Musk and Treasury's Payment Systems (He Punched the Bursar...)

Updated Feb. 6, 2025:  Elon Musk and his DOGE team are seeking (and apparently gaining) access to Treasury’s computer systems for managing payments.  Unfortunately, a lot of the media coverage has done a poor job of explaining the particular concerns, in part because there isn't very good understanding of exactly what Treasury does. Let met try to add some clarity here, recognizing that there's still a lot we don't know about what is motivating Musk.

 

A Uniform Law Project of Note: Special Deposits Act

Last week, bolstered by a continuing legal education program offered by the American Law Institute, I started studying a new uniform law that will be recommended to your state legislature in the coming days and months. It is called the Special Deposits Act. As of today it has not yet been enacted by a state legislature. But trust me when I predict that you want to study it too - especially because the choice of law rules will work differently for this uniform law than for, say, the digital assets amendments to the Uniform Commercial Code. In other words, if one of the green states in the map below adopts the law, parties can contract for that state to govern the special deposit as well as to be the forum for disputes, even if there's no other relationship with that state.

 

 

 

 

 

 

 

 

 

 

A special deposit is payable on the occurrence of a contingency and the identity of the party entitled to the funds is uncertain until the contingency happens. Right now, the law governing special deposits is nonuniform and the details can be uncertain, including the rights of creditors against those funds. One big impact of this uniform Special Deposits Act is this: in broadest terms, if a bank and depositor agree that a deposit account is a special deposit, and it meets the requirements for permissible purpose under the law, this law says that the funds in that account are not property of the depositor, including if the depositor files for bankruptcy, and cannot be reached by the depositors' creditors. (Fraudulent transfer law still applies and the drafters say there are other anti-fraud measures in place). The bankruptcy world may be interested in this law for an additional reason: possible use of special deposits in a bankruptcy case to pay professionals, or for large numbers of claimants, etc.

I also find this law interesting because of its implications for loans secured by deposit accounts under Article 9 of the Uniform Commercial Code. Even if a bank has a security interest in all deposit accounts of a debtor held by a bank, and is automatically perfected by control, the bank's enforcement rights are far more limited against the special deposit than against a typical bank account. In general, the bank cannot exercise rights of setoff or recoupment against a special deposit.

Again, as of today no state has enacted the Special Deposits Act. But given how the law is drafted, it will take just one state to adopt it, and for lawyers to encourage banks and depositors to opt in to that state's law, to have a much broader effect. Check out the materials here.

The Debt Limit Is Unconstitutional—But It's Not What You Think!

Anna Gelpern, Stephen Lubben and I have an article in The American Prospect entitled The Debt Limit Is Unconstitutional—but Not for the Reason You Think. Various commentators—and members of Congress—have suggested that the President “invoke the 14^th Amendment” to declare the debt limit unconstitutional. They're right to argue that the debt limit is unconstitutional, but the constitutional problem isn't the 14^th Amendment. Instead, it's Article I of the Constitution, namely Congress's power to enter into contracts. The tl;dr version is that Congress has a power to make binding commitments for the United States and the President is constitutionally obligated to perform those commitments. If the Treasury lacks the funds, then the President must borrow. No specific authorization is needed. Instead, it is implicit every time Congress appropriates funds to perform a binding commitment.

Relocating the constitutional problem with the debt limit isn't merely an academic exercise. It has two implications.

First, it changes the nature of the legal debate and puts the administration on much, much firmer legal footing. The 14th Amendment argument is weak because it simply is not a prohibition on defaulting. It's a prohibition on repudiation, and a default is not a repudiation. An Article I argument reframes the issue as being about the validity of the debt ceiling, rather than the ability to default. In other words, it goes to question of whether the House GOP has holdup power, rather than whether the administration is under some cryptic constitutional limitation that it must affirmatively "invoke."

Second, it means that the President not only can, but must disregard the debt limit in order to fulfill his own constitutional duty to "Take Care" that the laws are faithfully executed. In other words, breaching the debt limit is not merely an option, but a legal requirement if Treasury is short of funds. Once Congress has appropriated funds, the President must carry out the authorized spending.

Debunking Debt Ceiling Myths

The commentary on the debt ceiling standoff has featured a bunch of mistaken conceptions from across the political spectrum. Let's address them. 

Myth #1:  The 14th Amendment Prohibits a Default

A variety of commentators claim that the 14th Amendment prohibits the United States from defaulting. It does nothing of the sort. Read the text of the Public Debt Clause: 

The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.

The Public Debt Clause is a prohibition on disputing the validity of US debt obligations--that is disputing whether they are legitimately owed. There's not a word in the 14th Amendment about default. The drafters of the Public Debt Clause included some very experienced commercial lawyers. They understood the difference between defaulting on an obligation and disputing or repudiating an obligation.  For example, I might acknowledge that I owe a loan, but just not be able to pay it. That's different than saying "I don't owe the money."

The Public Debt Clause is a prohibition on Congress, the Executive, and the Courts from disavowing US debt obligations. It's not a prohibition on defaulting because such a prohibition would be meaningless. If a country is unable to pay its obligations, no constitutional commitment device can change that. A constitution cannot fill a bare cupboard. And if a country is simply unwilling to pay its obligations (but admits to them), then its creditors are left with whatever legal recourse they might have. But prohibiting default doesn't get creditors anything. Prohibiting disavowal does because it means that creditors retain their right to be paid.

What all this means is that "invoking the 14th Amendment" is meaningless, unless it is shorthand for "treating the debt limit as unconstitutional." Now it just so happens that the debt limit is unconstitutional—but not because of the 14th Amendment!

