Reading Reggie Middleton’s latest blog here on RGE (he looks much younger than I’d have guessed!) reminded me of a metric which is critical to assessing the velocity of a financial crisis as it affects a financial institution. In looking at American Express, he highlights (among a lot of other useful data) the extent to which charge-offs on credit cards are exceeding the growth of reserves. Both numbers are moving. Charge-offs are going up. Reserves are going up too to cover the losses from charge-offs, but are not growing as quickly.
As we all know, it is liquid reserves that enable a credit institution to cope with periods of uncertainty, underperformance and/or illiquidity. In the banking industry, the relationship between losses and reserves is referred to as the “coverage ratio” and it is a critical indicator of stress.
Those with too low reserves must borrow or recapitalise just at that point in the cycle when lenders and investors become wary sceptics as they contemplate the worsening business climate in general and deteriorating performance of the needy in particular. Those unable to secure credit or attract investment must look to official liquidity facilities, if available, and/or face forced asset liquidations and/or insolvency. Those who can secure credit or attract investment typically do so at a cost which impairs future profitability and so undermines future reserve growth (see From Capital-ist to Capital-less Economies).
It occurred to me to examine the coverage ratio in another context that I already planned to write about today: the FDIC.
For the past month or so, I haven’t been able to look at the FDIC without seeing a big, undercapitalised, monoline insurer. I didn’t want to see the FDIC that way, especially since Mervyn King, governor of the Bank of England and normally a very sensible bloke, is a huge admirer of the US deposit insurance system and wants to import FDIC principles here to the UK. If the FDIC is fundamentally flawed, then the UK may once again follow the US over yet another cliff with too little reflection of our inherent self-interest in avoiding yet another public policy disaster.
Facing my fears, as we all should if we aspire to be rational and make superior judgements, requires assessing the facts.
The following excerpt from Wikipedia describes the characteristics of a monoline insurer:
Monoline insurers (also referred to as “monoline insurance companies” or simply “monolines”) guarantee the timely repayment of bond principal and interest when an issuer defaults. They are so named because they provide services to only one industry.
The economic value of bond insurance to the governmental unit, agency, or company offering bonds is a saving in interest costs reflecting the difference in yield on an insured bond from that on the same bond if uninsured.
So what is the FDIC then? The FDIC “guarantee[s] the timely repayment of [deposits] when a[n insured financial institution] defaults.” The FDIC “provide[s] services to only one industry. The economic value of [FDIC deposit insurance] to the [insured banks] offering [deposit accounts and certificates of deposit] is a saving in interest costs reflecting the difference in yield on an insured [deposit] from that on the same [deposit] if uninsured.”
The similarities are too great. The FDIC is a monoline insurer in all the ways that matter.
Taking that as a starting point then, what makes the FDIC better able to withstand the rigours of a financial crisis than its private sector monoline brethren? Let’s look at the advantages the FDIC has over lesser monolines.
Regulatory Powers: The FDIC has the power to compel banks to increase their capital, limit their riskier business activity, and otherwise intervene to curb management’s rush toward bank failure.
Mandatory Participation: American banks have no choice but to buy their deposit insurance from the FDIC, and are obligated to do so. They have no choice but to pay the premia assessed by the FDIC when due if they want to remain in business. With more than 6,000 banks participating, the risks should be diversified (except, of course, that banks are herd animals so that risk outcomes are highly correlated for the sector as a whole). Risk-Weighted Premia: Theoretically, the FDIC’s risk-based CAMELS rating system should require riskier banks to pay more. It would be interesting to apply rigorous market backtesting methodologies to see whether CAMELS is performing as expected in this downturn, or whether like so much else, CAMELS has been distorted by forbearance and crony capitalism into another tool for industry concentration and selective competitive advantage favouring well-connected big banks during the M&A boom years.
Statutory Receiver of Failed Banks: When a bank fails, the FDIC takes over the assets and liabilities, and is able to rapidly arrange for bridge banks, purchase and assumption transactions to healthy banks, and otherwise realise value from failed banks while minimising systemic disruption to retail and commercial account holders. This is a critical function as the surest way to prevent draws of deposit insurance is to compel a work out that secures depositors unimpaired access to their accounts.
