Rolfe Winkler

Cross-posted from today’s NYT.

Killing zombies isn’t just a job for horror-movie heroines. It’s also one of Sheila Bair’s primary tasks. And the Federal Deposit Insurance Corp chief’s challenge has increased as the number of scary banks on the regulator’s watch list has spiked. Thankfully, there’s no financial excuse to keep FDIC from quickly exterminating the industry’s living dead.

On Tuesday, the agency reported 702 institutions on its “problem” list at the end of the fourth quarter — up from 552 in the third quarter. Moreover, total assets for banks on the list increased to $403 billion, or 3 percent of GDP. While these are terrifying figures, the FDIC also managed to collect $46 billion of fresh cash from banks, bringing its total cash and liquid securities to $66 billion.

That may not sound like enough. After all, the average estimated loss rate for failures since 2007 — excluding the collapse and simultaneous sale of Washington Mutual to JPMorgan – is 23 percent of assets. On that basis, FDIC’s kitty would appear to be some $27 billion shy of being able to handle its current list of troubled institutions.
But not all of the banks FDIC diagnoses as sick will need to be seized. As is often the case, many banks work their way through their difficulties, raise fresh private capital or are taken over by healthier rivals. And the FDIC can levy another special assessment on banks before asking the U.S. taxpayer for help anyway. Add it all up and the FDIC has no financial excuse not to get busy cleaning up the mess.

Yet the pace of bank seizures — up by half year-to-date — hasn’t kept pace with the growth of the problem bank list, which has nearly tripled. The worry is that has left too many zombies hobbling along, sucking up deposits and hoarding capital that might otherwise be lent by healthy institutions, thereby helping the economy to rebound.

True, the “Snowmaggedon” storms that closed Washington earlier this month complicated travel plans for FDIC staff. But the key lesson from the savings and loan debacle was that delays in closing insolvent banks increases the resolution costs for FDIC and, ultimately, taxpayers. With spring just around the corner, Bair needs to set her sights on a big zombie hunting trip.

I was heading out for Thanksgiving vacation when FDIC released the quarterly banking profile, so I wasn’t able to update an important chart: Total Insured Deposits, Unofficially…..

(ht Stephen Culp)

When the world was falling apart, FDIC increased deposit insurance limits….to $250,000 for individual non-retirement accounts and unlimited for business transaction accounts. But those increases were treated as “temporary” and so left out of FDIC’s total.

Since the $250,000 limit was extended to 2013 — decidedly not “temporary” — FDIC started collecting that data from its member banks. The data was published for the first time in Q3.

So in Q3, the official figure — which includes $250k limits — jumped from $4.8 trillion to $5.3 trillion. Throw in the $761 billion insured by the transaction account guarantee program and you’ve got a total of $6.1 trillion of insured deposits. Compare to Q3 ’08. Back then, before all the emergency measures, the total was $4.5 trillion. So the increases added $1.6 trillion, or 34%, to the total.*

I’ve juxtaposed that with the reserve balance on the Deposit Insurance Fund. It’s now negative, though that doesn’t mean FDIC is out of cash. And they’ve got another $45 billion coming this quarter, but for accounting reasons the reserve will still be listed as negative.**

But even with that cash coming in, the FDIC’s resources are under a lot of pressure. With 552 banks and $346 billion in assets on the “problem” list, FDIC will struggle to pay its bills.

Sheila will have to increase assessments on banks at some point, or start drawing on FDIC’s credit line at Treasury…

————

*The transaction account guarantee program is scheduled to expire in June of next year.

**The $45 billion to be collected isn’t a “special” assessment, it’s front-loading three years of “regular” assessments. The distinction is crucial. Since these assessments are regular, banks can treat them as a prepaid expense on their balance sheet, i.e. as an asset to be drawn down quarterly. That means they only have to draw down capital quarterly. The flip side is that FDIC can’t count the $45 billion as revenue. It has to treat it as “deferred revenue.” Deferred revenue is a liability on the balance sheet. Normally an assessment counts as revenue, which is added to the DIF’s equity balance.

Don’t you just love accounting?

Due to new accounting rules — FAS 166 and 167 — banks have to bring certain off balance sheet assets back onto their balance sheets starting next year. More assets, same capital = lower capital ratios. (More in this column about the individual impact on the large banks).

