Sheila Bair's Big Gamble

Last week the FDIC shut down another three banks, bringing total bank failures in the US so far this year to 98. Last year there were 25, and in 2007, there were only 3.

The Federal Deposit Insurance Corp. is not just the government entity that insures your cash deposits in the bank; the FDIC also has the unenviable task of unwinding banks that have run up massive debts and have no cash on hand to pay them off or cover their customer’s needs. When too many customers (depositors) learn of the rickety state of their bank and line up to demand their money, it’s called a run on the bank. Runs can drain a bank down to nothing, and the FDIC has to make the call when it’s time to close the doors and sell off the remaining deposits and assets to another, healthier bank, thus avoiding a situation where the FDIC has to make good on all the remaining cash demands of the depositors and creditors of the bank long after all the cash has been drained away.

Unfortunately for the FDIC, the pool of healthy banks willing (and able) to buy up the assets of ailing banks has dwindled, leaving the FDIC with a lot of assets on its hands that may in the long-term be worth money, but right now can’t be sold for even pennies on the dollar. The FDIC’s own cash pool, which comes from annual fees paid by banks (about 12 to 16 cents for every $100 of deposits) has dwindled.

In 2008, the FDIC spent $20 billion of its cash reserves on 25 bank failures; this year, that figure is more than $30 billion. Last week, the FDIC’s cash reserves went into the red—meaning that they need to raise cash fast to cover more expected bank failures. The FDIC estimated earlier this year that they would spend approximately $70 billion total by the end of next year, but raised that estimate recently to $100 billion, so the need for cash is hanging over FDIC Chair Sheila Bair like the sword of Damocles.

Big investment banks, like Goldman Sachs and JP Morgan, have been keeping an eye on the situation and trying to figure out how to make money from it all. Last month they proposed loaning money to the FDIC so Sheila Bair, who’s been a major critic of how Fed Chief Ben Bernanke and Treasury Secretary Timothy Geithner have run the financial industry bailout (without strengthening regulation in the process), can avoid going to her enemies for a loan.

The FDIC has two ways to raise more money. It can borrow money from the US Treasury (with Timothy Geithner’s approval) or it can levy a special assessment on banks. But the FDIC had already issued a special assessment last May, and Bair’s critics wailed that another special assessment would only drive more ailing banks into the ground. Bair didn’t much like the prospect of borrowing money from Goldman or JP Morgan at usurious rates or, heaven forbid, at adjustable rates (a type of loan that should be illegal, after all the damage it’s done to the economy and to people’s personal balance sheets, but of course it’s not—that would stifle business). So Bair came up with a compromise.

The FDIC will ask banks to pre-pay their annual assessments through 2012. In other words, Bair is taking an interest-free loan from banks. In order to avoid harming the banks that are still struggling, she gave them the okay to not report the prepayments on their financial statements, so their cash reserves will look better than they really are.

How is this different from the accounting tricks that banks have been using to hide their debts and overvalue their risky investments to make their cash reserves look good? According to Bair, the difference is in degree. The few pennies that make up the FDIC assessment will be small change compared to the other expenses on banks’ financial statements. But those assessments will add up to $45 billion to replenish the FDIC fund.

The other, more important question is this: will this $45 billion be enough? By the FDIC’s own estimate, they’ll need at least $50 billion to get through the end of 2010. By asking banks to pay their assessments through 2012 right now, that leaves a gap of two years when the FDIC can expect zero income from its main source but will still have to close down troubled banks. A taxpayer bailout will be inevitable.

The fact that Sheila Bair—the only top regulator in this country who’s been outspoken about the causes of the crash—can’t turn to either the Obama administration or to Congress to replenish the FDIC’s fund is a symptom of just how sick our system is. She’s betting that things will get better between now and next year, that new financial regulation will be in place, that the economy will turn a corner, and that Congress and the American people won’t view a request from her to replenish the FDIC’s fund with taxpayer money as a taxpayer bailout that marks her as the same kind of leach as Kenneth Lewis of Bank of America or Franklin Raines of Fannie Mae.

I hope she’s right.

Dark Pools and Other Financial Arcana

“Dark pools” and “flash trading” sound like terms you’d find in a Harry Potter movie. But if you work for a large investment bank, these terms are as familiar as stocks and bonds and the NYSE. Too bad mom and pop investors don’t know what they are or how they can affect the value of your savings. The Wall Street Journal defines dark pools as “private markets where large orders are transacted.” [Source: “Traders Blamed for Oil Spike,” Ianthe Jeanne Dugan and Alistair MacDonald, WSJ, 7/28/09.]

Usually used by investment banks, hedge funds, and mutual fund brokers to disguise large purchases and sales of stocks and mutual fund shares (the trades are undertaken anonymously and don’t appear on any public exchange), dark pools are privately run and not subject to regulation by any governmental authority. Recently the SEC has recommended that dark pools register with the government and provide basic information on their activities. The companies that own and run dark pools are largely in favor of this mild increase in scrutiny, probably because they fear the SEC and Congress will close them down entirely if they don’t submit to some form of regulation.

The companies that utilize dark pools to avoid price run-ups or steep declines are resisting the government’s move to bring their activities to light. They argue that dark pools smooth price swings and thereby benefit small investors who would be afraid to invest in a more volatile market. But that’s the very best reason to regulate or shut down dark pools entirely. As with mortgage fraud, the federal regulators must go after any mechanism or scheme that makes the act of investing in the stock market and/or mutual funds seem safer than it really is. If people fully understand the risks of what they’re doing, they will make better choices for themselves. At the very least, we can hope that fewer people will unwittingly commit financial suicide by borrowing money on a line of credit or taking out a second mortgage in order to pour that cash into the stock market.

I can’t even pretend to understand how flash trading works. But I do know that it’s one of many strategies that takes advantage of the speed-of-light trading that’s evolved since the computerization of the markets. With the introduction of the Internet, broadband, fiber optics, and other technological marvels, high-volume traders can now make vast sums of money on the fraction-of-a-penny difference between the millisecond when an order to buy or sell a security is placed and when that order is actually fulfilled. Money can also be made on how trades are routed through our vast computer system, because vultures wait at every step of the way to skim fractional cents. Not so very long ago—about ten or twelve years in the past—skimming fractional cents was considered fraud. Not anymore. Now it’s considered the right of every financial behemoth; a right that must be ardently protected...if you believe the big financial firms that are lobbying Congress and the SEC to stop any proposal that would ban flash trading.