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IndyMac, FDICIA and the Mirrors of Wall Street
January 6, 2009

IndyMac, FDICIA and the Mirrors of Wall Street

"The story of the third paragraph of Section 13 of the Federal Reserve Act (Section 13[3]) is one of the great 'sleeper' or 'mole' stories of all time in American banking history. This March, 76 years after its creation, the sleeper came vividly to life when the Federal Reserve used Section 13 (3) as the justification for the rescue of an investment bank, Bear Stearns. The action may signify a disturbing new era in federal monetary policy."

Walker F. Todd
"The Bear Stearns Rescue and Emergency Credit for Investment Banks"
August 11, 2008
American Institute for Economic Research

"Is there any reason why the American people should be taxed to guarantee the debts of banks, any more than they should be taxed to guarantee the debts of other institutions, including the merchants, the industries, and the mills of the country?"

Senator Carter Glass (D-VA)
Senate debate on the Banking Act of 1933 (Glass-Steagall Act)
Rixey Smith and Norman Beasley, Carter Glass: A Biography (1939)


Congratulations to the IndyMac transaction teams at the FDIC and OTS for announcing the sale of the failed bank last week. This transaction illustrates how the US financial system can and will be repaired in coming months, namely by putting good assets in strong private hands and liquidating the government's asset pile as quickly as possible. This is not to say that the IndyMac resolution is perfect, but getting this and other failed institutions back into private hands must be the first objective.

Peter Eavis in The Wall Street Journal (1/5/09) asks whether the terms for the consortium of private equity funds led by former Goldman Sachs (NYSE:GS) banker Steven Mnuchin are too sweet, but only time will tell that story.  Suffice to say that the requirement for the investors to continue the dubious loan modification experiment championed by FDIC chair Sheila Bair is, to us and the WSJ, a major hurdle to turn IndyMac around.

There are other issues raised by the IndyMac sale. As we predicted some time ago, the FDIC's Deposit Insurance Fund ("DIF") took a significant hit to make the Federal Home Loan Banks and Fannie Mae whole on claims against IndyMac. As the press release notes, the cost to the FDIC will be "between $8.5 billion and $9.4 billion, in line with previous loss estimates. Costs include prepayment fees of $341.4 million to the Federal Home Loan Bank of San Francisco, on the payoff of $6.3 billion in FHLB advances."

So 75% of the loss to the DIF due to IndyMac came from the repayment of FHLB advances.

Here is the understatement of the year: "It is unfortunate that many of the banks that have failed last year had a heavy reliance on Federal Home Loan Bank advances," said John Bovenzi, CEO of IndyMac Federal and FDIC Chief Operating Officer. "These secured borrowings and the associated prepayment penalties have the effect of increasing the costs to the FDIC and to uninsured depositors."

Users of The IRA Bank Monitor can confirm Bovenzi's statement that most of the failed banks resolved by the FDIC during 2008 have been excessive users of FHLB advances. By the way, "excessive" use of FHLB advances is defined by federal regulators as a ratio of advances to assets above 15%. We strongly recommend that all retail depositors avoid institutions that display excessive use of FHLB advances.

Remember, it was the availability of the FHLB advances as funding source which allowed the management of IndyMac to grow the bank's size beyond that supported by its natural deposit base, which was far smaller than the classical 60-70% of total assets community bank model. Like WaMu and Countrywide, but even to a larger degree, IndyMac leveraged government funding via the FHLBs with unsafe and unsound lending practices - and all with the full approval of federal regulators!

The FHLB advances allowed IndyMac to grow bigger and thus contributed directly to the size of the DIF loss. The role played by the FHLBs in the IndyMac loss begs the question as to whether the FHLBs should exist at all -- unless they impose higher credit standards on member banks! Are the FHLBs part of the problem or the "Prime Solution?" 

