Moral Hazard at the FDIC

There has been a lot of discussion about Moral Hazard regarding the large bank bailouts (which the recent financial reform legislation apparently now has "institutionalized"). And there has been a lot of commentary about the lack of help for America's community institutions; in 2010 alone, the FDIC has closed 108 such banks (at least as of this writing). It just appears to us that Washington protects the Wall Street firms to the detriment of Main Street.

We have written several blogs about this "unholy" alliance. Now, it appears that the FDIC, whose insurance fund was in the red by $21 billion at the end of the first quarter, has decided to become a player in the private sector by partnering with, you guessed it, Wall Street! This is a major strategic change in direction at the FDIC in how they deal with the disposal of troubled assets at failed institutions. Specifically, the form of the strategic direction change is to allow a partnership with the private sector in order for the FDIC to participate in the upside potential of loan work outs and sales. In technical lexicon, this is called an "Entity Sale" as opposed to a "Direct Sale" of the assets.

Partnering is not new to the FDIC, and it appears that the current strategic shift had its roots in the Resolution Trust Co. (RTC) model. The RTC was the entity that dealt with the troubled assets from the S&L crisis era. At that time, the FDIC, through the RTC, took back stock and warrants as part of their resolution in the largest failure cases of Continental Illinois and First City. This created the public perception and significant outrage that "nationalization" was occurring; this seems eerily similar to today's attitudes.

In one of their first forays into the entity sale strategy, the FDIC sold the assets of First National Bank of Nevada for between 30% and 50% of face value to Private National Mortgage Acceptance Company, LLC (PennyMac), a company founded by the former president of Countrywide. The FDIC provided interest-free loans to PennyMac, but kept an 80% equity stake, hoping to recover some of the losses should the real estate market turn upward.

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