Friday 10 October 2008

US Weighs Backing Bank Debt

The U.S. is weighing two dramatic steps to repair ailing financial markets: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits.
PDF

1 comment:

  1. US Weighs Backing Bank Debt

    By Damian Paletta, Carrick Mollenkamp and John D. McKinnon
    10 October 2008

    WASHINGTON – The U.S. is weighing two dramatic steps to repair ailing financial markets: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits.

    If the two moves come to fruition they would mark the government’s most extensive intervention yet in the financial system, as officials ponder increasingly far-reaching measures to stem the sprawling crisis.

    The top economic officials of the Group of Seven leading industrial nations will meet starting Friday in Washington where they intend to discuss a proposal from the U.K. government to bolster bank lending. Problems in the credit market have led to widespread dislocation in the financial system and the broader economy.

    Under the U.K.’s recently announced plan, which it is now pitching to the G-7 members, the British government would guarantee up to GBP 250 billion ($432 billion) in bank debt maturing up to 36 months. The British concept to expand its proposal to other countries has a lot of support from Wall Street and is being pored over by U.S. officials, according to people familiar with the matter.

    White House spokesman Tony Fratto said the U.S. “is reviewing the idea and discussing it with our British counterparts.”

    The move to back all U.S. bank deposits, which is only in the discussion stage, would be aimed at preventing a further exodus of cash from financial institutions, including small and regional banks, some of which are buckling under the strain of nervous customers. In recent weeks, customers have pulled money out of some healthy community banks under the assumption that the government will only insure all the depositors of larger banks in the event of a failure.

    To remove the ceiling on deposit insurance, multiple government agencies would first need to agree that there was a “systemic risk” to the economy, thereby invoking a rarely used legal power. Amid repeated efforts by the federal government to prop up ailing institutions, some bank regulators say the move is justified.

    It’s not clear that either idea will become reality, and U.S. officials downplayed expectations of any announcement this weekend. But as the crisis deepens and stocks continue to tumble, pressure is building on the Bush administration to find a solution that goes beyond the $700 billion financial rescue plan recently signed into law. Having the government back bank lending would effectively entail the U.S. being the backstop for the country’s financial system.

    Western industrial powers have taken various ad hoc steps to stem the global crisis. Central bankers have cut interest rates, governments have agreed to strip toxic assets out of banks, and regulators are mulling how to directly inject capital into the banking sector. So far, the moves have failed to calm markets.

    They have also been mostly one-country-only solutions that lack a broad coordination, despite the fact that the global financial system is linked. A move by one country has lately forced the hands of others, as happened when Ireland moved to insure its bank deposits last week. The European Union has struggled to develop a common approach to the crisis, exacerbating the problem.

    “The interdependence of the major global financial markets has been established beyond the slightest doubt,” said H. Rodgin Cohen, chairman of the law firm Sullivan & Cromwell and a top adviser to Wall Street firms. “As a consequence, it is essential that the major countries act collectively and cooperatively.”

    One major flaw in the global banking system, and a sign that problems extend beyond whether U.S. homeowners can pay their mortgages, is the fact that banks don’t trust each other enough to loan beyond an overnight period. That means that cash isn’t being circulated through the financial system and banks are relying too heavily on short-term loans, which does little to help pay off looming debts. Banks are hoarding cash, both to cover their debts and to improve their year-end books.

    The plan in the U.K. was hammered out by Treasury Chief Alistair Darling as well as the chief executives of major British banks earlier this week after a sharp drop in U.K. bank stocks.

    In the U.S., some $99 billion in just one type of bank debt is coming due between now and the end of the year. Hundreds of billions of dollars will need to be paid in the U.S. and Europe. Government backing would make it easier to issue new debt to help pay for that.

    The problems in so-called interbank lending, or short-term loans made between banks, date to August 2007. Markets froze after a little-known German lender called IKB Deutsche Industriebank AG ended up with big debts it couldn’t pay. More recently, the bankruptcy-court filing of Lehman Brothers Holdings Inc. sparked a new freeze in the interbank-borrowing market when money-market funds, laden with Lehman debt, yanked their cash out of the commercial-paper market, a vital cog in how companies fund their short-term obligations.

