Further Politicization of Financial Sector Bankruptcies

Last Friday's Wall Street Journal carried an article about the FDIC and bank dissolutions with this chilling subtitle- FDIC Expected to Use Discretion to Rank the Creditors; That Can Be Tricky.

Among the more ludicrous parts of the article was the report that current FDIC chair Sheila Bair,

"said at a board meeting last week that the authority to differentiate among creditors "will be used rarely" and only in instances where additional payments to certain creditors are "essential" to maximizing the value of a firm or to conduct its operations."

There is so much subjective judgment loaded into Bair's statement as to make it meaningless.

Essentially, recent new regulations have made financial sector bankruptcy a completely subjective, politically-determined process.

Whoever heads the FDIC has the power to effectively choose which firms will be propped up, which will be chosen to 'fail,' and, for the latter, which counterparties will be rewarded with better repayment terms than others.

Bair can talk until she's blue in the face, but it won't change two realities.

One, Bair can't bind subsequent FDIC chairpersons to her allegedly-limited intended use of the newly-granted powers to favor some creditors over others, with no basis in law.

Two, the simple existence of these powers means that all counterparties to financial institutions now realize they may lose their capital at risk at the whim of an FDIC chair. Whether their debtor is declared insolvent and, if so, what treatment the lender/counterparty receives, will potentially be totally a function of the subjective feelings that the sitting FDIC head has for that firm.

Nothing else has to matter.

The article continues,

"John Douglas, a partner at Davis Polk LLP and a former general counsel at the FDIC, said such differentiation could foster instability by driving more Wall Street financing to the short-term. The problems of both Bear Stearns and Lehman Brothers were exacerbated by short-term creditors, who pulled out amid concerns about the firms' health.

"You're giving the FDIC the authority to differentiate and....people are going to try to game the system in a way to minimize the possibility of getting hurt," he said, "If you're a short-term creditor...you've got a chance every night to decide whether to fund or not."

In another astute observation, the article quotes Kenneth Scott, a Stanford law and business professor, as saying,

"Discretion breeds uncertainty; it creates additional risk. Despite what your intent might be, it may lead creditors to cut off funding sooner and accelerate the process, not in any sense ameliorate it."

Any way you slice it, informed observers of this new regulatory power resident at the FDIC think it will drive more funding to shorter terms, so that such funding may be curtailed faster than the FDIC can freeze it.

Once again proving how often legislation causes unintended consequences.

By ignoring prudent, risk-averse behavior of capital-providing financial institutions, Congress has, in its idiocy, written laws injecting more uncertainty and subjectivity into the bankruptcy process for large banks, thus driving their funding counterparties to take steps in the future to limit their risks to such subjective, unpredictable processes for repaying counterparties to a seized institution.

Sheila Bair's Self-Serving Support Of Dodd's FINREG Bill

I happened to see FDIC chairman Sheila Bair interviewed at length on CNBC last Friday.

If you ever need proof of how regulators become captive to the majority in Washington, and learn not to express their true views, this interview was it.

Asked about the deeply-flawed Dodd FINREG bill, Bair of course supported it. Keeping mum about the actual open door to bailouts of creditors of failed banks, and the FDIC's favored status as the 'resolution authority,' Bair just nodded slowly, sagely, allowing how it would be an improvement over current regulation.

What did the CNBC co-anchors expect? Bair's agency won the fight to be the go-to outfit for financial sector liquidations. And there aren't even any rules or guidelines to restrain the FDIC, under the bill, from declaring any firm they choose to be in trouble and, therefore, closed.

Continuing their wide-eyed, naive trust in all government officials towing the ruling party line, the CNBC staff listened with rapt attention to every word Bair uttered. Never questioning her motives or her agency's ability to handle failed institutions that aren't small or midsized banks?

Peter Wallison, in a recent Wall Street Journal editorial, noted that the FDIC has no skills in handling the variety of businesses in a modern investment bank like the now-defunct Lehman. His point, of course, was that if the FDIC had been responsible for closing and managing Lehman, it would have been hopelessly overwhelmed by the firm's complexity.

