The Wall Street Journal reported yesterday on the government’s latest improvisation for propping up the banking system, called “loss-sharing”. Essentially, what it boils down to is that the FDIC encourages healthy banks to acquire failing banks by guaranteeing that it will cover 80% of any losses arising from the acquisitions. The Journal and others have correctly observed that this amounts to a taxpayer-funded giveaway to the acquiring banks. While it is certainly true that loss-sharing is yet another federal giveaway to banks, I believe that focusing on this part of the picture overlooks the most important aspect of the program.
As many in the media have been reporting recently, the FDIC is nearly out of money. Of course, the FDIC will not be allowed to go bust. When it runs out of money, it will simply get a bailout from the US Treasury. That being said, with the government and the mainstream media doing their best to convince us that a recovery is underway, an emergency bailout of the FDIC would have a large psychological impact and would call into question the rosy scenario being promoted by the powers-that-be.
So, if you’re the US government and you realize that your credibility depends on maintaining the illusion of economic recovery, how do you deal with the unpleasant reality that the FDIC is nearly bankrupt? Answer: loss-sharing.
When a bank is forced into receivership, the FDIC has to find another bank to acquire it. Obviously, nobody is going to want to assume the full liabilities of a failed bank, so the FDIC absorbs some of the losses, thereby making the acquisition worthwhile to the healthy bank. This process has been playing out on a weekly basis, with 85 banks being taken over by the FDIC so far this year. (The announcements are always made on Friday afternoons in the hopes that they will attract as little attention as possible.)
In the absence of loss-sharing, each time the FDIC brokers a takeover of a failed bank, it costs the FDIC money. Now that the FDIC is almost out of money, it would have to borrow money from the US Treasury in order to continue operations. Loss-sharing, however, allows the FDIC to continue bailing out banks without acknowledging its own insolvency.
With an FDIC loss-sharing guarantee in place, an acquiring bank can afford to pay a higher price for the failed bank than would otherwise be the case. This means that the FDIC has to provide less money up-front to make the acquisition happen. The losses which would otherwise have to be acknowledged and paid for are thereby papered over and postponed.
Essentially, what this amounts to is a public-sector version of the mark-to-market controversy. The issue with mark-to-market is whether companies are required to value their assets based on current market prices or whether they can use some other valuation model to present a rosier picture. Many analysts believe that a large percentage of US banks would be bankrupt if they were required to mark their assets to market. Not requiring mark-to-market valuation is therefore a way of averting bankruptcy by allowing banks to avoid coming to terms with reality.
Loss-sharing accomplishes exactly the same thing for the FDIC. If the FDIC were required to keep paying off the losses of failed banks, it would be forced to acknowledge its own insolvency and ask for a bailout of its own. By entering into loss-sharing arrangements, the FDIC is able to postpone the day of reckoning in the hopes that a smoke-and-mirrors recovery takes hold and eliminates the need to ever realize those losses. Of course, the flip side of this is that if the economy does not recover and banks continue to lose money, the eventual losses to the taxpayer will be even greater.
So, in addition to the obvious fact that loss-sharing is yet another way for the government to give money to banks, its more important function is to allow the FDIC to limp along a little while longer without admitting the fact that it is bankrupt. In other words, our government, which promised to clean up the financial system by improving transparency and accountability, is adopting the very same shenanigans that led to all of these problems in the first place. Anyone who understands the nature of the decisions that are being made should be very wary of any proclamations that the government makes about our improving economic prospects. If our prospects were really improving, desperate window-dressing measures like loss-sharing wouldn’t be necessary in the first place.