Treasury Credit as a Backstop: If it runs into trouble, the FDIC can borrow from the Treasury (just like everyone else in corporate America, it seems).
This is a formidable armory of powers and privileges. And we know the FDIC is experienced at using its powers to good effect, having proven itself several times through the past 75 years. Nonetheless, these powers may be insufficient if the scale of losses insured by the FDIC overwhelm the capitalisation of the insured banks and the resources of the FDIC.
This is where Reggie’s test of losses relative to reserve growth becomes a telling indicator of future problems.
Looking at the most recent Quarterly Banking Profile from the FDIC, we see an ugly picture:
Net Charge-Off Rate Rises to Highest Level Since 1991
Loan losses registered a sizable jump in the second quarter, as loss rates on real estate loans increased sharply at many large lenders. Net charge-offs of loans and leases totaled $26.4 billion in the second quarter, almost triple the $8.9 billion that was charged off in the second quarter of 2007. The annualized net charge-off rate in the second quarter was 1.32 percent, compared to 0.49 percent a year earlier. This is the highest quarterly charge-off rate for the industry since the fourth quarter of 1991. At institutions with more than $1 billion in assets, the average charge-off rate in the second quarter was 1.46 percent, more than three times the 0.44 percent average for institutions with less than $1 billion in assets.
Note that big banks – those presumably with favourable CAMELS ratings in years past, allowing them to gobble up their less favourably rated peers – have much worse charge-offs than smaller banks.
Large Boost in Reserves Does Not Quite Keep Pace with Noncurrent Loans
For the third consecutive quarter, insured institutions added almost twice as much in loan-loss provisions to their reserves for losses as they charged-off for bad loans. Provisions exceeded charge-offs by $23.8 billion in the second quarter, and industry reserves rose by $23.1 billion (19.1 percent). The industry’s ratio of reserves to total loans and leases increased from 1.52 percent to 1.80 percent, its highest level since the middle of 1996. However, for the ninth consecutive quarter, increases in noncurrent loans surpassed growth in reserves, and the industry’s “coverage ratio” fell very slightly, from 88.9 cents in reserves for every $1.00 in noncurrent loans, to 88.5 cents, a 15-year low for the ratio.
I had to smile at the heading. The clumsy phrasing of “Does Not Quite Keep Pace” has been carefully drafted in preference to the less wordy but more apt “Lags”.
The bottom line is that the “coverage ratio” is worsening for the FDIC flock, and the coverage ratio for the FDIC is not looking too healthy either. At the end of the second quarter, the FDIC reserve fund was down to a mere $45.2 billion after just 9 bank failures this year. While it does not publish a coverage ratio in respect of itself, IndyMac alone will require an estimated $8.9 billion of FDIC reserves to resolve, almost twenty percent of remaining reserves. The FDIC intends to raise reserves through a premium increase in October, but a lot can happen in two months in these febrile times.
So the FDIC may well become yet another troubled monoline insurer. Indeed, Sheila Bair, serial forbearance artiste chairman of the FDIC (formerly a Treasury official and Republican congressional aide), conceded as much when she raised the possibility this week that the FDIC might be joining the queue for a Treasury hand out to see it through short term liquidity problems.
“I would not rule out the possibility that at some point we may need to tap into [short-term] lines of credit with the Treasury for working capital, not to cover our losses,” Bair said in an interview.
The FDIC is too critical to the fabric of the US banking system to become another monoline casualty of the forbearance backlash crippling the banking industry. If there ever was a case for “systemic risk” deserving a bailout, the FDIC would get my vote (and presumably every Congressman’s too). But an FDIC bailout would be yet another signal to international creditors of America that the financial methods and models so widely exported and extolled over the past quarter century were fundamentally misguided and dangerous.
If the FDIC model fails, then what are the alternatives for deposit insurance? An intriguing idea floated in the Financial Times a couple weeks ago was to partially privatise deposit insurance through the excess liability reinsurance markets, allowing Warren Buffett to run his sliderule over the regulatory and risk management profile of banks to set a market price for insuring a failure.
