U.S. bank regulators pinned their hopes on Wednesday on new powers to avert another round of bailouts should crisis strike the handful of mega-firms now even larger than those previously considered too big to fail.
A commission investigating the causes of the financial crisis was told that financial reform legislation, signed into law in July, gives regulators more options, imposing stricter rules on risk-taking and management at large institutions.
The approach going forward will have to be different, said Scott Alvarez, general counsel for the U.S. Federal Reserve's board of governors. More regulation on the front side to try to prevent the problem and more drastic solutions in the event someone gets into trouble.
The Financial Crisis Inquiry Commission is holding its seventh public hearing, a two-day session focused on what to do about too big to fail, firms that are so central to the financial system that their disorderly failure could trigger a global economic meltdown.
Some financial institutions have grown even larger since the crisis, having absorbed the assets of failed competitors.
The real question before us is: How did we end up with only two choices - either bail out the banks, or watch our world sink? said commission Chairman Phil Angelides.
The financial crisis, that began with failing U.S. home mortgages, led to the collapse, bailout or government-brokered sale of major financial firms including Bear Stearns, Lehman Brothers, Washington Mutual, Citigroup and Wachovia in 2008, touching off the worst global recession in decades.
Although the U.S. economy has been growing since mid-2009, lending remains constrained and unemployment high, consequences of the crisis that are likely to linger for years.
The bailouts were wildly unpopular, and many politicians that supported them are still dealing with the voter backlash as November congressional elections approach.
The regulatory reform, known as Dodd-Frank after the chairmen of the two committees that hammered out the provisions, was aimed at curbing excessive risk-taking by countering the perception that too-big-to-fail firms enjoy an implicit government guarantee.
Some critics of the legislation argue regulators will still be highly reluctant to let a big financial firm fail.
REPORT DUE IN DECEMBER
Wednesday's hearing looked at the September 2008 Lehman bankruptcy, where regulators say they lacked authority to intervene and could not find a buyer, and Wachovia's government-brokered sale that began later that month.
Former Lehman Chief Executive Dick Fuld will testify later on Wednesday that regulators did not grant Lehman Brothers the same assistance as its competitors, knocking out the possibility of an orderly unwinding of the firm that could have avoided aggravating the financial crisis.
Thursday's session features Fed Chairman Ben Bernanke and Federal Deposit Insurance Corp Chairman Sheila Bair.
The Fed gets greater powers to regulate systemically important financial institutions under the new law, while the FDIC is the agency that would liquidate a firm.
The 10-member, congressionally-appointed commission is due to issue its report on the causes of the crisis by December 15.
Lehman's collapse was preceded by the government takeover of housing finance giants Fannie Mae and Freddie Mac. It was followed days later by extraordinary government aid to American International Group as credit markets froze with fear.
Wachovia, burdened with souring mortgages, also found itself unable to raise capital and was bought by Wells Fargo, which beat out a Citigroup bid that would have required government assistance. The FDIC played a major role in that deal, with Bair reaching out to executives in after-hour phone calls.
September of 2008 will likely be remembered as an epochal period in the history of American finance, Thomas Baxter, general counsel for the New York Fed, wrote in prepared remarks. He is scheduled to testify later on Wednesday.
Baxter defended the New York Fed's actions with respect to Lehman, saying it worked hard with the U.S. Treasury and other regulators to try to save it.
We did not succeed, but the effort made was serious and determined. We came very close, he said in written testimony.
In the end, Lehman was sentenced to bankruptcy when no buyer for the firm emerged from a series of high pressure meetings at the New York Fed on the weekend of September 14-15. No government assistance was offered.
Baxter hailed Dodd-Frank provisions aimed at forcing systemically important firms like Lehman to have more capital and liquidity, adding that this was precisely the type of medicine that Lehman needed.
But Harvey Miller, an attorney for Weil, Gotshal and Manges LLP, which represented Lehman in its final days, painted a different picture, saying that Fed and Treasury officials never explained their decision not to aid Lehman.
Miller said the government missed an opportunity to save billions of dollars in lost value when it opted against a government supported wind-down. This may have cost $40 billion to $50 billion up front, but it would have averted $700 billion in market losses in the first week after Lehman's bankruptcy.
The damages and harm precipitated by the Lehman bankruptcy could have been substantially reduced by innovative actions of the government. Instead, the government miscalculated and the financial system was pushed to the brink of collapse, he said, echoing statements by former Treasury Secretary Henry Paulson.
Fuld, who has testified multiple times in Washington since the firm's collapse, again said in his written testimony that the government could have acted sooner to defuse the crisis of confidence that led to the storied investment bank's downfall.
(Reporting by David Lawder and Dave Clarke; Additional writing by Emily Kaiser; Editing by Karey Wutkowksi and Tim Dobbyn)