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Bank Insurers Bet It All at the Deal Table… With Your Money

This is a syndicated repost published with the permission of Money Morning. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

Here’s a story about a bank that failed, got rescued, was resuscitated, and made its private equity investors more than 100% on their money, all the while costing the FDIC around $5.9 billion.

It’s not a story about a failed bank… although it is.

It’s not a story about how smart the bank’s private equity “rescuers” were… although it is.

It’s not a story about how the FDIC is such a great savior of banks.

Or that that moral hazard exists manifestly because the FDIC is a tool (not as in a tool used to fix something) that lets banks run hog-wild… although it is.

This is a story about how nothing has changed and why another bank crisis is coming…

They “Save” You Money by Inflating Loss Estimates

Back in early 2009, BankUnited of Miami Lakes, Fla., was insolvent and going under. The FDIC – that’s the Federal Deposit Insurance Corporation, which bails out depositors and whole banks when things go terribly wrong – tried to sell it.

BankUnited had stuffed itself with bad bets on option adjustable rate mortgages (ARMs). Those are mortgages that give borrowers the option to pay principal and/or interest every month – or not – and increase the total owed, which would later be subject to higher interest rates.

Nobody wanted to bid on the bank.

By May 2009, the FDIC was desperate. They figured closing the bank would cost them $6.4 billion. They called John Kanas, who was grilling outside his Long Island home.

John Kanas is a brilliant banker. In 30 years he built Melville, N.Y.-based North Fork Bank into a profitable machine. Kanas smartly sold it at the height of the market in 2006 to Capital One for $13.2 billion. Kanas made well over $200 million on the sale.

The FDIC knew Kanas and they knew he was working with billionaire Wilbur Ross of WL Ross and Company. The two were interested in getting into the distressed bank market. Kanas welcomed the call. They were ready to offer the FDIC a deal.

The deal, backed by Kanas and Ross, drew in private equity partners Blackstone Group LP (NYSE: BX), Carlyle Group LP (Nasdaq: CG), and Centerbridge Partners LP, a private investment firm.

It was a sweetheart deal…

While the investors put up just over $900 million in capital, the FDIC kicked in $2.2 billion in cash, would reimburse 80% of any losses on the first $4 billion at risk, and would for the next 10 years cover 95% of all additional losses.

Of course the investor group didn’t have to think about the terms, as those were their terms.

They had studied the sweetheart deal the FDIC made when it sold IndyMac Bank to another clever group of investors earlier in the crisis and knew how to deal.

Fast forward to 2011. With the help of the FDIC and their ongoing rescue of banks across the country, and with the extraordinary help of the Federal Reserve – which, in case you don’t know, is the tool of private banks in the United States (that’s “tool” as in they fix bank balance sheets, flooding them with free money and winks from Congress), BankUnited under John Kanas was flush enough to sell its shares to the public in an IPO that valued the bank at $2.7 billion, or triple what the privateers put up in capital.

Just last week the investor group, in the last of a series of secondary offerings, said goodbye to BankUnited (NYSE: BKU) and cashed out, having more than doubled their money.

The FDIC, on the other hand, took at least a $5.9 billion hit on the deal. Well, at least that’s what they claim, which makes them look “smart” because they had projected a $6.4 billion loss if they actually closed the bank.

So, what does this story tell us? It tells us a lot.

The Next Crisis Is Coming… Unless We Act

The takeaway isn’t that there are smart vulture investors out there who make billions of dollars on failed banks.

They exist on the profit motive – and good for them… and their institutional investors, including pension funds, and even shareholders in some cases.

The biggest takeaway isn’t that banks do stupid things and make bad loans and leverage themselves and implode. They’ve been doing that since they began.

The takeaway is that there’s another banking crisis coming because the moral hazard exists for one to develop.

If you look up “moral hazard” in the dictionary, among other government schemes going by various initials, you’ll see FDIC as a definition.

There’s a good, bad, and ugly to the FDIC.

The good is depositors are covered and can trust that they will be made whole if the covered institution they have their money in goes under.

The bad is that banks who have depositor insurance, and that’s all of them, because who would be stupid enough to put their money in an institution that isn’t insured by the FDIC? With that insurance, banks knowingly take dangerous risks with depositor money to make bigger profits because they can’t lose the bank, just their jobs. But, if your job allows you to bet the sky to fatten your salary and bonus pool, chances are you will hazard the risk of losing the bank.

The ugly thing about the FDIC is that with FDIC insurance, the whole banking system is predicated on the coddling and full faith and protection of moral hazard.

In order to prevent another banking crisis, the FDIC should be phased out and replaced with private insurance on deposits paid for by the banks themselves.

Sure, the banks already pay into the FDIC fund. But they pay a tiny amount relative to what they risk of depositors’ money and risks they pose to the system.

By making banks pay insurance premiums into set-aside insurance funds and legislating full disclosure as to premium payments and insurance coverage, depositors would make determinations on which banks are really safe. They would need to “reserve” additional monies to safeguard depositors, and those premiums would come out of their profits.

Banks with excess premium balances would attract more depositors and could use excess coverage cash to pay dividends to mutual shareholders as interest on deposits.

The BankUnited story should be a reminder to everyone that, more often than not, government (taxpayer) backstopping of private enterprise creates free market disruptions… and fosters extraordinary moral hazard.

The post Bank Insurers Bet It All at the Deal Table… With Your Money appeared first on Money Morning – Only the News You Can Profit From.

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