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The FDIC expansion explained

Tuesday, October 14, 2008, 12:56 PM

Regarding the expansion of the FDIC powers to include guaranteeing the senior debt of banks and their holding companies...in reviewing the details, I think I figured it out.

Here's the text:

The Secretary of the Treasury, in consultation with the President and upon the recommendation of the Boards of the FDIC and the Federal Reserve, has invoked the systemic risk exception of the FDIC Improvement Act of 1991. [Edit: love the name]

This action will provide the FDIC with flexibility to provide a 100 percent guarantee for newly-issued senior unsecured debt and non-interest bearing transaction deposit accounts at FDIC insured institutions subject to the terms outlined below.

Scope of Eligible Entities

Eligible institutions would include: 1) FDIC-insured depository institutions, 2) U.S. bank holding companies, 3) U.S. financial holding companies, and 4) U.S. savings and loan holding companies that engage only in activities that are permissible for financial holding companies to conduct under section 4(k) of the Bank Holding Company Act ("Eligible Entities").

Not all companies are eligible, but "bank holding companies" are eligible.  

Hmmmm...seems that I recently heard something about somebody switching from being an investment bank to a bank holding company recently...who was that?  Oh.  Here it is.

On Sept. 21, in a move that fundamentally changed the shape of Wall Street, Goldman and Morgan Stanley, the last major American investment banks, asked the Federal Reserve to change their status to bank holding companies.

Goldman would now look much like a commercial bank, with significantly tighter regulations and much closer supervision by bank examiners from several government agencies.

Yes, I remember being confused by this move at the time as it made no sense.  At least the explanations did not smell right.  We were told that GS and MS "asked" to be placed under "significantly tighter regulations and much closer supervision by bank examiners from several government agencies."

That would have been a first.

It is now clear to me what happened.  The government guarantee of all senior debt was already in the works some time ago, and GS and MS hopped on that gravy train.  At every turn, GS has been there with a slightly better seat at the table and better inside information than its competitors.  The Treasury Secretary happens to be a former GS CEO. Just an unfortunate coincidence, I'm sure.

As always, in this never-ending looting operation, the rules are bent and modified willy-nilly to support a favored class of institutions and individuals.

We now have an openly two-tiered system.

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33 Comments

radiance's picture
radiance
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Re: The FDIC expansion explained

What are the critical numbers/levels to watch for in the TED spread? What other variable would indicate a thaw of the credit markets?

Thank you for your hard work,

Ron

memorrison's picture
memorrison
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Re: The FDIC expansion explained

I must be loosing it as I thought I posted this comment earlier.... 

Would love peoples thoughts, but one of the untintended consequences I can see is Treasury securities loose - why would someone want to buy a government backed treasury yielding from a dismal .03% yield all the way up to a whopping 4.2% for a 30 year treasury when you can buy a "government" backed senior debt from one of the choosen firms at a minimum of twice the yield!!!  This seems to simple to me that I must be missing something.  If I am correct, we will be at a credit crisis at the Federal level soon when the world realizes this.... maybe Goldman can come the rescue of  Uncle Sam!

cmartenson's picture
cmartenson
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Re: Treasuries compared to senior bank debt

Mark,

I made that point in the prior posting. 

You are exactly right and I cannot think why one would not immediately pile out of treasuries and into the highest yielding senior debt of FDIC-insured institutions out there.

Here's what I wrote:

This is another gross marketplace  distortion of the highest order.  It means that sharp investors will now scramble for the highest yielding junk debt of the most troubled institutions so as to grab all that extra free yield.  Suffice it to say that moral hazard has just been kicked up a notch.  Instead of poorly performing banks being shunned, as they should be, they are now advanced to the front of the pack by virtue of offering a higher "risk free" yield than their more cautious competitors. 

Grab it while you can...the advantages of government subsidies have a habit of not lasting long.

Best,
Chris

NLP's picture
NLP
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Re: The FDIC expansion explained

OK, now just hold on one minute.  Morgan Stanley and Goldman Sachs conveniently ask the Federal Reserve for a change of status from an investment bank to a bank holding company just a mere 23 calendar days ago and now voila they reap a 100% debt guarantee from the FDIC in a just announced move today October 14, 2008?  

