By Dave Clarke
Creditors would face substantial losses in future government dismantlings of firms like AIG and Lehman Brothers, according to a U.S. regulatory proposal.
This "resolution authority" is a main plank in U.S. financial reform law enacted in July and is designed to avoid government bailouts of big financial companies.
Uncertainty over companies like AIG and Lehman at the height of the financial crisis in 2008 fueled a panic that almost froze global credit markets. Anger over the bailouts of companies the government deemed "too big to fail" continues to agitate voters going into midterm elections next month.
The Federal Deposit Insurance Corp's proposal, expected to be made public in coming days, will make clear that all creditors of big, non-bank financial companies should expect losses in a failure, according to a source familiar with the rule.
It is also expected to say that, in some cases, certain short-term creditors could expect additional payments, the source said.
Banks and financial firms are closely watching how the FDIC will treat creditors under the liquidation power granted by the financial reform legislation.
Chester Salomon, a bankruptcy lawyer with Becker Glynn in New York, said the rule would be very worrying for an investor.
"It provides a disincentive for investments in longer-term debt, which encourages banks to issue more short term debt," he said.
The FDIC's work on the rule has also caused concern among other regulators starting to implement the Wall Street reform law, which was enacted in July in the wake of the 2007-2009 financial crisis.
Treasury Department officials are concerned the rule could give incentives to some creditors to pull out of financial firms when they hit hard times -- creating a "run" -- if they believe the FDIC will hit them harder than others during a liquidation, the Wall Street Journal reported.
FDIC Chairman Sheila Bair sought to calm fears last week, saying that how creditors are treated under the new resolution authority would closely match how they are treated under bankruptcy proceedings.
"The authority to differentiate among creditors will be used rarely and only where such additional payments are essential to the implementation of the receivership or any bridge financial company," she said.
The reform law, the Dodd-Frank Act, allows the FDIC to move certain parts of failing institutions' business into a separate entity so that they can be sold at a later date.
FDIC officials have said subordinated debt, long-term bondholders and shareholders would not be allowed to be moved into this entity under the rule.
The officials said the agency hoped this would clear up industry questions about the issue and eliminate the perception that some institutions are "too big to fail."
(Reporting by Dave Clarke, Rachelle Younglai and Sakthi Prasad, Editing by Eddie Evans)
Copyright 2010 Reuters News Service. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.
Copyright © 2010 ABC News Internet Ventures