Excess liability insurance would spread deposit insurance risk beyond the UK banking sector to global catastrophe insurance markets, reducing the pro-cyclical liquidity impact of any deposit insurance claim. In normal circumstances it should cover the risk of a large UK bank failure at a cost well below pre-funding, particularly in upswings of the economic cycle, while spreading the costs in a managed way if claims are sustained during downswings. Periodic tendering would ensure that market pricing reinforces discipline in the banking sector toward better management throughout the business cycle, co-operation on rescues of troubled banks and efficient resolution processes. The capital efficiency of these flexible arrangements should give UK banks a competitive edge.
In globalised markets, with globalised banks, perhaps globalised deposit insurance through excess liability insurance and/or catastrophe bond finance is not such a bad option. It may not be popular, however, with the crony capitalists and their political clientele who prefer the cheaper option of socialising losses via the Treasury to taxpayers and global public creditors, but at least it’s an alternative to the US model for the UK and others to consider.
20 Responses to “Is the FDIC another troubled monoline?”
The FDIC is worse than a monoline. It is totally bust and insolvent
Without infinitely flexible currency using debt as the instrument, this whole charade would be over. Paper would have been redeemed for something of intrinsic scarcity and intrinsic value long ago, and the weak players rooted out with financial Darwinism. We are playing games within shell games now using currency gimmicks, confiscatory taxes and presumption upon future taxes, and a pawnshop network via Fed and Treasury. We are on the Western front with an anguishingly long line thinly manned. Every threat of a breakthrough is met with Just In Time reserves rushed to plug the breach. The reserves are tiring and morale dropping as the emergencies come thick and fast.How to insure once the losses overwhelm? How many layers of IOU’s can be issued to maintain the faith of the people. When mistake, error, fraud (SIN) diminish the solvency of every macro- and micro-unit, suddenly every player reaches about wishing for everyone(anyone) to play saviour and make whole a rended cloak. Warren Buffet now as John Pierpont in past; those whose works and wise judgements have enabled them to accrete material fortunes of a vast reservoir are called upon to sacrifice them to remedy the social pool’s folly. What will their terms be, what will the fools agree to in their terms? More IOU’s? Or must they become slaves and servants of a household–bow down and make lowly to work out the terms of their debt (bondage?). More likely will be violence and appropriation.As never before in this generation, as we pass through this purgative crucible of healing a financial system, will we have to confront the ultimate issues in mankind. Character, creation, investment, distribution, health.
“an FDIC bailout would be yet another signal to international creditors of America that the financial methods and models so widely exported and extolled over the past quarter century were fundamentally misguided and dangerous.”Great post LB. I would make one small change: an FDIC bailout WILL be yet another signal to international creditors… . Another term for this moment is “end game”.
FDIC strained by Bank failures – will lift premiums:http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a35CvKfLq65QFDIC ramping up Staff and Office Space in anticipation of further Bank failures:http://www.bloomberg.com/apps/news?pid=20601087&sid=a4CHPudHiwIs
Great post LB! Keep up the great workRegards,
The FDIC is playing FEMA to our financial Katrinas…Gustavs, Hannas, etc. Catastrophic events are queueing in line to devastate the soft underbelly of the economic heartland. “What is the wisdom of living 13 feet below sea level?” It is never good policy to live underwater to debt or natural disaster. That mother nature did not quickly discipline the foolhardy just encouraged more “settlement” in a basin. Now the wrath descends–they straitfacedly demand to be made whole by their wiser peers who have been bemused spectators.”You sunk my battleship, my city, my financial structure!!” No, You scuttled yourself by opening the valvecocks and forgetting how to shut them off! Trouble is that now NO ONE can shut them off.
Partial Privatization is the worst possible solution. It will tend synchronize the cycles of disparate economies, a process already in place. In the end, the public holds the bag for losses.Credit to Mish for suggesting that only non-interest bearing checking accounts should be insured by the FDIC, and the reserve limits should be pushed considerably higher. After all, if you expect any kind of return on your capital, how ever small, you should assume the risk of loosing your capital. Its the American way.
You got it… The FDIC is on a monoline to insolvency.