This is clearly actionable.  The veil is off and the mystery is OVER.  This corvair is DANGEROUS and unfit for the road. 

 

cmartenson's picture
cmartenson
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Ted spread?

Ron,

nope, no particular levels...the TED spread has historically sat between 0.3% and 0.5%.  Today it is around 4.3% indicating that stress remains int he banking system.

Also keep an eye out for the LIBOR swap spreads.

 

tjerrard's picture
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Re: The FDIC expansion explained

Great what does this all mean?

I suppose banking confidence has been restored.

I suppose that the world governments are now getting deflation under control.

I suppose the amount of money/credit being injected is only enough to control the deflation so inflation will not occur.

My deposits are now protected - the banks did not have a holiday! The stock markets were open! So all is well and recovery is just around the corner.

The rich get richer and I retire on fixed income in 2 years.

I'm happy! Right?

Art Shulenberger's picture
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Re: The FDIC expansion explained

Hi Chris 

 

Why can't this expanded deposit insurance have a deductible and/or cover only a percentage of the full amount at risk?

 

100% protection on existing FDIC insured accounts and 50% coverage of losses above and beyond the 50 or 100k cap.

 

 Insurance always has a deductible and other limitations.  Free, unlimited insurance is a total government give-away (welfare for billionaires).

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Re: The FDIC expansion explained
what action are you proposing? and by whom?
locklimitdown's picture
locklimitdown
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Re: The FDIC expansion explained

Chris

I have been as confused as you since the GS/MS change in status was announced. Why would they have asked for more oversight? Even more troubling IMO, were the new rules they would have to live under as merchant banks. As Investment banks they would have access to many multipuls the leverage on deposit. Making the switch over to merchant banking regulations would significantly reduce their access to liquidity.

Yup..Something stunk about the change and sure enough such was the case.

Thanks for some great detective work. Another piece of the puzzle is in place. 

TruthSpeak's picture
TruthSpeak
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Wow Sherlock!!! Right On.
Great Investigation.
NLP's picture
NLP
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Re: The FDIC expansion explained

I am not an attorney, however I am old enough to remember a funny little consumer advocate that forced a corporation to take ownership for safety issues in the name of the people.  Seems to me the setting is right for another (?) to come along and hold Paulson accountable for the obvious insider information that was given which protected MS and GS. 

 

joe2baba's picture
joe2baba
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Re: The FDIC expansion explained

as i understand it paulson was granted immunity. this is all "legal"

i saw that funny little consumer advocate a few weeks ago and btw he is running for president for the 5th time . and i am voting for him for the  third time. i am voting right after i fight a few windmills.

this is a line from one of my favorite movies " eddie and the cruisers" it is an exchange between the bass player and the lyricist. this line by the bass player sums it all up for me." hey wordman guys like us .........they discover oil under our garden.............all we get is dead tomatoes"

i went to a sustainability conference on friday one of "my senators"  was giving the opening remarks. i walked in and sat right in front and looked around and realized that if i did not get up immediately they would have to pull me off of him so i left.

i found one of his guys out in the lobby and let him know how i felt about the sellout. he was scared out of his wits (if he has any )

he lold me they are frightened in dc, they are building fema farme with razor wire around them. he told me there is a huge amount of ammo being sold. they are keeping a very close eye on the temperature out here. a rep from "my" other senator was there and he disappeared very quickly after i told him how i felt. this is not meant to stir up anyone's emotions these are the facts as i experienced them last friday.

and now i sit here looking out at the rain falling on my dead tomatoes

Xflies's picture
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Actionable ideas- so does this mean small cap Bank holdco's
now have a much lower risk of bankruptcy?  if that's the case, guys like DSL, NCC and a host of other small cap bank holding companies should be flying off this news, but they're not...  A temporary aberration?  I'll go buy some just for the option, they're down nicely today but I'll be definitely putting a stop limit order on these puppies just in case.
SteveS's picture
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LIBOR

I keep hearing that the immediate problem is the interbank overnight rate- that banks won't lend to each other, so, it seems to me,  the governement seems to be trying to push a string - trying different things to get banks to trust each other. So can someone explain why the government doesn't step in and take over the interbank loans directly (with due diligence of course). I realize the fundamental problems lie much deeper and there is probably no good solution, but it just seems attacking this problem head on would at least generate some short term relief and start getting some trust going again.

