Treasury, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC) officials increasingly are working long hours on weekends lately. It began Sunday, March 16, when the Federal Reserve rescued general and other creditors of the investment bank Bear Stearns. More recently—on Friday, July 11—the FDIC placed IndyMac, a large California-based mortgage lender, into receivership, then created a transitional “bridge bank” over the weekend to deal with depositors’ claims the following Monday. 

That same Friday, the shares of Fannie Mae and Freddie Mac, the main U. S. government-sponsored enterprises (GSEs) engaged in the purchase and guarantee of mortgages and mortgage-backed securities, experienced a 50 percent decline in their share prices in a few hours. Although the GSEs rebounded later, the precipitous drop came at the end of a tumultuous week in which rumors of their insolvency were rampant.

That weekend, while the FDIC was busy with IndyMac’s problems, regulators at the Treasury Department and the Federal Reserve were hard at work with Freddie’s and Fannie’s troubles. Sunday night, July 13, the Treasury announced that it would seek congressional authorization for an unlimited line of credit for the two GSEs, and the Board of Governors of the Federal Reserve announced that it would authorize emergency discount window credit to support the GSEs’ funding needs. 

Although in its Sunday announcement the Fed did not cite a specific statutory basis for its action, it harks back to a rarely used 1933 lending provision of the Federal Reserve Act. Section 13(13) authorizes emergency loans to individuals, partnerships, and corporations using as collateral bonds, notes and bills issued by the United States or its agencies. Among these agencies are the GSEs. The provision allows them to borrow as if they were corporations but to use their own earlier loans and obligations as security. 

In all three bailouts—Bear Stearns, IndyMac, and the GSEs—federal watchdogs have demonstrated a disturbing willingness to abandon their traditional supervisory and regulatory roles. More alarmingly, their actions are part of a larger drift that began in the 1980s: Increasingly regulators are moving away from their charge to protect the taxpayer that was established in 1933.    

In none of these instances, for example, was traditional conservatorship used, although, theoretically it still could be for the GSEs. Conservatorship is a standard device, dating from 1933, used to maintain public confidence in a financial institution that is in danger of closing. 

Traditionally, conservatorship freezes existing bank accounts and then allows limited withdrawals until authorities determine how much of those frozen accounts may be distributed pro rata to the claimants. After the appointment of a conservator, new deposits and other funds received as well as new investments would be fully protected.  Eventually, authorities decide whether the seized institution should be liquidated, with potential losses for uninsured prior claimants, or recapitalized and released from conservatorship.  (Insured deposits are repaid at par, regardless of their status as pre-existing or new accounts.)

Beginning with the banking and savings and loan debacles of the mid-1980s, banking industry lobbyists pressured Congress to change the laws affecting conservatorship in two important respects.

The first, brought about by the Competitive Equality Banking Act of 1987, was to authorize bridge banks. These are entities that receive new deposits in troubled banks and commingle them with established funds and accounts, while the Office of the Comptroller of the Currency (OCC) is administering the banks themselves. 

The second change was to amend the law of conservatorship in the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA).This change allowed the same type of commingling of old and new accounts in conservatorships as in bridge banks. The new rule attempts to spread out the risk of a failed financial institution so that no single individual, including original uninsured depositors, would suffer great losses. But the change also widens the damage that can be caused if the bank, after being placed in conservatorship, later fails. These failure resolution policies make prudent administration of failing institutions much more difficult and greatly increase the likelihood that taxpayers will pay for losses on old claims that rightly should have been paid off pro rata. 

While FIRREA included many provisions that protected taxpayers, it also contained other features that worked against the public interest and regulatory tradition. For example, it gave the FDIC authority to establish bridge banks, notwithstanding contrary provisions of state law. Lawmakers also decided against the taxpayers’ interests in the FDIC Improvement Act of 1991 by excluding corrective language that would have restored the 1933-1987 status of conservatorship. There have been no taxpayer-oriented banking reform statutes since 1991.  

Rational public confidence in a troubled bank is not diminished by freezing old accounts and pro rata payment of old deposits. They are old deposits, after all, and nothing can be done after the traditional conservator is appointed to increase or decrease the allowed distribution. In contrast, paying off old liabilities at par gives earlier investors preferential treatment and increases taxpayers’ exposure to losses. Such payoffs are barely disguised bailouts.

Keeping these liabilities separate is the best way to approach the challenges presented by these potential failures. But the weight of industry and regulatory opinion is in favor of full commingling and greater future bills for taxpayers. No federal statute currently prohibits the supervisory authorities from requiring the segregation of old from new deposits in failing financial institutions.

The issues raised in this article are analyzed in greater detail in Walker F. Todd, “Bank Conservatorship and Receivership,” Economic Commentary, October 1, 1994, Federal Reserve Bank of Cleveland.  It can be accessed at http://www.clevelandfed.org/research/commentary/1994/1001.pdf. 

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