 

FDIC's Poor Track Record in Holdco Bankruptcies

Last week I did a post about how the FDIC as receiver for Silicon Valley Bank probably doesn't have a claim against SVB Financial Group, the holdco of the bank. I got some pushback on that (including from a former student!), but I'm sticking to my guns here. It's a result that seems wrong and surprising, but if you look at the three most recent big bank holdco bankruptcies (this takes some digging in old bankruptcy court dockets), the FDIC has ended up with little or no claim.

The Blurring of Tech and Finance

I have an op-ed in ProMarkets about how Apple leverages control of the iPhone's NFC chip to push the dominance of its platform into new areas that let it hoover up more consumer data. The NFC (near field communication) chip is what lets the iPhone do contactless payments for ApplePay.  Apple strictly controls access to the NFC chip--it doesn't let AndroidPay use it, for example. But the NFC chip's uses extend beyond payments.  Apple is now using it to let the iPhone operate as a car key and a hotel room key. The catch? If you're a car manufacturer or hotel and you want this cool technology to work with your product, you're going to need to share some of the consumer data with Apple. 

What we're seeing here is an example of the increased blurring between tech companies and financial services companies, tied together by troves of consumer data.  This is a development that ultimately challenges the traditional regulatory boundaries of FTC and CFPB and is going to raise all sorts of issues for antitrust, consumer protection, and data privacy for years to come.

Collins v. Yellen: the Most Important (and Overlooked) Implication

The Supreme Court's decision in Collins v. Yellen has garnered a fair amount of attention because it resulted in a change in the leadership at the Federal Housing Finance Agency and largely dashed the hopes of Fannie and Freddie preferred shareholders in terms of seeing a recovery of diverted dividends. But the commentary has missed the really critical implication of the decision:  the Biden administration can undertake a wholesale reform of Fannie and Freddie by itself without Congress.

Collins v. Yellen

The Supreme Court ruled today in Collins v. Yellen, a case brought by Fannie Mae and Freddie Mac preferred shareholders that challenged both the constitutionality of the FHFA Director's appointment and the 2012 amendment to Treasury's stock purchase agreement with Fannie and Freddie that provided for all of Fannie and Freddie's profits to be swept into Treasury. The preferred shareholders are miffed because they believe that those dividends should be paid to them first, never minding the fact that but for the Treasury stock purchase, Fannie and Freddie would have been liquidated in receivership, resulting in the preferreds being wiped out. 

 

SCOTUS, following its ruling in Seila Law v. CFPB, held that the FHFA Director must be removable at will by the President. In light of this finding of unconstitutionality in the appointment of the FHFA Director, the Court remanded for consideration of damages from past profit sweeps. Future profit sweeps are permitted, however, as the Director is now clearly removable at will by the President.

 

While some media is pitching the outcome as a mixed ruling, it really isn't for the preferred shareholders. The preferreds took it on the nose here, and the market gets it: Fannie Mae preferred shares tumbled in value by 62% after the decision.

 

No More Bailouts

I have a new white paper out from the Roosevelt Institute's Great Democracy Initiative. The paper, which is co-authored with Lindsay Owens and Ganesh Sitaraman, proposes a standing emergency economic stabilization authority to provide an off-the-shelf immediately available response to common problems that recur in national economic crises.

The motivation for the white paper is that in the past dozen years we've been through two rounds of massive ad hoc bailouts. We shouldn't be doing this on the fly. Instead, we need to have a suite of programs ready to go. Think of this as an "in case of emergency, break glass" approach.

Fun with CLOs

Frank Partnoy has an important and unsettling piece in The Atlantic about how CLOs (securitized syndicated loans, in short) might be at the core of the next bank meltdown, which he sees coming as soon as later this year. Because 2020 was starting to get dull ... 

The Great American Housing Bubble

My new book, The Great American Housing Bubble:  What Went Wrong and How We Can Protect Ourselves in the Future was just released by Harvard University Press. The book is co-authored with my long-time collaborator, Wharton real estate economist Susan Wachter. It's the culmination of over a decade's worth of work on housing finance that began in the scramble of fall 2008 to come up with ways of assisting hard-pressed homeowners.

Summary of the McConnell Bailout Bill

The McConnell Bailout Bill (a/k/a HR 748 or the CARES Act), weighs in at just shy of 600 pages. I've taken the liberty of summarizing it in a powerpoint deck for teaching (syllabus be damned) and thought it might be helpful to make generally available. Here it is. (11:00 3/23 updated/corrected version).

I only warrant it as best efforts (meaning I might have misread or just missed something in this monster bill) and I have made no attempt to summarize the details of the social insurance program (UI, Medicare, Medicaid) interventions because they are outside my expertise. You'll have to read the bill itself (Part I and Part II) for that.  

I'll note quickly two things for Slips aficionados: there's no bankruptcy piece anywhere within the bill. There might end up being some very minor bankruptcy changes, but bankruptcy really isn't where the action is right now. 

You might consider how the airline bailout package in the bill compared with GM/Chrysler. That ought to be the benchmark for direct government rescue lending to real economy firms.  

The Bailout Cronyism and Corruption Have Already Begun

We need to bail out the economy, and it's not going to be cheap. The government is going to have to carry the economy for 18-24 months. There's no way of avoiding that. But we don't need to be stupid or corrupt about the way we do it. And stupidity and corruption is unfortunately so hardwired into the Trump administration's DNA that it is being reflected in virtually every proposal out of the administration. 

Start with Treasury's ill-advised proposal to send checks out to every man, woman, and child in the United States. Beside being operationally difficult and misdirecting much of the aid, it is first and foremost a political move. These are serious times. They call for serious responses, not political maneuvers.  

And now, we learn that Treasury Secretary Steven Mnuchin is proposing turning to Goldman Sachs executives to provide assistance in administering the bailout. It's hard to think of anything more politically tone-deaf other than perhaps delegating the bailout to Wells Fargo.