Whether private or government run the premiums charged should reflect the risk. The argument that the privately run insurance will be better run than the government run option has some merit. So far we have had private gains in the capital markets and government risk coverage (Exhibit A – Bear Sterns). Any privately run system will need to still be heavily supervised and overseen by the government still. I think the FNM and FRE companies are a similar case where private companies benefit since the government indirectly subsidizes their risk premium.On the other hand bank depositors who do not employ their capital efficiently (e.g. by purchasing shares, bonds, real estate, etc) are not contributing directly to the economy and rely on the bank to do it for them (thru say a CD). They get the lower return. Further lowered by the cost of the FDIC insurance, which will be further lowered by the increased FDIC premiums and further offset by inflation. At some point, depositors will decide they are better off investing in something else and the balance will get restored.
At the risk of appearing naive, I have to ask: when a bank pays an insurance premium to FDIC, what does FDIC do with the money? Buy Treasuries? Go to an ARS auction? Buy a basket of “AAA-rated” debt? So when they need to actually put cash dollars into the hands of nervous bailed-out depositors, what’s the impact of selling the asset they hold?
I assume the following snip means the FDIC funds are in the lockbox right next to social security funds:August 13 – Dow Jones (Jeff Bater): “The U.S. government’s budget deficit nearly tripled in July…Elevating spending was a $15bn disbursement by the Federal Deposit Insurance Corp. to cover insured deposits at failed financial institutions…
@ LB “Note that big banks – those presumably with favourable CAMELS ratings in years past, allowing them to gobble up their less favourably rated peers – have much worse charge-offs than smaller banks…. If the FDIC model fails, then what are the alternatives for deposit insurance? An intriguing idea floated in the Financial Times a couple weeks ago was to partially privatise deposit insurance through the excess liability reinsurance markets, allowing Warren Buffett to run his sliderule over the regulatory and risk management profile of banks to set a market price for insuring a failure…”And when Buffett’s slide rule for privatized insurance goes belly up, will Americans be liable for bailing out the world’s depositors, Fred-and-Fan style? America’s reserve currency is being reduced to the worth of “toilet paper” as John Williams said – which means there will be no money in the “land of plenty” with which to bail. Bernanke is failing miserably printing America’s way to prosperity: rather, he is destroying her economic liberty and paving her way to serfdom.Deficits are exploding, tax revenues are going down, and Bernanke simply sits there like a fool printing and expanding credit and artificially pushing interest rates below the flood of inflation. In short, he is destroying America’s economy. Under such conditions Buffett’s slide rule is no better than Greenspan’s magic wand.Economic growth is dependent on sound money, limited government and the unfettered workings of supply and demand.A true deposit insurance program which is totally voluntary and which gears its rates to the actual risks would be a blessing. In order to attract depositors, banks would have to have a solid base and have insurance. Alas, I doubt that the UK has anything that sober in mind.Here’s a page, abbreviated, from G. Edward Griffin. There is no doubt who the winners will be when the FDIC gets through bailing – those, of course, for whom the bailout system was devised:When a borrower cannot repay and there are no assets which can be taken to compensate, the bank must write off that loan as a loss. However, since most of the money originally was created out of nothing and cost the bank nothing except bookkeeping overhead, there is little of tangible value that is actual loss. It is primarily a bookkeeping entry.A bookkeeping loss can still be undesirable to a bank because it causes the loan to be removed from the ledger as an asset without a reduction in liabilities. The difference must come from the equity of those who own the bank. In other words, the loan asset is removed, but the money liability remains. The original checkbook money is still circulating out there even though the borrower cannot repay. The only way to do this and balance the books once again is to draw upon the capital which was invested by the bank’s stockholders or to deduct the loss from the bank’s current profits. In either case, the owners of the bank lose an amount equal to the value of the defaulted loan. So, to them, the loss becomes very real. If the bank is forced to write off a large amount of bad loans, the amount could exceed the entire value of the owners’ equity. When that happens, the game is over, and the bank is insolvent.This concern would be sufficient to motivate most bankers to be very conservative in their loan policy, and in fact most of them do act with great caution when dealing with individuals and small businesses. But the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Federal Deposit Loan Corporation now guarantee that massive loans made to large corporations and to other governments will not be allowed to fall entirely upon the bank’s owners should those loans go into default. This is done under the argument that, if theses corporations or banks are allowed to fail, the nation would suffer from vast unemployment and economic disruption…The FDIC “protection” is not insurance in any sense of the word. It is merely part of a political scheme to bail out the most influential members of the banking cartel when they get into financial difficulty… The first line of defense in this scheme is to have large, defaulted loans restored to life by a Congressional pledge of tax dollars…. The second line of defense is to have the FDIC step in and make those payments…The FDIC will never be adequately funded. The FDIC operates on the same assumption as the banks that only a small percentage will ever need money at the same time. So the amount held in reserve is never more than a few percentage points of the total liability. Typically, the FDIC holds about $1.20 for every $100 (written 1994) of covered deposits. At the time of this writing, however, that figure had slipped to only 20 cents and was still dropping. That means that the financial exposure is about 99.3% larger than the safety net which is supposed to catch it… By law, the money collected from bank assessments must be invested in Treasury bonds, which means it is loaned to the government and spent immediately by Congress. In the final stage of this process, therefore, the FDIC itself runs out of money and turns to the Treasury, then to Congress for help…It appears to me that America is going to be completely submerged when it gets through bailing.Excellent article, London Banker, as always.