We think that the Congress needs to restrict bank access to FHLB advances to only institutions rated CAMELS "2" or better, regardless of their collateral. On the IRA Bank Ratings system, that is an "B" rating or higher. Why should the FHLBs, through their lending activities, increase the cost of bank resolutions to uninsured depositors and the DIF (and the banking industry, which must ultimately pick up the cost)?

As with Fannie and Freddie, looking at the IndyMac resolution, reasonable people could argue that the largest government sponsored entity or GSE, namely the FHLBS, are actually a destabilizing factor in the US financial system, at least when it comes to supporting unsafe and unsound depository institutions.  More, news reports regarding the complicity of the OTS in falsifying IndyMac's financial statements for capital adequacy purposes begs the question as to the true, enabler role of all government agencies in causing the IndyMac loss. A shareholder of IndyMac's now bankrupt, once publicly listed parent company may well have a viable legal claim against OTS and other regulators for deliberately helping to falsify the firm's financial filings with the SEC! 

Users of either the professional version of The IRA Bank Monitor or the new Survey Tool option in the IRA Bank Cart can essentially synthesize a version of "Sheila's List" by running several discrete search screens and combining the results.  The screen for institutions with excessive FHLB advances, BTW, is among the most popular tools on our entire system. Don't tell us that the thousands of individual users of our bank tools who have requested an FHLB screen over the last several years don't understand the significance of excessive use of FHLB advances to the safety and soundness of depositories!

As we said in our previous comments, allowing the FDIC to move quickly to resolve bad banks is the quickest pathway to economic recovery. That is why we believe that President Obama should allocate none of the next $350 billion in funds available under the TARP for Citigroup (NYSE:C), JPMorgan (NYSE:JPM), Goldman Sachs (NYSE:GS) or the other large New York banks with significant trading book or derivatives exposure.  The political fight over who gets access to the next $350 billion in TARP funds will be an early test of the Obama Administration's priorities - and our ability as a nation to retrieve some remnant of our traditional values when it comes to economic and financial policy.

Choosing among the current cast of economic players, we hope that President Obama is going to give a special ear to FDIC Chairman Sheila Bair and her team. Indeed, we believe that Bair and the new SEC Chairman Mary Schapiro will become the two most important players in the Obama Administration. One of Washington's most respected conservative political observers told the IRA about Bair's tenure on Capitol Hill when we suggested her as an alternative to FRBNY President Timothy Geithner as candidate for Treasury Secretary in our previous comment ("On the Economy: For Barack Obama, It's All About Credibility"):

"I think Sheila Bair would be a good nominee. I know her very well. She was the traffic cop with Howard Green in the Republican Cloak Room, managing holds, bills and amendments. The mantra always was 'clear it with Sheila.' This did not mean that she had the power of approving or disapproving what the members wanted, but she collected the data on what was happening and could shoehorn in special requests. In other words, she was a good manager and a doer. She was clearly not on the same wavelength as conservatives, but she did her job fairly and never double-crossed us. I know she is under heat for doing the right thing at FDIC and not getting with the program, but that is exactly why she would be good at Treasury. Why is it that no one has pointed out that the key players in this insiders' cabal are all Democrats, starting with Hank Paulson, Robert Rubin and Bernard Madoff, etc., and probably Timothy Geithner. That's why we need an outsider at Treasury, and it would be good place to put the Republican that Obama promised would be in the cabinet. Gates doesn't count, because he has always been a bureaucrat and claims to be an Independent."

Another veteran observer of US banking policy disagrees, however: "I think Sheila Bair and Mary Schapiro are terrible appointments. I see nothing Bair has done that Republicans should identify with. I think she's the embodiment of Public Choice theory in practice. The idea that somehow these regulators are going to lead the country out of the mess they've created is contrary to at least 30 years of experience… An adjective like inexcusable should be apply to the IndyMac loss. The FDIC made a bunch of promises in connection with FDICIA that have proved to be as meaningless as those of OFHEO vis-à-vis the enterprises. These so-called reforms helped set the stage for the current crime wave. I think all of the so-called regulators should be abolished, because they have all served as facilitators of financial crime, serving as enablers for a corrupt banking industry."

