Banks to FDIC: Let Us Game the System

POGO, May 27, 2009

Banks to FDIC: Let Us Game the System

Last month, POGO submitted a public comment raising concerns that the Federal Deposit Insurance Corporation (FDIC) was not doing enough to address potential conflicts of interest in the Legacy Loans Program (LLP), part of the new Public Private Investment Program (PPIP) that was set up to deal with the toxic assets that are clogging the balance sheets of banks across the country. As we pointed out, most commentators who are sounding the alarm about the LLP have imagined complex scenarios in which banks could exploit the system by using intermediaries or swapping their toxic assets with other banks. But now it appears that some banks are proposing to game the system right out in the open.

The Wall Street Journal reported this morning that some banking industry groups are lobbying the FDIC to allow banks to bid on their own distressed loans as private investors. That might sound outrageous, but it was recently proposed in numerous public comments on the LLP.

For instance, Irene Esteves, CFO of Regions Financial Corp., wrote that "while banks will be participating as sellers, the LLP should be crafted in such a way that allows for participation as investors as well." Tanya Wheeless, President and CEO of the Arizona Bankers Association, urged the FDIC to "consider allowing banks and affiliates of selling banks to participate as 'purchasers' of pooled assets....There may be a scenario in which bank purchasers or affiliates (including a bank holding company) of a seller of assets might make sense." (She explained to the Journal that this would be a "win-win" for bankers.) And Norman Nelson, general counsel of the Clearing House Association, wrote that "the selling bank should be able to participate as an equity investor in a Public-Private Investment Fund to the extent of 50% of the equity designated for the private sector," and that in some cases, "the selling bank should be able to participate as the only private sector investor."

We think it's fairly obvious why banks should not be allowed to bid on their own assets, but perhaps it's worth reviewing. In its latest report to Congress (p. 147), the Special Inspector General for the Troubled Asset Relief Program (SIGTARP) found that the PPIP is "inherently vulnerable to fraud, waste, and abuse," and warned that "the same entity might buy and sell toxic assets for its own benefit." Since the FDIC is providing up to 6:1 leverage for the public-private investment funds (PPIFs), taxpayers might be forced to incur significant losses if the investments go bankrupt. In an article last month, Professors Laurence Kotlikoff and Jeffrey Sachs outline one possible scenario in which a bank could set up its own PPIF to overbid on its assets, making millions in net profit and leaving taxpayers to foot the bill. In order to cover the losses on these investments, the FDIC might have to dip into its Deposit Insurance Fund, the balance of which decreased by 25 percent during the first quarter of 2009.

But even if taxpayers don't incur significant financial losses on the PPIFs--and that's a big if--there's still the underlying issue that banks could gain an unfair competitive advantage by acting as both buyers and sellers of the eligible assets, which is sure to undermine public confidence. Mark Tenhundfeld, a lobbyist for the American Bankers Association, acknowledged to the Journal that "a bank bidding on its own assets has the potential to look awful in the public's mind."

Thankfully, the initial terms of the LLP prohibit private investors from participating in a PPIF that "purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF." As the FDIC and Treasury negotiate the final terms of the program, we urge them in the strongest possible terms to keep this provision in place, and to implement other safeguards to protect the government from the types of self-dealing described in the Journal article.

-- Michael Smallberg

UPDATE: FDIC Chair Sheila Bair just reiterated that banks will not be allowed to bid on their own assets.