Anyway, the FDIC has agreed to give big banks a 6 month reprieve on raising new capital to buffer the new assets. From Ian Katz at Bloomberg:

The Federal Deposit Insurance Corp. gave banks including Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. a reprieve of at least six months from raising capital to support billions of dollars of securities the firms will be adding to their balance sheets.Bank regulators including the FDIC and Federal Reserve want to permit a phase-in of capital requirements that rise starting next month under a change approved by the Financial Accounting Standards Board. The rule, passed in May, eliminates some off- balance-sheet trusts, forcing banks to put billions of dollars of assets and liabilities on their books.

“We’re still recovering from the damage these structures caused,” FDIC Chairman Sheila Bair said, explaining that the entities contributed to the financial crisis. The phase-in recognizes the “very fragile stage in our economic recovery,” she said at a board meeting Washington.

While Citi and Wells were raising capital this week to repay TARP, FDIC should have had them go for a few billion more to offset the impact of FAS 166/7.

(Reader note: One bug we’re still trying to work out is that links in the top line of a post aren’t “hot” in the front-page view of the blog. If you click “continue reading” the link is available)

The FBI agent inside the Galleon case (Goldstein, Reuters) More great work from Matt.

MIT team wins DARPA red balloon challenge (darpa.mil) But how did they do it?

Requiem for the dollar (James Grant, WSJ) A fun (and frustrating) piece to read. Grant is a good writer, but he throws provocative comments around without explaining them. He says we need to collateralize the dollar, presumably with gold, but acknowledges early in the article that the gold standard was far from perfect: “The lifespan of no monetary system since 1880 has been more than 30 or 40 years, including that of my beloved classical gold standard…” No doubt he has ideas to improve his “beloved” standard, and that would be useful to read. Too bad he doesn’t go into it.

Bair weighs loan principal cuts to fight foreclosure (Vekshin, Bloomberg) Writing off principal is the opposite of extend and pretend. But if Bair wants to pay for it using the Deposit Insurance Fund, she’ll have to stay aggressive with assessing insurance premiums on banks.

Amazon in secret plan to open high street shops (Davey, Times UK) Some brick and mortar for Amazon? Update: Amazon says “no plans” for physical stores. A non-denial denial…

The gambler who blew $127 million (Berzon, WSJ) “During a year-long gambling binge at the Caesars Palace and Rio casinos in 2007, Terrance Watanabe managed to lose nearly $127 million. The run is believed to be one of the biggest losing streaks by an individual in Las Vegas history.”

Schadenfreude Alert: Harvard in trouble (The Awl) This piece quotes another good article in this month’s Vanity Fair (have to buy the mag to read it).

The ultimate vanity plate (Taibbi, True/Slant) On the Porsche Cayenne owned by Morgan Stanley’s Rob Kindler: “2BG2FAIL” From Sorkin’s book.

Girl dumps tennis star over his 7-hr-per-day video game addiction (Telegraph)

NOT Obama’s job strategy…

I’m not good at taking vacations….

FDIC published its quarterly banking profile today. Here are the latest banking industry statistics at a glance. A few interesting takeaways I’d like to highlight. First, the problem bank list grew again. And it still understates total problem assets…both Citi and Bank of American should also be on this list.

The number of institutions on the FDIC’s “Problem List” rose to its highest level in 16 years. At the end of September, there were 552 insured institutions on the “Problem List,” up from 416 on June 30. This is the largest number of “problem” institutions since December 31, 1993, when there were 575 institutions on the list. Total assets of “problem” institutions increased during the quarter from $299.8 billion to $345.9 billion, the highest level since the end of 1993, when they totaled $346.2 billion. Fifty institutions failed during the third quarter, bringing the total number of failures in the first nine months of 2009 to 95.

Also, what will get lots of headlines today is that the Deposit Insurance Fund went negative as of September 30th. We already knew this to be true, and it’s not totally fair to report the negative balance without noting that FDIC does have cash. That said, the DIF is still in a very precarious position.

As projected in September, the FDIC’s Deposit Insurance Fund (DIF) balance – or the net worth of the fund – fell below zero for the first time since the third quarter of 1992. The fund balance of negative $8.2 billion as of September already reflects a $38.9 billion contingent loss reserve that has been set aside to cover estimated losses over the next year. Just as banks reserve for loan losses, the FDIC has to set aside reserves for anticipated closings over the next year. Combining the fund balance with this contingent loss reserve shows total DIF reserves with a positive balance of $30.7 billion.

Chairman Bair distinguished the DIF’s reserves from the FDIC’s cash resources, which stood at $23.3 billion of cash and marketable securities. To further bolster the DIF’s cash position, the FDIC Board approved a measure on November 12th to require insured institutions to prepay three years worth of deposit insurance premiums – about $45 billion – at the end of 2009. “This measure will provide the FDIC with the funds needed to carry on with the task of resolving failed institutions in 2010, but without accelerating the impact of assessments on the industry’s earnings and capital,” Chairman Bair said.

