An Old Hand Counsels Lawmakers [WSJ]
Former FDIC Chief Says New Rules Cost Less Than a Bailout
By STEPHEN POWER, DAMIAN PALETTA and JESSICA HOLZER
WASHINGTON -- Members of Congress are turning to a veteran of the country's previous banking crisis, William M. Isaac, as they search for alternatives to the Bush administration's $700 billion financial-rescue plan.
[William M. Isaac] Associated Press
William M. Isaac, a Federal Deposit Insurance Corp. former chairman, consults with Rep. Susan Davis on the financial rescue plan Monday.
Mr. Isaac, who was chairman of the Federal Deposit Insurance Corp. in the 1980s and guided the rescue of Continental Illinois National Bank and Trust, is emerging as a key figure in the debate. In marathon meetings at the Capitol on Sunday, Mr. Isaac spoke against the proposal to dozens of lawmakers. He offered ideas that stop short of a taxpayer-financed bailout of the nation's financial institutions.
Many lawmakers who voted against the plan have credited the views of Mr. Isaac. Some are introducing legislation that incorporate them.
"He worked us out of a big hole for little cost, and that's very attractive to me. If that doesn't work, then we can come back" to the original proposal, said Rep. Pete DeFazio (D., Oregon). On Tuesday, Mr. DeFazio introduced legislation that draws on Mr. Isaac's suggestions.
In contrast to Treasury Secretary Henry Paulson, who has demanded that his agency be given a $700 billion credit line and wide authority to buy financial firms' troubled assets, Mr. Isaac says the banking system can be stabilized through relatively simple regulatory changes.
Mr. Isaac has proposed reviving a 1980s-era FDIC program that helped shore up troubled savings-and-loan associations by issuing them promissory notes to buoy their capital bases and start lending again. Mr. Isaac also has proposed easing an accounting requirement known as the "mark-to-market rule," which requires firms to declare values on mortgage-security holdings that reflect their short-term worth. In the current environment, Mr. Isaac says, that rule effectively forces firms to value their assets at "unrealistic, fire-sale" levels. Mr. Isaac also has called for restrictions on "naked selling," in which investors short a stock without actually possessing it.
Those ideas have resonated with lawmakers, especially Republicans concerned about giving government a larger role in the economy.
"In my first term of office, I've seen how easy it is for lawmakers to spend other peoples' money; it makes your head spin," said Minnesota Republican Rep. Michele Bachmann. She said Mr. Isaac has a unique historical perspective.
"He was a credible valuable voice because he's been there and done that," Rep. Bachmann said. "We're told on the one hand that we're facing financial Armageddon, but we weren't given evidence to explain why ... and we weren't given information to show why this bailout was the only solution."
Critics of some of Mr. Isaac's ideas are lining up. Accounting firms and consumer advocates say loosening accounting rules in the way he has proposed would allow banks and other financial firms to value assets at inflated amounts, deceiving investors about the value of troubled assets.
"It's just bad for investors," said Beth Brooke, global vice chairwoman at Ernst & Young LLP in Washington. Barbara Roper, director of investor protection for the Consumer Federation of America, added, "Allowing companies to lie to investors and lie to themselves is not the solution to the problem, it is the problem."
Mr. Isaac, a 64-year-old resident of Sarasota, Fla., is chairman of the Secura Group, a Washington-based firm that advises banks and other financial institutions on dealing with regulators. He is also a contributor to many members of Congress, having given more than $80,000 to federal officeholders and political-action committees since 1990, according to the Center for Responsive Politics, a Washington watchdog group.
Mr. Isaac said he came to Washington reluctantly on Sunday. He had planned to take his two children to see the Tampa Bay Buccaneers play the Green Bay Packers. Several lawmakers in both parties had called after the Washington Post published a column he had written questioning the administration's proposal. "They just said, 'This bill is being forced upon us, we don't understand it ... can you help us?"' Mr. Isaac said. He agreed after encouragement from his wife, and arrived Sunday at 1 p.m.
Mr. Isaac said he hopes the administration and Congress will come around to some of his ideas. "If they do, I think the bill will pass," Mr. Isaac said. "If they don't, I think the bill is stuck."
How to Save the Financial System [WSJ Opinion]
By WILLIAM M. ISAAC
I am astounded and deeply saddened to witness the senseless destruction in the U.S. financial system, which has been the envy of the world. We have always gone through periods of correction, but today's problems are so much worse than they needed to be.
The Securities and Exchange Commission and bank regulators must act immediately to suspend the Fair Value Accounting rules, clamp down on abuses by short sellers, and withdraw the Basel II capital rules. These three actions will go a long way toward arresting the carnage in our financial system.
During the 1980s, our underlying economic problems were far more serious than the economic problems we're facing this time around. The prime rate exceeded 21%. The savings bank industry was more than $100 billion insolvent (if we had valued it on a market basis), the S&L industry was in even worse shape, the economy plunged into a deep recession, and the agricultural sector was in a depression.
