Bank Failures in Slow Motion, Part II

[Speech given at The Economic Recovery: Washington’s Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010 (Cont’d from yesterday). Click here to view Part I, “Bank Failures in Slow Motion”.]

“‘Deposit insurance’ is simply a fraudulent racket.”  – Murray Rothbard

Sheila Bair, the Chairman of the US Federal Deposit Insurance Corporation (FDIC), has said many times that the peak in bank failures would not occur until the latter part of this year. What’s the holdup? Why aren’t more banks being closed more quickly?

1. Maybe there’s nobody left at the FDIC who knows how to make a deal.

After all, the FDIC’s main dealmaker, Joe Jiampietro, left suddenly in August. Jiampietro came to work at the deposit insurer after working at JP Morgan Chase and UBS. He and his partner Jim Wigand sold more than $508 billion in assets including WaMu and Corus. The New York Times reported that Wigand and Jiampietro did good work for the government, “by acting like bankers, not bureaucrats.”

Wigand worked at the FDIC for a couple decades. The fresh blood was Jiampietro. He was the eyes and ears in the markets and advised on the biggest and most complex deals, meeting with bank execs, hedge-fund managers and other big investors to get their feedback on deal terms and other agency policies.

These two started hatching deals with companies like Rialto (a division of homebuilder Lennar). Rialto bought a 40 percent share of $1.2 billion in loans from failed banks for 40 cents on the dollar, with the FDIC carrying a loan for $1 billion at zero interest for seven years.

They also came up with the FDIC’s Securitization Pilot Program. Barron’s reported that the FDIC has $37 billion of bad bank assets to sell, but that the loans would only fetch 10 to 50 cents on the dollar. But US-guaranteed FDIC senior certificates enable “the FDIC to push much of the losses off its books, thanks to the US guarantee of principal and interest.” The notes are backed by loans (remember the ones worth 10 to 50 cents on the dollar) but ultimately the losses could be absorbed by Uncle Sam.

Ex-Federal Savings and Loan Insurance Corporation regulator William Black says the FDIC is selling the equivalent of Treasury bonds without Congressional approval while the deposit insurer should instead be selling off its bad assets. “[This program] hides the economic substance of what’s really happening – an unlimited taxpayer bailout,” Black contends. The FDIC disagrees.

2. Maybe it’s politics.

Bill Bartmann, publisher of the Bartmann Bank Monitor Report, says the FDIC isn’t closing banks faster because of politics.

“The FDIC is waiting until November to drop the other shoe,” Bartmann claims. He says 500 banks will be closed in 2011 after the mid-term elections have been completed.

Are bank failures political? Shorebank in Chicago was kept alive for months: “Senior Obama adviser Valerie Jarrett served on a Chicago civic organization with a director of the bank, and President Obama himself has singled out the bank for praise in lending to low-income communities.” But the politically connected bank was finally seized on August 20th, when the FDIC finally found a single buyer for the failed bank – Urban Partnership, which includes “American Express Co., Bank of America Corp., Citigroup, Ford Foundation, GE Capital’s equity investments arm, JPMorgan Chase & Co., Key Community Development Corp., Morgan Stanley, Northern Trust Corp., PNC Investment Corp., Goldman Sachs Group Inc., and Wells Fargo & Co. Former First Chicago executives who joined ShoreBank in recent months will run the bank.”

3. Maybe the number of bidders for bad banks has dried up.

The juicy deals Jiampietro and Wigand were making last year are over, The Wall Street Journal reports. According to Keefe Bruyette & Woods (KBW), acquiring banks were booking 4.5 percent capital gains on deals done in 2009. That is now down to 2.5 percent.

Investors are halting efforts to bid on the failed banks, saying the economics no longer make sense. A group led by former FDIC Chairman William Isaac recently ended a push to raise $1 billion for bidding on failed banks in the US Southeast, in part because of lower returns on potential deals. Likewise, a group of former Wachovia Corp. executives hoping to launch Charlotte, N.C.-based Union National Bank, recently pulled its federal charter application because bank-failure bargains are becoming tougher to find.

“In the current environment our view is that FDIC-assisted transactions are not really attractive entry points,” the Union National spokesman added.

Meanwhile, many of the early investors who were able to grab bargain deals in the beginning of the crisis say they are done for now. Sunwest Bank in Tustin, Calif., for example, snapped up assets from three failed institutions with discounts as high as 44%. The deals doubled the bank’s assets to $658 million and increased its head count from 68 to 140. Chief Executive, Glenn Gray, said he doesn’t expect to be a bidder again anytime soon, acknowledging how the pricing has changed.

4. Or maybe the FDIC just doesn’t have the money to close banks.

The FDIC Deposit Insurance Fund has already spent over $19 billion this year, which is well above the $15.33 billion prepaid assessments that it collected from banks for all of 2010.

The situation is probably worse than the FDIC is letting on, according to ex-regulator William Black, author of The Best Way to Rob a Bank Is to Own One. “The FDIC is sitting there knowing that it has both the residential disaster and the commercial real estate disaster [and] knowing it doesn’t have remotely enough funds to pay for it.”

Black is not surprised there aren’t more failures, but he says that we should be upset there are not more bank failures. The industry has used its political muscle to get Congress to extort the financial accounting standards board to gimmick the accounting rules so that banks do not have to recognize their losses.

Recent FASB rule changes allow banks to value assets at inflated bubble values that have nothing to do with their real value. As a result, reported bank capital is greatly inflated. According to Black, even insolvent banks are reporting lots of capital. Furthermore, he contends that the FDIC is “intentionally keeping foreclosures down because it knows it does not have enough money to pay off depositors who are insured by the FDIC.”

Maybe that’s why suddenly the expected losses on some of the bank closures in the third quarter were considerably below historical norms. The FDIC estimated the expected losses as a percentage of assets for three banks that were seized on August 20th – Sonoma Valley bank, Los Padres Bank and Butte Community Bank – to be 3 percent, 1 percent and 3.5 percent respectively – a fraction of the average expected percentage loss for 2009 closures, which was 22 percent, and for 2010 closures, which was 23 percent.

Black believes that delaying the seizure and liquidation of insolvent banks will make ultimate losses grow. It’s a “Japanese-type strategy of hiding the losses,” which will result in a lost decade or two.

The FDIC is required to maintain a Deposit Insurance Fund (DIF) of 1.25 percent of insured deposits. As of June 30 of this year, the DIF held negative $15.2 billion, standing behind $5.4 trillion in insured deposits. That’s negative 0.28 percent. In its second-quarter banking profile, the FDIC noted the 10 basis-point improvement in the DIF from the first quarter, when the DIF was at negative 0.38 percent.

However ValuEngine’s Richard Suttmeier calculates that the DIF is currently $33.66 billion in the hole or negative 0.62 percent

But don’t be afraid, Chris Dodd and Barney Frank have taken care of everything. The Dodd-Frank Wall Street Reform and Consumer Protection Act not only made the increase in deposit insurance of $250,000 permanent, but it requires the FDIC “to take steps necessary to attain a 1.35 percent reserve ratio by September 30, 2020.”

So, in a decade, the FDIC will have $1.35 standing behind every $100 you have in the bank – promise – you have Chris’ and Barney’s word on it.


Doug French
for The Daily Reckoning

The Daily Reckoning