The DIF will continue to be negative after FDIC gets the additional $45 billion at the end of this year. That’s not a “special assessment,” it’s the next three years’ regular assessments being collected up front. The distinction is crucial. Because it’s a regular assessment, FDIC won’t count it as new reserves for the DIF. Instead it will be counted as deferred revenue on the DIF’s balance sheet.

Why is that important? Because unlike the $5.6 billion special assessment in Q2, banks don’t have to take a hit against their capital all at once for this assessment. They get to treat it as a prepaid expense.

More later….

Do you think we should establish a government-backed insurance fund for big banks’ risky trading activities? Probably not. But that’s precisely what the administration and Congress agree should be done. Today Sheila Bair proposed her own variation on the theme. At first glance her idea sounds better, but it’s just as bad as the others.

From Alison Vekshin at Bloomberg:

Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

As I noted in my column yesterday, Barney Frank’s legislation would have taxpayers front money for systemic bailouts while large financial firms would be on the hook to pay the money back.

Of course that would never happen. Banks would never pay. Look how hard it’s been to get banks to replenish the Deposit Insurance Fund. Anyway, Sheila agrees that ex-post funding is a bad idea.

But pre-funding is an equally terrible idea. If there’s a fund somewhere that’s supposed to protect the system, that will codify TBTF and reinforce moral hazard. Not only will investors know some firms are TBTF, they’ll see there’s a pile of cash to protect them. This would put TBTF firms at an advantage in the marketplace.

Now, some would argue that it would penalize the firms because they’d have to pay capital into the fund. Perhaps in the short-term. But soon enough everyone will be content that the system is “safe,” people will be making money and Congress will tell the regulators to lay off.

This is not just a hypothetical. Look at our experience with the Deposit Insurance Fund. From 1996-2006, FDIC was prevented by statute from collecting insurance premiums. Congress, in its infinite wisdom, had determined the DIF didn’t need any more money because the system was firing on all cylinders.

The S&L crisis–which cost $150 billion to resolve–taught us the moral hazards of government insurance funds for bank creditors. Because their money iss guaranteed, depositors don’t care what kind of risky activities their bank are engaged in. They just go to the bank that offers the highest interest rate.

We’re reminded of this fact by GMAC today, whose subsidiary Ally Bank is able to attract billions in deposits by offering high interest rates. And read the Puget Sound Biz Journal’s article on WaMu. They were so desperate for funding amid a bank run last fall that they started offering 1-yr CDs at 5%.

And think about what’s being insured here. Trading. In derivatives, stocks, bonds, forex, commodities …. all of it with leverage. Trading + leverage = high risk!

Despite the moral hazards of deposit insurance, we insure commercial banks because the functions they provide (managing the payment system, turning savings into loans) are important to society. In the fullness of time, I have my doubts that even this makes sense. But arguments supporting it are at least defensible.

This new scheme that Bair is proposing would insure investment banks, and all the risky trading activities they engage in.

Again, we’re acting to protect the needs of TBTF banks rather than protecting the needs of society. What we should be doing is getting trading activities out of the banks to begin with.

The repeal of Glass Steagall essentially put the Wall Street Bull inside the China Shop we call the commercial banking system. We’re surprised when he trashes the place every few years?

But instead of kicking him to the curb, we’re expending all this effort putting the China in bubble wrap…..which in the long-run is no match for the Bull….

GMAC sold more FDIC-backed debt today… (Reuters)

General Motors Acceptance Corp on Wednesday sold $2.9 billion in three-year government-guaranteed notes, according to a market source familiar with the sale. The 1.75 percent notes were priced at 99.991 to yield 1.753 percent, or 31.6 basis points over comparable U.S. Treasuries.

The notes are guaranteed under the Federal Deposit Insurance Corp’s temporary liquidity guarantee program.

GMAC has permission to sell up to $7.4 billion of FDIC-backed debt, in addition to the $12.5 billion of TARP money already received and the $2.8-$5.6 billion of additional TARP cash they’re negotiating for.

In exchange for upping GMAC’s TLGP allowance, Sheila Bair supposedly extracted concessions on the interest rates GMAC will be able to advertise for deposits.

On BankRate, they’re still listed as #3 for 1-yr CDs.

