Super Liens, FHLB Advances and the Road to Forbearance

“Then faced with the worst financial crisis in a century, U.S. policymakers of the 1930s deliberately enacted a set of reforms that included central bank restructuring, bank regulatory reforms, federal deposit insurance, and a separate, politically accountable, publicly funded rescue mechanism, the RFC. Those policymakers paid careful attention to statutory and institutional structures that separated the fiscal policy operations of the debt rescue mechanism, the RFC, from the monetary policy operations of the central bank, which then were dominated by the Federal Reserve’s discount window.”

Walker F. Todd History or and Rationales for the Reconstruction Finance Corporation Economic Review , 1992, Issue Q IV Federal Reserve Bank of Cleveland

As this issue of The IRA goes to press, Wells Fargo (NYSE:WFC) has made a competitive bid for all of Wachovia Bank (NYSE:WB) that does not require open-bank assistance from the FDIC. We believe that this is a far superior transaction for both organizations. Citigroup (NYSE:C) should not be buying anything, in our view, thus regulators should support the new WFC bid.  The fact of an auction for WB is the best news we have heard in months and indicates that private investors are starting to do more than shop.

Earlier this week, a reader of The IRA sent us a note captioned Benutzt den Augenblick!, the favorite caption of Goethe which once graced the masthead of the Villanova Free Press:

“Just wanted to drop you a line and let you know how much I enjoy your insightful and sober commentary… I am particularly impressed with your prediction this past Spring that the only issue in November’s election would be the economy. Nice call! I have many friends and colleagues who ask me ‘What the hell is going on?’ I simply refer them to your website.”

Thanks John. Go Wildcats!

Meanwhile in Washington and on the Big Media, the crisis continues. It appears that the Congress is being stampeded into meaningless action by the team of “Paulson and Poodle,” the descriptive that another IRA reader assigns to Treasury Secretary Hank Paulson and Federal Reserve Board Chairman Ben Bernanke. The same reader takes issue with description of the Democratic presidential ticket as socialist: “How could any successor government be more statist/intrusive than what Paulson-Bernanke have done and are now proposing? Take a look at the revulsion expressed in the blogs following Bernanke’s spilling the beans over what they are really up to: a massive transfer of wealth from taxpayers to shareholders and CEOs of financial institutions.”

No argument here. It is worth recalling that over the past century in the US, most of the worst acts of statism, if not outright socialism, committed in Washington have come under nominally republican governments.  Presidents Richard Nixon, Bush I and Bush II, and both parties in the Congress, have all presided over dramatic increases in the role of the state. Indeed, the reckless fiscal policies of Bush II have arguably set the US on a course towards eventual default — unless we radically change direction.  Call that our latest long-term prognostication.

A member of the media asked yesterday: “I’m trying to do a column addressing the question: If this bailout plan gets passed, how will we know if it’s working?”

Good question.  We don’t believe that any action taken in Washington can prevent a serious recession in 2009-2010. Even were authorities in the US and EU act to take our advice and immediately provide a facility to bolster bank capital positions and embrace open-bank assistance a la the WB sale, the reduction of available credit to the real economy will continue and recession will become full blown economic slump, not only in the US but around the world. Our fear is that once this badly flawed legislation is in place, the markets will refocus on the deteriorating economic fundamentals not addressed by this plan – like yesterday’s job numbers.  But as we said that the top of this comment, the fact of an auction for WB is very positive news.

The withdrawal of liquidity among banks also is being reflected in the real economy with the elimination of the float between consumers and service providers. We see local vendors in the New York region demanding upfront payment instead of allowing normal 30-day terms. We hear reports from clients about hotels in the EU asking for cash payment or adding extra premiums on credit cards due to fear that payments will not be processed. And the clients of these hotels are actually producing thousands of Euros in cash to pay, this because they too fear that their credit cards will be turned off.

In New York, we see suppliers in the home construction industry with shrinking or no backlogs. Last year, for example, it took 8-10 weeks to get custom windows from premium makers like Marvin and Andersen. Now the turnaround time is less than a month from placing the order to actual delivery. We spoke to a dealer for Marvin in Yorktown, NY, this week and the comment was that the Northeast is the only market in the US for replacement windows that has not cratered. And you don’t want to hear about our conversations with several car dealers in Westchester County, NY.

Even Senator Richard Shelby (R-AL) has begun to show signs of stress. This week, he begun to prattle about how the increase in the FDIC insurance limit from $100,000 to $250,000 will further tax “the depleted deposit insurance fund.” Nonsense. If the ranking Republican on the Senate Banking Committee does not understand the funding of the deposit insurance fund, then we are really toast. As we described in earlier comments, the FDIC has the ability to tax the banking industry’s income and assets to offset losses from failed banks. Any monies borrowed by the FDIC from the Treasury to finance resolutions or open-bank transactions a la Wachovia will be repaid by the industry, whether the insurance limit is raised or not.

