Will the PPIP Bankrupt the FDIC?

Yesterday's New York Times had a very interesting article on the role the FDIC will play in the Public-Private Investment Plan, Treasury Secretary Geithner's new and improved version of the original TARP "Cash for Trash" plan. For a discussion of the over all outline of the plan and how it will work/not work go here and here.

The Times article focuses on one element of the plan, which is the FDIC's guaranteeing of the non-recourse loans to the public private partnerships. The first question that springs to mind is: Why the FDIC? The simple answer is that it is an end-run around Congress. This is, however, not what the FDIC was set up to do. It was set up to guarantee bank deposits, which lowers the economic impact if a bank fails, and also helps prevent bank failures by minimizing the potential bank runs.

Being able to do this at all requires a very broad interpretation of the FDIC's mandate (see the NYT article for details). It appears that the FDIC is getting into this a bit blind, or is not being straight with the taxpayers. Here is a key quote from the article:

"So how is the F.D.I.C. planning to insure more than $1 trillion in new obligations? This is where things get complicated and questions are being raised. The plan hinges on the unique, and somewhat perverse, way the F.D.I.C. values the loans. It considers their value not as the total obligation, but as 'contingent liabilities' -- meaning what it expects it could possibly lose. As the F.D.I.C's charter dictates: 'The corporation shall value any contingent liability at its expected cost to the corporation.' So how much does the F.D.I.C. think it might lose? 'We project no losses,' Sheila Bair, the chairwoman, told me in an interview. Zero? Really? 'Our accountants have signed off on no net losses,' she said."

If only America's inventors, entrepreneurs, artists, musicians and film industry had the creativity of our accountants, then America would once again be the undisputed master of the world. The idea that there would be no net losses from this program is optimistic to the point of insanity. The plan is set up so that on each individual transaction, if the private investors win and make money, then the Treasury/FDIC makes money (mostly the Treasury) and vice versa.

Except only in the wins private investors make out like bandits, while collectively the government makes modest profits -- and on the losses, the private investors lose a little bit, and the government loses big. On the government side, the losses would be mostly borne by the FDIC while the Treasury would get most of the gains.

The more transactions there are, the higher the probability that overall the program loses money. After all, having four out of five coin flips turn up heads is not all that astonishing, but if it happened 400 out of 500 times, you just might want to have a close look at the coin. Does Ms. Bair have a two-headed coin she plans to use for this exercise?

In a broader sense, the PPIP program will only be "successful" if it loses money. The idea is to get the toxic assets off the banks books at prices that are not so low as to totally wipe out bank capital. Without the government support, private investors are not willing to buy the assets for anything close to what the banks can afford to sell them for, at least over the short term. The hope is that over the long term these securities will work themselves out, and the winnings on the assets that work out will help offset the losses.

The whole aim of the program is to raise the level of bids that private investors will make for the assets. Unless you think that all the hedge funds out there are totally irrational, that means that the idea is to get the PPIP to overpay for the assets, but by a lesser amount than the government would if it went about this solo.

If it were not about raising the bids to higher than economic levels, then Citigroup (C) or Bank of America (BAC) could simply sell the assets today for what current market participants are willing to pay. It's not like there are no vulture investors who would be interested in owning the assets. They just want to own them at a price that makes it likely that they will profit from them.

The only way that the FDIC would not lose significant amounts is if there are very few "coin flips," or if the plan is a complete flop and fails to close the bid-ask spread enough to create a functioning market. The latter is a real possibility now that FASB knuckled under political pressure and relaxed the mark-to-market rules, thus reducing the incentive for the banks to sell off the toxic assets.

The FDIC could end up guaranteeing up to almost $1 Trillion in very risky non-recourse loans, for which they will get a small fee, and they are projecting no net losses! Seriously, Shelia, there is this bridge I have in lower Manhattan, a real landmark property -- care to make a bid on it? Are the accountants that signed off on "no net losses" the ones that signed off on Enron's books or the ones that signed off on WorldCom's? Does Bernie Madoff's bean counter have a new gig?

After the FDIC runs up at least tens of billions of losses from this program, its coffers will have to be replenished. After all, it's not like the FDIC is going to be sitting around with no calls on its capital from its normal operations. There have already been over 20 bank failures this year, and there are sure to be many more.

