'Come Monday, It'll be All Right': Buffett, the U.S. Financial Crisis and the Need for a Reliable, Private Liquidity Consortium

Abstract

During the 2007-2008 Financial Crisis, several large U.S. financial institutions either faced insolvency or became insolvent as investors lost confidence in the financial system and traditional funding sources evaporated. Self-preservation efforts led many banks, broker-dealers, and other financial firms to seek (often unsuccessfully) funding from private equity firms, competitors, and sovereign-wealth funds. Warren Buffett received several such funding requests because he had ready access to large amounts of capital and because financing from a trusted and savvy investor such as Buffett carried an imprimatur that the investment was likely to be sound. But not even Mr. Buffett had sufficient resources to single-handedly recapitalize the many struggling U.S. financial firms. Nevertheless, other avenues for private funding seemed haphazard and potentially hazardous for many U.S. financial firms as they struggled to survive in a dangerous world that they helped to create but that now seemed destined to destroy them. In the absence of trusted and reliable sources of private funding, struggling firms were forced either to submit to an uncertain and unwieldy bankruptcy process or to risk being subjected to an ad hoc government-facilitated take-over, the terms for which seemed opaque and subject to change at a moment’s notice. Transactions where public funding was used were sure to provoke public outrage and a painful berating by Congress. The public outcry over such taxpayer-funded rescues and the absence of more politically palatable alternatives led Congress to include provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) that provide a framework for a government liquidation of a struggling financial firm that is not federally insured and that poses a significant risk to the financial stability of the United States. Although the Dodd-Frank Act and the rules of the Federal Deposit Insurance Corporation promulgated under that Act codify and clarify the government’s authority to take over a struggling non-bank financial firm, they may not make that alternative much more politically palatable than the ad hoc approaches used during the Financial Crisis. Moreover, certain provisions of the Dodd-Frank Act designed to reduce moral hazard and promote the continued operation of struggling firms may make the Dodd-Frank Liquidation Framework particularly troubling for management, shareholders and would-be creditors of firms to which such provisions might apply. Nevertheless, the absence of a formalized process to facilitate the private recapitalization or orderly liquidation of a systemically important struggling financial firm could leave such firm with little other alternative. Therefore, it is important to consider other options to the Dodd-Frank Act Orderly Liquidation Framework that could minimize government involvement in a winddown of a troubled non-bank financial firm while offering incentives for private investors willing to risk capital to facilitate an efficient recapitalization.This article analyzes the difficulties that certain U.S. financial institutions faced in seeking to obtain emergency funding during the Financial Crisis and explores similarities and differences between the 2007-2008 Financial Crisis and the decline and rescue of the hedge fund, Long-Term Capital Management, a decade earlier. It also analyzes the Dodd-Frank Act provisions that authorize government liquidation of non-bank financial firms and the rules promulgated and proposed by the FDIC to implement those provisions. It contends that certain provisions of the Dodd-Frank Orderly Liquidation framework may make it unworkable for those firms that are most likely to be subject to that framework. The article asserts that there may be benefits to promoting -- through favorable regulatory treatment, tax incentives, or otherwise -- the formation of private consortia of liquidity providers, which could include banks, broker-dealers, large institutional investors, and private equity firms with ready sources of cash that have the flexibility to provide short-term capital infusions to financial institutions in times of crisis. It concludes that a formalized structure to promote private liquidity consortia could serve as a preferable alternative to both the Dodd-Frank Act liquidation provisions and to the type of ad hoc consortia formed to address the failure of LTCM and, ten years later, the impending bankruptcy of Lehman Brothers.