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.