Cleaning up: the FDIC plans to bring a more grassroots style to the US banking industry

The Federal Deposit Insurance Corporation, under the tutelage of chairwoman Sheila Bair, has been spearheading a banking clean-up on a massive scale. And while the sector faces much uncertainty, one thing is sure: the US banking landscape is set to change for good. Writer Suzanne Miller

Over the past two years, Wall Street's financial leaders have had their fair share of late nights and migraines as they adapt to the post-crisis world. Perhaps few have been more challenged, however, than the chairwoman of the Federal Deposit Insurance Corporation (FDIC) Sheila Bair, who wields the clean-up broom for much of the US banking industry.

Known for her tough-minded independence - she was awarded the Kennedy Library Foundation Award for political bravery in 2009 - she has sparred openly with bankers, politicians and other regulators in her dogged determination to bring a more grass-roots style of banking back to risk-addicted Wall Street.

Playing for high stakes

As she completes the final year of her term in 2010, Ms Bair stresses that US banks cannot expect to go back to the old status quo. "I can already see, for instance, some of the responses to improving standards for securitisation and the comment letters [from banks] that say: 'let's just go back to the way things were'. We can't afford to do that."

Ms Bair knows what is at stake. The FDIC is spearheading a banking clean-up of gargantuan scale, even as it works feverishly to implement new regulatory changes aimed at preventing future disasters such as Lehman Brothers and AIG from happening again. It is a gruelling task. Fifty US banks have failed in just the first four months of this year, following 140 last year - the largest number in one year since 1992. The failures have seriously strained the FDIC's deposit insurance fund.

The FDIC's projection for losses to its deposit fund over the next five years is $100bn, although it says it has already reserved much of that from different sources, including $45bn it collected in prepayment fees from banks.

Meanwhile, there are some 702 banks on the FDIC's 'problem institution list'. Failed banks have combined assets of about $170bn, and banks continue to reserve for losses at unprecedented levels. In a recent report, Moody's Investors Service estimated that banks will charge off another $296bn in loans through 2011. The FDIC has had its hands full trying to find sellers for the $41bn in assets it holds in receivership. That number is set to swell this year, with bank failures predicted to peak in 2010. The FDIC, which was never intended to fill the role of asset manager, hardly relishes the job. Its real mission is to find options that offer the "least cost resolution", aimed at minimising the loss to its insurance fund. In other words, it needs buyers for its bad assets.

But finding buyers has not been easy. The few attractive banks that tumbled into receivership early in the crisis - Washington Mutual and IndyMac Bank were among the most well-known - were quickly snapped up by the likes of JPMorgan and a group of private equity investors, respectively. Most of the pickings left over are mid-sized and smaller banks, weighed down by problem loans that are tough to value in a regulatory environment fraught with so much uncertainty.

cp/82/GET-Swonk.jpg

Diane Swonk, chief economist of Mesirow Financial in Chicago

Master plan

So where will capital requirements be a year from now and what additional problems may be lurking in loan portfolios? These are some of the concerns worrying investors.

"Those banks that are in good shape have already made their strategic purchases and don't want to load up on more too quickly," says Diane Swonk, chief economist of Mesirow Financial in Chicago. "We are moving past the period of low-hanging fruit and into a phase where there are a lot of banks going bad but not a lot of buyers."

That is one of the reasons the FDIC was essentially forced to open the bidding process to non-banks for IndyMac Bank last year, after it failed to find a buyer among the lender's stronger rivals. Bankers say the FDIC has worked the phones aggressively in its attempts to find buyers. "A while ago, the FDIC was shopping around a bank a day. At one point, it was seven," says Ms Swonk.

Over the past 12 months, the FDIC has been auctioning off these assets through structured partnerships to private companies and others. But as its asset portfolio has continued to swell and buyers have dropped off, the FDIC has resorted to new tactics of packaging loans and selling them as securities in the secondary market - a manoeuvre that has so far proved wildly successful, thanks, in part, to the FDIC's backing.

In February and March, the FDIC structured three such deals totalling $4bn, kicking off with a structured sale of guaranteed notes valued at $1.8bn. The notes were backed by residential mortgage-backed securities from seven failed bank receiverships. The other two issues were backed by residential, commercial and construction loans - one from the assets of Corus Bank, which was closed in September 2009, and the other from Franklin Bank, closed in November 2008.

