Linus Wilson's  Instablog

Another Friday and another bank that was deemed “healthy” by regulators and the U.S. Treasury sees its bailout shares wiped out.  Taxpayers this time lost $4.1 million as the Federal Deposit Insurance Corporation (FDIC) seized the southern California Pacific Coast National Bank.  Sunwest Bank of California will assume Pacific Coast’s deposits and assets.

Sheila Bair the FDIC head, apparently anxious about the fact that her agency had wiped out a combined $303 million in taxpayer capital injections in two weeks, sat down with Paul Solomon of PBS’s Newshour.  The FDIC is as much in the bailout business as the U.S. Treasury, but she used the interview to slam the U.S. Treasury’s efforts.  She criticized the Troubled Asset Relief Program (TARP) capital injections into the big banks and, in the same breath, she said that the FDIC’s under-priced credit default swaps called the Temporary Liquidity Guarantee Program (TLGP) was the best way to run a bailout. 

Just because the FDIC has not lost much money on their under-priced credit default swap insurance does not mean that it never can or never will.  American International Group (AIG) profited handsomely from selling credit default swap insurance until a few months before the Federal Reserve and later the U.S. Treasury injected billions of dollars into that failed institution.  The FDIC is moving into the lines of business that brought AIG near bankruptcy.

I’m no fan of the Treasury’s capital injections from TARP.  The Congressional Oversight Panel’s February Report and I have criticized them as overly generous to the recipient banks.  Moreover, my solo and joint research has argued that they injected the wrong type of capital if they wanted banks to make more good loans.  That research has said that there is little economic justification for injecting cheap capital into institutions that pose no systemic risk.  This point seems particularly relevant after the failures of CIT Group (CIT) and UCBH Holdings (UCBH), which cost taxpayers a combined $2.6 billion.

Yet, the FDIC’s loan guarantees are probably worse than the TARP capital injections.  TARP was passed by Congress and signed by the President.  What Congressional or Presidential authority did the FDIC have to get into the credit default swap business?  The Congressional Oversight Panel (COP) in its November 2009 report estimates on page 69 (71) that the FDIC’s loan guarantee program amounted to a $13.4 billion to $28.9 billion subsidy to the banks.  The impact of this subsidy is that banks such as Goldman Sachs (GS) and Morgan Stanley (MS), which may have received subsidies of $2.3 billion and $3.7 billion under that program, will be encouraged to be over-reliant on the short-term, repo financing that brought down Lehman Brothers and Bear Sterns.  If short-term creditors get nervous, the FDIC or the Federal Reserve through the discount window loans will step in and bail them out.

For all its problems, the U.S. Treasury has been much more transparent in its efforts to shore up the financial system.  It publishes term sheets and contracts in a timely manner.  Not so with the FDIC.  The FDIC is flaunting the Freedom of Information Act (FOIA) by not disclosing basic details of the loan guarantees and lines of credit that have granted a group of hedge fund and private equity investors that bought the failed assets of Corus Bank.  My research shows that these loan guarantees inflate asset prices, yet the cheap loans may not hurt taxpayers and the deposit insurance fund if the toxic asset sales are from failed banks.  Perhaps more questions need to be asked of the FDIC.  So far it has been clever in avoiding the bailout tag, but it has been and still is an active participant in the bank bailouts.

Disclosure:  I only have long positions in broad-based index funds.  This is not investment advice.

According to the Los Angeles Times, San Francisco's United Commercial Bank (UCBH) became the first bailed out bank to enter the Federal Deposit Insurance (FDIC)'s receivership.  After being seized by regulators on Friday, November 6, 2009, its deposits were assumed by East West Bancorp (EWBC).  Unfortunately, for taxpayers who bought $299 million of preferred stock and warrants in November 2008, common stockholders and preferred stockholders were wiped out in the transaction. 

