Archive for the ‘FDIC’ Category

Suppose that a systemically important financial institution (the official designation, now in true DC style the acronym SIFI) actually fails.  Do we get a financial crisis?  Are owners/creditors punished for endangering the economic system or partly/largely bailed out by loans/transfers from taxpayers?  A few days ago here in Chicago, the acting chair of the FDIC, Martin Gruenberg, spoke to the Chicago Fed about how the FDIC would “systemic resolve” a failing SIFI without endangering the financial system while actually placing losses on those who own and are owned by the institution.  Speech here.


I am glad the work is proceeding.  If, . . oops I mean . . . when we end up in the next financial crisis, we will at least have a plan.  And an ex ante plan may help reduce the frequency of crises.  As  Gruenberg said, “developing a credible capacity to place a systemically important financial institution into an orderly resolution process is essential to subjecting these companies to meaningful market discipline. “

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Bringing Order to Chaos

The FDIC has released its final rule on the orderly liquidation of systemically important financial institutions, here.  I remain skeptical that orderly liquidation of a bankrupt large financial institution is possible.  What incentive is there for a floundering institution to devote resources to preparing for this when it is fighting for survival?  What can the FDIC to institutions that fail to comply , kill them again?  Do we really think that this rule will help senior debt holders sleep better or stop the spread of concerns the way concerns spread after Lehman?

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While I am hesitant to grade the Financial Crisis Inquiry Commissions Report because it covers so much ground, it is great reading for those of us interested in the topic. Unfortunately, it checks in at 662 pages as a pdf file, including footnotes. The main report is filled with anecdotes, active prose, boring prose, and some terse, accurate summaries. As an example I completely agree with: “In Washington, four intermingled issues came into play that made it difficult to acknowledge the looming threats. First, efforts to boost homeownership had broad political support . . . . Second, the real estate boom was generating a lot of cash on Wall Street and creating a lot of jobs in the housing industry at a time when performance in other sectors of the economy was dreary. Third, many top officials and regulators were reluctant to challenge the profitable and powerful financial industry. And finally, policy makers believed that even if the housing market tanked, the broader financial system and economy would hold up.”  This seems spot on. 

But I also agree with the minority report by Hennessey, Holtz-Eakin, and Thomas, that “the majority’s approach to explaining the crisis . . . is too broad.”  The main report blames everything that anyone has ever blamed for the financial crisis and Great Recession. It tells a nice story, but one has to wonder if some of the characters are really necessary.  The first dissenting report is more focused.  And it provides some evidence against the causal factors that they do not see as central.  The main report rounds up all the suspects in the living room, the first dissenting report tells one story of who was involved in committing the crime.

There is also a final dissenting report by Wallison, which holds the view that government housing policy is to blame and that the private sector, while woefully inept, is blameless.  Bankers and investors who bought the assets were 1) simply trying to compete with the government (presumably to see who could lose the most money?) and 2) are rather dumb (“Human beings have a tendency to believe that things will continue to go in the direction they are going”).  Wallison does not blame stupidity nor the factors that made banks “especially vulnerable” to the initial losses.  But stupidity can cause crises, and if we see it, it is a cause and we should look for deeper reasons why it was able to survive and grow big – where were the market forces for smarts?  But I agree with this report when it says that “opinions in general are not worth much” and are not substitutes for data.

The document is mostly a call to arms for real data work.  As more and more data become available, we can parse the large set of hypothetical causal factors to determine which were instrumental and which factors, if eliminated, would have made little difference.  For example, would eliminating outright fraud and corruption in mortgage origination have helped significantly?  Or is this a major concern to those defrauded but only a small part of the macroeconomic fallout?  Or consider the role of credit rating agencies.  Given that AIG was supporting the mortgage market by insuring hundreds of billions of MBS and CDO’s on MBS, and given that the investment banks themselves were happy to hold off balance sheet and write insurance on lots more of these assets, was credit rating a problem because no one knew that these AAA assets were pretty risky or because the credit rating agencies were convincing an otherwise skeptical world that these assets were safe?   Some popular writing suggests that both buyers and sellers wanted these assets to be highly rated. Maybe the credit rating agencies should have known better, but it might have made little difference if they did not exist. Only hard analysis will tell.

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The FDIC has approved an “interim” rule on the orderly liquidation of large financial company here.  Dodd-Frank (Title II) moves on.  According to the law, in the event of the failure of a financial institution whose failure poses significant systemic risks, the FDIC can be made receiver and rapidly impose losses on equity and debt holders.  The idea is that rapid sale of assets can preserve business value, reduce actual bankruptcy (legal) costs (over a billion now for the Lehman bankruptcy), and reduce the uncertainty and illiquidity that affects claims during the bankruptcy process.  This may be a big step in limiting too big to fail.  The legal hurdles however are very large – can this mechanism resolve an incomplete contract in a complex institution without a big fight?  I would rather we never find out.