While we’re on the subject of auto bailouts, John Stoll and Sharon Terlep of WSJ are reporting that GM dipped into its bailout fund from Treasury to help rescue supplier Delphi:

General Motors Co. by the end of the week will outline plans to draw down more U.S. government money it will use to aid Delphi Automotive LLP and also give an update on a closely watched escrow account of its bailout funds, according to several people familiar with the matter.

GM’s additional borrowing will mostly be limited to Delphi’s funding needs and is expected to be north of $2.5 billion, based on prior announcements.

According to the article, the U.S. has committed $50 billion to the GM bailout, $30.1 billion of which was committed when the company filed for bankruptcy. Much of that amount went into an escrow account GM can tap as needed.

Another failure in Georgia. And two in Naples.

#100

• Failed bank: Partners Bank, Naples FL
• Acquiring bank: Stonegate Bank, Ft. Lauderdale FL
• Vitals: as of 9/30, assets of $66 million, deposits of $65m
• DIF damage: $28.6m

#101

• Failed bank: American United Bank, Lawrenceville GA
• Acquiring bank: Ameris Bank, Moultrie GA
• Vitals: as of 8/11, assets of $111 million, deposits of $102m
• DIF damage: $44m

#102

• Failed bank: Hillcrest Bank Florida, Naples FL
• Acquiring bank: Stonegate Bank, Ft. Lauderdale FL
• Vitals: as of 10/1, assets of $83 million, deposits of $84m
• DIF damage: $45m

#103

• Failed bank: Flagship National Bank, Bradenton FL
• Acquiring bank: First Federal Bank of Florida, Lake City FL
• Vitals: as of 8/31, assets of $190 million, deposits of $175m
• DIF damage: $59m

#104

• Failed bank: Bank of Elmwood, Racine WI
• Acquiring bank: Tri City National Bank, Oak Creek WI
• Vitals: as of 9/30, assets of $327 million, deposits of $273m
• DIF damage: $101m

#105

• Failed bank: Riverview Community Bank, Ostego MN
• Acquiring bank: Central Bank, Stillwater MN
• Vitals: as of 8/31, assets of $108 million, deposits of $80m
• DIF damage: $20m

#106

• Failed bank: First DuPage Bank, Westmont IL
• Acquiring bank: First Midwest Bank, Itasca IL
• Vitals: as of 8/31, assets of $279 million, deposits of $254m
• DIF damage: $59m

This week’s bonus: a promotional video from Sheila….

One problem I have: It’s not fair to compare the number of bank failures during this cycle to the number in past cycles. As a % of GDP, the deposits in failed banks is far higher this time ’round:

(Click chart to enlarge in new window)

Yes, I include Citi, BofA and Wachovia in the failed bank bucket. None of them could have withstood last year’s crisis were it not for bailouts and ultra-easy money.

Also, it’s important to remind folks that the big four banks have grown significantly larger in recent years….

In the latest government gimmick to protect bank capital, the FDIC plans to replenish its Deposit Insurance Fund by front-loading regular premiums in lieu of another “special assessment.”

The good news is that the fund gets replenished and taxpayers don’t foot the bill. The bad news is that Sheila Bair is missing a great opportunity to shrink the financial sector.

Under a proposal released by the FDIC, banks would prepay three-and-a quarter years of regular assessments on December 30, $45 billion in total.

The gimmick is how that $45 billion will be treated on balance sheets — as an asset that won’t drain capital, not all at once anyway.

Because the funds were already scheduled to be collected, banks will be able to treat this assessment as a prepaid expense on the asset side of the balance sheet. In other words, the banks will pay the cash today but will reflect it in earnings over the next three years.

Had Bair instead decided to charge another “special” assessment, the hit to earnings would have come up front.

Hitting earnings means reducing bank capital by a like amount and reducing lending a lot more. That’s because banks lend money based on a multiple of their capital — at a ratio of 25 to 1 if one uses tangible common equity in the denominator. So reducing earnings through special assessments has an outsized impact on banks’ ability to lend.

Is that really a bad thing? We’re told that without “more lending” the economy can’t recover. But the economy is still saddled by huge amounts of debt. More lending provides the temporary illusion of growth — propping up asset prices and industries dependent on credit — but in the end only adds to our burden.

In any case, we know the financial sector has grown too large relative to the rest of the economy. If we’re serious about shrinking it, that means less lending. There are no two ways about it.

“Assessments should hit earnings and reduce lending today,” says Martin Weiss, president of Weiss Research Inc, an investing consulting firm. “Gimmicks like this will backfire.”

