Risk in an economic system’s internal banking infrastructure is like energy in an isolated physical system. It can neither be created nor destroyed, but can only change its form and location within the system. Prior to 1933, bank depositors bore the risk that bank failure might result in a loss of their deposits. In 1933, the United States, with the passage of the Glass-Steagall Act, tried to eliminate, or at least reduce, the risk borne by individual depositors in the event of a bank failure. For the most part, it worked, and in the process made bank failures less common, as banking runs became somewhat superfluous. There was no need to beat the other depositors to the teller’s window when the return of the money was insured by a creation of the federal government. Technically speaking, the federal government did not itself insure the deposits, at least not then, but the deposit insurance fund had the full faith, if not credit, of the United States government.

But this risk-shifting did not eliminate any risk. It just spread it around more evenly within the system. In the process, it alleviated the need for bank customers to inquire as to the financial health and management of the banks to whom they entrusted their money. So long as they didn’t exceed the rather generous limits (for an average individual) of deposit insurance, and the banking system itself was generally healthy, they had no reason to worry about the bank’s risk management competence, or lack thereof. It would take more than one bad bank to destroy the safety net of deposit insurance, and what are the odds there would be much more than one or two bad banks at any particular time? Depositors turned a blind eye to the risky projects banks underwrote with their money, opting instead for the offers of free toasters and silverware in deciding where to place their accounts.

It is said that bad currency will drive out good. The same is true for banks whose main liabilities are insured by a third-party, quasi-government entity. Banks that invest in highly speculative but riskier projects (bad banks) drive out those that opt to treat the deposits of its customers with fiduciary care. But the enabling legislation (Glass-Steagall) providing for deposit insurance also provided for very severe regulations and oversight on what banks could do with their depositor’s money. Most specifically, commercial banks whose deposits were insured by the FDIC could not partake in a whole range of investments considered too risky. Then Glass-Steagall was repealed by the Gramm-Leach-Bliley Act of 1999. Which would have been fine, had deposit insurance been eliminated along with the regulations and restrictions. But it wasn’t. Now, bad banks could finally drive out the good ones. The stage was set for disaster.

It came from a quarter probably no one expected, at least so far as the commercial (deposit-taking) banks were concerned. Until the repeal of Glass-Steagall, commercial banks had never played heavily in the burgeoning securities markets for residential and commercial real estate. They were not prohibited from investing, via residential and commercial mortgages, in these markets, but generally did so just to hold the paper as their own investments. If the investment went sour, the losses flowed straight to their bottom line. Enough bad investments, and the bank would get a visit from FDIC inspectors and soon enough, usually on a Friday, the bank would shut its doors under its old management and reopen under new management the following Monday. With Glass-Steagall’s repeal, the wonderful world of securitization was opened to them and they finally got to compete with white-shoe investment houses for underwriting deals, and were finally allowed to actually buy and sell securities, including those tied to the residential real estate market. All this came with the FDIC backing whatever mistakes they might make with their depositors money.

The mistakes cascaded into a torrent along about the middle of 2007, when it was discovered to apparently everyone’s surprise that residential real estate prices don’t have a one-way trajectory, and that there needed to be more substance to a borrower’s ability to repay a loan than his ability to fog a mirror held closely to his face by a friendly mortgage broker in his credit-besotted stupor.

All of the sudden, the securitization gig was up.

The holes securitization losses bored into the bank’s balance sheets left many of them decimated and near collapse. The FDIC stepped in, but it was too late. The damage was done. Banks began failing, i.e., were unable to meet their creditors demands for cash, at magnitudes never before seen. It only took a few Wachovia’s and Indymacs and Washington Mutuals, and the insurance fund was broke. It is now roughly $20 billion in the red, with no relief anticipated until 2012 at the earliest, even with the fund requiring three-year advance payment of premiums from those banks still standing and able to contribute. The fund is statutorily required to keep 1.15% of reserves against insured deposits. The highly leveraged fund is doing no better now than its failed client banks, with less than zero money available in-house to meet its obligations.

So the FDIC turned to the US Treasury for money. It now has a $500 billion credit line with the Treasury. Yes, $500 billion. A half trillion dollars that these self-same insured depositor-taxpayers are on the hook for if the banks go belly up. The FDIC is now not unlike a too big to fail banking enterprise, dependent on taxpayer largesse to keep it afloat. The risk came back around to the folks (the depositors-taxpayers) that had initially tried to dispense with it. Risk doesn’t evaporate. It just takes new forms.

Now we basically have a system where the folks that wished to dispense with the risk of losses are faced with bearing the brunt of them, but only after their agent for risk suppression tries to mitigate losses. The FDIC’s loss mitigation strategy is questionable at best. It now sells to hedge funds and buy-out shops portions of its assets. It is doing so on such favorable terms that one hedge fund adviser to a deal was quoted as saying, of his clients “They’re guaranteed to make a profit. It’s just not sure how much.” But the projects can most assuredly lose money, whether the risk of loss falls on him or on those risk-averse depositors/taxpayers. 

Where things go from here is anybody’s guess. It seems that the lesson to be learned is a simple one from physics–energy/risk in a closed system, such as the internal banking system for an economy, can not be eliminated by government fiat. It can change form, it can be dispersed, but it never goes away. It is the essence of government hubris to believe otherwise.


FDIC memorandum on Deposit Insurance Fund Loss, Income and Reserve Ratio.  June 8, 2010


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