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The FDIC Continues to Promote the Fantasy That It Can Resolve Megabanks

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Due to being a bit under the gun before taking off on holiday (I hope you all enjoyed the posts from Matt Stoller, Lambert, and the other guest writers), we didn’t address a May 10 speech by the acting FDIC chairman, Martin Gruenberg, on the FDIC’s current thinking on how to resolve so called systemically important financial institutions, or SIFIs. I’m turning to this now because I see some people who ought to know better, such as the normally solid John Hussmann, taking the FDIC”s claims at face value.

As an overview, Dodd Frank gave the FDIC new powers for resolving large, complex financial institutions, which are often referred to as “orderly liquidiation authority” or “Title II resolutions”. Nowhere does the Gruenberg speech mention that the FDIC does not have the authority to put a megabank down; it requires Fed and Treasury approval as well. So it seems unlikely, in the wake of Lehman, that any Administration is going to hazard euthanizing a foundering financial institution using an untested processes.

It’s worth noting that the FDIC has retreated from its position in a paper it published a bit more than a year ago, a description of how it would have used its expanded powers in the case of Lehman. Gruenber’s speech is de facto climbdown from that piece, which we shredded in a series of posts (here, here, here and here; it took that many rounds to beat back staunch administration defender Economics of Contempt.

The guts of the latest FDIC scheme is to resolve only the holding company and keep the healthy subsidiaries, including all foreign subsidiaries, going on a business-as-usual basis:

…the most promising resolution strategy from our point view will be to place the parent company into receivership and to pass its assets, principally investments in its subsidiaries, to a newly created bridge holding company. This will allow subsidiaries that are equity solvent and contribute to the franchise value of the firm to remain open and avoid the disruption that would likely accompany their closings. Because these subsidiaries will remain open and operating as going-concern counterparties, we expect that qualified financial contracts will continue to function normally as the termination, netting and liquidation will be minimal.

The subsidiaries would be moved over to a new holding company; the equity in NewCo would become an asset of the holding company now in receivership. The old equityholders would likely be wiped out and the bondholders may wind up taking losses.

This all sounds wonderfully tidy and neat, right? Problem is it won’t work.

The rather large fly in the ointment is that counteryparties would be concerned that putting the holding company into what Satyajit Das calls “a strange hypnotized state” would trigger cross defaults across agreements, including derivative agreements, where the holding company had guaranteed a contract. Per Das:

This would mean all derivative contracts could be terminated and this may trigger large payments which the FDIC may need to fund (i.e. is the American taxpayer going to pay out counterparties claims?).

Remember that in the US, banks (ex Morgan Stanley) have their derivatives booked in the depositary, which means any losses to depositors as a result of derivatives positions gone bad would be borne by taxpayers. And as we’ve written at excruciating length with respect to the Lehman bankruptcy, the magnitude of the losses cannot be explained by overvalued assets plus the costs resulting from the disorderly collapse. Derivatives positions blowing out (as well as counterparties taking advantage of options in how contracts can be closed out and valued) were a major contributor to the size of the Lehman black hole.

Moreover, even if this novel procedure did not trigger cross defaults, counterparties to the subsidiaries would seek to terminate contracts. Unless the FDIC (or another government funding source) were to stand behind the subsidiaries, including foreign subs, this attempt at a holding company resolution would trigger the sort of subsidiary level distress that the FDIC intends to avoid. Many banks’ foreign operations have little or no capital in them, relying on a “home-host” arrangement in which the mother ship (the foreign parent) sends more funds and/or capital when local regulators or counterparties require it. Concerns about how badly this model worked in the Lehman failure, when the US parent raided the London broker-dealer in a last-ditch effort to save itself, have led to more regulators adopting a “ring fencing” posture, requiring local operations to be better able to stand on their own. This posture is becoming more widely accepted abroad, in part due to the view of leading international regulators and international bank lobbying groups that Dodd Frank resolutions won’t work, due to the failure of the US law to recognize that bankruptcy (and resolution) falls to nation-based courts. As we noted in an earlier post:

For one, the Bank of International Settlements, which has access to perfectly good securities and bank regulatory experts, worldwide, begs to differ [with the FDIC]. In its Report and Recommendations of the Cross-border Bank Resolution Group the BIS said that even if cross border resolution regimes were better coordinated, (which, of course, Dodd Frank does not achieve), it “recognizes the strong likelihood of ring fencing in a crisis” due to the failure to implement cross-border burden sharing and the national nature of legal and bankruptcy regimes. It thus recommends a framework that “helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders.” In other words, it accepts a national process as inevitable and recommends dealing with that reality.

