Archive for September, 2009

You Don’t Want To Pay Deposit Insurance Premiums A Year In Advance? Fine – Then Pay Three Years Worth! You Wanna Try For Six?

Wednesday, September 30th, 2009

So the FDIC is proposing to have banks pay three years worth of deposit insurance premiums in advance, as opposed to the single year contemplated just a few days earlier. (see “Humpty Dumpty and the FDIC”). This move should raise around $45 billion, replenishing a fund which had fallen to less then $11 billion at the end of the second quarter and apparently slipped into a negative balance this week.

A prepayment of fees is seen by the banking industry as preferable to a special assessment like $5.6 billion they got hit with earlier this year, since rather than being treated as an immediate expense it’s counted as an asset which gets drawn down as the premiums would normally come due. So by this bit of accounting legerdemain a sudden hit to bank earnings is avoided and (regulators willing) the lending capital of the bank may be preserved.

As I noted earlier, insurance premiums should be set counter-cyclically, which is to say raised during periods of strong bank earnings and eased during periods of contraction. And indeed, the FDIC proposes its’ next outright increase in assessments (3 basis points) to be postponed to 2011.

The problem here is that the proposed prepayment constitutes a massive shift on the asset side of banks balance sheets from actual cash to funds pre-paid to the FDIC, and that’s an asset that can’t generally be tapped to meet liquidity needs except in very limited form and under dire conditions e.g. a potential bank failure. The FDIC’s decision to go the prepayment route as opposed to borrowing from the Fed or Treasury may be more politically palatable, but for weak banks that have received government support these premiums will effectively be prepaid with taxpayer money anyway. As for stronger institutions, one has to question the wisdom of weakening the cash position of viable firms just as a wave of commercial real estate mortgage defaults may be about to hit the banking system.

Since we as taxpayers are in essence loaning much of the money to prepay these premiums through federal bailout funds, a more forthright and stabilizing alternative would be to be straight with the American people: have Treasury or the Fed loan the money necessary to recapitalize the FDIC and, for now, let strong banks keep as much cash on the books as possible, facilitating both stimulative lending and confidence in the event of further losses. And then, when the recovery finally does come, have the discipline and recall of history to raise deposit insurance premiums on all sound banks, tapping bank profits to pay back the taxpayer with interest.

After all, haven’t we had enough smoke and mirrors for one crisis?

Humpty Dumpty and the FDIC

Thursday, September 24th, 2009

As a graduate student in the early 1990’s I developed a mathematical model to explore the question of what the optimal level of bank deposits and deposit insurance premiums should be. For those whose enthusiasm for differential equations is limited, a key conclusion was that deposit insurance rates should be set counter-cyclically, meaning when the probability of a downturn is high  – near the top of an economic boom – rates should be increased, and vice versa. The intuition here is that one does not want to pull capital out of the banking sector during a bust, when it’s most crucial to revive lending. Rather, it’s optimal to build reserves against bank failures when the system is flush and the chance of a bust is most elevated. Note that risk is actually lower post-collapse: Humpty Dumpty may have had a great fall, but afterward, assuming the king’s men know how to make an omelet, it’s all upside (or, in that case, sunny-side up).

At the time, my thesis advisor and I applied this model to the European Union, illustrating difficulties in harmonizing policy if member states differed in risk aversion and economic conditions. (if we failed to convince policymakers of this I suspect the late unpleasantness has done so). But it now appears those who need a lesson in when to raise deposit insurance rates reside not in Brussels but Washington.

Unfortunately, in 1996 Congress capped the FDIC insurance fund at 1.25% of deposits, constraining the FDIC’s ability to raise premiums during economic expansion. With banks able to finance lending through means other than deposit base growth (e.g. bonds, securitization etc.) tying insurance premiums to deposits in a fixed ratio meant the risk level of a bank’s assets could grow faster then either deposits or deposit insurance premiums, a recipe for an undercapitalized FDIC fund.

