Willem Buiter of the Financial Times takes down Geithner and the Fed.
More on robbing the US tax payer and debauching the FDIC and the Fed
March 26, 2009 5:34pm
The US authorities have no money to fulfil their ambition of stopping large US banks from failing without taking them into public ownership. The $300 bn left in the TARP kitty is all that is available for recapitalising banks, purchasing toxic assets and providing other financial support. Congress has thrown its toys out of the pram and is unwilling to appropriate more funds for the rescue of the banking sector.
As an aside: it is astonishing that Congress and much of the US populace are apoplectic about $165 mn (perhaps $182 mn) of bonuses paid to AIG executives and employees, when $170 billion or so of public money is at risk (and tens of billions probably already gone out of the window) in the rescue of this most undeserving of companies. Perhaps you can only get indignant about what you can comprehend… .
The US authorities are reduced to begging, stealing and borrowing the rest of the funds they believe they will need. The two main proximate sources of funds are the FDIC and the Fed. The ultimate sources of funds will be (1) the US tax payer and the beneficiaries of future US spending programs that will have to be cut, (2) the holders of nominally denominated liabilities of the US state, including the monetary liabilities of the Fed and US Treasury bills and bonds.
Owners of dollar-denominated debt instruments will see the real value of their claims on the government eroded by future inflation if, as I expect, the recent and prospective future increases in the US monetary base (driven by credit easing and, in the future also be quantitative easing) cannot be reversed in the future. The main obstacle to such a reversal will be the US fiscal authorities, who are unlikely to let the Fed dump large amounts of US Treasury debt, acquired by the Fed as part of its quantitative easing program, into the markets.
I believe that the raids by the US Treasury on the FDIC and on the Fed are illegitimate and, in the case of the FDIC, quite possibly illegal.
The FDIC is supposed to be an independent agency of the US federal government. Its website tells us that “The FDIC receives no Congressional appropriations - it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities” . The FDIC also has no borrowing capacity except that granted it by the US Treasury.
The operating budget of the FDIC for 2009 is $2.24 billion, a big increase from the $ 1 billion set in 2008, but still a tiny number. Its current Treasury borrowing limit is $30 bn, again nowhere near enough to make an impact on the black hole that is the asset side of the balance sheet of the US cross-border banking system. With an insurance fund of just over $45 billion, the FDIC insures more than $5 trillion of deposits in U.S. banks and thrifts. The insurance fund is therefore less than one percent of the amount of insured deposits.
The near-demise of the US banking system means that, should even a single large deposit-taking bank go bust, there is not enough money in the kitty to pay off all insured depositors. The FDIC would have to borrow - hence the usefulness of the increase in the borrowing limit. It is both unwise and illegitimate to use that borrowing limit instead to subsidise potentially non-viable banks (likely to still be non-viable even after the subsidy) as well as the private investors who plan to purchase these banks’ bad loans through the Legacy Loans Program.
The FDIC’s Mission Statement is clear: “The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress that maintains the stability and public confidence in the nation’s financial system by insuring deposits, examining and supervising financial institutions, and managing receiverships.” I don’t see anything there about guaranteeing debt from or loans to private entities wanting to buy bad loans from bad banks. The Federal Deposit Insurance Corporation Improvement Act of 1991 also does not, as far as i can see, authorise the FDIC to engage in the kind of quasi-fiscal activities it is engaging in through the Temporary Liquidity Guarantee Program (see below) and is about to engage in under the Legacy Loans Program.
But help is on the way! Senate Banking Committee Chairman Chris Dodd of Connecticut is proposing, in a bill submitted on March 5 2009 (the Depositor Protection Act of 2009) to increase the FDIC’s Treasury borrowing limit from $30 billion to $500 billion. With the deposit insurance limit now at $250,000 at least until the end of 2009 (up from $100,000) and so many large deposit-taking banks in the US insolvent but for past, present and anticipate future hand-outs from the tax payer, the increased borrowing limit of $500 bn may come in handy to make whole the insured depositors if and when one or more large banks keel over.
But this does not appear to be the use (the proper use) that the US authorities have in mind for it. Instead the increase in the FDIC’s Treasury borrowing limit to $500 billion is likely to be diverted to the entirely improper use of providing debt guarantees for debt used to co-finance the purchase bad loans from the banks under the Legacy Loans leg of the Private-Public Investment Program (PPIP). This quasi-fiscal role of the FDIC is on top of the earlier prima-facie illegitimate use of FDIC resources under the FDIC’s Temporary Liquidity Guarantee Program (TLGP), under which the FDIC guarantees newly issued senior unsecured debt of banks, thrifts, and certain holding companies.
The FDIC, under the TLGP also provides full coverage of non-interest bearing deposit transaction accounts, regardless of dollar amount. This is a legitimate use of its resources, albeit an unwise one. As of February 28, 2009 the amount of debt insured under the TLGP was more than $268 billion. After debauching the Fed to pay for the bail-out of insolvent US banks, the US administration is now subverting the purpose of another so-called independent government agency.
