First we want to start with an apology to our friends at Bloomberg News, the AP and anybody else with whom we have discussed the sufficiency of the FDIC’s resources over the past several months. We were not clear enough in our description of the cost of resolving the 110 banks we expect to fail between June 30 of this year and July 1, 2009 and how this cost relates to the cash resources available to the FDIC. In fact, the cost of resolving insolvent banks, the visible amount in the Deposit Insurance Fund, and the actual monies available to the FDIC, are not connected at all.
As luck would have it, the takeover of Washington Mutual by JPMorgan Chase (NYSE:JPM) after the close yesterday, an action that will result in no loss to the FDIC or depositors, provides a road map for a workable assistance plan from Washington. Let’s first walk through an inventory of the vast financial resources available to the FDIC as it ramps up to handle what is going to be an increasing number of bank resolutions and sales over the next few months, resolutions that will result in losses. Then we’ll comment on the impending death of the Paulson plan and provide our view of a workable alternative financed largely by the banking industry and private investors.
Why the FDIC Will Not Run Out of Money
The first line of defense for the insured depositors of US banks is regulatory takeovers and sales such as the WaMu transaction, where the acquirer assumes all deposits and buys all of the assets after a resolution by the FDIC. The FDIC takes no loss and private investors bear whatever risk remains in the assets of the failed bank. The equity and bond holders of WaMu naturally remained with the failed, publicly listed holding company and will be wiped out in bankruptcy. See our previous comment in The IRA about the difference between a bank and a bank holding company from a public company creditor/shareholder perspective (“What is to be Done?: Interview with Bert Ely”).
The next line of defense for depositors in US banks is the income of the banking industry. The FDIC has open-ended authority to tax the US banking industry through deposit premiums. While the visible income of the industry is shrinking rapidly due to the diversion of funds into loan loss provisions, in the first half of 2008, provisions ($81 billion) plus net operating income totaled over $100 billion.
Moreover, behind the income of the banking industry is $1.3 trillion in tangible equity capital, a base of support that alone should be sufficient to absorb any losses the industry may generate. While the FDIC may not be able to tax the industry in real time to absorb all of these losses as and when they occur, the fact is that this capital base is the first line of defense for all depositors of all US banks – insured or otherwise.
As the FDIC noted in an open letter to Bloomberg News posted yesterday: “The fund’s current balance is $45 billion – but that figure is not static. The fund will continue to incur the cost of protecting insured depositors as more banks may fail, but we continually bring in more premium income. We will propose raising bank premiums in the coming weeks to ensure that the fund remains strong. And, at the same time, we will propose higher premiums on higher risk activity to create economic incentives for poorly managed banks to change their risk profiles. The fund is 100 percent industry-backed. Our ability to raise premiums essentially means that the capital of the entire banking industry – that’s $1.3 trillion – is available for support.”
A final note on the FDIC’s “visible” reserves, the fiscal relationship with the Treasury, and what it means in terms of the safety and soundness of bank deposits from our statement to the media yesterday:
“The FDIC does not and will not run out of money. Like all federal trust funds, the FDIC’s insurance ‘trust fund’ does not exist. The reserves shown in the fund simply evidence the amount of money contributed by the banking industry into the fund. Like all federal trust funds, the cash raised by FDIC insurance premiums goes into the Treasury’s general fund. When the agency needs cash, then the Treasury makes the money available. When the positive balance shown in the FDIC insurance fund is depleted, the FDIC simply runs a negative balance with the Treasury, a loan that the banking industry will repay over time. Indeed, the FDIC is preparing to raise the industry’s insurance premiums to generate even more cash to deal with the rising levels of bank failures. Also, in the remote chance that the FDIC ever reached the statutory borrowing limit from Treasury, the Congress will simply raise the limit.”
Nuff said. And yes David Evans, we still love you.
A Private Sector Alternative to the Paulson Plan
We salute Senator Dick Shelby and the House Republicans for digging in their heels and saying no to the ridiculous proposal from Treasury Secretary Hank Paulson. The Paulson Plan, which was vigorously supported by Fed Chairman Ben Bernanke, never had a chance to work because it starts from a false premise, namely that by allowing banks to swap illiquid assets for Treasury bonds, banks will sell or finance this collateral to make room for new loans.
Anyone who works in the banking industry knows that most large banks have basically shut down new business origination. The managers of these institutions, especially those with solvency issues, are still trying to avoid writing off losses on illiquid assets because they know that to do so will result in a takeover by the FDIC and career death for all of the managers who made these bad decisions. And yet it is precisely a market-based resolution that is in the best interest of the US taxpayer, the economy and the well-managed banks in the US that did not slither into the subprime, derivative swamp.
We are glad to see that President George Bush finally took our advice and invited the two presidential candidates to the White House to discuss the financial crisis. But unfortunately, Bush still does not understand that Paulson, Bernanke and the other incompetent, conflicted former Goldman Sachs (NYSE:GS) banksters and academic economists who populate the US Treasury and Federal Reserve Board (excluding all bank supervision personnel, naturally) are the biggest obstacles to forging a workable plan to help re-liquefy the banking system.
We hear from several sources who were in the room that the meeting between Bush, John McCain (R-AZ) and Barrack Obama (D-IL) quickly devolved into a pissing contest between the two presidential candidates. Obama initially took control of the meeting, this while Nancy Pelosi (D-CA) and Harry Reid (D-NV) sat in silence. McCain then began to mumble something incomprehensible about “a plan” but we see no evidence that the AZ senator has formulated a serious proposal. So nasty and sharp was the exchange between McCain and Obama that President Bush had to get in between the two men. Who says the first debate is going to be delayed?
