There was perhaps no issue of greater importance to the financial regulatory reforms of 2010 than the resolution, without taxpayer assistance, of large financial institutions. The rescue of firms such as AIG shocked the public conscience and provided the political force behind the passage of the Dodd-Frank Act. The force is reflected in the fact that Titles I and II of Dodd-Frank relate to the identification and resolution of large financial entities, and Title VIII relates to the resolution of financial market utilities. How the tools established in Titles I, II and VIII are implemented is paramount to the success of the Dodd-Frank Act. This post concerns what we can we learn about the likely success of these tools via the lens of similar tools created for the resolution of the housing government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac and why those tools were not used when Fannie Mae and Freddie Mac experienced distress during the 2008 financial crisis.

As background, similar tools to those we see for resolution of systemically important entities were actually created for Fannie and Freddie in the Housing Economic and Recovery Act (HERA) of 2008. I served as senior staff on the Senate Banking Committee from 2001 to 2009; during which time I assisted in the drafting of HERA as well as negotiating many of its provisions. I cover some of this history in a recent working paper.

It is generally accepted that a resolution mechanism aims to achieve some or all of the following goals: 1) allocating losses; 2) protecting favored creditors, to the extent that any exist; 3) containing contagion; and 4) maintaining critical facilities. Number 4 is particularly important with Fannie Mae and Freddie Mac, given their outsized role in our national mortgage market. All of these issues were considered by Congress in creating the resolution mechanism in HERA.

In order to reduce uncertainty, Congress decided to model HERA on the resolution powers contained in the Federal Deposit Insurance Act (specifically sections 11 and 13). We at the Committee staff level quite literally “marked-up” the FDIA, under the orders of Senator Shelby to make these provisions as “bank-like” as possible.

Of course there are substantial differences between the GSEs and banks. Some of these make a GSE resolution easier, such as the absence of a need to coordinate a cross-border resolution. Accordingly the Committee made some departures from FDIA. For instance HERA has no least-cost resolution requirement, and accordingly no systemic exemption from such. HERA also has no explicit policy role for the Treasury Secretary in the event of a GSE insolvency. The Treasury Secretary, on behalf of the President, plays a crucial role in triggering the FDIC’s systemic risk exceptions. As part of such, Treasury has an opportunity to weigh in on the systemic importance of a particular institution. As the Office of the Comptroller of the Currency, the primary regulator of National Banks, is housed within the Treasury Department, the Treasury Secretary also plays an important policy role in the area of bank regulation. HERA reject such an approach. The powers of Treasury, as it pertains to the GSEs, is simply that of a creditor, who may exercise the rights of a creditor.

The Committee also expected that the FDIC’s usual practice of a purchase and assumption would be impractical, if not impossible. In order to maintain critical facilities, some sort of bridge bank or good bank-bad bank structure would need to be created. Hence HERA allows for all GSE activities to continue, allowing support of the mortgage market, while losses are imposed on creditors according to an established chain of priorities.

As the accounting scandals at first Freddie and then Fannie came to light, the Bush Administration proposed housing a new GSE regulator at Treasury, modeled on the OCC. Such would have offered Treasury some policy role over the GSEs. Congress, on a strong bipartisan basis, rejected that approach. Treasury’s only role under HERA’s GSE reform is that of a general creditor; its rights are those of a creditor. These rights derive from Section 1117 of HERA and only come into play if and when the Treasury purchases obligations of a GSE. As HERA makes explicit these rights are those “received in connection with such purchases.” (12 U.S.C. 1719(g)(2)(A)). The intent of HERA’s Section 1117 was to allow the Treasury to provide financing similar to that of debtor-in-possession financing witnessed in corporate bankruptcy. Essentially Treasury would help “keep the lights on” were a GSE to become insolvent. As Treasury is acting on behalf of the taxpayer, its “rights” are intended as an avenue to protect the taxpayer from loss on any purchase of GSE obligations. Had Treasury not assisted the GSEs, such rights would not have come into existence. The expansive policy role played by Treasury in the conservatorships of Fannie and Freddie was not one envisioned by Congress or one authorized by HERA.

On September 6, 2008 FHFA invoked its authorities under HERA to place Fannie and Freddie into conservatorship. Given that Congress in fact created tools before the failures of Fannie and Freddie that would have allowed those entities to fail without cost to the taxpayer and without disruption to the broader mortgage market, why did FHFA and Treasury disregard those tools? In other words, why did the federal government offer support to the GSEs instead of letting them be resolved in accordance with HERA? The answer to this question is instructive to understanding whether the resolution tools prepared under the Dodd-Frank Act may also be overlooked during the next crisis?

The foremost explanation for why the GSEs were not resolved in accordance with HERA appears to have been concern regarding the reactions of foreign official creditors. Central banks in China, Japan and Russia held large amounts of GSE debt. Congress was aware of these holdings and rejected treating these creditors as favored pursuant to HERA. Apparently Treasury Secretary Hank Paulson did not share this Congressional preference during the financial crisis of 2008. Failures of too big to fail institutions will again pose concerns of foreign policy. Sovereign wealth funds, for instance, have been significant investors in U.S. banks, such as the Abu Dhabi Investment Authority’s investment in Citibank. Given the potential for foreign official holdings of U.S. financial institutions’ securities and potential foreign policy concerns, to truly end implied guarantees, the treatment of foreign official creditors should be credibly addressed.

Another potential rationale for ignoring tools under HERA with respect to the GSEs was that removing the implicit guarantee of Fannie and Freddie would call into question other implied guarantees. If Washington would allow creditors in Freddie to take a haircut, what does that mean for creditors in Citibank? It is likely that Hank Paulson did not want to find out.

Additionally, lots of banks held GSEs securities. About a dozen or so banks failed due to losses on their GSE preferred shares. Others only survived due to TARP assistance. Hundreds might have failed had the GSEs gone into receivership, as HERA required but FHFA ignored. Bank holdings of GSE securities were in excess of 100% of total industry Tier I capital. Given the wide and deep holdings of GSE securities across US banks, large losses on those securities would have inflicted significant damage on the banking system. Similarly, inter-bank obligations call into question the credibility that one bank can be allowed to fail without setting off a chain reaction of other bank failures (so that a great deal of political will would have to be exercised before allowing a systemic institution to default to creditors pursuant to Dodd-Frank).

Perhaps no reason more than a vague fear of panic is needed for regulators to throw public funds at large financial institutions, even when they have the tools to resolve these companies without public money. Until Congress can design mechanisms that adequately constrain regulators, personnel choices become all the more important. Tom Hoenig’s appointment to FDIC is a step in that direction, whereas appointments of regulators viewed as “soft” on bailouts would be a step in the wrong direction. The Senate must make a strong commitment to rejecting nominations that lack a strong aversion to bailouts. As importantly regulators should take steps to make the overall system more resistant to the failure of systemic institutions. Continuing to allow high bank holdings of GSE debt is a continuing mistake. Asset concentrations should be avoided regardless of the political power of the issuer.

All this leaves me skeptical that Dodd-Frank will actually end bailouts. Yes a path to doing so is there. But such a path also existed in HERA. It wasn’t chosen. It would likely not be chosen under Dodd-Frank. If we are serious about ending too-big-to-fail, we have a lot of work ahead of us.

The preceding post comes to us from Mark A. Calabria, Director of Financial Regulation Studies at the Cato Institute. The post is based on his remarks at the 2015 AALS Annual Meeting, panel on The Future of the Federal Housing System.