It Will Get Better—But Not Soon

The good news is that oil is under $50 a barrel. The bad news is the recession is going to get worse before it gets better. I surely get tired of hearing (and talking about) the bad news, even though it has been accurate so far in predicting the future of the financial and economic mess we (that is, the world) are in.

We have seen some dramatic and unprecedented action by the Fed that has resulted in preventing a complete collapse of the financial system, but it hasn’t fixed much for the future. If the Fed’s and Treasury’s guarantees were withdrawn, we wouldn’t have any functioning market. In addition, we have experienced a zigzag of operations surrounding the newly authorized TARP $700 billion rescue program. The recapitalizing of the banks that Secretary Paulsen settled on has been poorly administered thus far, and may do the banking system more harm than good in the long run. Having regulators pick winners and losers in the competitive banking world is not a winning strategy. I haven’t met many regulators that would be outstanding bankers-they are too risk-averse. Furthermore, this plan to put money in the financial system doesn’t produce the real capital that the system needs. In fact, there’s no flood of new loans for the economy because of this feature.

Finally, we have the bailouts of the “too big to fail” banks, with Citi being the outstanding example of such, and insurer AIG showing how this concept can be put to use outside of insured depository institutions.

Many say the RTC and FDIC were the creators of this moral hazard back in late 1980s. But the new “Citi-way” is not the way we at the FDIC handled big banks when they were in such bad shape they needed help. We did not routinely provide “open bank assistance” (and only did so in the very rare case where the management was exemplary).

Here is what we did do, however: We did keep banks open and operating insofar as the powers in the financial system and creditors were concerned. We did provide funding for stability only after the bank was closed and the shareholders lost everything and because a new corporation was put in place. If a bank needed government help, then we required a new team be brought in to run the bank and, subsequently, the FDIC became the sole owner of the rejuvenated bank. We would then sell the bank, or take it public, as soon as possible.

The mechanism developed for this maneuver was known as the bridge bank, which was created to take over assets and liabilities and a financial operations of the bank that failed. Operations could continue as though nothing had happened, as far as creditors were concerned. And while we didn’t completely get rid of the moral hazard, we put a pretty good dent in it. Under this scenario, the penalties of operating recklessly were as obvious to the bank’s management as to its shareholders. The shareholders lost everything when the bridge bank was put into place.

As I was finishing my term as FDIC chairman, Congress enacted a new law that stipulated that the FDIC had to take the “least-cost method” in resolving failed banks. This new law was an effort by ideological folks to prevent the FDIC from covering all depositors (not just those insured up to $100,000). Their effort to fight the moral hazard threats usually did cover all depositors (insured and uninsured) when a bank failed because that is what bank buyers wanted and were willing to pay for. They didn’t want their best customers to take a loss on the uninsured part of deposits. Those large depositors were the most valuable asset of the bank.

It seems to me that the concept of the bridge bank ought to be put back into use in cases like Citicorp. Certainly the government is providing the funds to keep it solvent, so the government ought to own the bank. Government ownership would be a least-cost solution, since the whole bank would belong to the FDIC.

And to take this one step further, where would the FDIC find new board members and managements for the bridge banks? There’s an unemployment problem in the country and the banking sector has plenty of talented people looking for jobs. So far, the taxpayers have been getting a bum deal. So let’s reduce moral hazard and increase returns for the taxpayers.

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