(Institutional Risk Analytics) First we want to start with an apology to our friends at Bloomberg News, the AP and anybody else with whom we have discussed the sufficiency of the FDIC's resources over the past several months. We were not clear enough in our description of the cost of resolving the 110 banks we expect to fail between June 30 of this year and July 1, 2009 and how this cost relates to the cash resources available to the FDIC. In fact, the cost of resolving insolvent banks, the visible amount in the Deposit Insurance Fund, and the actual monies available to the FDIC, are not connected at all.
As luck would have it, the takeover of Washington Mutual by JPMorgan Chase (NYSE:JPM) after the close yesterday, an action that will result in no loss to the FDIC or depositors, provides a road map for a workable assistance plan from Washington. Let's first walk through an inventory of the vast financial resources available to the FDIC as it ramps up to handle what is going to be an increasing number of bank resolutions and sales over the next few months, resolutions that will result in losses. Then we'll comment on the impending death of the Paulson plan and provide our view of a workable alternative financed largely by the banking industry and private investors.
Why the FDIC Will Not Run Out of Money
The first line of defense for the insured depositors of US banks is regulatory takeovers and sales such as the WaMu transaction, where the acquirer assumes all deposits and buys all of the assets after a resolution by the FDIC. The FDIC takes no loss and private investors bear whatever risk remains in the assets of the failed bank. The equity and bond holders of WaMu naturally remained with the failed, publicly listed holding company and will be wiped out in bankruptcy. See our previous comment in The IRA about the difference between a bank and a bank holding company from a public company creditor/shareholder perspective ("What is to be Done?: Interview with Bert Ely").
The next line of defense for depositors in US banks is the income of the banking industry. The FDIC has open-ended authority to tax the US banking industry through deposit premiums. While the visible income of the industry is shrinking rapidly due to the diversion of funds into loan loss provisions, in the first half of 2008, provisions ($81 billion) plus net operating income totaled over $100 billion.
Moreover, behind the income of the banking industry is $1.3 trillion in tangible equity capital, a base of support that alone should be sufficient to absorb any losses the industry may generate. While the FDIC may not be able to tax the industry in real time to absorb all of these losses as and when they occur, the fact is that this capital base is the first line of defense for all depositors of all US banks - insured or otherwise.
As the FDIC noted in an open letter to Bloomberg News posted yesterday: "The fund's current balance is $45 billion - but that figure is not static. The fund will continue to incur the cost of protecting insured depositors as more banks may fail, but we continually bring in more premium income. We will propose raising bank premiums in the coming weeks to ensure that the fund remains strong. And, at the same time, we will propose higher premiums on higher risk activity to create economic incentives for poorly managed banks to change their risk profiles. The fund is 100 percent industry-backed. Our ability to raise premiums essentially means that the capital of the entire banking industry - that's $1.3 trillion - is available for support."
A final note on the FDIC's "visible" reserves, the fiscal relationship with the Treasury, and what it means in terms of the safety and soundness of bank deposits from our statement to the media yesterday:
"The FDIC does not and will not run out of money. Like all federal trust funds, the FDIC's insurance 'trust fund' does not exist. The reserves shown in the fund simply evidence the amount of money contributed by the banking industry into the fund. Like all federal trust funds, the cash raised by FDIC insurance premiums goes into the Treasury's general fund. When the agency needs cash, then the Treasury makes the money available. When the positive balance shown in the FDIC insurance fund is depleted, the FDIC simply runs a negative balance with the Treasury, a loan that the banking industry will repay over time. Indeed, the FDIC is preparing to raise the industry's insurance premiums to generate even more cash to deal with the rising levels of bank failures. Also, in the remote chance that the FDIC ever reached the statutory borrowing limit from Treasury, the Congress will simply raise the limit."
Nuff said. And yes David Evans, we still love you.