 

 

Woodman's picture
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Re: Treasuries compared to senior bank debt
[quote=cmartenson]

You are exactly right and I cannot think why one would not immediately pile out of treasuries and into the highest yielding senior debt of FDIC-insured institutions out there.

 

[/quote]

 Will the yield come down on the junk debt now that it will be less risky?

Davos's picture
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Re: The FDIC expansion explained

http://www.financialsense.com/fsu/editorials/vaughn/2008/1014.html

Both video links within are funny - in a very pathetic way.

Everyday I realize that I am less concerned about a depression and more concerned with our democracy, or what is left of it... 

pir8don's picture
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Rational behaviour and survivors

In the seventies I studied a book by Jurgen Habbermas named "legitimation crisis". His theesis was that capitalism would end because government would behave increasingly in ways that contradicted or made no sense to the rationality of the general populace. He expected people to withdraw legitimacy (my spellings awful but u no wot I mean). There are lots of things he didn't forsee but he seems so far to be at least half right.

I keep my posts small so they are easily skipped. Hows the Amish recruitment going Xflies?

I have so far resisted the temptation to quote from my favourite sources (Ayn Rand included) but here's one anyway. Don't know the source - found it on a Keith Jarrett record cover.

"Those that create out of the haulicaust of their inheritance, anything more than a convenient self-made tomb shall be know as survivors" 

Don

Xflies's picture
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Actionable conclusions- so Chris, would you buy some of the
down and out bank holding companies?  Does this recent news, as much as you hate it, pose an opportunity for bank holding companies which are trading like they will go bankrupt?  While the gov't has said that they are prepared to let some institutions go bankrupt, do you think it will be in these smaller bank holding companies like NCC and DSL whose subs are regional banks?  If they let these go down, won't it spark another wave of confidence destruction?
ds's picture
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Re: Treasuries compared to senior bank debt
This clause about insuring corporate debt applies to newly-issued debt (according to the original post). Therefore, we can't "grab it while you can" because it won't exist for a while. And when it is issued, why would the yield be twice the Treasury yield? By the time it is issued, the markets will understand that it has almost the same risk as a Treasury, so the yield will probably be nearly the same as a Treasury. Where's the opportunity? Sometimes I think there is a little too much FUD here. However, I do appreciate the great content and research!
memorrison's picture
memorrison
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Re: The FDIC expansion explained

DS-

You have a good point about "newly-issued" debt.  It would have to be at substantially higher rates than treasuries as the cost of issuing the debt is as follows according to the press release

Participants will be charged a 75-basis point fee to protect their new debt issues, and a 10-basis point surcharge will be added to a participating institution's current insurance assessment in order to fully cover the non-interest bearing deposit transaction accounts.

If the Bank is to make any profit on issuing this debt - it is only logical that the coupon would be higher than current treasuries.  I was to quick in my comment on the % above because I was thinking of current corporate paper.  But the point still is valid, even if it is only 50 basis points higher, which I think is unlikely that it would be that low, given the same risk why not get more return.......

Thanks for pointing that out..

On a side note, I think this quote from King Henry is very telling.... (from the Wall Street Journal)

  A final deal between regulators was hashed out in Mr. Paulson's office Sunday afternoon. For Mr. Paulson, who had spent a career as an investment banker, the decision marked a reversal. Just weeks earlier, he said that injecting capital directly into banks would appear to be a sign of "failure."

srbarbour's picture
srbarbour
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Perpetually expensive debt explained!

[quote] This clause about insuring corporate debt applies to newly-issued debt (according to the original post). Therefore, we can't "grab it while you can" because it won't exist for a while. And when it is issued, why would the yield be twice the Treasury yield? By the time it is issued, the markets will understand that it has almost the same risk as a Treasury, so the yield will probably be nearly the same as a Treasury. Where's the opportunity? Sometimes I think there is a little too much FUD here. However, I do appreciate the great content and research![/quote]

I see you don't fully grasp the magic of double dealing.

Say you have two entities. The first ABC, a 'new' banking enterprise. It has no cash, but since it is a "bank" all of its senior debt is protected. This bank then gets an infusion of cash (say, $5 billion) from DEF bank. This is issued as 'Senior debt', so its 100% protected (by your tax dollars).