And that's going to be true of the very large financial firms which Dodd's bill envisions failing.

It's gotten to where you really cannot trust the bulk of CNBC's on-air personnel to ask anyone real hardball questions that might provide real insights or truth.

What Does The FDIC's Need For Backstopping Imply For America's Financial Power?

Dennis Berman wrote an interesting piece in Tuesday's Wall Street Journal concerning the current cries abroad- yet again- for an end to the role of the US dollar as the international reserve currency.

I've read these pieces for over 20 years now, and, until now, I have always considered them wishful thinking on the part of foreign economic wannabes.

Berman even included the comments of one academic who continues to label this desire wishful thinking.

But there are developments in the US domestic economic and financial situation which could well herald the final coming to feasibility of these calls for an end to US 'economic hegemony.'

For me, they became more thought-provoking and sobering with the recent spate of articles calling attention to, of all things, the FDIC insurance fund's near depletion.

Of all the FDR-era New Deal programs, the FDIC may well be the first to officially crater. And this marks, I believe, a very differential milestone of a very troubling sort for US economic power.

Why? Why this one somewhat innocuous program, rather than, say, Medicare, Social Security or Medicaid?

Precisely because, while those latter three are explicit social wealth transfer payment schemes, the FDIC program was designed to be a private business-funded insurance program to prevent a repeat of the 1930's era bank collapses which caused depositors' funds to simply evaporate.

That Sheila Bair may have to call on Treasury to write a check to replenish this bank sector-financed program is deeply worrying to me. It means that federal regulatory ineptitude has caused the bank deposits insurance program obligations to have outrun its resources, making this promise essentially empty.

Since the US has an outstanding deficit, any funds lent to the FDIC from Treasury must, given money's fungibility, be borrowed from the financial markets. Thus, the promise to safeguard consumer bank deposits- and money market balances, too- is being financed with borrowing.

There is nothing "there" anymore. The deposit insurance promise will now simply be dependent upon market funding appetites.

This was always supposed to be a federally-designed and -managed scheme whereby private commercial banks paid insurance premiums to be used to guarantee the consumer deposits of banks which were declared bankrupt and seized.

Now, the premiums and their income have been overwhelmed by bank failures. The program hasn't worked, although it took some 70 years to occur. Whether the rate was too low, or FDIC bank closures too lenient, poor design and/or mismanagement has resulted in this program failing.

If a privately-financed, government-run scheme from the New Deal era has failed, what is one to imagine has occurred with government-financed, government-run schemes? Because government-financed is now just another term for borrowed funding.

I suspect the longer term implications for the looming FDIC fund insolvency is going to be skyrocketing interest rates on US debt and a consequent impoverishment of Americans due to the gradual, practical, if long term aversion to dollar-denominated obligations by the rest of the world.

Everyone understands government borrowing for impractical social schemes. But when a US private sector-funded program is seen to become unaffordable, it has to call into question the soundness, creativity, ingenuity and superiority of the now-crippled American capitalistic system for wealth creation.

What once was the envy of the world as an economic wealth-creation engine has been severely damaged over the past several years. Perhaps, now, we are seeing, sufficiently seriously to make the rest of the world's investors finally doubt the once-accepted truism that America is the best country for wealth creation on the globe.

More Punditry On Next Steps for US Banks

The Wall Street Journal carried two editorials this week concerning the ongoing difficulties of the larger US banks. Specifically, Nouriel Roubini and Matthew Richardson, both of NYU, wrote on Tuesday that, at some point, "government has to show it can handle major insolvencies."

They also made the point that, thanks to overly-generous bailouts of equity investors in the past six months,

"The government has got to come up with a plan to deal with these institutions that does not involve a bottomless pit of taxpayer money. This means it will have the unenviable tasks of managing the systemic risk resulting from the failure of these institutions and then managing it in receivership. But it will also mean transferring risk from taxpayers to creditors."

Roubini and Richardson also note that current levels of several factors, unemployment being one, are already higher in actuality than in the stress test. So, what assurance do we have that these so-called 'stress tests' are really using stressful assumptions in the first place?