More importantly, Goldman is objectively not the right institution to help. Goldman does virtually no small business lending, and their consumer lending is a small portfolio of loans to affluent individuals. It’s not even at the top of the bracket in commercial lending generally. Goldman is primarily an investment bank that does M&A and securities underwriting; they're not known as commercial bankers. The challenges in the bailout response are restructuring and commercial banking issues, including a lot of operational problems. That's just not where Goldman's strengths lie. So why Goldman? Just more cronyism.

This should be a bright flag to ever member of Congress that Steven Mnuchin cannot be trusted to lead the bailout efforts. If he does, we're looking at something a lot worse than HAMP 2.0. A key part of any bailout is going to be its governance. There's inevitably going to be a fair amount of discretion involved in the bailout efforts. We need the bailout to be led by serious people. Sadly, there are not many serious people in any position of authority in the Trump administration. That suggests that Congress needs to come up with a governance structure for any bailout funds that is new and independent of the Trump administration.

I don't mean by this that it needs to be a bunch of people who share my political views. There are plenty of competent and serious people from both parties who aren't in the Trump administration. Hopefully this is a time that Senator McConnell recognizes that he can't turn the keys over the Trumpists; the effectiveness of a bailout is going to depend on whether Congress gets the governance structure right. We need to take a serious problem serious and not see it as an opportunity for self-enrichment and political gain. 

 

COVID-19 Response: The Need for Speed

While Congress struggles to figure out the best way to respond to the coronavirus pandemic, it is very apparent that immediate relief measures are necessary, if only to buy time for a more comprehensive approach. Layoffs are already happening and with they continue, it will result in more economic disruption from diminished consumption.

1. Sending out checks isn't fast enough (and can't happen in two weeks)

There is, fortunately, some recognition of that speed is imperative, but there's a right way and a wrong way to do it. The wrong way is what the Trump administration is proposing, namely sending everyone a check. Besides being poorly tailored—$1,000 isn't enough for those who really need help and is wasted on many other folks—the problem is it just cannot happen fast enough. No one is being honest about the operational problems. Treasury Secretary Steven Mnuchin is going around saying that he wants to get checks for $1,000 to every American within two weeks. That's just not possible, and Mnuchin should stop overpromising. 

Here's why it won't work fast enough: for Treasury to send everyone a check, it would need to know where to send the checks. It doesn't. Treasury knows where to send checks to individuals who are receiving Social Security and Disability Insurance (actually, it would be electronic transfers in almost all such cases). But what about everyone else? Treasury doesn't know (a) who is still alive, and (b) where they live. The first problem might mean sending out some checks that shouldn't happen, but the second problem is more serious, as it means that checks won't get where they need to go. Treasury is able to send me a tax refund because I give an address with my tax return. At best Treasury has year-old information, which will be wrong for many people. Those people who most need the money are the people who are most likely to have moved in the last year—economically insecure renters (see Matthew Desmond's Evicted on this). Sending everyone a check really isn't a very good solution. 

2. Foreclosure/eviction moratoria are equivalent to an immediate cash injection to the economy.

Fortunately, there's a better solution:  an immediate national moratorium on foreclosures, evictions, repossessions, utility disconnects, garnishments, default judgments, and negative credit reporting for all consumers and small businesses. The point of a national collection action moratorium is not to be nice to debtors. A national collection moratorium is a stimulus measure:  it has the effect of immediately injecting cash into the economy in that it allows people and businesses to shift funds from debt service obligations to other consumption. It's basically a giant forced loan from creditors to debtors. And it happens immediately, without any administrative apparatus. There's nothing else that will have such a big effect so immediately. Congress should move on moratorium legislation asap as a stand-alone bill to buy itself some more time for a longer-term fix.  

Now let's be clear—what I am talking about is not debt forgiveness. It is forced forbearance. The debts will still be owed and may accrue interest and late fees (there may be ways to limit those, but that's another matter). That's important because it substantially reduces the argument that the delay constitutes a Taking—government is always free to change how remedies operate, such as changing foreclosure timelines, etc. without the changes being a Taking.

This is exactly what a moratorium would be doing. A number of states and localities have already undertaken such moratoria, and FHFA and HUD have done so for federally or GSE insured or guarantied loans. But we've got a national crisis, so this should be done uniformly on the federal level using the Interstate Commerce power for the entire consumer and small business debt market. Given that all collection actions involve the mails or wires and that debt markets are national, this seems squarely within the scope of federal power. 

Now a collection moratorium is not a permanent fix and will cause some dislocations itself. Consumers/small businesses will eventually need to come current on their obligations, and they may need assistance to do so, but that's something that we can work on later when we're not in free fall. But right now what we need more than anything is time, and a collection moratorium can buy us some time more broadly and more immediately than any other possible step. 

Federal Reserve Emergency Lending as a Coronavirus Response

Senator Elizabeth Warren has put out a plan for mitigating the economic fallout from the coronavirus. Of particular note is that she is proposing having the Federal Reserve use its emergency lending power to support businesses affected by the coronavirus in order to ensure that they are able to provide paid health care leave to affected employees and avoid mass layoffs.  

This post addresses whether the Fed has the legal authority for such lending, what precedent exists, how it differs materially from the 2008 bailouts, and why it's a good idea. (Full disclosure: I consulted with the Warren campaign on this plan.)  