And note also: FDIC asserts, in their Lehman counterfactual (and, they assume, in Title II resolutions generally), that the local regulator would have cooperated. Yet the FSA, in its Turner Review, has fallen in line with the BIS ring-fencing notion. The FSA is moving towards requiring local entities be better capitalized and is placing little faith in yet to be realized greater international coordination. Both documents pre-date the finalization of Dodd-Frank, which, in its obliviousness to the international dimension, simply confirms the prior BIS/FSA line.

Similarly, the Institute for International Finance, a blue chip group from the industry (meaning it has every reason to depict Article II as workable, since the alternative is structural remedies, aka breaking up banks, and/or much higher capital levels for national entities, would have a disruptive impact on their operations) has been on the same page as the BIS and has seen nothing in Dodd-Frank to change its mind: see pages 31-2 of their latest on this subject:

Title II remains problematic in the limited attention that it pays to cross-border issues…

…cooperation and coordination is, under Dodd-Frank, dependent upon the goodwill of the different parties and perceived common interest in the circumstances…

Much, accordingly, remains to be done to render the Dodd-Frank approach appropriate for application in the context of cross-border financial groups.

And the ring-fencing isn’t just a regulatory response to the heightened awareness of the difficulties of winding up failed banks; it’s also a defensive posture taken when financial players get nervous about counterparty risk. In an important article, Gillian Tett described how financial integration in the Eurozone has gone into reverse (aside: a reappearance of the Tett of 2005-2007 looks to be a crisis indicator):

….amid all the speculation about Grexit, they told me, banks are increasingly reordering their European exposure along national lines, in terms of asset-liability matching (ALM), just in case the region splits apart. Thus, if a bank has loans to Spanish borrowers, say, it is trying to cover these with funding from Spain, rather than from Germany. Similarly, when it comes to hedging derivatives and foreign exchange deals, or measuring their risk, Italian counterparties are treated differently from Finnish counterparties, say.

In the long run, a return to more autarkical finance may be inevitable. As Carmen Reinhart and Ken Rogoff found, high levels of international capital flows are associated with large and more frequent financial crises, so reducing the level of cross-border money movement may be necessary to increase financial stability. But having sudden eve-of-possible crisis changes in behavior can in and of itself trigger dislocations. As Richard Bookstaber pointed out in his book A Demon of Our Own Design, in tightly coupled systems, measures to reduce risk that focus on particularly institutions or issues typically make matters worse. And that may well happen here. For instance, if Mr. Market were to believe the Fed, senior bondholders should demand higher interest rates in return for the risk of being exposed to haircuts in the case of distress, which is something they had good reason to think they’d be spared, given that the Treasury Department has had a “bondholders must not take losses” policy. Note that this move comes when regulators are pressuring banks to reduce their dependence on repo financing and raise more term funding.

It would have been much better for the authorities to make a full bore effort to discourage the use of products that have limited social value and contribute to the excessive integration of firms and markets. Credit default swaps and complex over-the-counter derivatives top our list. But despite the severity of the crisis, regulators and politicians were unwilling to challenge the primacy of the bankers, with the result that the FDIC continues to pretend that an inadequate approach like Dodd Frank resolutions will work. With distress in Europe rising and Morgan Stanley looking wobbly, we are likely to see sooner rather than later how much the failure to implement real reforms will cost us all.

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28 comments

  1. SteveA

    The whole business is a dodge to recapitalize and fund failed financial firms without requiring another TARP vote in Congress or FED involvement in a new Maiden Lane.

    Also, FDIC does not have the expertise in multi-jurisdictional law or non-depository operations to carry out the DF mandate.

    In his speech, Gruenberg specifically mentions the great new understanding that FDIC has with British financial regulators. Judging from the US/British bankruptcy disputes on MF Global (in which FDIC is not involved), Gruenberg is giving a false impression of the cooperation possible between sovereign jurisdictions.

    1. ReadTheLaw

      No, it is not a “dodge” to avoid TARP or Maiden Lane-tyope intervention. The law requires “Living Wills” on the part of the banks to provide for orderly resolution in BANKRUPTCY COURT, you know, with judges, lawyers, journalists in the room, etc., etc., as opposed to the panic and cobble-something-together in secret situation that we had last time. Will it work? Maybe not, but it seems preferable to the Yves Smith Plan, which seems to be complain that policy makers haven’t outlawed the offending instruments so therefore . . . what? People who are actually trying to deal with these problems live in the real world where sometimes a PERFECT PLAN is impossible to achieve, so successive iterations of a plan are developed and implemented over time. Get real – you’re just an unwitting tool of those who want bank-managed bailouts.

