Many seemingly disparate elements of market movements in the past two weeks are intrinsically entwined, and therefore reveal the overall strategy that regulators and the Treasury are relying upon crucially (implicitly or explicitly) to resolve the credit crisis.
Many have noted that the “run” on IndyMac actually occurred after the FDIC had already seized the institution. None have gone further with this notion, however, noting that the “run” was more on the FDIC rather than IndyMac. Why would depositors run the FDIC? Largely because the FDIC has limited reserves of only $53 billion, backed by an additional $40 billion line of credit at the Treasury.
While the FDIC announced that it only expects to face losses of some $4 to $8 billion at IndyMac, what’s the problem? The problem is that IndyMac’s insured deposits total some $26 billion, and the FDIC is laying out those funds now to cover depositors. Once the FDIC sells off IndyMac’s assets, it will eventually recover the remaining $18-$22 billion. Historical statistics show that the recovery will average about six years and proceed along a linear path, i.e., one-sixth per year.
So the FDIC gets to lay out roughly half their reserves today to cover just the IndyMac deposits. A few more bank failures will eat through the remaining reserves pretty quickly, resulting in the FDIC drawing upon their line of credit at Treasury, which, unlike that of the GSE’s is not unlimited. Since banks today are larger, on average, than during previous crises the probability of several more large deposit insurance payouts is high.
The FDIC priced premiums based on the eventual recovery, not the peak initial outlay. It should therefore come as no surprise to anyone that the FDIC will not be able to afford the peak load of the crisis on the basis of current reserves. In the meantime, therefore, the Federal Reserve will now lend to the failed bank estates to help fund the recoveries, notwithstanding that they have already committed roughly half of their own $800 billion balance sheet to other lending facilities. Ultimately, the Federal Reserve is becoming the banker of first resort for bailouts and the government in general is supplanting lending overall. Hence, we may be reverting to the industry of two hundred years ago, where the First and Second Banks of the United States were private banks as well as the country’s central banks, an incredibly profitable position.
In summary, I noted in a recent presentation how Ben Bernanke in his seminal 1983 American Economic Review article on the Great Depression maintained that, “As a matter of theory, the duration of credit effects depends on the amount of time it takes to: 1) Establish new or revive old channels of credit flow after a major disruption, and; 2) Rehabilitate insolvent debtors,” (272). We are doing a lot of creditor rehabilitation and have added new channels of nationalized credit flow, but very little revitalization of old private channels of credit flow. I fear that without private buy-in, we are crowding out the private sector and limiting economic growth and therefore recovery potential.