Last December the FDIC put out for comment a proposal for a Single-Point-of-Entry (SPOE) Strategy to implement its Orderly Liquidation Authority (OLA) under Title II of Dodd-Frank. Single-Point-of-Entry has gotten a lot of policy traction. The Treasury Secretary supports it and there’s huge buy-in from Wall Street. And it’s an approach that is likely to ensure financial stability in the event that a systemically important financial institution gets into trouble. There’s just one problem with it. SPOE means “No Bank Left Behind”.

Here’s the idea behind SPOE. SIFIs have complex corporate structures with lots of subs under a holding company and all sorts of liabilities at both holding company and subsidiary level. The SPOE strategy is based on splitting off the subs from the holding company in a single fell swoop. The HoldCo gets placed into FDIC OLA receivership and all of the subsidiaries (along with their liabilities and certain HoldCo liabilities) are transferred to an FDIC-run bridge holding company. The only liabilities that would remain with the old HoldCo would be the long-bonds (senior and subordinated). These bonds would get repaid based on what the FDIC was able to sell/recover on the assets of the subsidiaries. The FDIC’s bridge holding company (HoldCo2) would get financing from the FDIC, which would fund the loan through a line of credit with Treasury. So HoldCo2 loses money (let’s say because the subs holding lots of bad mortgages or dodgy MBS or bad derivative positions), the FDIC will be on the hook.

So three key things to see here. (1) the equity and the long-bonds of the HoldCo would get wiped out or get pennies on the dollar in the FDIC receivership. And (2) all of the liabilities of the subsidiaries would be paid in full because (3) the FDIC (and ultimately Treasury) are taking on all of the credit risk of the bank’s operating subsidiaries.

The fundamental operation of SPOE is that all creditors of the banks get bailed out. SPOE involves the guarantee of all bank liabilities other than the long-bonds of the bank holding company. In other words, not only are deposits and the payment systems protected, but all of the derivative counterparties, all of the commercial paper creditors, all of the repo counterparties, and all of the securities lending counterparties get bailed out.

Traditionally, when a bank fails the FDIC protects the insured deposits, and also guaranties the bank’s payment systems obligations and often the uninsured deposits. But other bank creditors, like derivative counterparties get only the protection they have bargained for—their collateral and guaranties. The same is true when a bank holding company is placed into bankruptcy. Unfortunately, it’s a slippery slope from protecting payment systems, to protecting liquidity (to ensure payments can get made), to protecting all types of short-term credit and then to giving away the farm (or bank). But didn’t we create the Fed and Federal Home Loan Banks to make sure that there was liquidity when times get tough? Shouldn’t that be enough? Why do we need to protect all types of short-term credit? Wasn't the lesson from 2008-2009 that we should be trying to discourage this sort of shadow banking?

SPOE institutionalizes the 2008-2009 bailouts. It ensures that Wall Street will be rescued if a SIFI goes down. The result is to eliminate all credit risk for Wall Street when dealing with SIFIs, which ensures that the SIFIs will stay too-big-to-fail and that there will not be market discipline.

SPOE should also look very familiar to the sharp-eyed observe. It's nothing other than the much-criticized structure used in the Chrysler and GM bankruptcies. The good assets and favored liabilities are transferred to a new, government-backed entity, while the disfavored liabilities remain with the old, liquidating entity.

To be sure, the problem with Chrysler and GM was that no one knew ex ante which liabilities would be favored and which would not be, so it was impossible to price for them. While SPOE does not have that problem, it suffers from the inverse problem—the long-bonds of the HoldCo are essentially co-cos, just with the conversion trigger being OLA, rather than some pre-receivership event. As a result, the HoldCo long bonds are going to have to have a pretty high yield, and there’ll have to be a lot of them to make the SPOE strategy effective. And who’s going to buy them? SIFIs aren’t going to be allowed to invest in this junk.

I appreciate that SPOE ensures minimal disruption from the failure of a SIFI, and that seems to be the FDIC's goal with OLA. But there’s a cost to limiting post-failure disruption. That’s the enormous pre-failure market distortion that comes from guaranteeing all bank liabilities other than the long-bonds of the holding company. What happens to market discipline? Do we really want the government to be in the business of guaranteeing payment on all repos and derivative contracts of banks?

I don’t think the FDIC’s proposal intends to be a “No Bank Left Behind” solution, but that’s the effect. If we’re going to throw in the towel on market discipline and put the public fisc behind all Wall Street dealings with SIFIs, we should just be honest and nationalize the SIFIs. If the public is going to take the downside risk, it should also get the upside benefit.

No one wants to have that conversation (and I don’t think it’s the right thing to do), so instead, we pretend that the public fisc really isn’t on the hook: the bridge institution will merely have a line of credit from the FDIC, which will have a line of credit with Treasury, but there won’t be any risk because it will all be well collateralized and the FDIC is really a mutual insurance fund. The structure of second-loss public capital backing first-loss private capital is a time-honored tradition in US bank regulation, going back to the 1863 National Bank Act. This is how National Banks were originally structured, how Federal Reserve Notes originally worked, and how the FDIC’s Deposit Insurance Fund works. This structure is all about disguising the role of the government in the financial markets while ensuring that the benefit is still there. But it should be no surprise, then, when the government ends up on the hook.

If the FDIC is going to be guaranteeing all bank liabilities, it needs to be charging full freight for the service. This means having much larger FDIC insurance premiums that reflect individual SIFI’s level of non-deposit liabilities. If there’s going to be a guarantee, it needs to be explicit and priced. The bitter has to go with the sweet. I suspect that if Wall Street has to pay full freight for a government guarantee, it won’t be so enamored with the SPOE strategy. For now, however, Wall Street thinks it sees a free lunch and is licking its lips over SPOE. I hope the FDIC wises up to this, and I hope that Congress makes clear that the full faith and credit of the United States is only given at market rates.