To be sure, the proposal isn’t the worst that could have been expected. The FDIC might have chosen to borrow from Treasury or from banks themselves. It’s far better to have banks pay directly. This avoids moral hazard by making those who benefit from the Deposit Insurance Fund responsible for its solvency.

Still, given Bair’s desire to shrink the biggest banks, it’s a shame that she’s willing to sheath her sharpest weapon.

Last week Tim Geithner dropped multiple F-bombs in a meeting with regulators unenthusiastic about his plan to concentrate oversight of the financial system at the Fed.  Sheila Bair was one of his targets, but today she held her ground.  In testimony before the Senate Banking Committee this morning, she had this to say about concentrating regulatory power at the Fed:

…we do not see merit or wisdom in consolidating federal supervision of national and state banking charters into a single regulator for the simple reason that the ability to choose between federal and state regulatory regimes played no significant role in the current crisis.

One of the important causes of the current financial difficulties was the exploitation of the regulatory gaps that existed between banks and the non-bank shadow financial system, and the virtual non-existence of regulation of over-the-counter (OTC) derivative contracts. These gaps permitted lightly regulated or, in some cases, unregulated financial firms to engage in highly risky practices and offer toxic derivatives and other products that eventually infected the financial system…

She hits back at the administration pretty hard:

In light of these significant [regulatory] failings, it is difficult to see why so much effort should be expended to create a single regulator when political capital could be better spent on more important and fundamental issues which brought about the current crisis and the economic harm it has done.

She makes great points throughout.

But we can’t let Sheila and FDIC off too easy, though.  They’ve been undercharging for deposit insurance for years, which meant they didn’t have the resources necessary to resolve too-big-to-fail financials when they collapsed last fall.  Instead FDIC was forced to delay the reckoning, offering big banks a federal guarantee for their debts.

But at least Bair recognizes the terrible precedent that has been set, and wants to move decisively to reverse it.

John Dugan over at OCC also questions the wisdom of concentrating too much power at the Fed, though he and Sheila clearly have their disagreements when it comes to the proposed Consumer Financial Protection Agency.  She’s a big fan of existing proposals.  He’s got qualms with it.

Incidentally, I agree with my colleague Matt Goldstein that it’s good to see Tim Geithner get mad for a change.  A little anger is certainly appropriate.  I also agree with him that Geithner’s anger seems misdirected.

FDIC Chairwoman Sheila Bair is right now testifying in front of the Senate Banking Committee on “establishing a framework for systemic risk regulation.”  This is of course hugely important.  How do we end “too-big-to-fail?”  And how do we resolve failures that are so big they pose a systemic risk?

There’s so much valuable stuff in this testimony, readers should really see all of it.  To help you get through all 30 pages, I’ve highlighted key passages and provided commentary (in pink italics…I didn’t choose pink, btw, Scribd just read my formatting that way!).

Bair clearly knows what’s wrong with the system, and she articulates it more clearly than any other policymaker in Washington.  She really does want to put the screws to big banks in order to end too-big-to-fail.  She would do so by establishing a Financial Services Oversight Council to, among other things “actively control” leverage. She would also beef up resolution authority so policymakers could wind down bloated behemoths like Citi.

Right now they can’t resolve anything.  Regulators’ choice is between bankruptcy and taxpayer-funded life support.  Bankruptcies don’t work with systemically important institutions.  This we learned from Lehman.  Taxpayer subsidies only allow failed companies to keep operating on the public dime.  Neither is desirable.

My chief worry in what she’s proposing is that whoever ends up becoming the systemic risk regulator may not have the same cojones she does.  Who’s to say they will actually put the screws to the firms being regulated?

If they don’t, its sheer presence may backfire, especially if–as she proposes–there’s an “insurance fund” backing its resolution authority.  Private market players will then misinterpret the systemic risk regulator as an implicit government guarantee that protects them from risk.  Exhibit A is OFHEO with Fannie and Freddie.  Exhibit B is FDIC itself and its Deposit Insurance Fund.  Investors and/or depositors in these federally-backed institutions take MORE risk that creates BIGGER systemic problems than if there was a credible possibility they’d eat their own losses.

All of this would be much easier if the Fed just exercised its authority over bank reserve requirements.  Requiring banks to hold significantly more capital in reserve, and preventing them from hiding risk off their balance sheets, would solve just about every problem we face.

(For ease of reading, click on the top right button to toggle to full screen.  If that doesn’t work, click on the link at the top to go directly to Scribd.)

Sheila Bair Systemic Rist Testimony 072309