The debauching of the FDIC is, however, different in one respect from that of the Fed. The Fed has an independent source of revenue - seigniorage, that is, the revenue from issuing base money, part of which is non-interest-bearing (bank notes) and part of which (commercial bank deposits with the Fed) earns an interest below what the Fed earns on its assets.
The FDIC has no independent source of revenue (ignoring the premia charged for the deposit insurance, which is chicken feed). Getting the FDIC to guarantee loans is therefore just a cute and non-transparent way of having the US Treasury guarantee those loans. But it’s off the books, off-budget and off-balance sheet as far as the US Treasury is concerned. With a bit of luck the guarantees will not be called. And if they are called - well, that will be then and this is now. If the FDIC can insure $ 5 trillion worth of deposits with a mere $45 bn fund, think of what amount of lending the FDIC can guarantee when it borrows its full allotment of $500 bn! The bill will be presented to the tax payers later.
How large could the bill be, that is, how much money could be transferred from the US tax payers to the banks or the investment funds bidding for toxic assets?
The potential for subsidies to the private parties involved in the PPIP’s Legacy Loans and Legacy Securities Programs is truly astonishing. Jeff Sachs, in a recent Financial Times column, provides a representative calculation for the Legacy Loans Program. Note that this is targeted not at toxic assets (assets whose value is unknown) but on bad loans, whose (low) fundamental value can be ascertained without too much effort.
What follows paraphrases Jeff Sach’s argument and calculation. I put all of it in quotation marks, even though a few words have been changed.
“For every $1 of bad assets that an investment fund authorised under the PPIP buys from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the bad assets purchased by the investment fund fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the bad assets. The investment fund is not responsible for part of the FDIC loan not covered by the liquidation value of the bad assets. At most it loses the equity it put in.
Consider a portfolio of bad assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The fair value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, i.e. $360 billion.
Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC non-recourse loan. The FDIC makes a “heads you win, tails the taxpayer loses” offer to the private investors.
With a little arithmetic, we can calculate the size of the transfer from the tax payer to the banks and the investment funds. In this example, the private investment fund will actually be willing to bid $636 billion for the $360 billion of fair value of the bad assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders.
Under the rule of the Geithner-Summers Plan, private equity investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion each. The FDIC will loan $546 billion. (All numbers are rounded). If the bad assets actually pay out the full $1 trillion (which happens with 20 percent probability), there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.
Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.
The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the bad assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than it gets in payouts on the bad assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.”
The problem of collusive behaviour between the private investment funds and the banks for whose assets they bid will undoubtedly rear its ugly head. Indeed, the banks could set up their own investment funds (through SPVs registered in places where information is even harder to obtain than in Liechtenstein) and so make sure the underpriced put provided by the FDIC through its non-recourse loan can indeed be exercised.
This is a very bad deal for the tax payer indeed. And the Legacy Securities Program works on the same principles, although the non-recourse leverage provided by the Fed will be less than that provided by the FDIC for the Legacy Loans Program.
I have written at length before about the ever-expanding quasi-fiscal role of the Fed. This began as soon as the Fed began to take private credit risk (default risk) onto its balance sheet by accepting private securities as collateral in repos, at the discount window and at one of the myriad facilities it has created since August 2008. It is possible - I would say likely - that the terms on which the Fed accepted this often illiquid collateral implied even an ex-ante subsidy to the borrower. But the Fed is refusing to provide the necessary information on the valuation of the illiquid collateral, interest rates, fees and other key dimensions of the terms granted those who access its facilities, for outsiders, including Congress, to find out what if any element of subsidy is involved.
Should the borrowing bank default and should the collateral offered also turn out to be impaired, the Fed will suffer an ex-post capital loss on its repos and other collateralised lending operations against private collateral. It does not have an indemnity from the Treasury for such capital losses.
The Fed also created the Maiden Lane I (for Bear Stearns toxic assets), Maiden Lane II (for AIG’s secured loans and Maiden Lane III (for AIG’s credit default swaps) special purpose vehicles in Delaware. The losses made by Maiden lane II and III when the Fed paid off the investors (counterparties) of AIG at par, were, however, not booked on the balance sheets of the two Maidens, but were booked on AIG’s balance sheet, keeping Maiden Lane I and II, and the Fed, clean for the time being. The financial shenanigans used by the Fed (in cahoots with the US Treasury) to limit accountability for these capital losses are quite unacceptable in a democratic society. Clearly, the US authorities are using the financial engineering tricks and legal constructions whose abuse by the private financial sector led to our current predicament, to engage in Congressional- and tax payer accountability avoidance/evasion. To watch the regulators engage in regulatory arbitrage is astonishing.
With the onset of credit easing, the Fed now also takes private credit risk onto its balance sheet through outright purchases of private securities (including commercial paper and possibly corporate bonds) and by making non-recourse loans through the TALF (that is, though unsecured lending). There is no full (100 percent) Treasury guarantee for this credit risk taken by the Fed. In fact, the $1 trillion TALF has at most $100 billion of Treasury funds to back it up.
