Mission Creep: The Incredible Expanding Power to Bailout

I’ve been watching the three big regulators in the Financial Crisis (the Fed, the FDIC, and the SEC) start doing things unheard of only a year ago.  What has been baffling is no one has changed any laws or charters while these things keep happening.  I’m not a lawyer and I don’t have the time to go poking around a lot of the charters and laws surrounding these institutions, but you have to start wondering if some of their more unconventional moves are technically legal.

I’ve been watching the Fed Open borrowing at the Discount Window and accepting some really strange collateral.  The Discount Window used to be exclusive to member banks.  I’ve been looking over what they now accept as collateral and am surprised. Take a look at the list and see if you’d like to be left holding the bag on some of these things.  I’m not sure I want these off budget quasi agencies turning their balance sheets into dumping grounds for some of the most heinous looking gambles available on the market.

The NY Times Reporter Andrew Ross Sorkin has been poking around the charter and law concerning the FDIC.  The FDIC was chartered to provide deposit insurance to bank deposits.  You would think that is a fairly straight-forward task.  However, when the charter was written, the size of the task at hand today was  unfathomable and it seems the FDIC is tiptoeing around some of its charter provisions.   The FDIC is barred from incurring any obligation greater than $30 billion and its about to take part in guarantees that would commit $1 trillion in the PPIP bank bailout program. Sorkin reports on what he calls “mission creep” here.

Now, because of what could politely be called mission creep, it’s elbowing its way into the middle of the financial mess as an enabler of enormous leverage.

In the fine print of Treasury Secretary Timothy F. Geithner’s plan to lend as much as $1 trillion to private investors to help them buy toxic assets from our nation’s banks, you’ll find some details of how the F.D.I.C is trying to stabilize the system by adding more risk, not less, to the system.

It’s going to be insuring 85 percent of the debt, provided by the Treasury, that private investors will use to subsidize their acquisitions of toxic assets. The program, extraordinary in its size and scope, is the equivalent of TARP 2.0. Only this time, Congress didn’t get a chance to vote.

These loans, while controversial, were given a warm welcome by the market when they were first announced. And why not? The terms are hard to beat. They are, for example, “nonrecourse,” which means that if an investor loses money, he owes taxpayers nothing. It’s the closest thing to risk-free investing — with leverage! — around.

At Conde Nast Portfolio, Felix Salmon sums up the possible overreach and the potential risk to the FDIC and its missions.

The sneaky way that the FDIC is getting around this obstacle is to say that the value of those obligations is actually zero, since zero is the “expected cost to the corporation”. And the FDIC’s chairman, Sheila Bair, is coming out with some very peculiar statements in trying to justify the massive expansion in her agency’s power and budget:

She also defended her agency saying that the F.D.I.C. has not experienced mission creep: the various programs that it is participating in are meant to insure the stability of the financial system, which she says was always the goal of the agency.

No, Sheila, the goal of the Federal Deposit Insurance Corporation was always, quite narrowly, to insure deposits. Deposit insurance is one way in which governments help to insure the stability of the financial system, but it’s not the only way, and it’s disingenuous in the extreme to say that just because you were insuring deposits in the past, you’re qualified and legally allowed to do anything else which might make the financial system more stable.

After all, the OCC and the OTS and the Federal Reserve and even the SEC are all involved in insuring the stability of the financial system too, and no one’s suggesting that they can therefore take on hundreds of billions of dollars of contingent obligations.

But this is all academic, really; just as the FDIC isn’t really able to take on these debts, there’s no one remotely able to stop it from doing so, not when it’s all part of Treasury’s grand plan. All it needs is the thinnest veneer of legality, and it seems to have found that. It’s a fait accompli.

There seems to be a lot leeway built into that general charter point that all have to “insure the stability of the financial system”.  Does this include making moves that bring so much risk into these quasi-agencies that they themselves might become unstable?