Bankruptcy and Mindfulness

The practice of mindfulness and other types of meditation are growing on the coasts and within the law school and lawyer communities. Perhaps these practices can provide meaningful benefits to bankruptcy clients, bankruptcy lawyers and bankruptcy professors and judges. The essence of "mindfulness for lawyers" efforts begins with the notion that the adversary system can take a toll on home life, friendships and our own notions of who we want to be. A meditation practice can help us concentrate and be the best lawyers we can be and also the best friends and family members we want to be; and perhaps even help us to be the kind of persons we want to be. It is a mix of focusing more fully on the present, mixing that with lovingkindness to ourselves and others, and observing what is going on in our minds, all without judgment.

Consumer bankruptcy debtors, creditors, practitioners and judges are constantly faced with problems for which the legal system is at best a partial solution. In most cases there are a few true winners and a host of partial winners, partial losers and complete losers. Mindfulness can help us keep a focus on the matter in front of us and also help us maintain our passion for life and practice.  On the business bankruptcy side, our duty of loyalty combined with the zealous representation ethic can allow the day-to-day fighting to change our character and perhaps even our values. In every community there are a host of ways of starting such a practice.  The book 10% Happier by Dan Harris is an easy entry point and in most communities there is a Mindfulness Based Stress Reduction course available.  More and more law schools and bar associations are providing such opportunities. Mindfulnessinlawsociety.com and themindfullawstudent.com are excellent resources.  I am enjoying teaching mindfulness to law students as well as faculty and staff at Saint Louis University Law School. 

 

 

Libra and Financial Inclusion

Facebook’s proposed Libra cryptocurrency project has truly stirred up a hornet’s nest of controversy.  Critics have generally focused on Libra as a currency and the power of Facebook in society and its appropriation of users’ privacy.  

I think that discussion misses a key point.  Libra will be, first and foremost, a payment system.  It will be a payment system that happens to operate using a currency index, rather than a single country’s currency, and clear using blockchain rather than other clearing software, but it’s still a payment system, that is a system for moving value between parties.  The payment system aspect is what both makes me incredibly skeptical about Libra’s financial inclusion claims and about Libra’s prospects for success. 

Reflections on the foreclosure crisis 10th anniversary

Before it was the global financial crisis, we called it the subprime crisis. The slow, painful recovery, and the ever-widening income and wealth inequality, are the results of policy choices made before and after the crisis. Before 2007, legislators and regulators cheered on risky subprime mortgage lending as the "democratization of credit." High-rate, high-fee mortgages transferred income massively from working- and middle-class buyers and owners of homes to securities investors.

After the crisis, policymakers had a choice, to allocate the trillions in wealth losses to investors, borrowers or taxpayers. U.S. policy was for taxpayers to lend to banks until the borrowers had finished absorbing all the losses. The roughly $400 billion taxpayers lent out to banks via the TARP bailout was mostly repaid, apart from about $30 billion in incentives paid to the mortgage industry to support about 2 million home loan modifications, and $12 billion spent to rescue the US auto industry. The $190 billion Fannie/Freddie bailout has also returned a profit to the US Treasury.  Banks recovered quickly and are now earning $200 billion in annual profits. Of course, equity investors, particularly those wiped out by Lehman and many other bankruptcies, or by the global downturn generally, lost trillions as well. The long-term impact, however, was to shift corporate debt to government balance sheets, while leaving households overleveraged.

Thomas Herndon has calculated that 2008-2014 subprime mortgage modifications added $20 billion to homeowner debt (eroding wealth by $20 billion). In other words, all the modification and workout programs of the Bush and Obama administrations did not reduce homeowner debt by a penny. In fact, mortgage lenders added $20 billion (net) fees and interest onto the backs of distressed homeowners. During the same period, $600 billion in foreclosure losses were written off by private mortgage-backed securities investors, implying a similar or greater loss in wealth for foreclosed homeowners. These data include only the private-label side of the housing finance market; adding the debt increase and wealth losses for Fannie and Freddie homeowners could conceivably double the totals.

Nearly 9 million homes were foreclosed from 2007 to 2016. While some were investor-owned, even those often resulted in the eviction of tenant families. Four and one-half million homeowners still remain underwater, i.e. owe more mortgage debt than the value of their home.

 While baby boomers' housing wealth was decimated by foreclosures and increasing mortgage debt, millennials piled on student loan debt, closing the door to home buying and asset building. A recovery built on incomplete deleveraging, and new waves of consumer debt buildup, contains the seeds of the next crisis. While various pundits bemoan the resurgent federal fiscal debt, we would do well to address policies that continue to stoke unsustainable household debt.

CLO Yawn

There's a big story in the NY Times about how the financial structures being used to finance many corporate loans—so-called Collateralized Loan Obligations or CLOs—look very similar to those used to finance mortgages during the housing bubble.  Yup.  That's true. CLOs are a securitization structure, like MBS.  (If you want to know more gory details, see here.)  But that's really where the similarities end.  While the financing transactions are similar, the asset class being securitized is fundamentally different in terms of the risk it presents, and that's what matters.  The financing channel might be more vulnerable to underpricing than other financing channels because of opacity and complexity, but is the underlying asset class that matters in terms of societal impact.  This is for (at least) four reasons. 

ISDA Promotes a Race to the Bottom

Frustrated that Congress did not decide to collapse the CFTC and SEC as part of Dodd-Frank, and facing the reality that the SEC is still working on its rules under Title VII of Dodd-Frank, ISDA, the swaps industry trade group, is out with a white paper that urges the adoption of a "safe harbor."

This is not the infamous bankruptcy safe harbors, but rather a rule that would be adopted by both regulators. The basic idea is that compliance with one regulator's rule is "good enough." That is, swaps traders could choose which regulator they want.

What could possibly go wrong?

The Economic Growth, Regulatory Relief, and Consumer Protection Act

Or EGRRCPA, for short. That is the official name of S. 2155, a bill which seems to be tearing Senate Democrats apart. Republicans are uniformly in favor of the bill, which Bloomberg describes as "another faulty bank-reform bill." Some Democrats see it as needed regulatory relief for small banks, while others, including the one who used to blog here, see S. 2155 as a rollback of keys parts of Dodd-Frank for big banks that remain too big to fail.

