Turning the FDIC into AIG

It looks like Sheila Bair is trying to turn the FDIC into AIG, minus the bonus scandal. The government's latest plan to aid ailing banks, the Public-Private Investment Program, relies heavily on the FDIC to ensure adequate capital is available. Specifically, the FDIC will insure debt backing 85% of the loans made through the PPIP. While the FDIC plans to charge for this insurance, no shortage of evidence exists that the government systematically under-charges for insurance.

This under-charged amount is a subsidy, as it allows the insured parties to be shielded from risks they would otherwise have to pay for. If a private investor with FDIC guarantees never has to use the guarantee, the insurance looks great. This is not unlike a car insurer that would look very profitable if no cars ever got in an accident. But, if the FDIC guarantee is used, the government will take tremendous losses. In this way, the FDIC guarantee is a gamble... no one knows whether it will be used or not. AIG made this exact same gamble (the FDIC program is exactly a credit default swap on the assets in the program), and lost big. And now the entity that insures our deposits is making that same bet, with an uncertain outcome.

What is certain is that this guarantee contains a subsidy, by precisely the amount that the insurance is underpriced. This subsidy will be split between the banks and investors participating in the program. By delivering this subsidy in a relatively obscured manner (this subsidy doesn't require writing an actual check to banks), the Treasury has managed to skirt Congress's need to approve funding for the program. Clever, unless the FDIC loses on its gamble. Then, the FDIC will have to cover potentially enourmous losses from the PPIP, surely enough to swamp the already struggling fund. No one expects the FDIC to go bankrupt, as such a failure would wreck havoc on the financial markets and cause mass panic. Instead, the taxpayers would have to bail out the FDIC, just as we have bailed out AIG.

Ms. Bair has already commented that she does not expect there to be any losses from the program. As the NY Times points out, that sounds shockingly like another executive's declaration:

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

The executive who uttered this line? None other than AIG's Joseph J. Cassano.