      1. steelhead23

        You are being overly dismissive and insulting to our hostess. This reminds me of how to deal with kids playing with matches. Some kids are drawn to fire with the same awe as a moth and cause fires and even deaths. Yves is merely pointing out that the best way to deal with this problem is not to build better fire stations, but simply to eliminate the child’s access to matches. Credit default swaps and complex derivatives are the financial equivalent of matches and we’d damned well better take them away from the banksters before they roast us all!

        1. Nathanael

          The derivatives are all contrary to basic common-law principles of insurance law, and should just be declared contrary to public policy and repudiated.

          As long as all the derivatives contracts are rendered null and void, that solves most of the problems listed in this article.

  2. Pierre Garenne

    Another great myth is the purported belief that some sort of prevailing ethic or morality exists in the world of finance that mitigates unbridled self-interest and which apparently kicks in at some point in the various chains of financial activities.

    The presumption that a few poachers turned gamekeepers could, even with the best will in the world, impose general interest criteria or regulations, is farcical given that the milieu itself is entirely corrupt and corrupting, the supposed doorkeepers having been “captured”.

    By the very nature of the system “banks” and surrogate entities can and will invent ways of avoiding, circumventing and preempting regulation faster than any regulation or regulator can limit their “corrupt” behavior –regulation is by nature ex post; the milieu has already found new, more slippery ways of making a fast trillion. I have yet to see any sign that their self-interest could possibly coincide with the “common good”.

    This state of affairs will continue until such time as a significant number of financial decision-makers, throughout the various national and international financial systems as a whole, suffer punishment, such that the fear of loss and punishment inhibits their behavior.

    Given that Obama can now authorize the “judicial” killing of anyone he designates as a threat to the US, this could be usefully extended to far better effect, far beyond purported members of Al Qaeda, to include a significant number of decision-makers in the financial world.

  3. Conscience of a Conservative

    The FDIC is simply not in control when it comes to the big banks. The Fed is, and the Fed is once again entertaining a motion to allow a bank to move derivatives from its holding company to the FDIC insured banking unit, “Morgan Stanley”. And then you have JP Morgan opening up it’s CIO position in London outside the knowledge of anyone except Jamie Dimon. How can we believe the FDIC can be expected to exercise it’s powers when the Fed and the big banks go around it.

    1. Warren Celli

      Mr. Market and Mr. Mean continue to duke it out for control of the phony baloney mothership machine of global credit control (the gotcha by the short hairs machine).

      Mr. Market, the good old fashioned keep the marks alive Vanilla Greed for profit guy, is really becoming agitated, as Mr. Mean, the newer more Pernicious Greed for control and herd thinning who wants to kill off most of the marks, hangs tough and constantly cleans Mr. Market’s clocks.

      Mr. Mean is very clever. He has turned the tables and is running Mr. Market’s good cop bad cop game on Mr. Market. How ingenious, who woulda thunk it? The same scam game Mr. Market used to bump and grind every sucker on the planet that ever walked through his doors is being used against him now.

      Oh heavens, if only we could bring back the good old days where Vanilla Greed for profit had control of the good cop bad cop game. Boo hoo.

      Can we all say trickle down naked cannibalism?

      Deception is the strongest political force on the planet.

      1. Warren Celli

        Apologies Conscience of a Conservative, this should have been a general comment and not a reply to you.

        1. Susan the other

          I’m catching up today and recuperating from jet lag. So indulge me if I’m totally nonsequitir. But just thinking about what the EU is up to with their bailout fund whereby each of the 17 contribute to a bailout fund and any country whose debt is over 60% GDP can tap it for zirp for 25 years. Their own insurance fund. No need for CDS. And my question is then why can’t the megabanks set up such a fund, or alternatively the healthy subs of the megas, and thereby protect taxpayers of individual countries.

          Then again there could be a resolution upward instead of down to taxpayers. Resolve the insolvencies up to a Globally Insured Deposits mechanism. Why should taxpayers of one country pay for the international bankers’ global party?

          I’m confused by the phrase of Yves, return to an autarkical financial system. Not sure if this calls for taxpayer participation or a self-sufficiency of just the banks themselves.

          Just a personal observation: I was always such a bad organizer I wound up with way too much stuff over the course of 20 years. I think this is an apt metaphor. So in desperation one day I sacrificed a bedroom and turned it into a junk room. Question: why can’t the insolvent megas sacrifice the most hopelessly insolvent among them and put all the junk in that bank? Nevermind.