These economic problems led to massive credit problems in the banking and thrift industries. Some 3,000 banks and thrifts ultimately failed, and many others were merged out of existence. Continental Illinois failed, many of the regional banks tanked, hundreds of farm banks went down, and thousands of thrifts failed or were taken over.
It could have been much worse. The country's 10-largest banks were loaded up with Third World debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of them would have been insolvent. Indeed, we developed contingency plans to nationalize them.
At the outset of the current crisis in the credit markets, we had no serious economic problems. Inflation was under control, GDP growth was good, unemployment was low, and there were no major credit problems in the banking system.
The dark cloud on the horizon was about $1.2 trillion of subprime mortgage-backed securities, about $200 billion to $300 billion of which was estimated to be held by FDIC-insured banks and thrifts. The rest were spread among investors throughout the world.
The likely losses on these assets were estimated by regulators to be roughly 20%. Losses of this magnitude would have caused pain for institutions that held these assets, but would have been quite manageable.
How did we let this serious but manageable situation get so far out of hand -- to the point where several of our most respected American financial companies are being put out of business, sometimes involving massive government bailouts?
Lots of folks are assigning blame for the underlying problems -- management greed, inept regulation, rating-agency incompetency, unregulated mortgage brokers and too much government emphasis on creating more housing stock. My interest is not in assigning blame for the problems but in trying to identify what is causing a situation, that should have been resolved easily, to develop into a crisis that is spreading like a cancer throughout the financial system.
The biggest culprit is a change in our accounting rules that the Financial Accounting Standards Board and the SEC put into place over the past 15 years: Fair Value Accounting. Fair Value Accounting dictates that financial institutions holding financial instruments available for sale (such as mortgage-backed securities) must mark those assets to market. That sounds reasonable. But what do we do when the already thin market for those assets freezes up and only a handful of transactions occur at extremely depressed prices?
The answer to date from the SEC, FASB, bank regulators and the Treasury has been (more or less) "mark the assets to market even though there is no meaningful market." The accounting profession, scarred by decades of costly litigation, just keeps marking down the assets as fast as it can.
This is contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace events, regulators must give institutions an opportunity to survive the temporary impairment. Assets should not be marked to unrealistic fire-sale prices. Regulators must evaluate the assets on the basis of their true economic value (a discounted cash-flow analysis).
If we had followed today's approach during the 1980s, we would have nationalized all of the major banks in the country and thousands of additional banks and thrifts would have failed. I have little doubt that the country would have gone from a serious recession into a depression.
If we do not halt the insanity of forcing financial firms to mark assets to a nonexistent market rather than their realistic economic value, the cancer will keep spreading and will plunge the world into very difficult economic times for years to come.
I argued against adopting Fair Value Accounting as it was being considered two decades ago. I believed we would come to regret its implementation when we hit the next big financial crisis, as it would deny regulators the ability to exercise judgment when circumstances called for restraint. That day has clearly arrived.
Equally egregious are the actions by the SEC in recent years lifting the restraints on short sellers of stocks to allow "naked selling" (shorting a stock without actually possessing it) and to eliminate the requirement that short sellers could sell only on an uptick in the market.
On top of this, it is my understanding that short sellers are engaged in abuses such as purchasing credit default swaps on corporate bonds (essentially bets on whether a borrower will default), which lowers the price of the bonds, which in turn causes the price of the company's stock to decline further. Then the ratings agencies pile on and reduce the ratings of a company because its reduced stock price will prevent it from raising new capital. The SEC must act immediately to eliminate these and other potential abuses by short sellers.
The Basel II capital rules adopted by the FDIC, Federal Reserve, Office of Thrift Supervision and the Comptroller of the Currency last year are too new to have caused big problems, but they must be eliminated before they do. Basel II requires the use of very complex mathematical models to set capital levels in banks. The models use historical data to project future losses. If banks have a period of low losses (such as in the mid-1990s to the mid-2000s), the models require relatively little capital and encourage even more heated growth. When we go into a period like today where losses are enormous (on paper, at least), the models require more capital when none is available, forcing banks to cut back lending.
As I write this article, I am seeing proposals by some to create a new Resolution Trust Corp., as we did in the 1990s to clean up the S&L problems. The RTC managed and sold assets from S&Ls that had already failed. It was run by the FDIC, just like the FDIC. We needed to create the RTC in the 1990s only because we could not comingle the assets from failed banks with those of failed thrifts, because we had two separate deposit insurance funds absorbing the respective losses from bank and thrift failures.
I can't imagine why we would want to create another government bureaucracy to handle the assets from bank failures. What we need to do urgently is stop the failures, and an RTC won't do that.
