Saturday, March 21, 2009

Some More Thoughts On The FDIC And The "Systemic Risk Exception" Clause

As I dug a little more into the mystery of the amended Bloomberg headline discussing FDIC's travails, some interesting facts came up. On September 25, 2008, Bloomberg staff reporter David Evans (not to be confused with U2's The Edge) came out with a piece called "FDIC May Need $150 Billion Bailout as More Banks Fail." The article reaches its gloomy conclusion based on Chris Whalen's estimate that by the end of 2009, 100 U.S. banks will fail with collective assets of more than $800 billion, and quotes Richmond Fed director Mark Vaughan in saying "It's not going to be Armageddon. But it's going to be bad.'' Additionally, Evans discussed the potential fate of uninsured deposits, which he estimated at $2.6 trillion or 37% of the total $7 trillion in deposits held at U.S. FDIC member banks, and concluded that if "the government were on the hook " to protect these deposits as well, the FDIC's all in cost for failed bank rescues could swell "to more than $400 billion."

What is interesting, is that the very same day Evans came out with his FDIC critique, the agency immediately issued a rebuttal in the form of an open letter to Bloomberg News claiming David Evans "does a serious disservice to your organization and your readers by painting a skewed picture of the FDIC insurance fund." The letter, written by FDIC Public Affairs Director Andrew Gray, makes for a fascinating read as it discloses some curious, and previously undiscovered facts:
Let me be clear: The insurance fund is in a strong financial position to weather a significant upsurge in bank failures.
Even under an amended title, Sheila Bair's most recent public appearance on March 20, in which she claimed that "Without additional revenue beyond the regular assessments, current projections indicate that the fund balance will approach zero", does not make it sound like the insurance fund is "in a strong financial position" at all.
The FDIC has all the tools and resources necessary to meet our commitment to insured depositors, which we view as sacred. I do not foresee – as Mr. Evans suggests – that taxpayers may have to foot the bill for a "bailout."
Luckily for Mr. Gray "do not foresee" will not hold up in court as a determination of guarantees.
Let's look at the real facts about the FDIC insurance fund. 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.
At the time this letter came out, the TLGP did not exist. However now, in addition to having "the capital of the entire banking industry available for support", the FDIC, in a poetic flip of words, also has to issue capital to support the entire banking industry. The letter continues:
Moreover, if needed, the FDIC has longstanding lines of credit with the Treasury Department. Congress, understanding the need to ensure that working capital is available to the FDIC to provide bridge funding between the time a bank fails and when its assets are sold, provided broad authority for us to borrow from Treasury's Federal Financing Bank. If necessary, we can potentially raise very large sums of working capital, which would be paid back as the FDIC liquidates assets of failed banks. As per our authorizing statute, any money we might borrow from the Treasury must be paid back from industry assessments. Only once in the FDIC's history have we had to borrow from the Treasury – in the early 1990s – and that money was paid back with interest in less than two years.
Interestingly, Chris Dodd's Depositor Protection Act of 2009 legislation will make it possible for the FDIC not only to borrow from the Treasury but do so with some serious style - to the tune of $500 billion, up from the previous maximum borrowing limit of $30 billion. Somehow I think the FDIC will take a little longer than 2 years to repay that particular loan.

The last part of the letter is most interesting:
Finally, Mr. Evans' suggestion that the "government" could ever be "on the hook for uninsured deposits" demonstrates a misunderstanding of FDIC insurance. To protect taxpayers, we are required to follow the "least cost" resolution, which means that uninsured depositors are paid in full only if this is the least costly option for the FDIC. This usually occurs when a bidder for the failed bank is willing to pay a higher price for the entire deposit franchise. We are authorized to deviate from the "least cost" resolution only where a so-called "systemic risk" exception is made. This is an extraordinary procedure which we have never invoked. And again, any money we borrow from the Treasury Department must be repaid through industry assessments.
Just what is this Least Cost resolution? And even more so, the ominous sounding Systemic Risk Exception? Here is what a legal dictionary has to say about the former:
§ 360.1 Least-cost resolution.

(a) General rule. Except as provided in section 13(c)(4)(G) of the FDI Act (12 U.S.C. 1823 (c)(4)(G)), the FDIC shall not take any action, directly or indirectly, under sections 13(c), 13(d), 13(f), 13(h) or 13(k) of the FDI Act (12 U.S.C. 1823 (c), (d), (f), (h) or (k)) with respect to any insured depository institution that would have the effect of increasing losses to any insurance fund by protecting:

(1) Depositors for more than the insured portion of their deposits (determined without regard to whether such institution is liquidated); or

(2) Creditors other than depositors.

