Speaking yesterday to the U.S. Chamber of Commerce’s Fourth Annual Capital Markets Summit, Deputy Secretary of the Treasury Neal S. Wolin made the case for Sen. Chris Dodd’s (D-CT), including this:

This should not be a partisan or ideological debate. As David John of the Heritage Foundation has said, “Taxpayers should never again be forced repeatedly to bail out financial services firms like AIG because a company poses a risk to the entire financial system and regulators lack the necessary tools to close the company safely.”

We are happy to learn that President Barack Obama’s Treasury Department is reading our financial markets analysis, but we are also somewhat alarmed by the misquote used to support the Dodd financial regulation bill. Here is the conclusion to the paper that Wolin asserts supports the Obama financial regulatory scheme:

Regrettably, the Obama proposal exhibits both flaws by assigning the FDIC a role that it is unprepared to play and giving the Federal Reserve and other regulators such broad powers that a constitutional challenge would be inevitable. Far from a solution, the Obama plan practically guarantees that regulators will need to back up their poor decisions with massive taxpayer bailouts of firms that followed regulators’ directives and got into serious trouble anyway.

A better approach to preventing another crisis is to modify U.S. bankruptcy law to accommodate the special problems of resolving huge financial firms and to allow the courts to appoint receivers with the specialized knowledge necessary to best deal with their failure. By creating an open process controlled by an impartial judiciary guided by established statutory rules, financial firms, investors, taxpayers, and others would have the advance knowledge that large financial firms that were once known as “too big to fail” can now be closed if necessary without risking disaster. In addition, requiring all larger financial services firms to hold significant amounts of capital to cover losses would greatly reduce the systemic risk that they could pose to the financial system. Higher capital levels would enable many firms that would fail under today’s capital levels to survive a crisis, saving shareholders and bondholders their investments, employees their jobs, and taxpayers billions of dollars in federal bailouts. Congress and the Administration need to learn and heed the lessons of 2008, or a repeat crisis will just be a matter of time.

If the actual body of the paper was too opaque to discern our views on the subject, the Obama Treasury might have been tipped off about our very different view on the subject by the title of that paper: Using Bankruptcy and Capital Standards to Address Financial Institutions That Are “Too Big to Fail”

And just so there is no future confusion, here is the latest paper, titled Dodd Financial Regulation Bill: Super Regulators Not the Answer, from David John on the subject:

The Senate Banking bill proposes to create a new $50 billion fund to be used in “emergencies” to close or restructure failing financial institutions or those perceived as being in danger of default. This fund is certain to be used for bailing out any politically significant financial institution and is nothing less than a permanent TARP program.

If the Treasury, Federal Reserve, and FDIC agree, failing financial institutions would be turned over to the FDIC for resolution. Three bankruptcy judges must also agree, but this appears to be more window-dressing than any substantive requirement, since the closing or restructuring would be handled by the FDIC and not through bankruptcy courts.

Despite rhetoric about using bankruptcy for most failures, the draft makes it clear that this is to be handled through a bureaucracy subject to political pressures, since the bill also does not include language adapting the bankruptcy process to the special needs of complex international financial institutions.

A far better approach would be to create a special section of the bankruptcy code and use it to handle the failures of all major financial institutions. In addition, the FDIC has neither experience with complex international financial failures nor the expertise to handle the failure of these financial institutions.