United Commercial Bank had convertible preferred stock that yielded about 9 percent when the US Treasury agreed in late October 2008 to buy preferred stock that paid a below market 5 percent dividend.  (Convertible preferred stock has lower yields than non-convertible preferred stock because of the valuable conversion option attached.)  This investment, when made, seems to be typically bad as opposed to the CIT Group, $2.33 billion TARP investment, which was outrageously bad.  CIT Group entered Chapter 11 bankruptcy last week.  This puts gross losses from the bank bailouts at over $2.6 billion and climbing.

As losses from the TARP investments mount, any returns taxpayers get from banks repaying TARP seem well deserved. 

Disclosure:  I only have long positions in broad-based index funds.  This is not investment advice.

The WSJ reports that the FDIC is planning to put a cap on the rates under capitalized banks are offering on deposits.  This is a good idea.  The only puzzle is, “Why have regulators not been doing this already?”

The FDIC proposes to limit zombie banks to offering no more than 0.75 percent over the national average for deposits.  Banks on their last legs routinely use the FDIC guarantee and high interest rates to siphon CDs and deposits from healthy banks.  Depositors don’t care because they won’t lose any money as long as the deposits are FDIC guaranteed.  Then the zombie bank turn around and loan out those deposits on the most speculative ventures they can find.  When the 100th strip mall in Boca Raton, Florida can’t find tenants, those loans go bad and the FDIC picks up the tab.

The twice bailed out GMAC LLC the parent of Ally Bank won’t get to pay 76 basis points above the national average come January 1, 2010.  Nevertheless, why should they be allowed to offer deposit rates above the national average at all.  Another finance company, CIT Group, which is in Chapter 11 bankruptcy, was limited by regulators from taking in new deposits through its banking arm.  The federal government has too much discretion to decide which banks live and which banks die.  I’m afraid that healthy banks and taxpayers will have to ultimately pay for the lax regulation of GMAC. 

Disclosure:  I own broad-based index funds.

Dick Bove, the banking analyst from Rochdale Securities, gave Bank of American (BAC) shareholders a scare when he wrote in a research note that the government would require BAC to raise $45 billion more in common equity capital prior to allowing it to pay back the monies it received from the Troubled Asset Relief Program (TARP).  On the next trading day, BofA’s shares dropped by five percent.  Mr. Bove’s note should be heeded as much as the advice that the government will never let Lehman Brothers fail.  Bank of America is on the verge of exiting TARP, but only managerial ineptitude could blow the deal.  The case is good to let Bank of America exit TARP.  Ken Lewis needs to structure the exit in a way that both taxpayers and BAC shareholders will win.  I have in the past said that both JP Morgan Chase’s and Goldman Sach’s exit of TARP would benefit taxpayers.  If all of TARP is paid back, BofA’s exit would also benefit taxpayers

If BofA pays back all of the $45 billion of TARP funds, taxpayers win and BAC shareholders win.  If they only pay back part, the last $20 billion, both taxpayers and BAC shareholders are the losers.  Taxpayers lose because they are stuck with the measly 5 percent dividend shares that are worth less than par.  BofA shareholders lose because they are still in TARP limbo with stock in a bank, shedding key employees and customers.  BAC can do right by taxpayers and its shareholders by paying it all back and eschewing taxpayer subsidies.  No better signal can be sent than paying back the $45 billion all at once.  An academic study coming out of North Carolina argues that banks that have repaid TARP have seen their stock prices rally.

The stress tests used the Tier 1 Common equity ratio as its metric of a bank’s health.  This is consistent with my solo and joint research that argues that common equity capital is the most important capital for banks to make good lending decisions.  If you look at BofA’s Tier 1 common equity ratios as of the end of last quarter, they look remarkably similar to those BofA’s rival JP Morgan Chase’s when it exited TARP in the second quarter.  Using these ratios reported in TheStreet.com, it seems that BofA only needs to raise between $0 to $7 billion to exit TARP.   BofA has over $2 trillion in assets.  The folks down in Charlotte, North Carolina are being silly by squabbling about a trivial common equity offering to exit TARP.  If BofA’s managers are smart, they will satisfy regulators and mimic their more successful rival JP Morgan Chase in order to leave the government’s embrace.