Ms Bair says the deals have been a tremendous success with investors. "We recently completed a sale of private-label mortgage-backed security wrapped with a FDIC guarantee. It was tremendously oversubscribed, at 1000%. It seems there is a lot of demand out there. We're doing this to see if we can get better pricing for our assets with securitisations." She says the FDIC could be ready to jump-start a securitisation programme for its higher quality assets in the next few months.

While Ms Bair says it is "very cheap" to fund loans with deposits right now, she notes that securitisation has the advantage of broadening the range of investors. "There are obviously fewer bidders who are going to buy whole banks. So we want to check it out and see what kind of pricing we get."

Some investors say this could be one of the FDIC's smartest moves yet in transferring the assets off its balance sheet. Because some believe the market is close to a bottom in mortgage prices, there is growing interest among distressed mortgage specialists for troubled commercial real estate.

The flipside, of course, is that there are hundreds of mid-sized and community banks that are expected to succumb to bad commercial real estate loans this year - so it is unclear how strong an appetite will remain if the distressed mortgage market becomes overinundated once again. But even if that happens, most believe it is just a matter of time before the FDIC will mop up the problem loans under its roof. The bigger question is what happens to the broader banking industry once the FDIC dusts its hands of these problems.

Even if several hundred more banks were to fail this year, the US banking industry would still be severely overbanked. Consider that even after last year's failures and mergers, commercial bank and savings institutions totalled 8012. Some suggest the US is facing a period that will be defined by a Darwian survival of the fittest, although this will hardly solve the overpopulation problem.

"The banks that are better capitalised are in the catbird's seat and are able to look at everything that comes on the market," says Toos Daruvala, head of consulting firm McKinsey's banking and securities practice in the Americas. "We could see more small banks going into FDIC receivership and being forced to cleanse their balance sheets to be bought by larger banks."

cp/82/GET-Bair in action.jpg

Tough talk: chairwoman of the FDIC, Sheila Bair (left), speaks as Lanny Breuer of the US Criminal Division listens at the Financial Crisis Inquiry Commission in January this year

A question of size

But market observers agree there are only so many weaker banks that global names such as JPMorgan, Bank of America and Citigroup - or even the mid-sized banks - will want, given these smaller banks have narrow lending niches and limited prospects for expanding franchises.

Indeed, many are uncertain about the future of the bigger banks themselves as politicians and regulators mull legislation that will likely limit their size or even force them to shrink. Several of these bigger banks have already participated in an unprecedented consolidation in the industry over the past two years, with Lehman, Bear Stearns and Merrill Lynch all being absorbed by commercial banks.

Are these banks already too big? It is unclear what the competitive models for US banks will even look like two years from now, as the industry contends with higher capital levels and a list of new regulations that could clip the wings of depository institutions engaged in proprietary trading and other perceived risky trading activities.

In a new report, The Next Normal: Banking after the Crisis, McKinsey cautions that higher capital requirements, challenged economies and regulatory changes will likely mean big US and European commercial and investment banks ending up generating "middling" returns on equity of about 15% over the next few years - well below their pre-crisis levels of more than 20%. And this is a best-case scenario. The report warns that in a more extreme scenario, all but the emerging markets banking giants "will find it extraordinarily difficult to return even their cost of equity".

Others suggest that mid-sized banks may end up struggling more than their bigger counterparts. The challenge is whether or not these banks will make enough money in future to pay for the sins of the past, says Bert Ely, chief executive officer of the bank consulting firm Ely & Co. "This is a question for the mid-sized banks - the bigger ones are basically pulling through. But a lot of smaller ones are going down."

Mr Ely adds that regulatory uncertainties could stop many banks from developing strategic plans for some time, even market leaders. "Wells Fargo prides itself on cross-selling. But a new consumer protection agency may look askance at cross-selling and think there's too much bundling," he says. "This is all highly speculative and makes it hard to understand how these banks can expand or not."

Top US bank regulators such as John Dugan, comptroller of the currency, acknowledge that US banks face a tougher time ahead. Still, Mr Dugan believes US banks will remain highly competitive. While others argue this will only be so on a selective basis, he is determinedly optimistic: "US banks are struggling from a profitability perspective, but the profit trends are better and the credit costs seem way more manageable now than they were a year ago. They have much stronger capital reserves and liquidity now so are better poised for the future."