It is both. Indeed, if the bill were stripped of its title IV, I think most people could live with it. But title IV is a doozy.  

Most notably, it raises the threshold for additional regulation under Dodd-Frank from $50 billion in assets to $250 billion. Banks with more than $50 billion in assets are not community banks.

The banks in the zone of deregulation include State Street, SunTrust, Fifth Third, Citizens, and other banks of this ilk. In short, with the possible exception of State Street, this is not a deregulatory gift to "Wall Street," but rather to the next rung of banks, all of which experienced extreme troubles in 2008-2009, and all of which participated in TARP.

My prime concern – given my area of study – is that these banks will no longer be required to prepare "living wills." That is, they will not have to work with regulators on resolution plans.

How then do we expect to use Dodd-Frank's orderly liquidation authority if they fail? It would be impossible without advanced planning. Same for the misguided attempts at "chapter 14." I have real doubts about the wisdom of "bankruptcy for banks," but if it is ever to work, it will require lots of advanced planning (and luck).

And we can't use the normal FDIC approach of finding another, bigger bank to take them over, because that would simply create another colossus, like Wells Fargo. Certainly we don't want that.

Maybe a bailout then? Is that the "new" plan?

How S.2155 (the Bank Lobbyist Act) Facilitates Discriminatory Lending

If you think it's ridiculous that the CDC can't gather data on gun violence, consider the financial regulatory world's equivalent:  S.2155, formally known as the Economic Growth, Regulatory Relief, and Consumer Protection Act, but better (and properly) known as the Bank Lobbyist Act.  S.2155 is going to facilitate discriminatory lending. Let me say that again.  S.2155 is legislation that will facilitate discriminatory lending. This bill functionally exempts 85% of US banks and credit unions from fair lending laws in the mortgage market.  Support for this bill should be a real mark of shame for its sponsors. 

Bankruptcy's Lorelei: The Dangerous Allure of Financial Institution Bankruptcy

I have a new (short!) paper out, Bankruptcy's Lorelei:  The Dangerous Allure of Financial Institution Bankruptcy. The paper, which builds off of some Congressional testimony from 2015, makes the case that proposals for resolving large, systemically important financial institutions in bankruptcy are wrongheaded and ultimately dangerous. At best they will undermine the legitimacy of the bankruptcy process, and at worst they will result in crash-and-burn bankruptcies that exacerbate financial crises, rather than containing them.  The abstract is below.

The idea of a bankruptcy procedure for large, systemically important financial institutions exercises an irresistible draw for some policymakers and academics. Financial institution bankruptcy promises to be a transparent, law- based process in which resolution of failed financial institutions is navigated in the courts. Financial institutions bankruptcy presents itself as the antithesis of an arbitrary and discretionary bailout regime. It promises to eliminate the moral hazard of too-big-to-fail by ensuring that creditors will incur losses, rather than being bailed out. Financial institutions bankruptcy holds out the possibility of market discipline instead of an extensive bureaucratic regulatory system.

This Essay argues that financial institution bankruptcy is a dangerous siren song that lures with false promises. Instead of instilling market discipline and avoiding the favoritism of bailouts, financial institution bankruptcy is likely to simply result in bailouts in bankruptcy garb. It would encourage bank deregulation without the elimination of moral hazard that produces financial crises. A successful bankruptcy is not possible for a large financial institution absent massive financing for operations while in bankruptcy, and that financing can only reliably be obtained on short notice and in distressed credit markets from one source: the United States government. Government financing of a bankruptcy will inevitably come with strings attached, including favorable treatment for certain creditor groups, resulting in bankruptcies that resemble those of Chrysler and General Motors, which are much decried by proponents of financial institution bankruptcy as having been disguised bailouts.

The central flaw with the idea of financial institutions bankruptcy is that it fails to address the political nature of systemic risk. What makes a financial crisis systemically important is whether its social costs are politically acceptable. When they are not, bailouts will occur in some form; crisis containment inevitably trumps rule of law. Resolution of systemic risk is a political question, and its weight will warp the judicial process. Financial institutions bankruptcy will merely produce bailouts in the guise of bankruptcy while undermining judicial legitimacy and the rule of law.

Visa's Maginot Line: Chip Cards and the Equifax Breach

The media attention on the Equifax breach has been primarily on consumer harm.  There's real consumer harm, but it's generally not direct pecuniary harm.  Instead, the direct pecuniary harm from the breach will be borne by banks and merchants, and it's going to expose the move to Chip (EMV) cards in the United States without an accompanying move to PIN (as in Chip-and-PIN) to be an incredibly costly blunder by US banks.  Basically, Visa, Mastercard, and Amex have built the commercial equivalent of the Maginot Line. A great line of defense against a frontal assault, and totally worthless against a flanking assault, which is what the Equifax breach will produce.  

Equifax: A Call for Public Utility Regulation of Consumer Reporting Agencies

This post diagnoses what went wrong with Equifax and proposes a solution:  a public utility regulation regime for consumer reporting agencies in which the CRAs would be restricted in their ability to pay dividends and executive compensation unless they meet certain performance metrics in terms of reporting accuracy, dispute resolution, and data security.  Here goes: 

Trump's Bank Regulators: More Swamp Creatures

Following his appointment of Steven Mnuchin as Treasury Secretary, the President has nominated Joseph Otting, former CEO of OneWest Bank, to be the chief federal bank regulator as head of the Office of the Comptroller of the Currency. The OCC is the bank cop for the nation's largest banks. The OCC determines whether banks are taking too many risks with depositor and taxpayer money, and is charged with preventing failures of banks that are too big too fail, in other words, with preventing the next financial crisis.