Now, the insurance fund is down to less than 11 billion and more bank failures loom as the “other shoe” of commercial mortgages gone bad threatens to drop. With newly expanded authority, the FDIC levied a $5.6 billion special assessment in the second quarter and has authorized itself the continued imposition of such fees moving forward. These acts effectively raise deposit insurance premiums during a period of economic weakness, which is precisely the wrong time to do so. Healthy banks are drained of capital needed to revive lending, and, paradoxically, are left more vulnerable to losses. Simultaneously, those supported by TARP, TALF etc. now effectively have those funds prematurely withdrawn, at cross-purposes with the Federal programs’ mission of restoring bank balance sheets.

Bloomberg reports that, to his credit, Rep. Barney Frank, Chair of the House Financial Services Committee said yesterday “This is not the time to raise assessments on the banks,” and FDIC Chairman Sheila Bair is said to be considering having banks pre-pay 2010 premiums in lieu of a surcharge. This is a step in the right direction if the prepayments are counted as assets on bank balance sheets, thus avoiding an immediate reduction in lending capital. But those assets would vanish and capital fall next year, just as bad commercial loans come a cropper and the fund is further strained.

Though it might be politically unpalatable, taxpayer-funded Treasury loans to the FDIC, coupled with borrowing from stronger banks would be less counter-productive alternatives. They’d also be more honest, since troubled banks paying premiums with money lent through federal programs amounts to taxpayer support for bank insurance anyway. Borrowing from the Fed is also an alternative, and while I like many others am loath to grow the central bank’s balance sheet further, so long as the FRB and the FDIC are responsible in seeing to it premiums are raised in recovery years so that the loans are repaid, this expansion need not be inflationary.

If the king’s men want to put Humpty back together again, they need to realize you can’t have your egg and eat it, too.

Cadillac Plans and Yacht Taxes

Monday, September 21st, 2009

A key component of Sen. Max Baucus’ proposal to pay for health care reform is a 35% excise tax on so-called Cadillac insurance plans, defined as those costing $8,000 for individuals and $21,000 for families. This revenue is designated to cover $215 billion of the $856 billion estimated cost of the bill, while, according to President Obama’s comments, discouraging insurers and employers from offering more coverage then the Administration claims employees need.

Leaving aside the rather dubious claim that $667 per month buys one unnecessary protection (funny how other people’s desire for coverage can seem like hypochondria when a sneeze gets you choppered to Bethesda), you may already have detected some of the contradictions in the reasoning behind this tax. If the President is correct and demand for higher-end plans collapses due to this surcharge, the revenue produced by the excise tax will also vanish, thereby failing to fund reforms at the anticipated level.

It’s a Republican president, George H. W. Bush, whose policies provide evidence Obama’s prediction might be correct. In 1991, Time magazine reported Bush’s tax on luxury boat purchases almost immediately preceded an 88% first quarter drop in  South Florida sales of such vessels (I’ve no stats on Kennebunkport transactions). Of course this was during a period of pronounced economic weakness not unlike the present one, but then that’s when even a 10% levy like Bush’s boat tax can most depress demand.

Unlike would-be weekend mariners hard-pressed to build their own boats, consumers unwilling to accept the government’s judgment on what procedures and treatments they need insurance for have a “do it yourself” option: to save and self-insure against uncovered expenses, perhaps using increased compensation paid by employers in lieu of Cadillac plans. If they can do so in certain retirement accounts, the excise tax and immediate income taxes are avoided. However, depending on income and other factors, some may self-insure with after-tax dollars, meaning Baucus’ surcharge can effectively lead to higher income taxes. If Cadillac plans do disappear, this is one way their demise could lead to at least some revenue for the Baucus plan, though I suspect far less then the projected excise figure.

The bottom line is the tax on Cadillac plans amounts to the government telling citizens that if they buy health insurance in excess of what Washington feels is reasonable they must also contribute to the purchase of coverage for others. This leveling policy’s acceptance depends on voter’s altruism to less fortunate Americans, possibly at the expense of their own health care, and on people’s faith in government deciding how much health insurance they need, inevitably translating into which treatments they receive.

There are strong moral and public health arguments for subsidizing the medical  care of the disadvantaged. But leveling health care is going to mean leveling with voters as well, and when one looks through the rhetoric to the underlying economic reasoning (as many seem to be doing) you can see why this is a hard sell.

Why I am doing this…

Saturday, September 19th, 2009

While an economist is not yet legally required to have a blog, so few do not these days that I feel conspicuous in my silence. So watch this space for a few of my thoughts on the state of the economy and the world.