We continue to believe that the proposal to increase deposit insurance coverage without a) making the banking industry increase premiums and 2) removing the emergency support for toxic-waste polluted money market funds, will cause instability in other parts of the financial system. But it is important to note that as of Q2 2008, most of the banking industry was actually doing fine.  The vast majority of US banks are at or below the average 1.4 value of the IRA Banking Stress Index (a higher value equals greater stress).  While we expect to see more bank units pushed higher as the average also climbs in Q3 2008, the bulk of the industry is likely to remain well-below the average stress level.  A breakdown of the industry is shown below. Subscribers to the IRA Bank Monitor may display the index values for individual institutions.

THE IRA BANKING STRESS INDEX — Q2 2008

Criteria

Units

Assets (000)

Units with Overall Index Values at or Below 1995 Index Baseline Value (1.0)

5,998

$5,912,110,969
Units above Index Baseline (1.0) but below Current Average Value of 1.4

1,319

$5,418,723,215
Units with Overall Index Values Above the Current Average Value of 1.4

1,066

$1,949,609,798

Source: FDIC/The IRA Bank Monitor

Of interest, as of June Washington Mutual Bank had an index value of 21.6 vs. the index baseline value of 1.4 (1= 1995). Wachovia Bank was at 13.2vs. the index benchmark of 1.4 (the maximum index value is 100). Sovereign Bank (NYSE:SOV), an affiliate of Banco Santander (NYSE:STD) which has been mentioned as having financial troubles, was actually below the stress index benchmark at 1.2 at the end of June, reflecting substantial changes in that bank’s once above-peer score on the IRA Banking Stress Index. From the outside, at least, it appears that STD has been cleaning house rather aggressively at SOV.

Such distinctions are small comfort to the creditors of Washington Mutual Inc (“WMI”). A hearing will be held today in Federal Bankruptcy Court in Delaware, regarding the 9/26/08 voluntary filing by WMI. A meeting will be held for the unsecured creditors of WMI on October 15, 2008. The filing indicates that there are more than 5,000 creditors of the failed holding company. As we mentioned in our last comment, the resolution of the bank subsidiary of WMI represented the first time that the equity and debt holders of a large holding company were wiped out, the proper and appropriate treatment in our view.

Hopefully everyone now understands the difference between a bank and a bank holding company, but this realization is making it near impossible for even solvent banks to raise capital – much less commercial firms that were dependent upon commercial paper. Thus our view that the Treasury must eventually embrace some type of capital facility to allow solvent banks to raise new equity capital — or inevitably head down the road to forbearance for insolvent banks as was the case with the zombie S&Ls in the 1980s.

Just the existence of $200-300 billion in authority for banks to sell preferred equity to the Treasury would, in our view, immediately stabilize the interbank credit markets. As long as bank counterparties believe that solvency issues exist among their peers, the market for everything from short-term interbank lending to swaps will remain gridlocked. The asset purchase program just approved by the Senate does nothing to address the issue of solvency.

The Wasington Mutual and WB transactions were brilliantly executed by the FDIC, OTS and OCC. In each case, the confidentiality and integrity of the bidding and sale process was maintained. Moreover, the degree of cooperation between the agencies was exemplary. What a shame that the competence and sense of purpose displayed by the professional staff of these agencies is not reflected by the political appointees at Treasury and the Federal Reserve. Yet this loss event has effectively closed the market for private bank capital. Banks, solvent or not, are being squeezed into illiquidity.

As we noted in our last comment, in the takeover of Washington Mutual Bank the $58.4 billion in advances from the Federal Home Loan Bank outstanding as of June 30, 2008, was conveyed through the receivership into the newco that was eventually sold to JPMorgan Chase (NYSE:JPM). The covered bonds issued by the bank unit were also conveyed into the newly chartered bank. In our view, this is significant for several reasons.

First, the resolution of Washington Mutual Bank and the bankruptcy of WMI, as with Countrywide, again underlines illustrates the fact that the obligations of the bank unit, whether institutional counterparty positions, covered bonds or FHLB advances, are all senior to the parent company creditors. Now you understand why we have dwelled so long on the example of Countrywide Financial vs. Countrywide Bank FSB. If you are taking risk exposure on a bank, be “in the bank.”

Indeed, we continue to believe that a Chapter 11 filing by the parent of Countrywide Bank FSB, which is now a subsidiary of Bank of America (NYSE:BAC), remains possible. Remember, when Washington Mutual Bank was taken over by the FDIC, all of the extant litigation and other claims were left behind with WMI. Now the vendors and bond holders of WMI get to fight with the trial lawyers over what remains of the company’s non-bank assets.

Second and more ominous is what the Washington Mutual and WB Bank resolutions imply for the future solvency of the largest GSE, namely the FHLBs. Both Washington Mutual Bank and Wachovia Bank have significant FHLB advances, which are collateralized with various types of relatively high-quality mortgage paper. Indeed, just about every bank resolved so far this year was a significant user of FHLB advances.

No surprise, then, when users of the IRA Bank Monitor ask us where to look for troubled banks, we point them to the screen for FHLB advances. Banks with more than 15% of total assets financed via advances are considered above the threshold established by regulators as “unsafe and unsound.” Subscribers to The IRA Bank Monitor login and click here to see the latest screen for excessive use of FHLB advances as of Q2 2008. Notice that there were more than 140 institutions on the list as of the end of Q2 2008.

