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    Default FDIC R.I.P - Eric Janszen

    FDIC R.I.P

    With the balance sheet of the Federal Reserve exhausted from lending to insolvent banks and non-bank financial firms, and polluted by hundreds of billions in risky assets taken on from all corners, Treasury Secretary Tim Geithner put a hammer to the last uncompromised taxpayer financed piggy bank* yesterday, the one that guarantees said taxpayer’s bank deposits, the Federal Deposit Insurance Corporation. We will regret it.

    The FDIC, the only remaining credible bank regulatory institution left in the U.S., is about to dilute its balance sheet with high risk debt liabilities and in the process become entangled financially and politically in the financial fiasco.

    The FDIC will extend its Great Depression era mission to thwart bank runs by insuring 100% of bank deposits should the fractional reserve actually available to bank customers, often less than 5%, run out in a panic. As of yesterday the company engaged in a program to try to undo the run on non-bank financial institutions that happened when investors in securities backed by the incomes of the perpetually under- and unemployed, and collateralized with homes built in vast excess of demand and collapsing in price, were doomed to 80% to 99% declines even before the economy crashed. Soon your bank deposits will be insured by a company that insures hedge funds against losses on securities that ought to never exist in the first place.

    To understand the latest toxic debt recovery plan, we start with an analogy written by an author unknown to us. (If the author sees this and recognizes it, please send us a note so we can give you proper credit.)
    Sub-prime mortgage asset-backed securities primer: an apt analogy Heidi is the proprietor of a bar in Detroit. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans.Word gets around about Heidi's drink now pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi's bar and soon she has the largest sale volume for any bar in Detroit

    By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.

    A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi's borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide. Naive investors don't really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation's leading brokerage houses.

    One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. Heidi demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Heidi cannot fulfill her loan obligations and claims bankruptcy. DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans. The suppliers of Heidi's bar, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 50 workers.
    With this as background, the latest toxic debt plan goes like this.

    The bank and brokerage houses claim that they must be bailed out of bad investments in asset-backed securities by the government at taxpayer expense or the economy will continue to collapse, unemployment will rise to 50%, and everyone who isn’t already living in cardboard box will be soon. President Obama himself makes the case on national television that the financial firms must be rescued to get the drinks flowing again, because alcohol is the lifeblood of the American economy.

    Politicians from both political parties, whose primary campaign contributors are the banking and brokerage firms now in peril, engage with heads of government banking and finance departments in dramatic round-the-clock negotiations, which government department heads used work for the very same troubled bank and brokerage houses.

    To no one’s surprise, they arrive at a solution to allow hedge funds, managed by men who used to work for the banks and brokerage houses, to gamble on the future rise in DRINKBOND, ALKIBOND, and PUKEBOND prices on the premise that the alcoholics whose incomes guarantee payment of the debts that are the assets behind the bonds will stop drinking and repay their debts. If they do, the hedge funds make money. If they do not then the government guarantees the loss with taxes levied on employed middle-class non-drinkers. Geithner and Bernanke call this arrangement a “public-private partnership” but taxpayers may see through that and call it a “racket.” And, as I said, now the FDIC is into it.

    The simple and obvious solution is to audit and declare insolvent banks and brokerages insolvent and put them into receivership, wipe out the shareholders, replace management, sell the assets, and put law breakers in the slammer as happened in the U.S. after the S&L crisis in the late 1980s, and in Norway in the early 1990s, and in fact anywhere and everywhere a government is politically independent of the nation’s financial industry. But wait, isn’t that what Geithner is proposing today?

    Ray of Hope or Stake Through the Heart?

    The latest toxic debt plan was yesterday. Today Geithner asked Congress empower “someone” (who?) to take over non-bank financial institutions much as the FDIC is authorized to take over insolvent banks.
    Geithner wants new financial wind-down authority
    March 24, 2009 (Reuters)

    WASHINGTON (Reuters) - U.S. Treasury Secretary Timothy Geithner on Tuesday joined the Federal Reserve in calling for authority to wind down failing non-bank financial firms that threaten the financial system.

    Geithner, in prepared testimony before the U.S. House of Representatives Financial Services Committee, said Congress should approve legislation giving the government the ability to step in to put a major institution under conservatorship and avoid a damaging bankruptcy.

    "As we have seen with AIG, distress at large, interconnected, non-depository financial institutions can pose systemic risks just as distress at banks can," Geithner said. "The administration proposes legislation to give the U.S. government the same basic set of tools for addressing financial distress at non-banks as it has in the bank context."
    On the surface this looks like the old Janszen plan from a year ago: create a Resolution Trust Corporation II, audit the banks and financial institutions, put the insolvent institutions into receivership, wipe out the shareholders, fire management, sell off the assets in an orderly way at market prices to prudent and well run institutions, and if the audits reveal evidence of criminal misconduct then charge and try the perpetrators. Is that what this new Geithner request is about? Of course not.

    I see at least four immediate problems with new expanded powers to take over non-bank financial firms.

    1. What institution is sufficiently independent and trustworthy to be given this new power? Not the FDIC; now it’s part of the bailout, with a vested interest in the outcome. The Treasury? The Fed? Who?
    2. Several non-financial institutions were, like Amex, turned -- abracadabra -- into banks in order to qualify them for bank bailout funds. Why not use the same principle to allow the FDIC to turn non-bank institutions in to banks, audit them, then put them into receivership if needed? Why does "abracadabra, you're a bank" only work to a financial institution's -- and shareholders' -- benefit?
    3. If the FDIC already has the power to take over regional insolvent banks, why not extend its charter to take over larger banks? Will new powers granted to a another institution accomplish with non-bank financial institutions what the FDIC has so far not accomplished with insolvent banks using established powers?
    4. How do we know that politically connected non-bank institutions will not get a pass, just as certain bank institutions apparently have, while those that lack connections are shut down? Even the threat such selectivity will cause otherwise well run financial institutions to change their behavior to reduce the risk of being shut down, such as by further building reserves and reducing lending even more.

    At this point not only should the market decide the fate of these institutions, it will. It will do so by taking down the stock market as the FIRE Economy continues to disintegrate.

    After a brief rally in stocks, the next shoe to drop will be in the corporate debt market. Remember the LBO bubble? While the de-leveraging may be over on a corporate credit market wide basis, the pricing in of business fundamentals – sans the miracle of debt securitization and leverage, and teetering atop a still over-priced mortgage debt market -- has just begun, and the stock market is lagging. An additional 30% to 40% drop from here is coming.

    * Of course, there is no "piggy bank." The FDIC is little more than an account of the Treasury Department, and all of the "money" committed is nothing more than claims on future cash flow of U.S. households and businesses, and -- if we're lucky -- the cash flow of households and businesses in other countries.

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    Last edited by EJ; 03-24-09 at 11:07 PM.

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