FDIC says it’s prepared for the next Lehman

May 11, 2012, 12:55 AM UTC

Government plan for troubled banks involves a temporary take-over by Uncle Sam.

FDIC says it can avoid a Lehman repeat

FORTUNE — The next Lehman Brothers may not happen over the course of a weekend. It could take a couple of months. The question is if that would be an improvement.

On Thursday, Martin Gruenberg, who is the acting chairman of the Federal Deposit Insurance Corp., speaking at a conference put on by the Federal Reserve Bank of Chicago, laid out for the first time publicly the government’s plan to deal with the next Lehman Brothers-like failure. Under the Dodd-Frank bank reform law, the FDIC has the responsibility of wind-downing large banks that regulators think are headed for bankruptcy.

He said the FDIC’s plan is for the government to take over the parent company of a troubled large bank, rather than let it fail immediately. The FDIC would then fire the bank’s executives and its board, and run its subsidiaries, like its branches or its stock trading operations, until the FDIC was able to find a buyer for the failed bank. In the process, Gruenberg says, the FDIC would wipe out the value of the bank’s stock. Some of the bank’s bonds would be converted into stock in the new bank. Other bond holders would take some losses. And the government would provide the financing to let the company continue to run.

The whole process could take a couple of months, Gruenberg said. But he said it would be a better route for the market in general than what happened after Lehman. “The goal of the resolution strategy is to come up with something that could be used and maintain financial stability,” says Gruenberg. Gruenberg says his agency has been in constant contact with the big banks and generally the reaction has been positive to the plan. “Their general response is that our plan make sense.”

At the conference on Thursday, some questioned whether the plan would work. Richard Bove, a bank analyst at Rochdale Securities, said he thought the plan would make bank stocks more risky. Mark Flannery, an economist at the University of Florida, said banks were savvy enough to figure out how to shift all their assets so that the government wouldn’t be able to get a hold of them.

Others in the past have questioned if the FDIC would be able to force bond holders of a failed bank to take losses. If the holders of those bonds are other banks, then that could cause other banks to fail as well. Anat Admati, an economist at Stanford University, who is on the advisory panel that helped the FDIC come up with resolution plan, says the government still has to iron out its process for deciding when the FDIC would take over a bank. “One can do a great job of preparing a plan,” says Admati. “The question is whether it would really get triggered.”

One participant asked Gruenberg if the FDIC would consider testing its resolution authority on Fannie Mae and Freddie Mac. Gruenberg responded that the FDIC had no authority over the large mortgage guarantee companies that were taken over by the government in late 2008.

Republicans in the House of Representatives have recently begun an initiative to repeal the part of the Dodd-Frank law that gives the FDIC resolution authority. Gruenberg seemed optimistic that those efforts wouldn’t succeed. “There’s fairly broad bi-partisan agreement that too big to fail is not a good thing,” says Gruenberg. “Without this, you create an expectation of public support that creates an uneven playing field.”