FDIC Receivership Banks

There is much in the allegory of Moby Dick that smacks of our efforts to kill the great banking crisis. Those of you familiar with my Geneva bank, Banque Rupp et cie, (see blogs passim) may not know of its US subsidiary, Bank Pequod, motto: "blubber is blubber you know; tho' you might get oil out of it?"
My strategic problem is currently to decide whether my bank should become, to use old fishing terms, a whale or a whaler, to double my bets by buying other banks hopefully dirt-cheap, or sell my own bank on, either way through the FDIC FBA policy-scheme. On July 9, the FDIC sought comments on “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” The policy statement suggests tough terms whereby the federal agency can sell failed banks to non-traditional buyers i.e. private equity firms. 61 comments were filed during the 30-day comment period – most from private-equity firms, their lawyers, financial-services trade associations and lobbyists, plus comments from academics, 4 U.S. senators and 6 individuals. The FDIC also received 3,190 form-letter comments in support mostly saying “yeah, sell the bastards! Good riddance!” It may no longer be fashionable to own a bank, but could be fashionable to buy one and then close it to new business, strip out its blubber, the assets, to get oil, from foreclosures, take maximum income and charge 80% of any remaining losses at the end to the FDIC?
Selling off busted, near-busted, banks, or banks than look like they could go bust sometime, to vulture fund investors strikes a dissonant chord about private equity players (hedge funds, or private corporate banks like Pequod etc.) among voting taxpayers, and of course to other banks who wonder why anyone is foolhardy to want to own a discredited bank? It may inadvertently lead to another storm of political discontent and even trigger more possible bank failures some way down the river, wrecked out to sea or on a landbank? So far this year, 81 US banks have failed, costing FDIC an estimated $21.5bn. And the situation may worsen - currently 416 distressed banks - highest level in 15 years (at end-June ’09, up from 305 at the end of March), maybe 800 by next year? The FDIC had that many on its “problem list” last in June 1994, when there were 434. Assets at troubled institutions total $300bn –worst level since end of '93.
FDIC’s insurance fund (at March 31), was down to $13.5bn. Bank failures in Q2 ‘09 cost FDIC’s insurance fund $9.1bn - offset by an emergency special assessment (raisings) of $6.2bn + $2.6bn raised in the regular quarterly assessment on FDIC-insured banks. Colonial Bank cost $2.8bn and Guaranty Bank, $3bn. FDIC Chairman Sheila C. Bair is seeking from the U.S. Treasury a $500bn line of credit (by the way, equivalent to the assets of the IMF, the BIS, and ECB).
FDIC’s special assessment in Q4 ’09 and another in Q1 ‘10 may tip more banks onto the butcher's block of the credit crunch. FDIC not only covers insured deposits; if costs of a troubled bank is judged to be getting too high by the FDIC it can seek to ‘combine’ the bank with another, or sell its carcass outright, and if not that it can manage the “unwinding” of a bank’s stockpile of smelly blubber. With 100s of banks potentially in receivership trouble and few willing to acquire the hard to value assets, private equity firms have offered to buy failed banks in the asset-stripping belief these banks can be restructured, perhaps into larger groupings, and profitably turned around or sold on, though not necessarily continued to operate as banks, or not until all current assets have been sold and debt recoveries completed. In fact the whole deal may appear to be more like paying receivers to take over and make for themselves whatever they can. Let’s not forget that mortgage assets have commercial, residential and land assets as collateral that should cover at least half of the outstanding loans. An owner can cherrypick. banks can deem loan contracts any time. Many accounts may have foreclosable collateral larger than the outstanding loan. Hence, a 60% asset discount should translate into a profit over time, which may be substantial once property and business values begin to regain lost ground. The FDIC issued a new version of its plan after comments were received, this time with weaker terms & conditions. These raise questions about federal government’s respect for existing covenants and regulations if set against its perception of the broader political-economy interest, including that of the FDIC balance sheet. In one instance, instead of the initially proposed requirement that new investors maintain a 15% Tier 1 common equity capital ratio to risk-weighted assets, the new ‘hurdle rate’ is only 10% . Private equity firms are excused the requirement of other bank holding companies and will not be called upon as a “source of strength,” should their investment in a bank they have bought need shoring up. This is a cause of concern. Bank holding companies have to make their reserves available if operations need support, but private equity firms don’t want to expose their investors’ capital by dedicating reserves to any one investment. For example, Cerberus Capital refused to put any more money into Chrysler – leaving it to government to bail out. FDIC made other compromises to attract private equity such as excusing them from having to cross-guarantee their portfolio-bank investments – unless they own at least 80% of two or more banks. Private equity did not get all it wanted. The final policy prohibits “insider” and “affiliated” loan transactions and strips firms of using a controversial “silo” structure to obfuscate ownership and control. Private-equity got FDIC to agree to share losses whereby the FDIC bears the larger share.
