I’ve just finished reading Andrew Ross Sorkin‘s excellent book Too Big To Fail (Penguin, 2009).  If you haven’t read it yet, put it on your list, because this one is really worth it.  The book tells the gripping tale of the financial crisis, beginning with the downward slide of Bear Stearns and Lehman and continuing through to adoption of the TARP program.   With particular focus on Tim Geithner, then President of the Federal Reserve Bank of New York, and Hank Paulson, then Secretary of the Treasury, who – along with many others in government and the private sector – worked tirelessly to try to fix a seemingly unending parade of problems, Sorkin captures the intensity of the times and offers insights into why things happened the way they did.   It’s a real page-turner, and surprisingly so given that the primary elements of the story are already well known.

As we now try to figure out how to deal with the Dodd-Frank Act (pdf) and its potential impact on financial institutions, it’s helpful to look back at what happened in 2008, as described in Sorkin’s book.  It’s striking to see how similar certain provisions of the Act (and the language used in the congressional committee’s report about the Act) are to the ideas expressed by people in government during the crisis itself.

In particular, concerns about moral hazard (the idea that undue risk-taking is promoted when managers and shareholders know they can be insulated from negative consequences) and about the real need for an alternative to the bankruptcy process for large financial institutions, were often voiced.  As quoted in Sorkin’s book, both Paulson and Ben Bernanke, Chairman of the Federal Reserve, expressed on multiple occasions the need for the government to have authority to resolve or wind-down complex financial institutions outside of bankruptcy.  Bernanke also spoke of the need to mitigate moral hazard  “by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors.”

And sure enough, in adopting Dodd-Frank, Congress explained that the “too big to fail” provisions address both of these issues front and center.  The Act provides for “orderly liquidation authority” if the Secretary of the Treasury (in consultation with the President,  and with the written recommendation of two additional  federal regulators) finds that liquidation is necessary to mitigate “serious adverse effects on financial stability” in the nation.  The liquidation is to be carried out in a manner that “minimizes moral hazard,” with costs being borne first by shareholders and unsecured creditors — and protecting taxpayers from these losses.

Several other provisions of Dodd-Frank can find their beginnings in the events of 2008 as well —  short sales, hedge fund regulation, derivatives, rating agencies, etc.  Turns out that Sorkin’s book, though likely not intended for this purpose, provides a fascinating background story and explanation for much of the content of the Dodd-Frank Act.