Streetwise Professor

September 28, 2009

I’ve Seen This Movie Before

Filed under: Economics,Financial crisis,Politics — The Professor @ 8:31 pm

The Federal Deposit Insurance Corporation is running out of money, and is thinking of ways to get it, like getting banks to prepay future deposit insurance premia and special assessments.

I know we’re not quite there yet, but this brings to mind events of 20+ years ago, during the S&L crisis.  In the late-1970s and early-to-mid 1980s, many S&Ls were insolvent, and the Federal Savings and Loan Insurance Corporation (FSLIC) didn’t have the money to seize them, and pay acquirers to take them over.  (An insolvent thrift’s deposit liabilities exceeded its assets.  To get somebody to take over the deposit liabilities, FSLIC had to pay the difference between liabilities and assets out of the insurance fund.)  Congress steadfastly refused to provide the money needed to replenish the FSLIC fund, so FSLIC resorted to various measures to keep going.  Mainly, it created “regulatory capital” out of thin air to permit insolvent thrifts to keep operating.  A bad thing, that, because such “zombies” had an incentive to double down and gamble their way out of insolvency.  Many didn’t, and lost even more money, thereby increasing the size of the financial hole FSLIC had to fill.

Another thing FSLIC did was sell off insolvent thrifts and instead of giving the acquirers a lump sum to cover the hole in the balance sheet of the acquired thrift, promised them a stream of payments (“yield maintenance,” for instance) that covered the difference between the cost of funding the deposits and the earnings on the bad assets.  It did this in a slug of deals in December, 1988.

Problem was that FSLIC grossly underestimated the cost of this financial support to the Treasury.  The assistance was tax advantaged, but FSLIC didn’t take this into account.  Moreover, in calculating the costs of the deals, it assumed that the acquirers would work out and sell the bad assets quickly, shortening the time that the government had to provide the support.  But since (due in part to the tax advantage) the assistance effectively paid an above market rate of return as long as the bad assets were on the books, the acquirers had the incentive to milk the assistance for as long as possible, thereby inflating the costs far above what the government estimated.

(Along with three colleagues, the late Vic Bernard and Roger Kormendi, and current dean of the U Chicago B-School, Ted Snyder, I performed an evaluation of the December ’88 deals that showed how badly the FSLIC blundered.  In retrospect, the numbers–in the billions–seem like chump change compared to what’s gone on in banking recently.)

A big part of the problem is that middling level government folks, well meaning to be sure, were matched up against heavyweights like the Bass brothers when negotiating these deals.  It wasn’t a fair game, by far.  The financial sharpshooters had no problems structuring deals that were very profitable to them, and very costly to the government.  It was an asymmetric information problem writ large.

Moral of the story: when government guarantors run short of money to cover their obligations in a timely, final way, they can do very stupid, costly, things.  Starved of the necessary funds by Congress, FSLIC fed moral hazard problems, and entered into hasty, cash-conserving transactions that provided benefits to acquirers that proved very hard for the government to value, and which wound up being very expensive.  These measures made the insolvency problem worse, and inflated the cost of resolving it.

FDIC doesn’t appear to be in such straits yet, but the fact that it is looking for “creative” ways to fund itself raises red flags.  The FSLIC experience suggests that it would be better to provide FDIC with the funds it needs today to meet its obligations to insured depositors, rather than rely on creativity which, in the stress inherent in these circumstances, can lead to decisions that make sense to FDIC in the short run, but which are very costly in the long run (and in present value terms).  That is, just as with businesses, cash flow problems can lead government guarantors to make inefficient, costly decisions.  Better to grasp the nettle now, give FDIC the wherewithal to meet its obligations, and figure out how to claw back the money from the banking industry later.

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