OneWest Bank was founded by Treasury Secretary Mnuchin in 2009  primarily to acquire, and foreclose, thousands of troubled mortgage loans made by the failed subprime lender IndyMac. Otting served as CEO of OneWest from 2010 until 2015. The President's two leading bank regulators made considerable fortunes by running this very unusual bank, relying on some big-time government funding.

IndyMac had specialized in "nonprime" mortgages, including no-doc interest-only loans and other toxic products, that failed massively in the foreclosure crisis. IndyMac was the first large federally-regulated bank to fail and be bailed out by the FDIC in 2008.

The California Reinvestment Coalition determined from several Freedom of Information Act requests that the FDIC will pay OneWest $2.4 billion for foreclosure losses on the IndyMac loans. Housing counselors in California identified OneWest as one of the most ruthless and difficult banks to deal with in trying to negotiate foreclosure alternatives on behalf of homeowners. In 2011 OneWest signed a consent decree with the federal banking agencies, neither admitting nor denying the agency's findings that OneWest had routinely falsified court documents in foreclosure cases, the practice known as robosigning. In his Senate confirmation hearing last week, Otting insisted that the regulators' findings of OneWest misconduct were a "false narrative." False or not, OneWest foreclosures, and its deal with the FDIC, do seem to have proven very profitable. Bloomberg estimates that Mnuchin made $200 million from the sale of OneWest in 2015, and Otting earned about $25 million in compensation and severance in his final year at OneWest.

OneWest was acquired by CIT group, one of the few banks that did not repay the taxpayers for their 2008 TARP bailout--the bank filed bankruptcy in 2009, stiffing the taxpayers for $2.3 billion. The bankruptcy reorganization and the shedding of CIT's debt allowed CIT to return to profitability and eventually fund its purchase of OneWest from Mnuchin and his partners.

photo credit Walt Mancin Pasadena Star-News

CFPB Arbitration Rulemaking--and Potential FSOC Veto

Today the CFPB finalized the most important rulemaking it has undertaken to date.  This rulemaking substantially restricts consumer financial service providers' ability to prevent consumer class actions by forcing consumers into individual arbitrations. I believe this is by far the most important rulemaking undertaken by the CFPB because it affects practices across the consumer finance space (other than mortgages, where arbitration clauses are already prohibited by statute). 

Let's be clear--the issue has never really been about arbitration vs. judicial adjudication.  It's always been about whether consumers could bring class actions.  I don't want to rehash the merits of that here other than to say that the prevention of class actions is effectively a license for businesses with sticky consumer relationships to steal small amounts from a large number of people.   For example, am I really going to change my banking relationship (and its direct deposit and automatic bill payment arrangements and convenient branch) over an illegal $15 overcharge?  Rationally, no, I'll lump it, not least because I have no easy way of determining if another bank will do the same thing to me. In a world of profit-maximizing firms, we know what will happen next:  I'll get hit with overcharges right up to my tolerance limit.  Given that consumer finance is largely a business of lots of relatively small dollar transactions, it is tailor made for this problem. Class actions are imperfect procedurally, but they at least reduce the incentive for firms to treat their customers unfairly.  

The financial services industry seems to be circling the wagons for a last ditch defense of arbitration. There appear to be three prongs to the defense strategy.  First, there will be intense lobbying to get Congress to overturn the rulemaking under the Congressional Review Act.  There's a limited window in which that can happen, however, and it will be an uncomfortable vote for members of Congress, particularly with the 2018 election looming.  This one will be an albatross for them.  Second, there's an effort afoot to have the Financial Stability Oversight Council veto the rulemaking.  And finally, if the rule isn't quashed by Congress or the FSOC, there will assuredly be a litigation challenge to the rulemaking. 

I want to focus on the FSOC veto strategy, which has just popped up in the news.  

Some Further Thoughts on the "CHOICE Act"

Over at Dealb%k.

The Choice Act and Bailouts

Over at Dealb%k.

Clearinghouses in OLA?

In this short paper, I question whether derivatives clearinghouses can be "resolved" under Dodd-Frank's title II "Orderly Liquidation Authority." That, of course, presupposes that OLA is still around when and if a clearinghouse failed.

If not, we'd better think about what a chapter 7 filing of a clearinghouse would look like. As discussed in the paper, most clearinghouses are "commodities brokers" for purposes of the Code, and thus can't file under chapter 11.

Dodd-Frank: Executive Order O'Rama

The new Executive Order is out. At heart, it says nothing. The press will probably make it into a big deal. 

Update:  I should clarify that I have no doubt the administration plans to gut Dodd-Frank. The order simply says "we plan to gut Dodd-Frank," and thus I don't find it particularly interesting.

Dodd-Frank and the New Order

Apparently just in time for another missive from the White House – and a bit of a tantrum from the House – I've got a new Dealbook up where I suggest that Orderly Liquidation Authority and title II might be a first target. I also argue that there is no real plan for what to do after OLA is gone.

Preliminary Thoughts

On the new reality. Over at Dealb%k.

How to think about banks

Banking is not an industry; banking is not the real economy. The big banks especially are economic and political behemoths that remain unpopular and poorly understood in the popular imagination. Opinion polls show voters favor breaking them up, and some shareholders do too. While Wall Streeters may bemoan the fact that banks are no longer hot growth stocks, I suspect most voters who chose either candidate would not be saddened to see banks become public utilities. The Republican agenda to roll back Dodd-Frank, if this means unshackling the megabanks from speculating with public and taxpayer funds, will be the first betrayal by the incoming administration of its voter base.