The Emergency Liquidity Provisions of FDICIA: Walker Todd Was Right

To understand just how far back and how deep goes the rot caused by the political capture of Washington by the largest Sell Side investment banks, consider the key 1991 statutory changes in the Federal Deposit Insurance Corporation Improvement Act ("FDICIA").  These changes eviscerated the original collateral provisions of the Federal Reserve Act ("FRA") and authorized investment banks and other non-bank corporations to borrow from the Fed.  The changes to Section 13 of the FRA made possible the bailout of the Bear Stearns shareholders and creditors, and those of American International Group (NYSE:AIG), and thus enabled the vast Paulson/Bernanke/Geithner bailout effort using the Fed's balance sheet.  This odious act of insider dealing by lobbyists for the non-bank financial services industry, committed two decades ago, is part of the unwritten history of Washington and illustrates why "money politics" is at the heart of the current economic mess.  

In 1993, a researcher named Walker Todd at the Federal Reserve Bank of Cleveland published a monograph entitled "FDICIA's Emergency Liquidity Proivisions."  He noted that the changes to the FRA's lending provisions contained in the FDICIA legislation actually enabled to Fed to lend to any corporation:

"In a comparatively little-noticed amendment of the Reserve Banks' lending authority, FDICIA made potentially significant revisions to the emergency liquidity provisions of the Federal Reserve Act. In particular, the Act now permits all nonbank firms - financial or otherwise (called "nonbanks" here for simplicity) - to borrow at the discount window for emergency purposes under the same collateral terms afforded to banks. Ironically, while the principal thrust of FDICIA was to limit or reduce the size and scope of the federal financial safety net, at least as applied to insured depository institutions, this provision effectively expanded the safety net. This article describes the historical and theoretical backgrounds of the Reserve Banks' emergency lending authority for nonbanks and analyzes the changes made by FDICIA that affect that authority."

The amendment to FDICIA was introduced around the Thanksgiving holiday in the dark days of 1991, when Citibank NA was on the verge of failure and much of the US banking industry already was above the 1995=1 average stress level calculated by the IRA Bank Stress Index.   Keep in mind that in 1991, much of the US banking system was on life support due to problems from domestic real estate and LDC debt.  The Fed had already taken extraordinary, arguably illegal measures to keep Citi and several other troubled bank holding companies afloat. We wrote about the "too big to fail" machinations of Corrigan and his colleagues at the Fed on behalf of some of the larger banks in Barron's in September 1990 ("Welcome to Brazil? Fed Policies Are Debasing the Value of the Dollar").

The Senate markup session where the emergency liquidity provision was announced was led by a somewhat younger version of Christopher Dodd (D-CT), who not surprisingly couldn't explain the provision or its effect on the FRA and apparently was not the author.  The precise authorship of the amendment remains a matter of debate, but Senator William D Cohen (R-ME), later President Bill Clinton's Defense Secretary, eventually did explain the provision for the markup session.  Because this was 8 years ahead of Gramm-Leach-Bliley and the repeal of Glass-Steagall, commercial banks like Citi probably did not push this change at that time, according to several in the loop.  Instead, the leading investment banks, which were long jealous of the commercial banks access to the Fed Discount Window, reportedly pushed the provision and a lobbyist apparently explained the amendment to Cohen in advance.

Fed Vice Chairman Don Kohn, then a senior Federal Reserve Board staffer, reportedly was present and approved the amendment for the Fed, with the knowledge and support of Gerry Corrigan, who was then President of the Federal Reserve Bank of New York and Vice Chairman of the FOMC. In those days and generally, Corrigan was running bank supervisory policy for the Fed until his departure to join Goldman Sachs as chief risk honcho. While he was responsible for the decision to support the emergency liquidity provision of FDICIA, Fed Chairman Alan Greenspan reportedly never engaged directly on bank supervisory issues and may not have understood the significance of the issue at that time.  