CIT Group (CIT) filed for Chapter 11 bankruptcy on Sunday, November 1, 2009.  With that filing, taxpayers absorbed their first loss of bank bailouts.  Taxpayers will likely lose their $2.33 billion investment in CIT Group less than one year after it was made.  The Chapter 11 bankruptcy filing and the success of the prepackaged bankruptcy exchange offer reported on in the New York Times means that taxpayers, other preferred shareholders, and common stockholders get wiped out according to page 6 of the exchange offer filing.  

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The President and the Assistant Secretary of the U.S. Treasury who heads the Troubled Asset Relief Program (TARP), Herb Allison, disclosed details of their “small business lending” initiative  last week.  It is nothing of the sort.  It should be called the small bank subsidy initiative.  It amounts to a $6.25 billion to $31.25 billion government subsidy to banks, which will lead to a less efficient banking sector for years to come.  Contrary to its name, it will not extend credit to small businesses.

 The so called “small business lending” initiative is a bad way to increase lending to small businesses, regardless of whether the decrease in lending is due to a decrease in the demand for loans from small businesses or capital problems in small banks.  When businesses are afraid, they cut back borrowing.  At my university, I conduct a survey of Chief Financial Officers (CFOs) in our region. The results are that they have found their cost of borrowing has been dropping though out 2009, and they have no trouble borrowing.  The problem is that they are very pessimistic about the future.  I suspect that these results can be found on a national scale.  Thus, the decrease in loan volume is due in part to small businesses demand for credit.  It is not due to an increase in the supply of credit to banks. 

This “lending” initiative proposed to inject capital, preferred stock that pays dividends of three percent with no warrants attached, into small community banks that submit plans to lend to small businesses.  Banks already lend to small businesses, so the process of submitting plans is just a paper shuffle that does not increase lending.  What this program is likely to do is discourage regulators from resolving small zombie banks because they will not want to realize losses on the U.S. Treasury’s investments. Small zombie banks with access to cheap government capital will extend bad loans at below market rates and hurt the profitability of healthy community banks.  Government capital will get in the way of healthy competition.  It will prevent strong community banks from taking over the deposits and lending of weak community banks.

In testimony before the Congressional Oversight Panel on October 22, 2009, Herb Allison said that the “lending” initiative pass out between $10 and $50 billion to small banks.  Healthy small banks probably have costs of preferred stock greater than or equal to Old National Bank’s (ONB)’s preferred shares, ticker ONB-PB, of 8 percent.  Three percent is less than the interest rate on thirty year Treasury bonds!  Yet, the U.S. Treasury has never missed a payment on the debt it has issued.  In contrast, thirty-three banks, which were deemed “healthy” by their regulators, skipped their preferred stock payments to taxpayers in August 2009.  Regulators thought that CIT was healthy.  Yet, it was clear at the time at which the U.S. Treasury made its investment that the finance company was anything but healthy.  

If you pay a perpetual dividend of 3 percent on preferred stock with a cost of capital of 8 percent, that amounts to a subsidy rate of (1 – .03/.08)*100 percent = 62.5 percent!  That means taxpayers lose 62.5 cents for every dollar handed out to healthy small banks.  (The subsidy rate will be higher for less healthy community banks.)  Thus, if the program hands out $10 billion, taxpayers lose $6.25 billion.  If it hands out $50 billion, then taxpayers lose $31.25 billion.  Compare this to the Capital Purchase Program for healthy banks that the Treasury, thankfully, wants to end.  The preferred stock that was extended in that program paid a 5 percent dividend for five years and 9 percent thereafter with warrants that are worth about 3 percent of the par of preferred stock when issued.  By my calculations, that leads to about a nine percent subsidy rate, assuming the bank repays the taxpayer’s preferred stock in five years.  A 9 percent subsidy is a lot better than a 62.5 percent subsidy.  The bank bailouts are moving from bad to awful.

Disclosure:  I only have long positions in broad-based index funds.