The disposition of Washington Mutual by the FDIC and the ongoing bailout of AIG by the Federal Reserve point to a bias of fulfilling the claims of derivatives contract holders over the claims of stockholders and subordinated debt holders.
Recapitalizing the banks is proving difficult. Private investors remain on the sidelines. As the crisis unfolded last fall, private capital stopped flowing into the banks and the debt instruments used by banks to fund their lending activities. With this institutional bias toward fulfilling derivates contract claims over subordinated debt claims, there is no incentive for private capital to strengthen banks' balance sheets. Actions by the government have only served to keep private investment on the sideline.
The traditional sources of funding for lending activities are being shortchanged while owners of credit default swaps are being made whole. This has the perverse effect of rewarding those betting on failure. (Hey, isn't this the current Republican platform?)
I'd like to know if the FDIC request of a $500 billion line of credit is simply prudent planning in case of multiple big bank failures, or is this needed to make good on derivatives contracts of the failed institutions?
The details follow below the fold...
The Wall Street Journal recently reported that $50 billion in bailout money for AIG went to paying its derivatives counterparties. The original $85 billion line of credit extended to AIG has ballooned to $173 billion with a seemingly endless, open-ended commitment. The Fed remains as opaque as ever regarding the use of these funds.
Reviewing how the FDIC handled the largest bank failure to date just adds more speculative fuel to the fire that derivates contract holders are going to be made whole, despite their role in the collapse of our financial system.
The FDIC press release announcing the acquisition of Washington Mutual by JPMorgan Chase included rather boilerplate language:
JPMorgan Chase acquired the assets, assumed the qualified financial contracts and made a payment of $1.9 billion. Claims by equity, subordinated and senior debt holders were not acquired.
The FDIC mission is to promote the stability and confidence in the financial system by insuring deposits, among other things. The FDIC Resolution Handbook At A Glance spells out the order of payment of claims:
PDF (page 6 of PDF, page 86 of the original document)
The National Depositor Preference Amendment and related statutory provisions provide that claims are to be paid in the following order:
- Administrative expenses of the receiver,
- Deposit liability claims (the FDIC claim takes the position of the insured deposits),
- Other general or senior liabilities of the institution,
- Subordinated obligations, and
- Shareholder claims.
But what about these qualified financial contracts? Where are they on this list, and what are they anyway?
12 U.S.C. Section 1821(e)(8)(D) provides the definition of qualified financial contracts:
(i) Qualified financial contract The term “qualified financial contract” means any securities contract, commodity contract, forward contract, repurchase agreement, swap agreement, and any similar agreement that the Corporation determines by regulation, resolution, or order to be a qualified financial contract for purposes of this paragraph.
(vi) Swap agreement The term “swap agreement” means—
(I) any agreement, including the terms and conditions incorporated by reference in any such agreement, which is an interest rate swap, option, future, or forward agreement, including a rate floor, rate cap, rate collar, cross-currency rate swap, and basis swap; a spot, same day-tomorrow, tomorrow-next, forward, or other foreign exchange, precious metals, or other commodity agreement; a currency swap, option, future, or forward agreement; an equity index or equity swap, option, future, or forward agreement; a debt index or debt swap, option, future, or forward agreement; a total return, credit spread or credit swap, option, future, or forward agreement; a commodity index or commodity swap, option, future, or forward agreement; weather swap, option, future, or forward agreement; an emissions swap, option, future, or forward agreement; or an inflation swap, option, future, or forward agreement;
When the FDIC was initially chartered, deposits served as the primary source of funds for lending. Stability of the system required insuring depositors. And it still imbues confidence in the system by depositors today. But times have changed, and the use of deposits as the primary funding source for lending has gone by the wayside. This role has largely been assumed by subordinated obligations.
In banking, subordinated debt includes instruments such as asset-backed securities, collateralized mortgage obligations, and collateralized debt obligations. These instruments are primary sources of capital for student loans, car loans, credit cards, and mortgages.
So if we are so concerned with getting the banks lending again, shouldn't we be doing something to put confidence if the subordinated debt instruments that provide the bulk of the funding?
This is where things get messy. Transferring the risk of default of subordinated debt has largely been handled through the use of credit derivates. The idea being that transferring the risk of default would lead to more capital available for subordinated debt and therefore increase the pool of capital available for lending.
It seems to me that if we recognize that (1) the credit market remains frozen; (2) that the derivates market no longer satisfies the notion of expanding the pool of capital available for lending; and (3) that the derivates market needs to be overhauled and regulated, then it is time to start breaking derivatives contracts.
The same page of the FDIC Handbook that spells out the order in which claims are paid also enumerates several of the Special Receivership Powers granted to the FDIC. Chief among them
• A receiver may repudiate contracts of the depository institution that it deems are burdensome.
It may make sense to make qualified financial contract holders whole when looking at bank failures in an isolated situation. But we are facing a systemic failure, and the derivatives have played a significant role in the failure of the system.
Until subordinated debt holders are put on equal footing with derivates contract holders, the system will remain broken.
So, let me return to the question I posed above. Is the FDIC $500 billion line of credit all going toward backing deposits or is a significant portion of this line of credit needed to make qualified financial contract holders whole?
The FDIC reported at the end of February that it expects bank failures will cost the insurance fund $65 billion through 2013. Is the FDIC planning for bank failures at a level almost 8x greater than reported 10 days ago? Or is this a sign of looming derivates contracts that we will be assuming?
McClatchy recently reported:
Citibank, Bank of America, HSBC Bank USA, Wells Fargo Bank and J.P. Morgan Chase reported that their "current" net loss risks from derivatives — insurance-like bets tied to a loan or other underlying asset — surged to $587 billion as of Dec. 31. Buried in end-of-the-year regulatory reports that McClatchy has reviewed, the figures reflect a jump of 49 percent in just 90 days.
These banks also happen to be in the top 15 for insured deposits at the FDIC.
Geithner signaled his preference of enticing private capital to recapitalize the banks with the Public-Private Investment Fund. I don't see this working as long as derivate contract holders are more likely to recoup their investment through continued bank failures.