Saturday, March 14, 2009

Double (Non-)Indemnity


No, I'm not talking about Billy Wilder's excellent film noir adaptation of the James Cain novel. I'm talking about the non-insurance provided by AIG and the FDIC. In each case, the real insurer is the taxpayer.

Actually, the vast majority of AIG was a well-run company. We're really talking about the small, London-based AIG Financial Products division. This is the group that trashed the company by writing a mountain of CDS contracts with zero capital backing them up. At any rate, Gretchen Morgenson explains that AIG is now the place where taxpayers' dollars go to die.

Meanwhile, Michael Kranish informs us that thanks to Congress, the FDIC didn't collect insurance premiums from banks for years.

The federal agency that insures bank deposits, which is asking for emergency powers to borrow up to $500 billion to take over failed banks, is facing a potential major shortfall in part because it collected no insurance premiums from most banks from 1996 to 2006.

The Federal Deposit Insurance Corporation, which insures deposits up to $250,000, tried for years to get congressional authority to collect the premiums in case of a looming crisis. But Congress believed that the fund was so well-capitalized - and that bank failures were so infrequent - that there was no need to collect the premiums for a decade, according to banking officials and analysts.

[…]

But if the FDIC suddenly had to take over a giant bank such as Citigroup or Bank of America, the fund would be drained "in a flash," said Cornelius Hurley, director of the Boston University law school's Morin Center for Banking and Financial Law.

[…]

Bair said yesterday that the agency's failure to collect premiums from most banks "was surprising to me and of concern." As a Treasury Department official in 2001, she said, she testified on Capitol Hill about the need to impose the fees, but nothing happened. Congress did not grant the authority for the fees until 2006, just weeks before Bair took over the FDIC. She then used that authority to impose the fees over the objections of some within the banking industry.

"That is five years of very healthy good times in banking that could have been used to build up the reserve," Bair, a former professor at the University of Massachusetts at Amherst, said in an interview. "That is how we find ourselves where we are today. An important lesson going forward is we need to be building up these funds in good times so you can draw down upon them in bad times."

[…]

Then, a booming economy left banks flush with cash, and by 1996 the insurance fund was considered so large that it could grow through interest payments and fees charged only to banks with high credit risk. Congress agreed that premiums didn't need to be collected if the fund was sustained at a level that was considered safe. Thus, about 95 percent of banks paid no premiums from 1996 to 2006, including some new ones that did not have to pay a premium, the FDIC said.

Congress mandates that the insurance fund must stay between 1.15 percent and 1.5 percent of all insured deposits. The reserve ratio on Dec. 31 was 0.40 percent, down from 1.22 percent at the end of 2007.

And so of course the taxpayers get to pay even more than they would have paid if the premiums would have been collected. I don't like the concept and existence of the FDIC even if it's done well. But a 1.5% capital ceiling? The only insurance outfit with a smaller capital reserve may well have been AIG Financial Products.

Remember why the FDIC was set up (at least purportedly). It was put in place after the 4,000 or so bank failures (along with bank runs) of the 1930s and it was meant to protect against a similar disaster in the future. The FDIC's mission is not to close a few banks here and there in a normal year. That's chump change that could be addressed in any number of ways. Rather, it is supposed to provide catastrophe insurance against a second Great Depression-like banking fiasco and stop massive bank runs. In that sense, it is much like AIG's CDS contracts which only insured the assets in question in the event of default. "No need for all of you people to make a run on your banks; you are insured by the FDIC. You can all sleep well knowing that your deposits are safe and secure."

But 1.5% is a joke. It is miles away from protecting against the kind of systemic collapse of the 1930s which means that the insurance it provides, much like AIG's CDS contracts, is a mirage. The real raison d'être of FDIC insurance is to give depositors the illusion of safety in order to keep them docile and convince them that a stampede is not necessary. FDIC insurance is herd control provided by one man with a dime store slingshot. If the herd ever figures out that he can't protect them from anything more savage than a single, toothless wolf with one bad leg, they'll flatten him. The FDIC would be crushed by even a smallish bank run (e.g., a run on 3% of deposited assets). But of course, the FDIC will run to the treasury as it is doing now. So in reality, it is once again the taxpayers who are the real insurers (this time insuring themselves). AIG and the FDIC are two peas in a pod. Both have written massive checks that only the taxpayers' bodies can cash.

(end of post; ignore continue reading statement below)

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