Acquiring banks also have such loss-sharing agreements with the FDIC, but at least they are regulated entities while private equity firms are not. Nor will private equity firms become regulated in order to buy banks, though this may change if Hedge Funds etc. come under SEC oversight. Private equity firms can buy failed or failing banks by banding together and dividing the equity commitment and investment liability. If there is no recourse against other private equity firm assets or even any cross-guarantees against other acquired banks, unless 80% owned, the consortia cannot be called upon or relied upon to be a “source of strength” for their depository, taxpayer-backed portfolio banks. Regardless of any rules on self-dealing, private equity firms will most probably find legal ways to lend from their newly acquired banks to leverage their other investment portfolio and extract fees. If they don’t lend to their own portfolio companies, they will surely lend to other private equity firms’ portfolio companies in a modified version of the “club deals” that bind them together. These firms have a mutual interest in generating deal fees, cutting up the assets, re-packaging ans selling on. The problem with banks is if over-leveraged they cannot borrow to fund their funding gaps because they cannot set aside sufficient “reserves,” and must rely on “off-balance-sheet” vehicles to sell assets, or if they cannot grow assets, then to acquire leveraged pools of assets, becoming leveraged inside and out. But now the originators of the leveraged-buyout business model want to apply another round of leverage to already crippled banks in order to squeeze out all possible profits. The FDIC needs therefore to be aware of the risk that ‘saved banks’ sold to high return financial engineers may become problem banks again in the future, much as Lehman Brothers did on a large scale having been saved several times in it history. In a comment letter to the FDIC, the Private Equity Council, without recognizing the irony of its comment, suggested that higher capital ratios for private equity buyers of failed banks would increase the risk at those banks because their owners would essentially have to employ more leverage to generate sufficient returns to meet the higher capital standards – while still generating returns high enough to satisfy the investors in their private-equity funds. This is a self-made argument by hedge funds/private equity funds for why they are inappropriate buyers of banks. They clearly do not understand that capital reserves must be ‘own funds’ clear of obligations, not loans to them by investors.
Private equity should be allowed to buy banks, but should also be held to a higher standard, and no less high than for fully-regulated banks. They have a proven record of success at leveraging companies when they have access to cheap funding, and they also have a record of spectacular failures. The last thing US banks need is management that leverage them to generate rates of return at double or triple the average for traditional banking. FDIC is probably aware of this, of the need to avoid resorting to solutions to problems that will repeat past behaviour. The original herbert Melville's Pequod's quest to hunt down Moby Dick itself is allegorical. To Ahab, making a big killing, the white whale, became the ultimate and only goal in his life, and if expanded allegorically, everyone's goals. His vengeance against the whale is analogous to man's struggle against fate, or the public's against the banks. The only escape from psychosis is seen through the Pequod's encounters with other ships, whose captains warn against the folly of risking all for the sake of getting the big win. Melville implies people in general need something to reach for in life, a goal that can destroy one if allowed to overtake all other concerns, and that seems a neat version of bankers, their bonuses and hedge funds and their 50% returns - "Nothing exists in itself. If you flatter yourself that you are all over comfortable, and have been so a long time, then you cannot be said to be comfortable any more."