The FHLBs have a “super lien” agains the assets of a failed institution. To protect their position as creditor, they have a claim on any of the additional eligible collateral in the failed bank. In addition, the FDIC has a regulation that reaffirms the FHLBs priority and the FHLBs can demand prepayment of advances when institutions fail. But this arrangement is under growing scrutiny by federal regulators.

As the FDIC notes in a 2003 statement by the Advisory Committee on Banking Policy: “The FDIC has identified five problems with the current resolution process involving FHLB advances. First, prepayment fees increase loss to uninsured depositors and the deposit insurance fund… Second, the process can create resolution delays. Third, the process gives FHLBs a preferred status that no other secured creditor receives, including the Federal Reserve Banks. Fourth, it is inconsistent with depositor preference priorities established in the Federal Deposit Insurance Corporation Improvement Act (FDICIA). Finally, it is not necessary to protect FHLBs from credit risk or any other investment risk as the FDIC repays advances with principal and interest almost immediately at failure.”

In the wake of the Washington Mutual resolution, we’ve heard from several people in the bank regulatory community that as losses from bank resolutions mount, pressure is going to grow on the FDIC to tell the FHLBs to simply keep the collateral provided by a bank rather than pay the FHLB’s back at par upon resolution. Remember, most of the losses of failed banks to date have not come from paying out insured depositors, but from assets retained by the FDIC after a resolution. But that may not be the case much longer, especially with the Congress preparing to raise the insured limit on FDIC cover without raising insurance premiums. It is wrong to say that the banking industry has opposed increasing the limit on FDIC insurance; they just did not want to pay for it through higher premiums. But now they may have no choice.

“The increase in the deposit insurance cap without increasing premiums is going to justify the FDIC going to Treasury to ask for further reserves,” notes one prominent observer close to the regulatory community. “The proposed increase in deposit insurance coverage in the bailout legislation necessitates a move by the FDIC to change the relationship with the federal home loan banks.  It is essential for the FDIC to be able to act promptly in order to resolve failed institutions with all due haste, otherwise we go down the road to forbearance.”

In the event that the FDIC changes policy and tells the FHLBs to keep the collateral, then the largest GSE could be forced to attempt to sell that high-quality collateral backing advances into an illiquid market. As and when that day comes, the phones on the desks of the Treasury Secretary and Fed Chairman Bernanke (assuming he is still in office) are going to ring and the next GSE bailout will get underway.


Originally published at The Institutional Risk Analyst and reproduced here with the author’s permission.

2 Responses to "Super Liens, FHLB Advances and the Road to Forbearance"

  1. John Ryskamp   October 3, 2008 at 12:18 pm

    Two incorrect points in this:1. This is incorrect:”The fact of an auction for WB is the best news we have heard in months and indicates that private investors are starting to do more than shop.”It is a shotgun marriage, being advertised as an economic opportunity. FDIC has decided NOT to get involved with Wachovia, and is forcing Wells Fargo to bid.2. This is also misconceived:As we described in earlier comments, the FDIC has the ability to tax the banking industry’s income and assets to offset losses from failed banks. Any monies borrowed by the FDIC from the Treasury to finance resolutions or open-bank transactions a la Wachovia will be repaid by the industry, whether the insurance limit is raised or not.Any such tax would lower the value of bank stock. You don’t understand the one and only reason the Government is doing anything it is doing: to prop up the stock market. A collapse in the market would provoke a political crisis. The only thing which will stop government interventions is the conclusion by government that anything further would undermine the power of the political system: the writ would cease to run. That is about six weeks away.Your basic problem is that you are a legal neanderthal: you don’t understand how rights and power play out in the Federal Government, so you don’t understand the machinations or the priorities.We will fairly soon get a declaration of national economic emergency. Among a lot of other useless provisions there will be one I have been advocating a long time:a ban on housing evictions.This ban will be individually enforceable, permanent, absolute and complete. Since you obviously know nothing about the law, read Lindsey v. Normet. This case established housing at the low level of minimum scrutiny. ATTORNEY ALERT: it is about to be raised to strict scrutiny. This is the Constitutional revolution I discuss in my book The Eminent Domain Revolt.Show this to a lawyer friend of yours and get educated in what is really going on: we are abandoning the West Coast Hotel scrutiny regime, and are beginning to enforce the new maintenance regime.

  2. Guest   October 3, 2008 at 2:17 pm

    Many FHLBs have a blanket pledge of assets as collateral for advances. Removing the superlien provision pretty much gives the FHLB everything covered by the blanket pledge leaving nothing for for depositors or other creditors. Under the superlien the FDIC pays off the advances and then is able to maximze return to other creditors. If FDIC is doing their job as regulator they can head off any bank that is botrrowing too much from the FHLBs or brokered deposits or other sources. For every bank failure there is a bureacracy at FDIC OCC the Fed or OTS that hasn’t been doing their job.