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.

A little help for the FDIC

The FDIC is taking a little breather from bailing out failed banks to... wait for it... be bailed out itself. Turns out that this "no cost to the taxpayer" program that was supposed to be funded by deposit insurance premiums was charging too low of a rate, and is now stock dangerously undercapitalized (thanks to a provision that the FDIC's fund should be capped at 1.25% of deposits). So Senator Chris Dodd (D-CT), Chairman of the Senate Banking Committee, introduced a bill at the behest of FDIC Chairwoman Sheila Bair to raise the FDIC's borrowing maximum from $30B to $500B, a better than 10x increase.

This is a prudent move. The FDIC's deposit insurance fund is running dangerously low, with only $35B in the insurance fund as of Q3 2007, dropping to $19B by year end. The result is a paper-thin base of capital to insure deposits: the FDIC's $19B of capital amounts to 0.4% of U.S. deposits (known as the Deposit Insurance Fund Ratio, or DIF ratio). This is a substantial drop from the usual 1.2%+ range. To raise this ratio, the FDIC has two options: borrow from Treasury, or make the banks pay more. Making the good banks pay for the bad banks' mistakes during a credit contraction has drawn howls of protest (including from this space). Eliminating any doubt of the FDIC's solvency is the right move at this moment in the crisis... let's hope Congress speeds through this policy change.

Wall Street isn't the only place that misunderstands incentives...

Amidst the flood of bailout programs, the FDIC's program to expand insurance to unsecured bank debt has received relatively little attention. The FDIC program - the Temporary Liquidity Guarantee Program (TLG)- essentially extends FDIC's Deposit Insurance Program to banks' bonds. Without this insurance, banks could experience "bank runs" caused by bondholders' unwillingness to refinance bonds as they come due. Of the virtues one would want in a government intervention, this program has many. It is highly effective in its objective, it keeps government separated from management decisions, and it minimizes cost to taxpayers. However, the FDIC plan is rife with moral hazard issues that could be minimized using existing FDIC mechanisms.

This program turns FDIC into an AIG-like bond insurer: participating banks pay an insurance premium to have their debt insured against losses. AIG insured $500B in bonds, and required several hundred billion dollars of capital injection. The FDIC plan insures over $1.4 trillion in debt, with no initial capital other than fees collected through the program. These fees are based solely on the how long the debt will be guaranteed for, at a maximum of 1% of insured capital. This implies less than 1% of losses. Losses in excess of that would be funded by special assessments on existing banks (although backed by the full faith and credit of the government).

This mechanism, while eliminating direct costs to taxpayers, is one of two moral hazard problems in the TLG. The first is the special assessment: a responsible bank would now be on the hook for the mistakes of the less prudent banks. If a bank has to pay for the downside of bad loans whether they make them or not, shouldn't they make bad loans so they can at least participate in the upside? Massive TLG assessments on prudent banks incentivize banks to take risky bets so that they can participate in both the upside and downside of bad loans - just the opposite of the behavior the FDIC would like.

Second, the FDIC - for reasons unknown - decided to charge rates on newly secured deposits independent of the riskiness of banks. The normal insurance progam charges different fees based on capital levels and oversight. Banks that take on additional risks to deposits again gain upside without having to pay for it under the current pricing. Instead, fees should increase when banks increase risk, aligning incentives to make good loan decisions.

The FDIC should scale the fees charged by this program using the existing risk-based deposit system, and Congress should alleviate the moral hazard of the TLG by capitalizing the insurance fund directly instead of charging conservative banks for the poor lending of their competitors. While Congress is considering this issue, they can fix the same flat-rate distortion that exists in other government schemes, such as the Pension Benefit Guaranty Corporation.