(b) Purchase and assumption transactions. Subject to the requirement of section 13(c)(4)(A) of the FDI Act (12 U.S.C. 1823(c)(4)(A)), paragraph (a) of this section shall not be construed as prohibiting the FDIC from allowing any person who acquires any assets or assumes any liabilities of any insured depository institution, for which the FDIC has been appointed conservator or receiver, to acquire uninsured deposit liabilities of such institution as long as the applicable insurance fund does not incur any loss with respect to such uninsured deposit liabilities in an amount greater than the loss which would have been incurred with respect to such liabilities if the institution had been liquidated.

[58 FR 67664, Dec. 22, 1993, as amended at 63 FR 37761, July 14, 1998]

And here is an interesting tidbit on the Systemic Risk Exception:

To get a grip on the too big to fail problem, Congress established a difficult-to-trigger systemic risk exception. A least-cost resolution can be foregone - and by implication a resolution method selected that results in uninsured depositors and other creditors being protected - only if the Board Of Directors of the FDIC, The Board of Governors of the Federal Reserve System, and the secretary of the Treasury, in consultation with the president, determine the least-costly approach "would have serious adverse effects on economic conditions or financial stability."
Personally, I have never encountered any legislative loopholes that need a quorum of these four most critical pillars of the U.S. economy. It is obvious the FDIC and lawmakers realized that there is something of huge value to be protected here in case there is a "systemic risk event." And while it is likely not deposits over and above the insurance maximum, it might potentially have to do with "other creditors" rights. Which is where, if one were to get conspiracy theory minded, it would be possible to presume that in certain cases bank creditors (maybe even foreign investors who own this debt) would receive a least-cost resolution exemption. But even without that detour, in the case of a consensus that we have crossed the threshold of "systemic risk" (a phrase thrown around a little too freely these days), it is prima facie the case that U.S. taxpayers would be on the hook to bail out not only failed banks' uninsured depositors but also creditors.

Now while the implications of this very fine print could be potentially staggering to the blissfully ignorant American public, the immediate change in the Bloomberg headline seems to be the least Bloomberg could do to avoid receiving additional angry letters, and to bring the public a step closer to these disclosures. Curiously, all this comes on the heels of Friday's announcement that the NCUA is putting two massive credit unions into conservatorship after stress-tests disclosed "an unacceptably high concentration of risk from mortgage-backed securities" and the agency's insurance fund will see a loss of $1.2 billion from the closures, according to spokesman John McKechnie.

Maybe the FDIC was a little early in its allegations that Bloomberg and Evans were doing anyone a disservice, as the reporter's grim forecast is slowly starting to become reality.


Didn't even finish typing this, and the FDIC's troubles are already growing. This just out:

Washington Mutual Sues FDIC for over $13 Billion
In a complaint filed with the U.S. District Court for the District of Columbia, the thrift's former parent accused the FDIC of having on January 23 made a "cryptic disallowance" of its claims, prompting the lawsuit.

It also accused the FDIC of agreeing to an unreasonably low price in arranging the a $1.9 billion sale of the banking business to JPMorgan on September 25, when regulators seized Washington Mutual and appointed the FDIC as receiver.

JPMorgan did not buy the parent holding company, which filed for Chapter 11 bankruptcy protection the following day.

In its complaint, Washington Mutual seeks to recover as much as $6.5 billion of capital contributions it said it made to its banking unit from December 2007 through the seizure.

Washington Mutual also seeks the return of $4 billion of trust preferred securities it said were wrongfully transferred to the banking unit, and said it may be entitled to as much as $3 billion of tax refunds. It also seeks damages of $177.1 million related to unpaid loans made to the banking unit.

If successful, this lawsuit will not help out FDIC's increasingly troubled financial state. Sphere: Related Content
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Anonymous said...

> he FDIC, in a poetic flip of words, also has to issue capital to support the entire baking industry

baking industry? do they need $ too?

Tyler Durden said...

$1 trillion bail out. coming to a baker near you

Anonymous said...

The printing will continue. Buy STUFF before the dollars are worth nothing.

Anonymous said...

This Wamu lawsuit tells me the imbeciles that ran that bank into the ground are not sufficiently humbled.

I say, got for it. If you win the lawsuit, fine, if not, you and your managers swing from the tree you should already have been dancing under, long ago.

David said...

What are the units on these plots. Aren't they usually quoted as a spread in bps?

Anonymous said...

This doesn't fit with the reports in 2008 that uninsured depositors in IndyMac would get back about 50% of their money, even though the DIP was going to lose $4-8B (now $10B). I did some poking around, and it appeared (although I could be wrong) that the DIP actually splits any recovered assets with uninsured depositors, rather than being ahead of them in line. And the fact that the IndyMac uninsured depositors didn't lose all their money bears this out. So it doesn't appear that the systemic risk clause is needed for that. However, it could be needed in order to cover unsecured lenders, which would fit with your theory.

Tyler Durden said...