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