Because this 'new' bank ABC is created by former executives from DEF the terms are rather favorable, and the debt has a very high interest rate. In exchange ABC buys up all sorts of Junk bonds on the cheap in the hopes they don't default, but to be frank no one cares because the executives will pay themselves insane salaries either way.

If the junk bonds don't pay out, ABC ceases to exist DEF gets its money back -- and depending on the exact rules the interest added to the principle as well... -- and the process is repeated again. If successful, DEF still gets lots of cash on a really expensive debt. The executives of ABC and DEF make out like bandits, the companies merge, and everyone is happy.

There, you see how there will always be 'expensive debt' now?

As I said earlier, this goes past moral hazard and straight to pure insanity.

--

Steve

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Re: The FDIC expansion explained

I¨m from Argentina, I know very well what a holyday banking is... Here we had the pilot test, so that afterwards it coud be implemented all around the world...

I would like to know what does this graphic of the Federal Reserve means? http://research.stlouisfed.org/fred2/series/BOGNONBR?cid=123

cmartenson's picture
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Re: The FDIC expansion explained

Two things:

a)  The 75 bp surcharge does not apply during the first 30 day grace window

b) Because a bank can roll its senior debt by calling the old and issuing new then the old debt has an embodied "put" option unless the company is too stupid to roll its debt before going under.  During the first 30 days it can do this with no surcharge and after it is with a 75 bp charge.  Given the spreads out there, and the 8 month window,  there is a lot of embodied value in this government subsidy. It will be taken advantage of.

Xflies's picture
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Of course it will be taken advantage of... why do you think they
did it?  Isn't that what they did this for, is to have banks use it?  Guaranteeing interbank debt is what they saw as a solution to getting the capital to flow from the gov't's subsidies/bailout/TARP to the public.  Is it permanent?  No... does it help?  Yes...  Will it cost a lot?  Maybe... Net net, without knowing the 'Maybe' and focusing on what IS... I'd say this is a Net Net positive.  You can whine later, the gov't is too busy trying to save this country... again, if anyone has suggestions, I'm sure they'd like to hear it or perhaps help and try to get Chris on more speaking engagements where maybe he'll be heard but he better be ready to offer solutions, not just criticism.
srbarbour's picture
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Re: Of course it will be taken advantage of... why do you think

[quote]did it? Isn't that what they did this for, is to have banks use it? Guaranteeing interbank debt is what they saw as a solution to getting the capital to flow from the gov't's subsidies/bailout/TARP to the public. [/quote]

Uh no. guaranteeing debt has everything to do with capital flight fears, and is primarily driven by the fact that Europe has done something similar.  It is also an exceptionally crude and poor way to do it.

A bare minimum better solution would be to declare only existing debt protected. That'd at least stabilize the system without introducing massive moral hazard and gaming of the system.

[quote] Is it permanent? [/quote]

No, but 3-years is way too long. That's plenty of time for lawyers to corrupt the system to hell and back. I'd have been very leery about extending this system more than 3-months. Better that all the banks and the market is constantly on their feet. Long enough to restore short term lending, but not long enough to risk massively gaming the system.

[quote] Will it cost a lot? [/quote]

Yes it will. Corruption will be on a massive scale. The taxpayers will be robbed by at least 100+ billion dollars, more likely 500+ billion. This is way to easy to abuse, and that's only at a glance. Massive corporations with years to get a feel for the system, and armies of lawyers to hunt down all the nooks and crannies will soon be robbing us blind.

This is extremely dangerous. 

[quote]Maybe... Net net, without knowing the 'Maybe' and focusing on what IS... I'd say this is a Net Net positive. [/quote]

The net positive is that it massively reduces the risk of lending to another party. This will encourage banks to lend large sums of money, and may even shatter the frozen credit markets.

It also prevents capital flight.

Unfortunately, it'll also tend to stop the healthy deleveraging of the system and encourage some entities to  increase leverage to even more absurd levels than in the past.  Can we do 600:1, Hell yeah!  Provided, of course, they can scare up the funds.