  4. wunsacon

    Yves, this is an OT / “typo” alert for the last paragraph of today’s “comments-closed” post titled “Aeschylus’ Eumenides: The Furies on Justice”:

    “So the Furies, the representatives of an old, unforgiving order, will willing in the end to yield.”

    >> Due to being a bit under the gun before taking off on holiday (I hope you all enjoyed the posts from Matt Stoller, Lambert, and the other guest writers)

    Welcome back. And, speaking for myself, I very much enjoyed reading your colleagues’ posts.

    1. Yves Smith Post author

      Dunno why comments were closed. Thanks for the alert. Have fixed it.

  5. Tom

    Yes welcome back and what a come back with Eumenides!
    The line:
    “for the very child of vanity is violence;”
    especially caught my eye after have read over at “Drudge”:
    “War in White House: Holder and Axelrod ‘had to be separated’…”
    a case study in vanity leading to violence.

    Best
    TomV

    1. Mayo and Chipoltle

      Axlerod and Holder go together like Fannie Mae and MERS. The Justice Department continues to promote another fantasy but let’s not goeth there-eth.

    2. TK421

      I wonder what they were fighting over. How many innocent Pakistanis to blow up this week? How many poor people to incarcerate for using marijuana in states that have decriminalized it? Which whistleblower to prosecute next?

  6. Emperor Snark

    “It would have been much better for the authorities to make a full bore effort to discourage the use of products that have limited social value and contribute to the excessive integration of firms and markets.”
    Woulda, shoulda, if it coulda. Didn’t Bair say the agency was kinda depressed, rub down. Banks weren’t failin’ like they did in the 30s.

    By the way, the Pentagon does this type of ‘social value’ thing much better. Here’s where the Banks and corporations enjoy total free reign: ..”the U.S. kills people with drones in Pakistan, it then targets for death those who show up at the scene to rescue the survivors and retrieve the bodies, as well as those who gather to mourn the dead at funerals”

  7. Ms G

    “It would have been much better for the authorities to make a full bore effort to discourage the use of products that have limited social value and contribute to the excessive integration of firms and markets. Credit default swaps and complex over-the-counter derivatives top our list.”

    Aren’t the authorities moving in exactly the opposite direction already with the very quietly reported move by Obama-Geithner-Treasury to put in place a system that BACKSTOPS DERIVATIVES at the clearinghouse level?

    Or is this totally unrelated?

    http://online.wsj.com/article/SB10001424052702304840904577422393164106270.html

  8. backwardsevolution

    Yves: “I hope you all enjoyed the posts from Matt Stoller, Lambert, and the other guest writers.”

    Yes, they did an exceptional job. Well done!!!!!

    Hope you had a wonderful holiday, and thank you for your superb writing.

  9. Hugh

    So much of this must be conceived as a negative to be understood. The Dodd-Frank resolution powers are really Potemkin reforms meant to prevent the resolution of a TBTF from happening. It is unlikely that the failure of a TBTF would be a singular event. A credit event, a euphemism for a crash, big enough to take out one TBTF would take out multiple TBTF, probably even all of them due to their interconnectivity. It’s important to remember that in 2008 the TBTF were only saved through a general bailout of the whole financial sector by the Fed and Treasury. Indeed the initial partial approach of saving AIG, and thereby Goldman, and letting Lehman fall failed miserably. Goldman (along with Morgan Stanley) had to be saved again just 7 days later by its conversion into a bank holding company (a completely bogus designation btw) making it eligible for access to the Fed’s short term loan facilities.

    With regard to swaps, JP Morgan remains the hog king of them, but swaps are and have always been BS. They aren’t just underpriced insurance but fatally mispriced insurance. In a major credit event, the sellers don’t have the assets to cover them. Netting, that sellers of swaps are also buyers of them, doesn’t help because it too is BS. This is true for three reasons. First, the buying and selling of swaps does not affect the underlying risk. It’s still there. Second, the swaps market is not symmetric. If bank A sells swaps to bank B and then hedges by buying swaps from bank C, and then if bank C goes under, bank A will have perfectly netted positions and still be completely exposed to bank B. Third, swaps can also be gambling. They can be purchased even though the buyer has no exposure to the underlying risk, that is as a bet. This means the final risk introduced into the system can be a multiple of the underlying risk. This combination can and did send the system over the cliff in 2008, and it has not been changed substantially since. Absent governmental backstops, cascading defaults (sparked by a crash here, the collapse of the euro in Europe, or political instability in China) still could take out the system and the interconnected TBTF.