Banks are now basically franchisees of the government's, i.e. the taxpayers', full faith and credit, as recently and eloquently explained by Professors Saule Omarova and Robert Hockett  Banks create and allocate capital because the government recognizes bank loans as money and puts taxpayers' full faith and credit behind bank IOUs. The conventional story that banks convert privately-accumulated savings into loans to borrowers is a myth. Because banks are public-private partnerships to create and allocate capital, the public can and should play a central role in insuring that the financial system serves the needs of the real economy, not just the financial economy.

So here is the first test for our new federal leaders. Are you tools of Wall Street, doing its bidding by undoing financial reform, or will you turn banks into the public utilities they ought to be?  

What is the point of that?

Perhaps as a result of GM, I've been thinking about notice issues in connection with insolvency. Thus, I was a bit surprised to see these three notices, all related to Lehman cases pending in Hong Kong (and schemes of arrangement in those cases), which appeared in this morning's Financial Times.

Note that in the title the notice is addressed to the "Scheme Creditors," as "defined below." Yet below, we are told that Scheme Creditors are "as defined in the Scheme."  So unless you are an insolvency fanatic – I plead guilty – and going to run down the documents and read them, this published notice has told you absolutely nothing.

They might as well run an add that says "A company is insolvent. You might be a creditor. Or maybe not.  Good luck."

Regulatory Déjà vu All Over Again

A new CMBS issuance is set to test whether regulators will treat the 5% retained credit risk under Dodd-Frank as loans or bonds.  The difference matters because there are different capital charges for loans and bonds.  If regulators treat the retained credit risk as bonds (which matches the technical form of the retained interest), then the risk retention requirement will be much more onerous.  If they treat the retained credit risk as loans, it is just as if the bank securitized only 95% of the loans, rather than 100%.  

Thoughts on the GM Ignition Switch Opinion

The Second Circuit handed down its much-anticipated decision on the GM successor liability claims. Bottom line is that most, if not all, of the various claims against New GM are not barred by the Sale Order because of lack of procedural Due Process.  That said, there's a lot more in the ruling.  My thoughts below the break: 

The Bad CHOICE Act

I'm testifying before House Financial Services tomorrow regarding the "CHOICE Act," the Republican Dodd-Frank alternative.  My testimony is here.  It's lengthy, but it doesn't even cover everything in the CHOICE Act--there are just too many bad provisions, starting with the idea of letting megabanks out of Dodd-Frank's heightened prudential standards in exchange for more capital, then moving on to a total gutting of consumer financial protection, and ending with a very poorly conceived good bank/bad bank resolution system executed through a new bankruptcy subchapter.  The only good thing about the Bad CHOICE Act is that it has little chance of becoming law any time soon. 

Puerto Rico: Debt Restructuring and Takings Law

Per the last words of my PROMESA post, click here for an interview with Professor Charles Tabb, who discusses the (limited) impact of the Takings Clause on debt restructuring and moratorium legislation. 

Constitution image courtesy of Shutterstock.com

Thoughts on MetLife

Over at Dealb%k.

Puerto Rico: PROMESAnkruptcy

The House Natural Resources Committee has released draft legislation - with the acroynym PROMESA - in response to Puerto Rico's financial crisis and Speaker Ryan's call for action. The contents continued to shift over the past few days but a recent version is here. PROMESA spans many topics, including an oversight board, employment law, infrastructure, and beyond. Without detracting from the importance of this range of topics, this is Credit Slips, so these initial observations focus on debt restructuring provisions principally housed in Title III of the bill.

1. PROMESAnkruptcy: The new territorial debt restructuring law would not be in title 11 (home of the Bankruptcy Code). But as shown in the visual, section 301 incorporates many key title 11/Bankruptcy Code provisions, including automatic stay, financing, majority voting rules, cramdown, discharge, and the discharge injunction. Other sections of PROMESA repurpose title 11 provisions with slight tweaks, while still others expressly depart from current bankruptcy law and make new rules. For the lawyers, also note that the Federal Rules of Bankruptcy Procedure also apply (section 308). Still, the drafters don't want to call it bankruptcy or chapter 9. Okay. I commend the drafters for recognizing the importance of a mechanism to bind holdouts and I'll call it whatever they want, within reason. PROMESAnkruptcy may sound a little funny, but let's be clear that Puerto Rico's dire situation is no joke. 

Puerto Rico: The Multiple Issuer Problem

One problem complicating any resolution of Puerto Rico's financial distress is that there are a multiplicity of issuers. There are separate claims on separate issuers, and it won't work to resolve just some of them, as they are all ultimately drawing on the same set of economic resources.  While there are claims on different assets, they value of those assets derive from Puerto Rico's overall economic production.  This multiple debtor problem makes Puerto Rico materially different from, say Detroit, where there was one primary debtor (the City of Detroit). (I don't know the legal status of Detroit Public Schools--is it separate from the City, the way the Chicago Public Schools are?) As far as I'm aware, Chapter 9 filings have almost always been single entity filings, rather than filings of multiple associated cases, as occurs with Chapter 11. 

So what can be done to deal with the multiple issuer problem? Even if Puerto Rico were allowed to file for bankruptcy (or its various sub-territorial entities were allowed to file), it doesn't solve the problem. While there can be multiple bankruptcy filings and the different cases can be administratively consolidated, that is a very different thing that actual consolidation of debtors, and the inability to resolve claims on one debtor can hold the other cases hostage.  It doesn't do any good to resolve the general obligation debt if creditors can force the electric utility to raise prices through the roof.  With this sort of multiple entity case, the hostage value held by creditors increases significantly.