I don’t envy Ben Bernanke the extremely uncomfortable position he finds himself in. He can insists on minimizing the quasi-fiscal role of the Fed by insisting on a 100% US Treasury guarantee for any credit risk, other than the credit risk of the US sovereign, that the Fed assumes. In that case the amount of financial ammunition that the US state, broadly defined to include the US Treasury, the FDIC and the Fed, have at their disposal to deal with financial sector reconstruction is inadequate. Or he can compromise the independence of the Fed and let the central bank be used as an off-balance sheet and off-budget special purpose vehicle of the US Treasury, reducing transparency and undermining democratic accountability. Talk about a rock and a hard place.
Even faced with this kind of dilemma, however, certain practices are clearly improper and unacceptable. The (ab)use of the Maiden Lane SPVs to hide some of the losses made by the Fed and the US Treasury and to channel money non-transparently to AIG counterparties (in the case of Maiden Lane II and III is just plain wrong. So is the refusal to make public the information required to judge the appropriateness of the terms and conditions attached by the Fed to the use of its facilities.
Conclusion: we need banking; we don’t need these banks
The raiding by the US Treasury of the financial resources of the FDIC and the Fed is not just unwise, illegitimate and possibly illegal, it is also unnecessary. For some reason, perhaps an example of cognitive capture of the Treasury and White House policy makers by the spin doctors and skilled persuaders of Wall Street, Tim Geithner, Larry Summers, Ben Bernanke and Sheila Bair all appear to believe that to save the banking sector you have to save the existing banks as going concerns. Indeed, in view of the astonishing survival rate of CEOs and other top managers in the zombie banks, they may even believe that to save the banking system you have to rely on the continued contribution of those whose past best efforts brought us this crisis and debacle.
All that matters is banking as a function and activity, that is, new lending and borrowing by banks. When a massive disaster strikes the existing banks, it is essential to decouple the stocks of existing assets and liabilities from the flows of new lending and borrowing. The good bank model does that.
Both Fed Chairman Bernanke and US Treasury Secretary Geithner have called for the creation of a special resolution regime (SRR) with prompt corrective action (PCA) for non-bank systemically important institutions. Bernanke clearly had AIG in mind when he told the US Congress on March 20, that there was a need for a special insolvency regime that “permits the orderly resolution of a systemically important nonbank financial firm”. With a proper federal resolution authority, AIG could have been put into conservatorship or receivership and could have been unwound slowly, with not just the shareholders but also the unsecured creditors taking the haircuts (losses) justified by the financial condition of AIG. Bernanke’s words that a proper special resolution regime for non-banks would permit the Conservator or Administrator to “unwind it slowly, protect policymakers, and impose haircuts on creditors and counterparties as appropriate,” truly are music to my ears.
I also agree with Chairman Bernanke’s statement that “given the interconnected nature of our financial system and the potentially devastating effects on confidence, financial markets and the broader economy that would likely arise from the disorderly failure of a major financial firm in the current environment, I do not think we have had a realistic alternative to preventing such failures.”
But with a proper SRR, there can be orderly failures of major financial firms, banks and well as non-banks. The US has a proper SRR for FDIC-insured banks. That now includes all Wall Street banks. The orderly failure and resolution of one of more Wall Street banks need therefore pose no threat to financial stability. Indeed, with the limited resources the US authorities have at their disposal, the failure and orderly resolution of all dodgy Wall Street banks may well be the best way to stabilise the financial sector and to get financial intermediation - new lending and borrowing between banks and the non-financial sectors - going again. With the information the authorities now are acquiring (I hope) about the soundness of the large banks (whose balance sheets and financial fitness are being scrutinised as part of the Treasury’s Capital Assistance Program), the authorities will soon know which banks should be allowed to survive and which ones should be put out of their and our misery.
Why hasn’t the FDIC’s special resolution regime been used to resolve the large Wall Street zombie banks, but just the tiddlers in the boonies (OK, add WAMU)?
Any large, deposit-taking Wall Street bank (the old bad bank or OBB) with a significant amount of non-insured deposit liabilities on its balance sheet and a survival-threatening amount of toxic assets, can be split into a new good bank and a new bad fund virtually with the stroke of a pen, using the proposal by Bulow and Klemperer and Hall and Woodward (see also Buiter (1) and (2)). The new good bank gets the insured deposits and the non-toxic assets. If liabilities net of insured deposits of the OBB exceed toxic assets, the new good bank will have positive equity. Give that equity in the new good bank to the new bad fund. The new bad fund does not have a banking license and cannot make new loans or acquire any new assets. It simply manages down its portfolio of existing assets in the interests of its owners. It gets no further government financial support of any kind. If it fails, it goes into Chapter 11 or Chapter 7. Both the shareholders and the unsecured creditors can be expected to take a hit. That is as it should be.
If the new good banks needs additional capital, it can go to the market or obtain it from the government. Government guarantees (just from the Treasury, please) are only granted to new bank borrowing or bank lending.
Save banking. Allow the zombie banks to die.