Normally, it would do this by assessing a levy on the banks. But is this the time to be depleting bank capital by dramatically increasing FDIC insurance premiums? For starters, it is moral hazard writ large, as smaller community banks -- most of which do not hold large amounts of these toxic legacy assets (they may have other problem loans, most notably in commercial real estate) -- have to subsidize their larger competitors who screwed up royally.

More likely what will happen is that about a year from now, the FDIC will come to Congress with its hat in hand and say, "Bail us out, or everybody's checking account will be at risk!" Congress will then have no choice but to hand over the funds. That's not the way it's supposed to work -- spend the money first, then ask Congress for the appropriation.

The PPIP program is relatively well designed, but far from without flaws. It will aid in real price discovery (provided it isn't totally gamed) and does allow for the Treasury to participate in the upside of the deals that work out. While I still would prefer the "Swedish Solution", if we are not going to go down that path, then the PPIP is probably the best we can hope for. Still to pretend that the expected cost of this is zero is simply disingenuous. A little honesty and transparency would be nice.

-- Dirk van Dijk

Comments

[Harry Walsh:]

Once again, the government assumes that these assets are worth more than the uncooperative market is willing to pay. And Sheila Bair projects no losses, so why do the investors need insurance? The FDIC is putting itself in a position like the AIG financial products group's position: a big risk exposure with no reserves for losses. The projected exposure is less than AIG's, a mere one trillion, but the FDIC is already short of reserves because of bank failures and is raising its deposit insurance fees. But possibly nobody will be interested in the PPIP, so the FDIC may dodge the problem that way.

Apr 08 08:45 AM

[wdhalgren:]

"The later is a real possibility now that FASB knuckled under political pressure and relaxed the mark-to-market rules, thus reducing the incentive for the banks to sell off the toxic assets."

I have to disagree with this statement. The accounting change doesn't alter the value of the assets and banks most certainly still want to sell them. After all, if these assets are held to maturity then their true valuation will no longer be subject to debate. All FASB has done is give the banks cover to either;

a) Sell the assets to US tax payers at inflated values, or
b) Sell stock to gullible investors, thus improving their ability to withstand losses from these still toxic assets.

Apr 08 09:15 AM

[deviljmg:]

Mr van Dijk makes the folowing claim - Unless you think that all the hedge funds out there are totally irrational, that means that the idea is to get the PPIP to overpay for the assets, but by a lesser amount than the government would if it went about this solo.

I have to disagree with this because it ignores the role of capital structure in pricing assets. For example, let's say a hedge fund has examined a pool of mortgages and thinks that ultimately they will be worth 75 cents on the dollar in three years. If the fund wants say a 15% annualized return on it's investment then the maximum they would bid for such a pool would be 50 cents. But under the PPIP (assuming the full 6-1 leverage) they could bid 65 for the same assets, put up less than 5 cents of equity and still clear their hurdle rate after interest expense. Obviously this example if a little oversimplified, but I think it illustrates the point that prices can rise without assuming anyone acting irrationally.

The article also ignores the role of liquidity in setting market prices. You'll almost always get better bids in a market where there are lots of participants and the belief that there will bids available if you ever want to turn around and sell an asset. For example, I was at a presentation recently from a senior institutional portfolio manager. She related that back in September their money market funds had to mark some short-term SIVs at 30 cents on the dollar because that's where the "market" was. They were able to hold assets and they matured at par. But due to fear and illiquidity these assets (or at least a small percentage of them) traded at a level that would have generated a 230% return in a matter of months despite the presence of all those smart sophisticated hedge funds out there.

All that said, I do agree the idea of zero losses on the FDIC side stretched credulity. Although zero net loss between the FDIC and the Treasury upside on deals that work is a little more plausible.

Apr 08 10:02 AM

[helplessobs...:]

They had better be careful how they handle the FDIC. It is the only thing that is keeping us from complete financial collapse as it is preventing a $5T - $10T run on the banks. If the public loses confidence in the FDIC and starts pulling money out of the banks capitalism and rule of law is doomed.