Puerto Rico's division of governmental authority into various government units is a form of asset partitioning.  This asset partitioning might have helped Puerto Rico get more credit than it should have on cheaper terms ex ante (for a model, see here), but ex post this sort of asset partitioning can blow up in a debtor's face if there is no way to reconsolidate in order to restructure. (Consider, for example, the value of the LA Dodgers without their stadium and without the parking lots by the stadium.) Partitioning via devolution of authority to multiple local government units and authorities is a more permanently binding form of asset partitioning than corporate subsidiaries or even than some securitization arrangements.

Below I present three ideas for how to resolve the multiple issuer problem: consolidation via exchange offer; consolidation via merger; and consolidation via the creation of a common co-issuer entity that is bankruptcy eligible.  

Why the 9th Circuit Fannie Mae "Federal Instrumentality" Ruling Doesn't Matter for the Net Worth Sweep Litigation

Now for a break from Puerto Rico. 

Some housing finance commentators (here and here, e.g.) have been very excited by a 9th Circuit ruling that Fannie Mae is not a governmental entity for purposes of the federal False Claim Act (FCA) because they believe that basically decides the issue of whether Delaware law applies to the controversial Net Worth Sweep undertaken by Treasury as part of its support of Fannie and Freddie. Unfortunately, this excitement reflects a misunderstanding of some legal concepts and issues. The 9th Circuit opinion is a big nothing for the Delaware Net Worth Sweep litigation. It does matter for those who try to bring FCA claims against sellers to Fannie and Freddie, but that's a different kettle of fish. 

I Can't Give Everything Away

Some thoughts on the new rules for broker-dealer OLA cases, over at Dealb%k.

Two Cheers for Fannie and Freddie Synthetic CDOs

My ears perk up whenever I hear the musical words "synthetic collateralized debt offering". (Bill Bratton and I did write the paper on history of these crazy things, after all....) So, it was with interest that I read a Wall Street Journal editorial decrying Fannie Mae and Freddie Mac's use of synthetic CDOs to transfer credit risk on mortgages to the private market through the STACR and Connecticut Avenue programs. Unfortunately, the WSJ piece does not accurately describe what Fannie and Freddie are doing and fails entirely to understand why unfiltered private capital is a recipe for financial instability in housing markets. 

Private Equity's Private Bill to Amend the Trust Indenture Act

One of the many creatures attempting to crawl its way onto the back of the omnibus appropriations bill is an amendment to the Trust Indenture Act.  The Trust Indenture Act is the 1939 securities law that is the major protection for bondholders. Among other things, the Trust Indenture Act prohibits any action to "impair or affect" the right of bondholders to payment or to institute suit for nonpayment absent the individual bondholder's consent. This legislation was passed in the wake of extensive study by the SEC of the unfair and abusive practices in bond restructurings in the 1920s and '30s, when ma and pa retail bondholders were regularly fleeced in corporate reorganizations.

The amendment in question is being pushed by the private equity firms that own Caesar's Entertainment Corporation (CEC), which is attempting to unburden itself from the guaranty of $7 billion of bond debt issued by its (now bankrupt) subsidiary, Caesar's Entertainment Operating Company (CEOC). 

There are several problems with the proposed Trust Indenture Act Amendment, ranging from political unseemliness to ineffective drafting to unintended consequences on capital markets. There might be good reason to amend the Trust Indenture Act, but not through a slapdash job intended to bail out some private equity firms from their own sharp dealings.  

Glass-Steagall Is Campaign Finance Reform

The financial wonkosphere just doesn't get it about Glass-Steagall.  Pieces like this one by Matt O'Brien concentrate on the questions of whether Glass-Steagall would have prevented the last crisis or whether it is better than other approaches to reducing systemic risk.  That misses the point entirely about why a return to Glass-Steagall is so important. No one argues that Glass-Steagall is, in itself, a cure-all.  Instead, the importance of a return to Glass-Steagall is political. But totally absent in much of the wonkospheric discussion is any awareness of the political impact of busting up the big banks.  

Let's be clear about why Glass-Steagall matters:  the route to campaign finance reform runs through Glass-Steagall.

The Ibanez Property Ring

There’s an interesting new article out on the celebrated Massachusetts U.S. Bank v. Ibanez case that suggests that the defendant, Antonio Ibanez, was at the center of a property fraud ring. It's not clear to me that there was anything illegal about Ibanez's activities, but even if there were, I don't think it much matters.  

Recycling News

    Catching up on some posting in other places:

• The Columbia Blue Sky Blog recently featured a summary of my article on the treatment of failed clearinghouses under Dodd-Frank. Interestingly, the EU recently opened the door to something similar to what I've been suggesting. Thanks to Colleen Baker for pointing that out.
• And over at Dealb%k, I look at LSTA's recent rejection of the ABI's chapter 11 reform proposals in light of two recent retail bankruptcy cases.

Glass-Steagall: It's the Politics, Stupid!

It was like eight nights of Chanukkah in one for me watching the Democratic debate last night. There was a Glass-Steagall lovefest going on. But here's the thing:  no one seems to get why Glass-Steagall was important or the connection between Glass-Steagal and the financial crisis. The importance of Glass-Steagall was not as a financial firewall between speculative investment activities and safe deposits. It was as a political Berlin Wall keeping the different sectors of the financial industry from uniting in their lobbying efforts and disturbing the peace of the nation.

Until and unless we realize that the importance of Glass-Steagall was political, we're going to continue wasting our time debating insufficient half-measures of financial regulation like the Volcker Rule, which has the financial, but not the political benefits of Glass-Steagall. More critically, we're going to pass regulations like the Volcker Rule and then wonder slack-jawed why they don't work, as the financial industry undermines them through the regulatory implementation and legislative amendments. Financial regulation is just not that complex technically, even if if has a lot of technical rules (it's the capital, stupid!). The problem we face is not technical, but political.