I agree with all the comments above, but let’s take a look at the bigger picture.Who is backstopping the banks? The FDIC.Who is backstopping the FDIC? The US Treasury.Who is backstopping the US Treasury? Ummm…NOBODY!!I think that the last bastion of confidence in the financial system, wherein Treasury debt is deemed to be “safe”, will soon be sorely tested.
The “money out of thin air” that a bank creates when loaning money is derived from reserves (which are assets). Even though it appears that the money was “created out of thin air”, the bank is still responsible for the loss in the case of a default on a loan. I will explain below:Lets say I deposit 100K into a bank. My deposit is a liability for the bank, and the 100K is deposit goes into a reserves account with the Fed. It is an asset on the bank’s balance sheet.Lets say that the bank then loans out 90K. When the loan is created the bank creating a new deposit account in the name of the person who receives the loan. This so-called “money out of thin air” goes on the liability side of the balance sheet. This, however does NOT increase reserves. The promissory note for the loan goes onto the asset side of the balance sheet.Now, lets say that the recipient of the loan spends the money on Tulip Bulbs. The 90K from the newly created deposit account is spent. As a result the 90K deposit account becomes depleted and 90K in reserves must then be removed from the liability side of the bank’s balance sheet. THIS IS WHAT MOST PEOPLE FAIL TO UNDERSTAND: Reserves (which are assets) decrease by 90K when money leaves the bank!The bank is now left with my 100K deposit account on the liability side of the balance sheet. The bank now has 10K in reserves plus the 90K in promisory note on the asset side of the balance sheet. All is still well.HERE IS THE KICKER: If the recipient of the loan then defaults, and the promisory note becomes worth ZERO, then the bank has a PROBLEM. The bank now has a liability of 100K (since I originally deposited 100K) but the bank now only has 10K in assets (reserves). The bank just LOST 90K!The “money out of thin air” was actually derived from reserves (which were derived from my original deposit)!
Written by Guest on 2008-08-31 12:49:08I can go with the insurance gurantee of checking accounts only. When the system gets blowout spreads, a fast transfer of savings to checking accounts would slow cash-out bank runs.I am doing cash outs by way of removing over the limit savings to other banks and to cash to go into segregated deposits boxes. That now is not a solution if the FDIC blows up, which it already has done. The delays of bank receivership are to allow the mechanisms of the FDIC to get put into place so that they have the staff to deal with the wrecks that are getting old.Without an express gurantee of checking accounts all should just notify their bank of a currency withdrawal. As for me, I find that the run for withdrawn cash is the impetus needed to get a move to sounder banking. The cash in hand is only going to get you a higher position in the line of folks that want out of their paper money and unsecured credit system. Once the herd gets spooked the value of your unsecured bank deposits will plummet far faster than the ones that hold earlier withdrawn cash, and then all will go to net asset value of the paper.The cash is an unsecured and non interest bearing call on the productive power and assets of the people of the United States. A bank account is a derivative of the above.