Just look at the accomplishments of the team of Paulson and Bernanke (“P&B”), the latter of whom has been the craven lap dog of the former GS CEO from day one. The Bear, Stearns fiasco was bad enough, but failing to find a smooth transition to the troubles at Lehman Brothers makes a complete mockery of Paulson’s claims to be trying to restore liquidity to the US financial system. Indeed, with friends like Paulson, Bernanke and Barney “Napoleon” Frank (D-MA), why should the American people be afraid of Al-Qaida?
You see, when P&B let Lehman be forced into a bankruptcy filing last week, more was lost than just thousands of jobs and billions of dollars in losses to shareholders and creditors. These losses are, at the end of the day, attributable to SEC Chairman Christopher Cox and the happy squirrels at the FASB. As our friend Brian Wesbury from FT Advisors in Chicago wrote:
“It seems clear that much of the current crisis has been exacerbated by mark-to-market accounting, which has created massive, and unnecessary, losses for financial firms. These losses, caused because the current price of many illiquid securities are well below the true hold-to-maturity value, could have been avoided. The current crisis is actually smaller than the 1980s and 1990s bank and savings and loan crisis, but is being made dramatically worse by the current accounting rules.” Amen brother Wesbury.
When Lehman failed, what was left of the CP market, mostly paper issued by prime borrowers, got flushed down the dumper as well. We hear from the channel that once Lehman filed, nearly every prime CP issuer in the US hit their standby lines of credit with various commercial banks. So much for recapitalizing the banking system. We expect that when the Q3 data from the FDIC is released, it will show a precipitous drop in unused credit lines at some of the major domestic and foreign banks domiciled in the US. You think P&B understand this? Dream on.
But there is more. We also hear from some very well-placed sources on Capitol Hill that when the Fed’s Board of Governors was presented with an $80 billion price tag for supporting Lehman the day before the bankruptcy filing, there were not five votes at the big Fed table to support the loan. When the Board does not take action, there is no record of the meeting, no transcript, no tape. Several member of the House familiar with the details reportedly will be calling for a forensic investigation of the Fed’s internal records, phone and email regarding this non-decision by the central bank. But they key fact is that Ben Bernake could not make the other governors take necessary action to forestall the uncontrolled collapse of Lehman. Recalling the “leadership” role played by every Fed chairman since Arthur Burns, what use is a Fed chairman who can’t get five votes when absolutely required?
As a result, it is further suggested, when JPMorgan Chase (NYSE:JPM) presented an ultimatum to Lehman management that weekend, the only choice was bankruptcy. We hear that JPM told Lehman that if they did not file, then JPM was going to put them out of business by closing down their clearing account. To get a sense for the conversation which reportedly occurred between JPM and the doomed broker dealer, recall the scene from the film The Godfather when Robert Duval gives an imprisoned capo under federal protection the option of picking the manner of his own death. Unfortunately and unlike the movie, as JPM eliminated a major investment banking competitor by compelling the suicide of a long-time clearing customer, no surety was provided for the members of the Lehman family.
The tragedy of the failure of Lehman is that by failing to obtain Fed support for an expenditure of $80 billion needed to manage an orderly sale or bank holding company conversion of the still-solvent broker dealer, P&B have created the very crisis of confidence that they now seek to solve via a $700 billion bailout of truly insolvent financial institutions. If this very public act of grotesque incompetence is not sufficient reason for President Bush immediately to demand the resignation of both Hank Paulson and Ben Bernanke, then what actions would be sufficient? How much more damage must P&B commit before President Bush and the republicans in Congress demand their heads?
Fortunately, the takeover of Washington mutual by JPM last night provides the Congress and the other inhabitants of Washington a road map for a truly workable assistance package based on private capital rather than mountains of public debt and moral hazard. As Bill Seidman suggested on CNBC last night, the FDIC, backed by the Fed, OCC and Treasury, must aggressively begin to triage and close insolvent banks, large or small. Once these institutions pass through the cleansing process of an FDIC resolution and receivership, a process that cleans the assets of any legal or other liability, crowds of investors and solvent commercial banks will be waiting on the other side to finance the re-liquefaction of these assets.
We believe that the Congress should provide an initial $500 billion in authority for the new Treasury secretary to direct into capital assistance for solvent financial institutions. Institutions taking such assistance must agree to issue warrants to the Treasury, either against common equity or the upside potential of illiquid but still performing assets on the books of these banks. If these assets are sold, the warrants must convey with the assets so that the Treasury and the taxpayer benefit, at least to some degree from the upside gain as the markets recover.
Likewise, failed assets that are sold out of a resolution by the FDIC may also carry warrants for the Treasury, depending on whether the acquirers are willing to pay close to fair market value or fire sale prices for the assets and assume all insured deposits. In the case of JPM’s purchase of WaMu, all depositors are fully protected and there will be no cost to the FDIC’s Deposit Insurance Fund, thus no warrant cover is required. This transaction is the optimal model for cleaning up the other bad banks, to paraphrase Bill Seidman, but not all resolutions will work so smoothly and result in no loss to the FDIC.
The key principle we believe must be part of any assistance package approved by the Congress is to try, wherever possible, to keep the troubled assets of the banks in private hands. If the government must take ownership of bank assets, then the FDIC is the proper vehicle to play that role. Apart from the FDIC, which is an independent, self-funded agency, the US government has absolutely no competence when it comes to owning or managing financial assets. The GSE fiasco makes that clear. But by providing the authority for the Treasury to selectively support capital infusions into solvent banks, and the aggressive closure and sale of insolvent banks, we can quickly clean up this latest nightmare on Wall Street and get the US economy back on track.
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Originally published at The Institutional Risk Analyst and reproduced here with the author’s permission.