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August 12, 2015

FSOC’s Decision Designating MetLife Systemically Significant Was Correct

MetLife and its many allies have been attacking the Financial Stability Oversight Council (FSOC) for its decision to designate the insurance giant as systemically significant. MetLife sued to overturn FSOC’s decision and the Wall Street Journal, for example, followed with two editorials criticizing FSOC and its Chair, Treasury Secretary Jack Lew. The first said the agency had run amok by acting arbitrarily in its decisions to designate firms as systemically important, while the second by Peter Wallison inaccurately claimed FSOC lacked the data to show MetLife is systemically important.

The Journal and its opinion writers, along with the various amici who filed briefs in court supportive of MetLife, miss a large part of the picture: the history, purpose, and context for FSOC’s nonbank designation authority, informed specifically by the AIG debacle and the massive government bailouts it required. Prior to the 2008 financial crisis, AIG was the world’s largest insurance company. However, in addition to selling traditional insurance products, one of its subsidiaries based in London accumulated hundreds of billions of dollars of liabilities by “insuring” the assets of many other large financial entities through the use of credit default swaps (CDS).  However, it recklessly set aside no reserves to cover those exposures. As a result, AIG became deeply interconnected with the entire financial system.

When the mortgage-backed securities AIG was “insuring” with CDS failed, AIG made the stunning disclosure that it lacked the capital necessary to fulfill its obligations. To prevent widespread so-called “collateral consequences” to the broader financial system, the federal government bailed out AIG with a combination of loans and capital infusions, ultimately totaling $182 billion. The funds were used to satisfy obligations to AIG’s counterparties, most prominently Goldman Sachs but also including a number of large foreign banks.  The bailout also paid for $218 million in bonuses to some of the very AIG executives who recklessly sold the CDS, failed to reserve for losses, and doomed the company to failure.

This was an unexpected threat that caught everyone by surprise. But without a rescue, AIG’s collapse would have caused significantly more damage to the economy than it actually did. According to the Federal Reserve Bank of New York, allowing AIG to fail would have resulted in a run on insurance companies, money market funds, and other financial institutions, leading to disarray in those markets and triggering yet further panics. In the words of then New York Federal Reserve President Timothy Geithner, allowing AIG to fail would have been even more damaging than the collapse of Lehman Brothers (see endnote below), which was perhaps the most high-profile immediate catalyst of the financial crisis. An AIG failure would have resulted in “mass panic on a global scale.”

Having prevented the complete crash of the financial system in 2008 caused by lightly or poorly regulated banks and unregulated nonbanks, policy makers clearly recognized the peril of allowing nonbank entities like AIG to escape comprehensive regulatory review and, if necessary, oversight. To prevent a repeat of the catastrophic damage to individuals, the economy, and taxpayers, the Dodd-Frank law gave FSOC the authority and responsibility to review and designate, if appropriate after considering the relevant factors and exercising its expert judgment, systemically important nonbank financial institutions for heightened supervision. The point of the law was really “no more surprises; no more AIGs.”

That’s what FSOC did in its consideration, evaluation, and designation of MetLife. FSOC crunched the numbers, conducted the analysis, and in the end made the decision – not taken lightly – to subject MetLife to enhanced oversight. It acted to prevent financial calamities similar to those of 2007 and 2008, and to prevent taxpayer money from being used to bailout and rescue a nonbank that posed a systemic threat to the country.

In criticizing FSOC’s decision, the Journal and MetLife’s amici make a number of points that miss the mark. For example, while the Journal writes that the Council “refuse[s] to say exactly which [alleged threats] make MetLife a systemic risk,” the Council did exactly that in its 341-page analysis of MetLife’s risk to the financial system. In fact, FSOC’s explanation for designating the company was exceedingly thorough. For instance, in considering “the extent of MetLife’s leverage,” FSOC noted that, taking into account its operating debt, “MetLife on a consolidated basis has higher total financial leverage and more total debt and operating debt than most of its peer life insurance organizations.” FSOC also observed that MetLife’s foray into a variety of complex financial activities – including funding agreement-backed securities, commercial paper issuance, and securities lending activities – and found that in the event of financial distress, these borrowing instruments could create liquidity problems for the company, which could be transmitted to the wider financial system.

The Journal writes that MetLife “presented evidence, based on the government’s own methodology for analyzing banks, showing that the giant banks could all survive even if they lost the full value of their exposure to MetLife,” and that FSOC “simply ignored it.” Mr. Wallison claims that “FSOC produced no data to contradict” this evidence. What they fail to explain is that this so-called “evidence” was a series of studies, paid-for by MetLife shareholders, and relying on significantly less information than was available to FSOC. One such study to which MetLife points is all of ten pages long (Oliver Wyman’s so-called “contagion study”). Purchased studies using incomplete information are not a proper basis for overturning a lengthy review process and a comprehensive analysis and decision.

The Journal and Mr. Wallison also inappropriately rely heavily on MetLife’s court brief, as if it contained objective, undisputable facts, which is not the case. It is one party’s arguments based on its attempt to convince the court to rule its way. No one genuinely interested in truly understanding the complicated, complex, and important issues raised by a designation would rely on only one side for an analysis. Moreover, by relying on just one party’s brief, they also ignore the FSOC’s own arguments as well as the entire 86,111 page record FSOC complied, used, and considered to make its determination.

Finally, the Journal and amici argue that the Council has an “administrative law problem,” though it is just the opposite. Administrative law is based on the principle that agencies, like people, must follow the law, and that is what FSOC has done here. The Dodd-Frank Act requires the Council to consider ten factors prior to designating a firm as systemically important, and FSOC did so.  In an attempt to overturn MetLife’s designation, the amici twist the words of the statute to falsely claim FSOC should have conducted additional, unnecessary analysis. However, that’s not what the law requires.

Congress created FSOC to keep our financial system safe, in part by reviewing and, if appropriate, designating nonbanks that are a systemic threat to the country.  It also gave FSOC detailed instructions for how it should accomplish that enormous task. FSOC followed those instructions that in connection with MetLife and its designation decision should be upheld based on the facts and the law.

Endnote: Peter Wallison writes in his Journal opinion piece that “Lehman’s role in the crisis is questionable,” and “chaos after it failed…was due to the government’s sudden reversal of” policy. In fact, Lehman Brothers’ failure immediately caused the Reserve Fund to “break the buck,” precipitating a run on the money market fund industry and threatening a shutdown of other wholesale funding markets like commercial paper and repos, which would have had an immediate impact on many non-money market mutual funds as well as commercial financing and the broader payments systems. While the Treasury Department guaranteed the entire $3.7 trillion money market fund industry days later to stop that run, the collateral consequences continued as the credit run on Morgan Stanley and Goldman Sachs made them “toast” within just days of Lehman’s collapsed, necessitating their bailout as well.



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