Apr 08 12:56 PM

[HerrHansa:]

It's like FDIC joined ISDA without telling ISDA. PPIP sounds more like derivative trading than a workable solution.

Apr 08 04:11 PM

[gtmcduffy@g...:]

It's not the PPIP- it's called the PPIF. I decided not to read the article as soon as I realized you couldn't even get the name right...
www.treasury.gov/press...

Apr 08 04:34 PM

[Esol Esek:]

I've got money in a jumbo cd in a credit union, and this absolutely makes me question the future protection of my funds via the FDIC. Why stain the FDIC? Why not creat a clean or dirty bank? The only answer can be that the FDIC will get guaranteed political support when it needs to ask for trillions. This is straight up nonsense, and it took a Goldman Sachs master to come up with something this slimy.

I see the commenter above didnt read, but still wrote. Mr Particular the Clown.

Apr 08 05:10 PM

[Lin:]

FOLKS ! PLEASE SEE website " Safe Haven " under google , it is choice for ' capital preservation " Once on site , see article entitled " Civilization at the crossroads " by John meyer , april 07, 09 . THis WILL open your eyes as to Why this is happening !

Apr 08 05:25 PM

[John McLeod:]

Back in August I wrote a post titled "The CDARS of Lebanon: Did Gramm-Leach-Bliley Doom FDIC?"
housingdoom.com/2008/0.../

Essentially, there are 3rd parties who are allowing (relatively) wealthy investors to work around the $250k (whatever it is now) limit on FDIC deposit insurance. This PPIP thing seems to be putting still more pressure on Sheila. I'm beginning to wonder if FDIC, like the big GSEs that were quasi-private and are now quasi-nationalized, are working a bit like Enron's QSPE off-balance-sheet vehicles -- convenient hiding places for risk that should be on Congress's balance sheet (and the national debt).

Apr 08 07:24 PM

[Ronald Pires:]

Note how it was said: "no NET losses". The key word is "net".

Bair is telling the truth, except that we are not doing the same "net" calculation that she is. If the net calculation is actually the difference between this program and putting these banks into receivership, then yes, of course there is "no net loss".

See? It's all in how you define your terms.

Apr 09 12:30 AM

[The Daily Bail:]

Dirk.

Here is what I wrote about this subject last night.

dailybail.com/home/the...

"The FDIC's Electric Kool-Aid Acid Test: Sheila Bair Has Lost Her Mind"

Apr 09 02:12 AM

[1worldcurrency:]

If you guarantee anything, eventually some sharp fraud will come along to claim it.

$250,000 for each depositor? The too big to fail banks are scrambling for that cash right now.

Apr 09 05:18 AM

[E.T. Explorer:]

This financial madness is like the storybook tale of "Alice in Wanderland". Banks hold depositors and debtors accounts which involves "Withdrawals, Deposits and Balances". One can't get a penny from a bank if you have no balance in your account and if you want a loan you better have some impressive collateral to cover it in case you can't pay it back.The question that begs to be asked and answered is, "howin the world can all of a sudden all the world banks suddenly are going broke?" I have heard of "April's Fool jokes, but this has gone too far to keep reading about any further.

Is there any wise old owl that can spill the beans on this preposterousgag of the century?

Apr 09 08:01 AM

[E.T. Explorer:]

This financial madness is like the storybook tale of "Alice in Wanderland". Banks hold depositors and debtors accounts which involves "Withdrawals, Deposits and Balances". One can't get a penny from a bank if you have no balance in your account and if you want a loan you better have some impressive collateral to cover it in case you can't pay it back. The question that begs to be asked and answered is, "how in the world can all of a sudden all the world banks suddenly are going broke?" I have heard of "April's Fool jokes, but this has gone too far to keep reading about any longer.

Is there any wise old owl that can spill the beans on this preposterous gag of the century?

Apr 09 08:08 AM

[p.e:]

Esol,
Are you sure your credit union is insured by FDIC? All federal credit unions, for example, must be insured by National Credit Union Share Insurance Fund (NCUSIF).
If anyone is concerned specifically about FDIC, credit union may be an option, although it is hard to believe that FDIC can be left w/o bailout if required.
One may check insurance of the particular credit union here:
www.ncua.gov/shareinsu.../

Apr 10 09:16 PM