When Todd, who published a commentary for AIER ("The Bear Stearns Rescue and Emergency Credit for Investment Banks") updating his earlier work, had the temerity to suggest internally within the Fed system that the changes to the emergency liquidity provisions of the FRA in FDICIA were dangerous and would place the Fed at risk of loss, he and his superiors in Cleveland reportedly was attacked by Kohn and other members of the Board's staff. 

The harsh reaction by the Fed's staff in Washington to dissonance from the provinces is understandable from a certain corporatist perspective.  The Fed's staff in Washington historically has been captive of the large New York banks.  Todd and other members of the FRB Cleveland management, reflecting a more Midwestern view, were censured during the Board's annual review of the reserve bank's performance and eventually Todd was forced to leave the Fed entirely.  Even the directors of the reserve bank reportedly were rebuked by the Board for allowing Todd to publish his heretical views!  The political backstory surrounding the adoption of the emergency liquidity provisions of FDICIA illustrates the shabby, at time vicious treatment of Todd and other reserve bank researchers during the Greenspan years. 

Remember that there were no hearings on the amendment at the time -- it was language submitted during a Senate markup by Christopher Dodd that survived in final conference report. Thus Kohn provided the only "official" Fed view on the amendment to FDICIA's liquidity provisions, the very provisions employed two decades later by Geithner, Bernanke and Kohn to do Hank Paulson's bidding and finance the ongoing bailout of Wall Street.  While Todd noted at the time the implications of the changes to FDICIA, the story of how the emergency liquidity provisions now employed by the Fed came into being remains to be told in full in public by the Big Media.

The legal enablement for the bailout, enacted some 20 years ago, was put in place with even less debate and transparency than the 2008 bailout for Bear, Stearns, AIG, GS and the rest of Wall Street.  The FDIC noted in its official post-mortem of the 1980s banking crisis: "Nevertheless, by 1991 and the passage of FDICIA, lawmakers -- having previously urged such programs -- were now unwilling to allow the agencies to exercise discretion in keeping banks afloat."  But nothing was further from the truth.  Some 15 years after publication of his monograph, it seems that Walker Todd was right and Corrigan, Kohn and the other culprits at the Board of Governors were wrong about FDICIA and the implications of changing Section 13(3) of the FRA.

The changes to the emergency liquidity provisions of the FRA via FDICIA, a law that actually promised to limit bailouts for large, insolvent banks and thereby protect the taxpayer, began the duplicity in Washington that continues to this day.  Just as Treasury Secretary Hank Paulson falsely sold the Congress on the TARP program based upon asset purchases and the hope of foreclosure relief to home owners, FDICIA was sold as regulatory reform to protect the taxpayer from big bank bailouts.  But, in fact, the political interests representing some of the leading Sell Side institutions on Wall Street used FDICIA to pave the way for the largest public bailout of private companies in modern human history.

The late Bob Weintraub, who served on the staff of the House Banking Committee and wrote extensively about economics and the Fed, told a colleague once that "the Fed can bail out anything in return for any collateral."  The importance of this obvious statement is overshadowed by a larger truth.  When federal agencies want to do something, such as bail out a client, they will do it regardless of their legal authority. When they don't want to do something, such as regulate banks, they will refuse to do it - even in the face of a legal mandate from Congress. 

Senator Carter Glass, who devised the Federal Reserve System but fought federal control of the central bank, prophesied that the Fed might one day become "the handmaiden of the Treasury" when a profligate government sought a bailout.  Little did Senator Glass ever dream that the bailout would occur under a nominally Republican government and that the Fed and Treasury already would be controlled by GS and other Wall Street firms!   

But hope remains if we return to first principles.  Transparency and accountability lead to credibility, the short version of why bankruptcy is better than bailouts.  That may be the chief lesson of the past year.  Hopefully our new President and his government will take the lesson as well.   

Questions? Comments? info@institutionalriskanalytics.com


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