http://www.cnbc.com/id/15840232?video=833657703&play=1FDIC Watch ListFDIC will need 500 bil minimum to backstop.
the very existence of the FDIC encourages irresponsible behavior by both depositors and depository institutions. this inherent flaw has ensured that one day, the FDIC will falter and be in need of a bail-out itself. it has also contributed to the monstrous credit bubble that has now burst, although it is of course impossible to gauge to what degree. banking has become a business without risk, as losses generally end up being socialized. this anti-capitalistic format has done great damage to the economy, and clearly the FDIC is part of it. one could maybe add that ‘without risk’ should be qualified by ‘until the time comes when socializing the losses becomes impossible because the losses have become too big’.
The FDIC would always work if it was required to keep enough money on reserve to cover the banks it insures. On the other hand, the banks themselves would have no investment money left in that situation, having given it all to the FDIC. The trouble with the current situation is exactly the opposite: the FDIC requires banks to keep only a small percentage of cash from its deposits on hand,(I believe it’s 10%, but I’m not positive) while they are free to place the rest in investments that have risk associated with them. The FDIC, which is supposed to insure all of these accounts against bank failure, keeps only 1.8% of them in reserve,(up from 1.2% last year) and the rest goes into treasury bonds, meaning it gets loaned out to the U.S. government. The total amount of reserve cash in this system at any point is therefore equal to the sum of the cash reserve requirements, or 11.8%. Basically what that means is that, at any given time, there can be nearly ten times as much debt as cash in our country. If a substantial portion of that debt defaults, the banks issuing it will not be able to resolve it and will fail. If 2% of insured banks fail in a short time, the FDIC will not be able to pay without Congressional assistance.I have yet to hear how any privatization scheme would solve this fundamental problem, created by the fact that the insuring agency, public or private, is not required to keep enough cash on hand to actually cover its assets. Moreover, even if the FDIC was completely privatized, Congress would still have to step in and bail them out in case of failure. The alternative, which I have actually heard some economists argue for, is to just let the banks default, in which case many perfectly good people would lose their life savings even though they had it in an insured savings account. Given that the perceived security of savings accounts is currently the only thing preventing the sorts of bank-destroying runs that ultimately created the great depression, I would have hoped this idea would be a non-starter, but apparently some people think serious financial collapse must be allowed to happen in order to preserve the free market.I do not agree. Recessions aren’t a bad thing unless they are large enough in magnitude to overwhelm the financial system of a given country, at which point they become major depressions that can lead severe poverty and political instability, including strong support for socialism and/or communism. Recessions are due to a compounding economic collapse driven by overspeculation, but the level of speculation that can be sustained in an economy is limited by the amount of cash reserve required in the banking institutions of that economy. The FDIC’s cash reserve, being one level removed, can serve as a stabilizing back-up, an institution that can slow the rate of a recession to preserve the financial infrastructure that keeps an economy going. I realize that it’s necessary to re-invest a large portion of cash to drive economic growth, so expecting the FDIC to cover all of the insured banks’ assets is not reasonable, but when speculative investments are allowed to grow too rampant the entire financial system is susceptible to collapse. While there is currently no agreement on how to determine when speculation has grown “too rampant”, I believe the debt to cash ratio is a good indicator of how catastrophic a debt collapse might be. If there is 10 times as much debt as cash, the economy could collapse to 1/10 of its previous value very quickly, overwhelming fundamental financial institutions and driving many citizens to desperation. On the other hand, an economy with twice the debt to cash ratio can only collapse to 1/3 of its previous value, which should give the financial system three times as much in reserve to fall back on. It’s all a matter of risk, and there’s a point at which the risks of financial collapse outweigh the rewards of rapid economic expansion.The only sure way to keep a serious collapse manageable is to keep the debt to cash levels reasonable by keeping the reserve requirement of the FDIC, or banks in general, above about 30%, though the exact number is debatable. Below that the debt to cash ratio rises exponentially, and a debt collapse becomes many times greater in magnitude.The most important thing for the debate, however, is not to oversimplify the issue by pretending that privatization will magically solve or even substantially affect the FDIC’s problems. This instability is fundamental to finance, regardless of who owns the bank.