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Just a quick post to flag, here, a candid and well-written overview of some of the policy failures leading up to the crisis and policy responses during the crisis by John Dugan, the outgoing head of the OCC (‘The what?’ you say. The OCC happens to have been a regulator of national banks.) And just so you don’t ignore the piece once you see it is a speech given to the “Exchequer Club,” which sounds like a group of guys that make one happy we rebelled against English rule, he contrasts this financial crisis with earlier financial disruptions, and notes how earlier policy responses were useful in this crisis:

“ . . .the systemic risk authority that Congress provided to the FDIC 19 years ago in FDICIA . . .  allowed the agency to guarantee obligations other than insured deposits in extraordinary circumstances . . .  Of course, this was the provision that we did use when the crisis hit, not only in individual cases involving several large institutions, but also more broadly to temporarily guarantee the obligations of a wide range of financial institutions, just as other governments were doing. As a result, this is the provision that has been widely criticized as the wellspring for the government’s “too-big-to-fail” actions, unfairly allowing bailouts of large firms about to fail, while smaller distressed banks have been forced to close their doors without government help.  . . . But here’s the thing of it: in the middle of the crisis, it worked. That is, in the absence of an orderly resolution mechanism for large financial firms, the provision worked phenomenally well to avoid runs and restore confidence, just as it was intended to do – and it will even end up making money for the taxpayer.”

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How should financial institutions compensate their employees?  A complicated question for the owners, and their ‘agents,’ meaning boards and compensation committees.  Economic theory is not very helpful because it is based on optimal contracting and the answer very much depends on the what is known or knowable about the manager or pool of possible managers.  Empirical evidence is also sketchy.  But the financial crisis speaks clearly — we want to avoid the situation in which an informed financial institutions makes money by selling out of the money puts.  This is like selling insurance against rare correlated or macro events and not keeping a reserve to pay out when the event occurs.  For example, insuring MBS, booking profits and bonuses in the goods times, and failing spectacularly in the bad (hello AIG and, through off-balance sheet holdings, Lehman).

 The government agencies have now weighed in.  The Fed, the OCC, OTS, and the FDIC have issued guidelines for compensation practices.  From the document, the key principles of good practice are:

“. . . (1) incentive compensation arrangements at a banking organization should provide employees incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risk; (2) these arrangements should be compatible with effective controls and risk-management; and (3) these arrangements should be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.”

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A preliminary report by the FCIC on the role of the credit rating agencies in the financial crisis.  While many of you will be familiar with the story, what is still striking, at least to me, is how little Moody’s (as an example) thought about risk in aggregate.  Here is a Moody’s quote from May 2007 (from the report), a few months after the March rumblings that kicked off the crisis:

“. . . the outlook for other major drivers of mortgage losses – home price appreciation, interest rates, and refinancing opportunities for subprime borrowers facing rate /payment rests – is less favorable. As a result, Moody’s is currently projecting that cumulative losses for loans backing 2006 subprime securitizations will generally range between 6% and 8%, though particularly strong or poor performing pools may fall outside of this range. … Barring cumulative losses well in excess of current expectations, we do not expect a material number of downgrades to bonds rated A or higher.”

What is striking, at least in retrospect, is how far, far outside this range we have fallen.  Was this really such an unusual event that falling outside Moody’s forecast range was unlikely?  Only two months later, in July 2007,  S&P was downgrading AAA tranches and Moodys followed suite shortly thereafter.

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The Senate Agriculture Committee just passed a bill regulating the derivatives market. Summary here. The legislation imposes clearing and trading requirements and real-time reporting of derivatives trades. It provides exceptions for some businesses like electric cooperatives which have argued that hedging business risks are important. It also tackles the moral hazard problem that the possibility of bailouts creates. (That is, if banks feel that the government will bail them out when they lose money, they take more risks since the downside is smaller for them). If the bill becomes law, the Federal Reserve Board and the Federal Deposit Insurance Corp. will be prohibited from providing any federal funds to businesses who are involved in derivative deals. This seems to imply that banks engaging in naked swaps transactions would have to spin off their swap dealer desks or be out in the cold in a crisis when others might be receiving bailouts. Of course, in a  crisis, laws change, and if no one spins off their desks, we are unlikely to let all banks go under (see Fall 2008).

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The FDIC is modifying the measurement tools it uses to assess the risks that large banks pose. The FDIC currently places each bank in one of four categories of riskiness. This assignment is based on supervisory ratings and capital levels, and is used directly to price deposit insurance but more generally to regulate and evaluate banks’ solvency/riskiness/capital adequacy. Moving forward, the FDIC plans to

draw finer distinctions among large institutions based on the risk that they post.

But more importantly, it changes some of the inputs for the assessment so as

. . . to better capture risk at the time an institution assumes the risk, to better differentiate institutions during periods of good economic and banking conditions based on how they would fare during periods of stress or economic downturns, and to better take into account the losses that the FDIC may incur if an institution fails.

That is, the assessment will be more forward-looking and reign in risk taking more in booms than in recessions. And, if the FDIC cares not only about how much money its insurance fund might lose but what the state of the world is when this happens — meaning are lots of other banks failing at the same time – then this approach will also pay more attention to systemic risk than individual risk. Finally, the FDIC approach will differ for institutions that are simply very large and those that are “structurally and operationally complex or that pose unique challenges and risks in case or failure.” All very good steps forward. The full details are here.

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FDIC Chair Sheila Bair speaking on March 8, 2010 gives a pretty standard description of the crisis and lays out quite a good framework for reform. The piece is FDIC centered, so emphasizes the problems of too-big-to-fail, failures in securitization, and regulatory arbitrage. But she dances a contorted political dance, like so many in DC forced to bow before sacred words, and ends with

“ . . . unless economic incentives are also appropriately aligned, regulation alone will fail.”

Uh, what appropriately aligns economic incentives if not the governmentally-enforced rules of the game, often called ‘regulation’? I guess everyone hates regulation, and everyone loves “laws that protect the American way.” And we wonder why we get the divided government we do. (Maybe I just need another cup of coffee.)

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