Again, we must take three immediate steps to prevent a further rash of financial failures and taxpayer bailouts. First, the SEC must suspend Fair Value Accounting and require that assets be marked to their true economic value. Second, the SEC needs to immediately clamp down on abusive practices by short sellers. It has taken a first step in reinstituting the prohibition against "naked selling." Finally, the bank regulators need to acknowledge that the Basel II capital rules represent a serious policy mistake and repeal the rules before they do real damage.
We are almost out of time if we hope to eradicate the cancer in our financial system.
Mr. Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985, is chairman of the Washington financial services consulting firm The Secura Group, an LECG company.
A Better Way to Aid Banks [Washington Post]
By William M. Isaac
Saturday, September 27, 2008; A19
Congressional leaders are badly divided on the Treasury plan to purchase $700 billion in troubled loans. Their angst is understandable: It is far from clear that the plan is necessary or will accomplish its objectives.
It's worth recalling that our country dealt with far more credit problems in the 1980s in a far harsher economic environment than it faces today. About 3,000 bank and thrift failures were handled without producing depositor panics and massive instability in the financial system.
The Federal Deposit Insurance Corp. has just handled Washington Mutual, now the largest bank failure in history, in an orderly manner, with no cost to the FDIC fund or taxpayers. This is proof that our time-tested system for resolving banking problems works.
One argument for the urgency of the Treasury proposal is that money market funds were under a great deal of pressure last week as investors lost confidence and began withdrawing their money. But putting the government's guarantee behind money market funds -- as Treasury did last week -- should have resolved this concern.
Another rationale for acting immediately on the bailout is that bank depositors are getting panicky -- mostly in reaction to the July failure of IndyMac, in which uninsured depositors were exposed to loss.
Does this mean that we need to enact an emergency program to purchase $700 billion worth of real estate loans? If the problem is depositor confidence, perhaps we need to be clearer about the fact that the FDIC fund is backed by the full faith and credit of the government.
If stronger action is needed, the FDIC could announce that it will handle all bank failures, except those involving significant fraudulent activities, as assisted mergers that would protect all depositors and other general creditors. This is how the FDIC handled Washington Mutual. It would be easy to announce this as a temporary program if needed to calm depositors.
An additional benefit of this approach is that community banks would be put on a par with the largest banks, reassuring depositors who are unconvinced that the government will protect uninsured depositors in small banks.
I have doubts that the $700 billion bailout, if enacted, would work. Would banks really be willing to part with the loans, and would the government be able to sell them in the marketplace on terms that the taxpayers would find acceptable?
To get banks to sell the loans, the government would need to buy them at a price greater than what the private sector would pay today. Many investors are open to purchasing the loans now, but the financial institutions and investors cannot agree on price. Thus private money is sitting on the sidelines until there is clear evidence that we are at the floor in real estate.
Having financial institutions sell the loans to the government at inflated prices so the government can turn around and sell the loans to well-heeled investors at lower prices strikes me as a very good deal for everyone but U.S. taxpayers. Surely we can do better.
One alternative is a "net worth certificate" program along the lines of what Congress enacted in the 1980s for the savings and loan industry. It was a big success and could work in the current climate. The FDIC resolved a $100 billion insolvency in the savings banks for a total cost of less than $2 billion.
The net worth certificate program was designed to shore up the capital of weak banks to give them more time to resolve their problems. The program involved no subsidy and no cash outlay.
The FDIC purchased net worth certificates (subordinated debentures, a commonly used form of capital in banks) in troubled banks that the agency determined could be viable if they were given more time. Banks entering the program had to agree to strict supervision from the FDIC, including oversight of compensation of top executives and removal of poor management.
The FDIC paid for the net worth certificates by issuing FDIC senior notes to the banks; there was no cash outlay. The interest rate on the net worth certificates and the FDIC notes was identical, so there was no subsidy.
If such a program were enacted today, the capital position of banks with real estate holdings would be bolstered, giving those banks the ability to sell and restructure assets and get on with their rehabilitation. No taxpayer money would be spent, and the asset sale transactions would remain in the private sector where they belong.
If we were to (1) implement a program to ease the fears of depositors and other general creditors of banks; (2) keep tight restrictions on short sellers of financial stocks; (3) suspend fair-value accounting (which has contributed mightily to our problems by marking assets to unrealistic fire-sale prices); and (4) authorize a net worth certificate program, we could settle the financial markets without significant expense to taxpayers.
Say Congress spends $700 billion of taxpayer money on the loan purchase proposal. What do we do next? If, however, we implement the program suggested above, we will have $700 billion of dry powder we can put to work in targeted tax incentives if needed to get the economy moving again.
The banks do not need taxpayers to carry their loans. They need proper accounting and regulatory policies that will give them time to work through their problems.
The writer was chairman of the Federal Deposit Insurance Corp. from 1981 to 1985. He is chairman of Secura Group, a Washington financial services consulting firm that is a subsidiary of LECG. |