    The U.K.’s decision to guarantee bank debt sparked talk that the U.S. would need to make the same move. On Thursday, the three-month dollar London interbank offered rate, or Libor, hit 4.75%. On the Friday before Lehman filed for bankruptcy protection, the three-month rate was 2.81875%. A surging Libor could exacerbate larger economic problems because many mortgages are tied to rates that fall or rise depending on Libor.

    Offering unlimited or steeply higher deposit-insurance limits in the U.S. would closely resemble what several European countries, including Germany, Denmark and Ireland, have done recently. Regulators would have discretion about whether to raise limits for just retail accounts or for corporate accounts as well. If they use the authority, it is expected to extend to all deposits, as the loss of large corporate accounts for banks can be devastating.

    “Our European friends have done it, so there will be great pressure to follow,” former Federal Deposit Insurance Corp. Chairman William Seidman said.

    The FDIC has roughly $45 billion in its deposit-insurance fund to cover $5.2 trillion of insured U.S. deposits. Lifting the cap entirely would mean the FDIC would be guaranteeing the remaining $1.8 trillion of U.S. bank deposits. An element of the recently enacted bailout law gives the FDIC much broader authority to borrow money from the Treasury Department to backstop its fund if it became necessary.

    A blanket guarantee on deposits could present risks apart from exposing the FDIC to enormous costs. Guaranteeing all bank liabilities without doing the same for money-market mutual funds or insurance companies could prompt customers to move money from one sector to another, seeking the best protection.

    Yet not making such a move opens up the possibility that customers with large deposits in U.S. banks might withdraw their funds and move them overseas to jurisdictions that offer more insurance.

    The possibility of removing the cap on deposit insurance was raised last week by Treasury Department officials who asked lawmakers to consider giving the FDIC broad discretion to determine the level of government insurance. Lawmakers instead opted to temporarily raise the existing $100,000 federal limit to $250,000, feeling that anything higher could threaten passage of the bailout package.

    But the worsening condition of the banking sector has fuelled discussions among government officials about whether they should be prepared to remove the limits entirely.

    “I think that lifting the cap entirely is something that may have to be done, really, just in the next few weeks,” said Camden Fine, chief executive officer of the Independent Community Bankers of America, a trade group.

    Bank regulators believe the “systemic risk” clause in federal law gives them the authority to lift insurance limits, though it has never been used to do so before. “We believe that we have significant latitude, in consultation with Congress, under the systemic risk exception ... to protect depositors and adopt other measures to support the banking system,” FDIC spokesman Andrew Gray said.

    Last week, the FDIC invoked the risk clause for the first time when it agreed to take on some potential losses to assist in the sale of Wachovia Corp. to Citigroup Inc. That deal fell apart Thursday, though, when Citigroup backed out of the deal after a contentious legal dispute with Wells Fargo & Co.

    Comptroller of the Currency John Dugan, one of the nation’s top bank regulators, said he supported the increased limit of $250,000. He added that policy makers had the power to back all deposits if necessary. “That is an important tool,” he said in an interview.

    Such a decision would require endorsements from the FDIC, Federal Reserve and Treasury Department. It is still not certain such an approach will be taken.

    Federal deposit insurance was created during the bank scares of the Great Depression. Raising insurance levels is one way policy makers could try to assuage the public about the solvency of their financial institutions.

    Thirteen banks have failed so far this year, the highest number since 1994. In roughly half of those cases, the FDIC sold off all of the failed banks’ deposits, which meant that no depositors lost money.

    But in several cases, acquiring banks purchased only the failed institutions’ insured deposits. That meant customers with levels above $100,000 potentially lost large amounts of money, though some of it can often be recovered later through the liquidation process.

    The FDIC estimated that IndyMac Bancorp Inc., which failed on July 11, had roughly $1 billion of uninsured deposits held by 10,000 depositors.

    Customers’ fears have spurred bank runs across the country, especially at wounded financial institutions. IndyMac and Washington Mutual Inc. collapsed, in part, because of late runs on their deposits. Wachovia, which came close to failing twice in recent weeks, has seen large outflows of deposits since last week, according to someone familiar with the matter. Wachovia declined to comment on its deposits.

    Dan Fitzpatrick, Joellen Perry and Sudeep Reddy contributed to this article.

    ReplyDelete