Too Big to Fail Red Herring

The Obama administration has perfected the fine art of taking a real issue and using it to justify a policy that will almost certainly make the problem worse. Claim to control medical costs, add another trillion dollar medical entitlement to truly break the bank—that sort of thing. Looks like we have another example coming.

The Treasury and House Financial Services chief Barney Frank are apparently cooking up legislation that will allow the government to wreck havoc with the creditors of large financial companies. This is in the name of imposing “market discipline” on institutions that may have to be rescued because they could endanger the system.

“The measure would make it easier for the government to seize control of troubled financial institutions, throw out management, wipe out the shareholders and change the terms of existing loans held by the institution,” according to the New York Times report.

Scroll back to September 2008. Lehman Brothers files for bankruptcy, the credit market seizes up and stocks tank. What difference would the proposed law make in that situation? Lehman management is out and shareholders are wiped out anyway. Instead of regular bankruptcy, where the creditors exert influence, government directly takes over.

So the difference is that lenders will no longer be able to enforce their contractual claims. Oh yes, that will be just the right remedy for a fragile credit market. You’ll tell lenders they’re toast! That will really get credit flowing.

The Chrysler bankruptcy, where the administration interfered to protect the interests of the automakers union, may be a precedent. Richard Epstein, professor of law at University of Chicago and currently at New York University, pointed out that government meddling in that process forced secured creditors to the brink, violating the priority rules that allow creditors to price risk.

“Upsetting this fixed hierarchy among creditors is just an illegal taking of property from one group of creditors for the benefit of another, which should be struck down on both statutory and constitutional grounds,” Mr. Epstein wrote.

This is the type of intervention that the proposed legislation would formalize for financial companies. Long-standing rules would no longer apply and the government would dictate the apportioning of property—judging by the Chrysler case, according to its political interests.

Rahm Emanuel does not want to let a serious crisis go to waste. “Too big to fail” is a great excuse. It’s being used to justify future government appropriations that can only worsen crises.

“These changes will impose market discipline on the largest and most interconnected companies,” says a Treasury official. But there won’t be a real market left after such a takeover. As for discipline, who’s going to discipline the appropriators?

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