[quote]You can whine later, the gov't is too busy trying to save this country... again, if anyone has suggestions, I'm sure they'd like to hear it or perhaps help and try to get Chris on more speaking engagements where maybe he'll be heard but he better be ready to offer solutions, not just criticism.[/quote]

Suggestions:

1) Establish in the FDIC a banking debt insurance system. Create a premium that can be paid so that any debt can be government guaranteed. Require the FDIC reviews the nature of the loans and limit this service to well known conservative lending practices. Make sure the contract stipulates that corporations that break these conservative requirements will have their insurance revoked and won't get their premiums back.

2) Don't guarantee any banking debt. Instead, just stand off to the side and remind everyone that the government still has $450 billion dollars of capital injections, and isn't afraid to use it if a bank is going under. Given this, there should be zero concern about banks defaulting anyway.   At least until the government runs out of cash. 

This also has the added benefit of making total losses more visible, and more immediate.   We won't know the damage under the current system until years after it has been done.

 

Take note, all this that took me a couple of minutes. I can't think of any reason that an army of government "experts" with a weekend to spare shouldn't be able to come up with something far better.

- -

Steve

pir8don's picture
pir8don
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Everybody knows

....the bus is too full and going too fast.
....the driver lied
....look there is another loosening wheel nut
....dear me! a whole wheel came off

(after Leonard Cohen)   

Will black humour save us?

Chris love "the job". Brave of you to put up the Elizabeth Kubla Ross thingy - shame it isn't getting more talk

kingkang's picture
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Re: The FDIC expansion explained

This has nothing to do with the FDIC expansion but do you guys believe that US Treasury bonds are the next bubble to collapse?!

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Re: The FDIC expansion explained

Steve, (srbarbour)

I took the liberty of using your text in an emailed note to Paul Krugman at the Times just now:

email to Paul Krugman:

Is it not the case that under the expansion of the FDIC powers to include guaranteeing the senior debt of banks and their holding companies, the following scenario is likely?


Say you have two entities. The first ABC, a 'new' banking enterprise. It has no cash, but since it is a "bank" all of its senior debt is protected. This bank then gets an infusion of cash (say, $5 billion) from DEF bank. This is issued as 'Senior debt', so its 100% protected (by your tax dollars).

Because this 'new' bank ABC is created by former executives from DEF the terms are rather favorable, and the debt has a very high interest rate. In exchange ABC buys up all sorts of Junk bonds on the cheap in the hopes they don't default, but to be frank no one cares because the executives will pay themselves insane salaries either way.

If the junk bonds don't pay out, ABC ceases to exist DEF gets its money back -- and depending on the exact rules the interest added to the principle as well... -- and the process is repeated again. If successful, DEF still gets lots of cash on a really expensive debt. The executives of ABC and DEF make out like bandits, the companies merge, and everyone is happy.

Will you please write about the moral hazard created by this latest government action?


(source of scenario text: poster on
www.PeakProsperity.com , in Blog, under "The FDIC expansion explained")

_ _______________________________________________________________

P.S. Thanks too, BTW, for your excellent responses to Xflies' "Of course it will be taken advantage of... why do you think"

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Re: The FDIC expansion explained

Has it occurred to you that Paulson's actions in wiping out

shareholders of 'rescued' companies are deliberate: that the aim is to  collapse the banking sector into Goldman Sachs & Morgan Stanley while elmininating their rivals. Along the lines of JP Morgan 1907?

Xflies's picture
Xflies
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Re: Of course it will be taken advantage of... why do you think
awesome post... good rebuttal with actionable suggestions.  Thanks!  The only thing I'd add is that before I make the assumption that these guarantees will last 3 years is still left to be seen and the cost to taxpayers will only be incurred if defaults come to fruition
ds's picture
ds
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Re: Perpetually expensive debt explained!
[quote=srbarbour]

I see you don't fully grasp the magic of double dealing.

[/quote]

You are correct. I never considered a scenario such as you described.

However, now that you describe it, I think it is brilliant. I'm thinking that I should establish a new banking corporation to carry out this type of arbitrage in order to recoup some of my tax funds the government is using for this plan. J

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Re: Treasuries compared to senior bank debt

Chris,

 

 

Is the FDIC like the Federal Reserve? Privately owned by the banks and private individuals? Where does the profit go from the money they collect off of interest or investments? Are they like a private insurance company with the facade of a Federal institution like the Federal Reserve?

 

 

 

TIA,

 

 

 

 

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Re: The FDIC expansion explained
Rescuing the Banks

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