FDIC LLP to LLC

Should governments feel free to sell banks and their assets to non-banks or to other banks simply to cut short the period of state assistance?
As we all know, Governments around the world have in various ways provided funding support for banks in trouble, which means for banks with under-performing or non-performing loans on such a scale that if written down fully and subtracted from banks’ reserves would endanger or severely question the current (or near future) solvency of the banks. That is at least the perception. It would be more accurate to say that the above applies most especially to medium and small-sized banks while for bigger banks a major additional problem threatening their solvency and thereby the economy generally has been inability to renew medium and long term loans to cover the ‘funding gap’ they have between loans and deposits.
What is much less well understood is that funding to secure the solvency of banks has not been directly at tax-payers’ expense, but mostly off-budget by swapping treasury bills for collateral consisting of larger amounts (by market value) of banks’ loans (variously securitized as bonds), i.e. heavily discounted (so-called ‘hair-cut’) with default risk covered by guarantees and insurance plus a substantial fee that may be repeated every time the swap is ‘rolled-over’.
The classic example has to be the US Federal Deposit Insurance Corporation, created by Congress in 1933 to restore public confidence in the nation's banking system. The FDIC insures deposits at the nation's 8,305 banks and savings associations and promotes ‘safety and soundness’ of these institutions by identifying, monitoring and addressing risks to which they are exposed. The FDIC receives no federal tax dollars – insured institutions fund its operations i.e. it is like an exchange for ensuring bank solvency with funding and insurance guarantees paid for by the members, the banks & savings associations.
Not all of the thousands of small banks need help, only about 8%. Some take pride in that, while at the same time using their FDIC membership as their solvency guarantee e.g. White Hall Bank, Illinois, which on its web-site states soberly "TEMPORARY LIQUIDITY PROGRAM - White Hall Bank has chosen NOT to participate in the FDIC's Transaction Account Guarantee Program. Our customers with non-interest bearing accounts will continue to be insured through December 31, 2009 for up to $250,000.00 under the FDIC's general deposit insurance rules. On May 20, 2009, FDIC deposit insurance temporarily increased from $100,000.00 TO $250,000.00 per depositor through December 31, 2013." Politically, however, for whatever blend of ideological reasons, including sometimes laws such as in the European Union, governments are anxious that their support measures should be paid off as soon as practical, and this stance can mean selling off the aid-supported banks and/or their impaired loan-books. ‘Impaired’ means portfolios of loans where the market value of the loans has fallen below ‘book value’ (to understand the accounting parlance I suggest you look it up).
Steps to increase transparency have reduced some of the uncertainty in the markets. FDIC specified simple indicators for short-term stress tests undertaken by major banks (19 of the largest). This framed the basis for ordering 10 major banks to raise a total of $75bn capital to protect against worst-case unexpected losses - a result better than many feared, leading to financial stocks trading at higher levels over the summer. Risks to the economy and financial sector remain as a pipeline of knock-on defaults feed through, and as the housing market has yet to reach bottom in terms of actual price falls appearing on for sale offers, and as additional unwinding of complex financial instruments progress, hopefully in an orderly manner without confidence-shaking shocks. Property values underpin almost everything directly or indirectly. Commercial real estate fundamentals, and therefore also banking lending growth, typically lag the economy 6-9 months. As a result, deep job losses in recent months are forecast to translate into rising commercial property vacancy through year end after recession may have formally ended, with rollbacks in rents and slow residential property recovery likely to continue through 2010. Commercial real estate fundamentals and the investment climate ultimately will benefit from improving capital flows and the economic recovery, especially since in the US that sector was generally not overbuilt heading into the downturn. On March 29, FDIC issued proposal for comments on the Legacy Loans Program (LLP). The FDIC and the Department of the Treasury announced the LLP (like the bank of England’s APS or Germany and Ireland’s ‘bad bank’ schemes), which will remove troubled loans and other assets from FDIC-insured institutions, but with the additional idea of attracting private capital with soft-loan terms to purchase the banks’ loans. At the time some banks let it be known they would like to be able to buy their own impaired loans back on the same terms as offered to non-banks, but of course that was a dimension too far politically.
