WASHINGTON - The Treasury Department proposed legislation yesterday that would allow the federal government to prevent the failure of large non-bank financial companies in severe distress that pose systemic risks to the economy, including those with municipal securities divisions. But it was not clear if the legislation would cover bond insurers, and market participants said it raised constitutional and other questions.

In an outline of the draft legislation, which is expected to be submitted to Congress later this week, Treasury Secretary Tim Geithner asked for authority to use a method, similar to the blueprint employed by the Federal Deposit Insurance Corp., "to intervene at the appropriate time to avert systemic risks posed by the potential insolvency of a significant financial firm."

Instead of subjecting a firm to bankruptcy or an injection of taxpayer funds with no controls, the legislation would grant the U.S. government resolution authority, which would allow it to put the firm into conservatorship or receivership, and then administer its reorganization or wind-down. The requested authority would extend to bank and thrift holding companies that control broker-dealers, insurance companies, and futures commission merchants.

The legislation would give the federal government authority to intervene in a distressed company by selling assets, renegotiating contracts, and addressing its derivatives portfolio among other powers. The government also would receive money from the repayment of loans or sale of any equity interest taken in the distressed company.

The government's intervention procedure would be modeled on the FDIC's resolution authority with respect to banks and the Federal Housing Finance Agency authority over government-sponsored enterprises. The authority would be funded in part by a mandatory appropriation to the FDIC out of the Treasury's general fund, or through assessments on the financial institutions covered by the legislation.

Geithner made the appeal for such authority on Tuesday at a congressional hearing citing the regulatory gap that Lehman Brothers Holdings Inc. and American International Group Inc. slipped through.

The potential authority could extend to firms with municipal broker-dealer divisions. Michael Decker co-chief executive officer of the Regional Bond Dealers Association, said that RBDA members Wells Fargo & Co., Fifth Third Bancorp, and First Horizon National Corp. could be included under the authority. Larger firms like PNC Financial Services Group Inc., and BB&T Corp. also could be included.

Decker said regional firms would not pose systemic risks like Lehman and AIG because they do not have leveraged balance sheets and do not get involved with highly structured products like collateralized debt obligations. He said the Treasury's requested authority would benefit the market.

"This is a welcome addition to the financial regulatory structure," Decker said. "It would give the Treasury a codified and organized way to deal with financial companies that are approaching insolvency but not in bankruptcy."

Other market participants also applauded the proposed resolution authority.

"A national resolution authority, and optional federal charter for insurance, are two key components for comprehensive regulatory restructuring," said Steve Bartlett, president and CEO of the Financial Services Roundtable.

Tim Ryan, CEO of the Securities Industry and Financial Markets Association, said that the issue "should be examined in the context of a systemic regulator and we look forward to seeing the details of [the Treasury] plan so that we can consider it, in consultation with our members."

The proposed legislation would extend government authority over insurance companies, but it is unclear if that authority would include monoline insurers. Jim Ryan, an insurance company analyst with Morningstar Inc. said the regulation of bond insurers has been discussed for more than a year.

"Unless there was a tremendous systemic meltdown, I can't see why [the government] would step in to help the bond insurers," Ryan said.

Spokespersons for Ambac Financial Group Inc. and MBIA Inc. said their companies would not comment until more detailed legislation is available.

Other market observers said the Treasury request raises significant market and constitutional issues.

Bradley K. Sabel, partner with Shearman & Sterling LLP in New York, said the Treasury might have trouble overseeing all the subsidiaries under a holding company.

"It's one thing to say we can do this at the top-tier entity, but this isn't going to be effective unless they can do the same thing for all, at least significant, subsidiaries," Sabel said. The Treasury will "have to work very fast to get educated on what all those subsidiaries are and where they are."

He added that the Treasury also may have to include some form of permanent regulation over the companies that would qualify as systemic risk or create a so-called moral hazard threat in the market.

"For the entities that are not bank or financial holding companies, are you really going to give the market the comfort I think this would likely give without having some degree of regulation over what they do? I don't think it's workable politically or practically without having some form of regulatory oversight," he said.

Bert Ely, an independent consultant in Alexandria, Va., said the Treasury request would complicate bankruptcy resolutions.

"This gets into fundamental questions of constitutional law," he said. The legislation "gets into the takings clause of the Fifth Amendment." The takings clause limits the power of eminent domain by requiring that "just compensation" be paid if private property is taken for public use.

Further, Ely said, the House and Senate judiciary committees would need to resolve the legislation's conflict with current bankruptcy laws.

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