The FDIC and the socialization of banking losses

With the Federal Deposit Insurance Corporation (FDIC) about to release its latest figures for banks it regulates and its own financial condition, now is a good time to review its role in this crisis. This post is about the FDIC’s role in the credit crisis, how it seizes banks and why I believe this matters.

In my opinion, Sheila Bair, the head of the FDIC,  is the best regulator in government these days (although not everyone feels that way). Her agency has taken on the workman’s regulatory role in this crisis of identifying undercapitalized institutions, seizing them and putting their assets in new hands. These actions are a necessary part of capitalism. When a bank is reckless, it must suffer the consequences.

However, it is the distribution of the losses from failed institutions which I would like to discuss.  Much of the loss falls on the FDIC and, hence, taxpayers. In effect, what is a necessary part of capitalism, the extinction of failed institutions, may in effect be a redistribution of wealth in disguise.

Last week, when I posted on Guaranty, the latest seizure by the FDIC, a reader noted that the loss-sharing agreement between BBVA, which had purchased Guaranty’s assets, and the FDIC was quite favorable for BBVA.

On its website BBVA states in Spanish:

BBVA ha suscrito con la FDIC un “loss sharing agreement”, que cubre todos los créditos adquiridos en la transacción, en virtud del cual la FDIC se haría cargo, en caso de producirse, del 80% de las primeros 2.300 millones de dólares de las posibles pérdidas, y del 95% a partir de dicho límite.

What this says is: “BBVA has signed a “loss sharing agreement” with the FDIC, covering all loans acquired in the transaction. Under that agreement the FDIC would cover 80% of the first 2.3 billion dollars of any losses that may occur, and 95% above that ceiling.”

Translation: The FDIC is on the hook for the lion’s share of any subsequent losses at Guaranty.  As a taxpayer, you would be right to feel you’re not getting a good deal here because you are ultimately the one picking up the losses. How?

Socialization of losses

It works like this. Last year, when IndyMac failed, it was the event which brought the credit crisis into mainstream consciousness. Mind you, the crisis had begun in February 2007 when HSBC wrote down billions of bad debt. But, for the man on the street, it only hit home when a run on IndyMac started in July 2008 and unsecured depositors lost money.

Soon after that event, I pointed out that the FDIC couldn’t possibly bail out all the banks likely to go bust in the crisis.  At the time, the FDIC had just over $50 billion in its kitty. The IndyMac bankruptcy alone was expected to cost $8 billion to the fund, a number that subsequently increased to $10.7 billion.

The losses have taken their toll. The last time the FDIC reported on its financial situation back at the end May, it said it had $13 billion as of the end of March. Now, we await a new report for the period through Jun 30.  Will the FDIC report any funds at all?  Is the FDIC insolvent now?  We will soon find out.  But, one thing is for certain: the FDIC will ask the U.S. Treasury for an enormous amount of money to pay for anticipated bank losses – hundreds of billions of dollars. And they will get it.

This is what is commonly known as the socialization of losses. So when Guaranty enters into a loss-sharing agreement with BBVA, you should realize any future losses will be paid out of funds contributed to the FDIC directly by Congress and the US taxpayer.

The FDIC as a redistribution mechanism

So, obviously, how the FDIC structures its deals to seize and dispose of assets is of great interest to everyone in the U.S.  I would argue that at present, the way assets are seized and sold represents a redistribution of income from taxpayers to the acquiring entities.  Let’s use the BBVA example to illustrate.

Imagine you are Sheila Bair.  You have shuttered 80-odd institutions this year and you realize that 150, 200, maybe 300 more institutions could fail still.  No way on earth does your organization have the manpower to deal with this avalanche of bank failures without sloughing the assets off on willing buyers.  How do you entice those buyers? In a word, price.

It’s what is known as a sweetheart deal.  There were a number of bidders for Guaranty including US Bank, and a private-equity consortium led by Gerald Ford which included Blackstone, Carlyle and TPG.  Yet, the deal went to BBVA in a loss-share agreement that caps their exposure at 20%?  I ‘d like to get in on a deal like that.  If you are a private equity buyer, you’re probably chomping at the bit for more deals like this.

Granted, with visions of a V-shaped recovery on the horizon, you could be forgiven for thinking there will be no further losses.  But what if there is no V-shaped recovery? Then, the American taxpayer is going to be covering a lot of losses – and that is a redistribution from taxpayers to the financial services industry.

More losses to come

I certainly believe the V-shaped recovery is unlikely.  More likely, we will see a sluggish recovery. And a relapse into recession is a distinct possibility. This means more losses on toxic assets at financial institutions, more exposure for the FDIC, and, thus, more socialization of losses.

Update: The FDIC approved a final statement of policy concerning acquisition of failed institutions which eased rules for private equity buyers.  Obviously, the FDIC wants more bidders at the table as I have suggested in this article.

The question is whether the loss-share agreements it is crafting with those bidders will expose the agency to losses which it cannot possibly repay without taxpayer monies.  As it stands now, the FDIC merely has a line of credit from the Treasury for $500 billion.  However, if losses are large, I doubt very seriously those funds will be repaid.

See FDIC press release here and Deal Book article here.