Wednesday's Journal contains an editorial by economist Glenn Hubbard and colleagues which argues the same point. They phrase it as a surfeit of carrots and a lack of sticks for bankers. Hubbard's piece follows with a fairly complex and unwieldy formulation of old banks, new banks, good banks, bad banks, and debt and equity holders swapping places in the various banks.

Contrary to Hubbard's contention that there is nobody left to buy a seized large, failed bank, I have argued in prior posts that such a contraction of existing, inept lending expertise should draw forth new, better-managed capacity from the likes of private equity and hedge funds. By purchasing problem assets on the cheap, buying branch systems and inheriting deposit bases, these new entrants would represent the first significant new capital to set up shop as large commercial banks in quite some time.

But what drew my attention, of course, is that both pieces begin by bemoaning the lack of bank closures, and too much risk being taken by the federal government on behalf of taxpayers.

It seems that more observers are concluding that the path on which our financial sector was placed last fall, beginning with the ill-conceived TARP program, has resulted in no normative measures by which to navigate subsequent developments. No banks apparently will be allowed to fail. Could this be why the market prices of so many bank equities have recently skyrocketed?

The implications are fairly clear. Even if the current administration continues to verbalize a reluctance to nationalize banks, its actions contribute to that effective result. No large commercial bank is seen as vulnerable to failure. Short-term trading as speculation is relatively safe.

By altering the normal path for failed banks, last used, or threatened, in the case of Wachovia, government has indicated that it sees bank insolvency as a temporary valuation mismatch, not a sign of ineptitude. Reality is being held at arms length by newly-improvised programs, tests and procedures so that no more large financial entities will be judged bankrupt.

Even if they actually are.

Somehow, this seems a recipe for disaster on a large scale. Rather like the Japanese approach to banking at the start of its infamous 'lost decade.'

Freely-trading capital markets are all about discovery of information and the accurate pricing thereof. How are markets to do that job when several large remaining banks are suspect of really being insolvent?

Sheila Bair's Mixed Signals

Friday's Wall Street Journal's Money & Investing Section carried a lead article entitled "Banks Told: Lend More, Save More." With a picture of FDIC's Chairman, Sheila Bair, accompanying it, the piece explored the mixed, opposite signals now being given to US banks- lend what the Federal government has invested in them, but, at the same time, build capital cushions.

As Brian Wesbury pointed out recently, about which I wrote in this post,

"In a related argument, Wesbury noted something genuinely novel and elegant. He opined that, with the Fed pushing rates to nearly zero, there was no way bank lending could expand.

He pointed out that, at a time when risk in the economy, among borrowers, is still so high, and rates are now so low, there is absolutely no way lending can be cost-justified. The risk-adjusted returns to ultra-low interest loans are negative. Wesbury thus observed that the problem isn't a lack of borrowers, but a lack of lenders willing to effectively take a loss on new loans.

He then pointed out how ludicrous was the situation in which banks have been placed by Treasury and the Fed. They are pilloried if they don't lend out the new, unwanted TARP-based 'capital' bestowed upon them by Hank Paulson.

But, if they do make loans at market rates in this environment, those loans will surely go bad, too, resulting in even more balance sheet damage and reprimands from regulators."

It's never fun to have to note a situation of governmental incongruity and wrong-headedness. In this case, Wesbury called this a full two weeks ago.

This is why, in my opinion, if we're going to nationalize the banking sector, we should do it correctly. Lending standards should be articulated from Washington, with clear, quantitative guidelines. If Federal money is going to back the banking system, let's not have loose, prone-to-misinterpretation signals.

If Treasury, the Fed and FDIC all want more bank lending, they should clearly express that in a formal regulatory message, complete with guidelines and a statement of responsibility for subsequent loan performance.

This is why it's not a great idea to mix Federal funding with private funding of banks. Now we have Federal directives to private shareholders that their bank employees should be doing more lending, though, as Wesbury notes, the chances of getting rates to compensate the risks are nil.

Gee, didn't we just spend about a dozen years doing this in the housing sector, via Fannie, Freddie, Barney Frank and two Presidents?

We could be in for a long, long learning period under the new, quasi-nationalized banking system the US now possesses.