Here’s another mission creep mentioned at Market Watch and provided by Treasury Secretary Timothy Geithner.  Author Ronald D Orol wrote about the potential of a too-big-too fail hedge funds in his article  “White House ponders: Are some hedge funds too big to fail?” Since we just found out that Larry Summers has been at a high priced call boy for one of those huge hedge funds, I can only imagine what’s going on behind close doors in conversations in the West Wing.

There have been some legendary failures of hedge funds.  Connecticut hedge fund Amaranth Advisors (asset size of $9.2 billion) went under in 2006.  You can’t get through an investment or financial institutions graduate level seminar without being doused in the lessons from the 2000 failure of Long Term Capital Management.  In the first three weeks of that September, LTCM’s equity fell from $2.3 billion to $600 million.  The mega failures of these firms was successfully managed and probably was the rationale behind letting Lehman fall.  However, because the Lehman fall was so detrimental to market conditions, we now appear to be on the path of bailout out all kinds of Financial Institutions. From the Market Watch article:

In an effort to limit the fallout from any future major hedge fund collapse — or private equity implosion — Treasury Secretary Timothy Geithner proposed on March 26 a framework for regulatory reform that not only included registration of hedge funds managers, but also called for new rules for buyout shops, venture capital and insurance companies.

Nevertheless, Geithner’s proposal leaves more questions than answers.

“Why should taxpayers pay for hedge-fund failures?” asked Georgia State University Business School Professor Vikas Agarwal who argues that already disgruntled taxpayers and legislators are sure to take issue with a government bailout of a major hedge fund.

New regulation of hedge funds would require legislation from Capitol Hill, or new rules from the Securities and Exchange Commission.”

Treasury Secretary Geithner appears to think that every ‘big’ financial institution, no matter what its purpose, is systematically significant and requires rescuing if it fails.   So, my question is why did the FED let these banks merge and acquire to get to be so systematically significant that they risk bringing down the entire financial system.  If there’s danger in being ‘big’, why let them get that big? Given that banks play a unique, almost public, role in the economy. It is worth saying that banks probably do deserve some special attention, but hedge funds?

But wait, it gets more interesting.  Take a look at this:

Possibly the most controversial aspect of Geithner’s plan for hedge funds focuses on how regulators could unwind systemically significant non-bank institutions by bypassing traditional bankruptcy proceedings that might pose a threat to the workings of the financial system as a whole.

His measure called for the creation of a resolution authority that could help unwind systemically significant banks, but the entity would likely also oversee the winding-down of mega-hedge funds and other super-sized alternative investment vehicles whose pending collapse would ripple catastrophically through the markets.

The resolution authority could be housed at the Federal Reserve or a brand-new entity designed for the purpose; it could also be set up by a new interagency panel that delegates authority to different agencies. But the most obvious agency to put such authority would be at the Federal Deposit Insurance Corp., which already routinely winds down failed banks through its deposit insurance fund.

Here’s how the FDIC program works: The agency charges banks fees to build up its deposit insurance fund, which are used to pay depositors of failed institutions. Keeping with this system, the FDIC could be required to set up a similar insurance fund or funds for large hedge funds, buyout shops and insurance companies.
However, placing the authority with the FDIC raises questions. Bankers complain that they already are being charged heavily to wind-down failed banks. They don’t want their fees to help unwind systemically significant hedge funds.

“It would be unfair to pull resources from the banking industry to resolve non-banks,” said Edward Yingling, president of the American Bankers Association.

FDIC Chairwoman Sheila Bair recently told a gathering of bankers not to worry: Should the FDIC be imbued with broader resolution authority, alternative investment companies would be regulated separately from banks.

That’s a bit like closing the barn door when the horses have already run off while still paying the folks for the horses that pulled the barn door open.  Anyway, you should read all the articles I’ve cited and follow this closely.   A lot of new regulation needs to put into place to get the system to reboot, but I’m not sure letting the old system get away with more crimes is going to help that process along at all.  I am, however, certain that I know who’ll be paying the retirement funds and bonuses of the bank robbers as well as refilling the tills of the banks.  Go buy some Astrolube,  you might as well be comfortable in the process.