The FDIC asked for comments from interested parties on the critical aspects of the proposed LLP to boost (some would say subsidise) private demand for distressed assets that are currently held by banks and thereby facilitate market-priced sales of troubled assets (even if no-one suggests the prices discovered are true market prices except in a very convoluted sense). It semmed necessary, however, really because FDIC funds were close to becoming exhausted, and because uncertainty otherwise about the value of these assets makes it difficult for banks to secure funding to support lending to households and businesses. At bottom, the fundamental aim is to avoid bank runs. The LLP combines an FDIC guarantee of debt financing with equity from the private sector and from the US Treasury. These private-public partnerships will purchase assets from banks and place them into what will be known as Public-Private Investment Funds (PPIF). Institutions of all sizes will be eligible to participate in the LLP to sell assets. It is expected that a range of investors will participate. The program will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies and other long-term investors. Investors will be pre-qualified by the FDIC to participate in auctions. For providing a guarantee, FDIC is paid a fee, a portion of which gets allocated to FDIC’s Deposit Insurance Fund. The FDIC is protected against losses by PP equity in the pool, the newly established value of the pool's assets plus fees collected. FDIC will continue to audit progress and it also structures the debt that a selling bank will get paid for when the legacy loans are sold by the participant banks into the market. Comments were required no later than April 10. Following consideration of various comments, by June the FDIC said it will develop this program by testing the LLP's funding mechanism through a sale of receivership assets i.e. assets of bankrupt banks. The first transaction to be offered, the receivership transfered a portfolio of (serviced) residential mortgage loans to a limited liability company (LLC) in exchange for an ownership interest in the LLC i.e. rather like an SIV. The LLC sold an equity interest to an accredited investor, now responsible for managing the mortgage loans. Loan servicing conforms to either the Home Affordable Modification Program (HAMP) guidelines or FDIC's loan modification program. Accredited investors were offered equity interest in the LLC under two different options: 1. an all cash basis, equity split of 80% (FDIC) and 20% (accredited investor); 2. sale with leverage, whereby equity split is 50% (FDIC) and 50% (accredited investor). The funding mechanism is financing by the receivership to the LLC using an amortizing note guaranteed by the FDIC. Financing is offered with leverage of 4-to-1 or 6-to-1 depending on bid offers by private investors. If the bid is 6-to-1 leverage, then performance of the underlying assets are subject to performance thresholds including delinquency status, loss severities, and principal repayments. If any of the thresholds are triggered over the life of the note, all principal cash flows to equity investors are applied instead to reduction of the note until the balance is zero. Performance thresholds do not apply if the bid is based on the lower leverage option. FDIC is protected against losses on the note guarantee by limits on leverage (in terms of a maximum ratio and $ amount), with mortgage loans collateralizing the guarantee & its fee. This is not especially controversial since it is a means of an orderly sell-off of impaired assets where government via the self-financing FDIC retains a role, but there is no taxpayer exposure unlike the cartoon above of Uncle Sam requesting citizens to invest in financial toxic waste (actually not abad deal if citizens could do so). And this is so far applied to collapsed institutions. What is more problematic is where still-operating institutions are sold off (see next blog).
My own preferred solution would be to restructure and bundle up mortgagees debt so they get some discounts by matching discounted bank assets to discounted house prices and outstanding loan values thereby reducing negative equity risk (at same or lower cost to banks and insurers), but that is not yet anywhere on the table for discussion other than something like that wished by more than a few legislators in Congress.