As the House of Representatives was preparing to pass legislation that would eliminate the new law's Orderly Liquidation Authority, which gives the Federal Deposit Insurance Corp. power to liquidate failed financial conglomerates, the FDIC's acting chairman, Martin Gruenberg, was outlining how the FDIC would carry out its duties under the OLA.
Gruenberg's speech to a conference hosted by the Federal Reserve Bank of Chicago Bank offered fresh details of how the new receivership process would take place.
Later Thursday, the House of Representatives approved a deficit reduction that would eliminate OLA. Senate Democrats have said they will reject the measure because it doesn't balance cuts in government spending with tax hikes and removes necessary programs. President Obama also issued a statement saying he would veto the legislation.
Apparently unconcerned about the action in Congress, Gruenberg said that the FDIC would have three goals in mind -- ensuring a firm's failure doesn't place the financial system in jeopardy; ensuring that investors and not the government bear the cost of the firm's losses, and ensuring that any financial firm rising out of the process emerges well capitalized and viable.
He said the most desired procedure would be to put a parent company into receivership and put its viable business units into a newly created bridge company that would keep operating.
"This will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm to remain open and avoid the disruption that would likely accompany their closings."
Counterparty contracts would be held by the bridge company and would not close out as they currently do in a bankruptcy.
"Because these subsidiaries will remain open and operating as going concern counterparties, we expect that qualified financial contracts will continue to function normally. We believe that this resolution strategy will preserve the franchise value of the firm and mitigate any systematic consequences," he said.
Finally Gruenberg made clear that investors and debt holders in a failed firm would feel the hit quickly.
Equity held by the failed firm's shareholders and claims of debt holders that will be part of the receivership will be converted into an equity share of the bridge holding company after the FDIC assures the bridge firm has adequate capital to continue operating.
"We must ensure that the bridge has a strong capital base and address whatever liquidity concerns remain," he said. "The FDIC will estimate the extent of losses to the receivership and apportion these losses to the firm's equity and subordinated and unsecured debt holders according to their order of priority," he said. "In all likelihood the firm's equity holders will be wiped out and their claims will have little or no value."
Gruenberg also said that debt holders of the failed company could find their debt unlikely to be repaid.
"To capitalize the new company, the FDIC expects that it will have to look to subordinated debt or even senior unsecured debt claims as the immediate source of capital. These debt holders can thus expect their claims will be written down to reflect any losses in the receivership that the shareholders cannot cover and like the shareholders, these claims will be left with the receiver," he said.
Only if there is remaining equity available will the debt holders get paid and Gruenberg said any equity they receive will likely get some in form of convertible subordinated debt and the rest in the form of unsecured debt.
Gruenberg also said that while the bridge company can temporarily tap Treasury funds, another scenario is that the FDIC would temporarily guarantee private debt.
A consumer group praised Gruenberg's explanation, suggesting it would send a message to Wall Street. "Chairman Gruenberg's message from today should be clear: the markets should understand that there won't be any bailouts next time," said Dennis Kelleher, president and CEO of Better Markets.
Frank Keating, president and CEO of the American Bankers Association, praised the announcement. "ABA has always believed that no bank -- or company -- should be too big to fail, and the FDIC's resolution strategy represents an important step in that direction. In any failure, it's the equity owners that should take losses," he said. "This strategy assures that but would continue the operations of the firm going forward to minimize market disruptions."
Paul L. Lee, co-chairman of Debevoise & Plimpton LLP's banking group, said Gruenberg described an idealized procedure and that actual use of the OLA would likely play out somewhat differently if big debts were at the subsidiary rather than the holding company level or if a subsidiary had to mark down assets. "There may be other fact patterns," he said.
Lee said the FDIC's staff has discussed a possibility where a failed company could end up with multiple receiverships and bridge companies.
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