    In other words, an orderly resolution of a single TBTF is just propaganda to placate the rubes. It is the wrong solution for the wrong problem. The TBTF would have to be resolved as a group, pretty much what we were saying back in 2008. The US probably could do this on a national basis with regard to its TBTF, but it could not do so without enormous international repercussions both because of the foreign subsidiaries involved but because of all the swaps and similar instruments bought and sold between US and foreign financial entities. I still think a real resolution of the banking sector would involve the wiping out of not just the equity holders, reductions to or wiping out the bondholders, but more importantly the wiping out of swaps. Wiping out swaps would remove the risk multiple. It would not, however, remove the underlying risk, but it would expose what the underlying risk is, that is we would know what the real irreducible price tag for the resolution of the banking sector would be. Or to be more precise what the price tag is to us after the stock and bond holders have been burned.

    1. scraping_by

      “It is unlikely that the failure of a TBTF would be a singular event.”

      On the other hand, with honest accounting any and all of the TBTF are insolvent. Insolvent banks can be closed and resolved. If there was a government group with attitude and resources, the current crop of bankster redoubts could be conquered one by one.

      Big ‘if’, though.

  10. hermanas

    Gambling addicts will devise strategy to stay in when the game is through. Thanks Hugh.

  11. lew

    This amounts to “systems are too complex to deal with”.

    If the FDIC can’t dis-assemble a bank because that is too complex a task, how can you think that you can manage an economy, which is orders of magnitude more complex?

    1. Hugh

      Complexity isn’t the issue. Indeed I would argue that while the economy is big, it isn’t particularly complex. The problem with the TBTF is that they are timebombs. We already know most of the ways they can be contained/replaced:

      1) Re-enact Glass-Steagall
      2) Ban swaps
      3) Break up the TBTF
      4) Restrict banking to plain vanilla activities, that is treat it as a public utility
      5) Remove current bank managements
      6) Enforce laws against fraud

      None of this is intellectually hard. It is politically impossible because the banks own the politicians. So step one to replacing the banksters is replacing the politicians. And for that the 99% have got to come to understand that anyone who is in office or held office needs to be voted out. It doesn’t matter if they are Republican or Democrat. They all have to go.

      1. lew

        You can argue that, but I don’t think you can prove it, and the facts are seriously against you.

        I read some time back that there are 10,000,000,000 prices in the greater NYC area. Every item in every little store, every apartment, office space, private sale of , every item in every warehouse, …

        And they all affect the prices of other items to some degree. And all those prices are affected by everything from the weather to the earth’s position in its galactic orbit.

        Sounds complex to me. And, in fact, there is zero evidence that any economic manipulation can improve things : countries that do so fail in direct proportion to the intensity of their efforts.

        Economists and most posters here on Naked Capitalism use the word system, but the explanations you use are for mechanisms, not systems. The conceptual gulf between systems and mechanisms is far larger than that between Newtonian physics and quantum physics.

        You are seriously wrong : no human or group of humans understands the economy in cause-and-effect relationships, without which you cannot produce a control system.

        There is no possibility of getting cause-and-effect relationships from the economy, as it is too large to do controlled experiments. No control system can be built on an econometric model : that is historical data, and the economy is an evolving system, an open system. By definition, those are complex.

        1. Hugh

          Your approach reminds me of that of Zeno of Elea who “proved” that motion could not exist because it required an infinite series of steps each with the same problem that first half the distance of each substep needed to be traversed. Like Zeno, you have proved nothing. A glass of water is filled with vast numbers of molecules. Yet we don’t think twice about using those incomprehensibly vast numbers of molecules to brew a cup of tea.

          A well known common mistake in argumentation is to use an argument that is too weak to prove what it intended. A less well known mistake is too use an argument that is too powerful. This is your case. We can use your argument to prove that we can not know anything about anything because as Zeno noted so long ago anything that we know or think we know can be infinitely divided, rendering it what you would call “complex” and hence unknowable. At best, it is an intellectual curiosity, but mostly it’s just sophistry which purposefully mistakes what knowledge is.

        2. Susan the other

          Lew. It would make sense to have enough money in the system to cover all liquidity contingencies. What is the max; what is the least? Must we tax, or can the control of the flow of money become the gears of finance which are regulated? I say print it all up and use it like water thru a sawmill. Why not?

  12. LeonovaBalletRusse

    Time for the BIS to bite the bullet and become the “bank of last resort.”

  13. Nathanael

    The derivatives contracts are in violation of basic principles of insurance law and gambling law.

    The solution is simple: the FDIC refuses to honor them and tells the counterparties to go fuck themselves.

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