Black Swans: Could Dodd-Frank have prevented the Lehman Crisis

April 25th, 2011

One of the key traits of Black Swan legislation is an ex post hubris that convinces its supporters (or perhaps it supporters use it to convince others) that if that legislation had been in effect at the time of the crisis, everything would have been different.

This report from the FIDC, contending that if Dodd-Frank had been in place in 2008, the Lehman crisis would essentially have been avoided. is textbook black swan legislation response (for more on Black Swans see here, herehere, and generally here).

David Skeel deftly summarizes the report here:

The FDIC has just released a report speculating about how Lehman’s crisis would have been handled if the Dodd-Frank Act had been in place in 2008. As the report imagines it, the FDIC would have intervened early in the crisis, and guided Lehman to a soft landing that got the utmost value for the business. The FDIC “could have participated in a meeting in the spring of 2008, together with [other regulators], to outline the circumstances that would lead to the appointment of the FDIC as receiver.” The FDIC could have parachuted in and conducted on-site oversight on Lehman’s premises from that point forward.   The FDIC could have prodded Lehman to sell itself or, if “Lehman were unable to sell itself, the FDIC would have commenced with marketing Lehman.” Once Lehman was taken over pursuant to the new resolution rules, the FDIC “would have minimized losses and maximized recoveries,” assuring that Lehman’s general creditors recovered roughly 97% of what they are owed—as compared to the roughly 20% they are likely to get in the actual bankruptcy case.

Yet, this report makes a number of “heroic assumptions” about what the FDIC would have done differently. Typical black swan analysis. If we had this law in place, everything would have been different, and we would have fixed it perfectly. Not quite. The same government actors that enforced the previous regulatory regime will enforce this regime:

Heroic assumptions abound, such as an assumption that the counterparties to Lehman’s derivatives would have been fully collateralized. Most heroic of all is the suggestion that the FDIC would have deftly nudged Lehman to plan for its demise, and that the FDIC would be able to handle a resolution on this scale.   The Dodd-Frank Act does include provisions that could improve regulators’ oversight in the future, such as its requirement that systemically important institutions prepare a “living will” (or “rapid resolution plan,” in Dodd-Frank terminology) that explains how the institution would respond to a crisis. But the claims that regulators will intervene early in a future crisis rather than delaying the inevitable (that “next time will be different,” to paraphrase the title of a recent book on financial crises), and that they’ll foreswear future bailouts because Dodd-Frank says they aren’t supposed to do them, are wildly implausible.

Skeel speculates why the FDIC would write this report now, after Dodd-Frank was enacted. As I noted above, this report may simply serve as an attempt to convince people that everything is great, and all problems will be avoided (These are not the Droids you are looking for):

Perhaps the most interesting question is why the FDIC would write a report that could prompt guffaws from financial experts. Two possible reasons come to mind. First, the FDIC made these kinds of claims throughout the debates that led to Dodd-Frank, and somehow they worked. The FDIC was given extraordinary new powers under the new resolution rules, even though the FDIC’s track record in handling large cases is not good. Second, the FDIC has been floundering in its efforts to implement Dodd-Frank’s new requirements. It may be that the report is designed to distract attention away from growing fear that the living will requirement will not be effectively implemented, and that the resolution rules are a disaster.

Professor Bainbridge is duly persuaded:

The FDIC would like us to believe that Dodd-Frank would have prevented the financial crisis. David Skeel slaps that idea down rather convincingly in 3 short paragraphs, which ought to tell you something about the report by itself.

H/T Overlawyered