Many hope these words will still ring true in the months ahead.

Suzanne Miller

cp/82/GET-Bair.jpg

The Federal Deposit Insurance Corporation chairwoman and the US comptroller of the currency talk to The Banker about their priorities for the coming year and what preventative measures they believe are vital if the US is to protect itself from future financial crises. Writer Suzanne Miller

cp/82/GET-Dugan.jpg

Q: What is your top priority for the next 12 months?

A: Sheila Bair: We need legislation to establish a non-bank resolution mechanism, so that when these large financial institutions get into trouble they can be closed in way that is orderly and which protects the public interest in a financial system that puts responsibility for losses on the shareholders and creditors, and not the government. Getting that in place is a priority for me before the end of my term. If legislation is passed, we would act quickly to put a structure in place. One of the advantages of having the Federal Deposit Insurance Corporation (FDIC) do this is that it has the infrastructure, the expertise and the contractors and systems to do the asset valuations and marketing.

John Dugan: My top priority before the end of my term is to get a sensible forward-looking reform for financial services enacted. It is critical that we are able to address problems that occur outside banking when financial companies become systemically significant so that we don't have a repeat of AIG. Likewise, it is important we have a well-designed resolution authority that appropriately deals with the too-big-to-fail problem. But when you have large non-depository companies such as a large insurance company or investment bank, I don't know if the FDIC has particular expertise in that area. I don't want to see the agency diverted from its core mission of dealing with deposit institutions.

I would like some flexibility built in, where we might be able to choose at those particular times who should handle the resolution. For instance, if Freddie [Mac] or Fannie [Mae] had a particular problem, would you want their regulator involved more directly than the FDIC?

Q: What is the best way to restart the securitisation market?

A: SB: The FDIC will be testing the securitisation market this year, using whole loans out of our receiverships. We are looking at higher-quality assets and probably at performing residential mortgage as well as commercial loan securitisations. Many things about securitisation need to be changed. We all agree the servicing incentives need to be re-aligned and that there needs to be greater transparency and ability of investors to see the loans and conduct due diligence. We are pioneering a bit and want to be careful with the structure and documentation, so it will be at least a few months before we launch. We hope the FDIC can play a positive role in coming up with new standards to help improve the securitisation market, to make it safe to re-enter for investors.

JD: I am worried the pendulum will swing too far back and that accounting restrictions will make it too difficult to securitise assets in future. The accounting problems need to be worked through. However, the legislative versions of skin-in-the-game typically say this means risk retention, unless regulators agree on standards applicable to the underlying loan. Regulatory standards as an alternative in the legislation has not had due attention.

Q: How do you think bank compensation should be addressed?

A: SB: If there was an overarching principle that fed the crisis, it was the fact that a lot of decision-makers were not focused on the prospect of downside risk. As an insurer, the FDIC would like to determine if there are ways to encourage compensation structures that make senior management and major revenue producers working out of these banks more accountable for losses if the transactions they put in place don't turn out well later on. Otherwise, if they don't think they are going to suffer consequences from their risk-taking, they will swing for the fences.

JD: Compensation, particularly for larger institutions where it has been most problematic, should be aligned with risk. However, enforcing risk-based deposit insurance premiums is not a way to do this. I don't think it should be done apart from a co-ordinated process with all the regulators. The danger is that you have different standards and no co-ordinated way to go at it. Deposit insurance premiums are a crude way to tackle the issue.

Q: The FDIC advocates pre-funding a proposed financial company resolution fund, which would call on banks to help absorb the cost of a future financial meltdown. What is your view?

A: JD: If there is a giant fund that's growing and not being used, it's a deadweight economic investment. It becomes a tempting target for political use for other purposes. And most importantly, if you have a fund out there that is used for failures, it implies a more implicit blessing for too-big-to-fail. If you don't fund in advance and have to borrow from the Treasury [at the time of trouble], I think that's a better way to think about it.

SB: A pre-funded resolution fund has significant advantages over an ex-post-funded system. It allows all large firms to pay risk-based assessments into the fund, not just the survivors after any resolution. It also avoids the procyclical nature of requiring repayment after a systemic crisis.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter