.

Critics like MIT professor Simon Johnson think the U.S. Treasury Department and the Federal Reserve will not let a systemically important financial institution fail, even with the FDIC in the wings ready to take over.

Other observers, like the New York finance lawyer who blogs at Economics of Contempt, think regulators will let systemically important financial institutions fail, believe the FDIC can unwind them, and point out that the Dodd-Frank Act requires it.

The FDIC’s April 18 report does not talk about repurchase agreements. Instead, it talks about qualified financial contracts, which it says includes repos, securities contracts, commodities contracts, forwards contracts, swaps, and any similar agreements.

It calls the temporary workout bank a bridge bank.

From the report:

A complex, systemic financial company can hold very large positions in qualified financial contracts, often involving numerous counterparties and back-to-back trades, some of which may be opaque and incompletely documented.

A disorderly unwinding of such contracts triggered by an event of insolvency, as each counterparty races to unwind and cover unhedged positions, can cause a tremendous loss of value, especially if lightly traded collateral covering a trade is sold into an artificially depressed, unstable market.

Such disorderly unwinding can have severe negative consequences for the financial company, its creditors, its counterparties, and the financial stability of the United States.

In contrast, the Dodd-Frank Act expressly permits the FDIC to transfer qualified financial contracts to a solvent financial institution (an acquiring investor) or to a bridge financial company.

In such a case, counterparties are prohibited from terminating their contracts and liquidating and netting out their positions on the grounds of an event of insolvency.

The receiver’s ability to transfer qualified financial contracts to a third party in order for the contracts to continue according to their terms—notwithstanding the debtor company’s insolvency—provides market certainty and stability and preserves the value represented by the contracts.