FDIC Guarantee: More Toxic Than the Target Itself

by: Rakesh Saxena November 14, 2008 | about stocks: BAC / BK / C / CS / GE / GS / JPM / MER / MS / STT / WFC    

Rakesh Saxena

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If you are figuring out why a good thirty days after the US government officials announced bank debt guarantees no issuer has tapped the marketplace, the Federal Deposit Insurance Corporation's Interim Rule (posted on the agency's website) is a self-explanatory document. By all accounts, at least ten major financial institutions are not going to engage the FDIC any time soon.

Earlier this week, General Electric (GE) revealed that it had reached an insurance arrangement with the FDIC for $139 billion of short-term and longer-term debt; but GE may want to scrutinize the Interim Rule once again from the perspective of objections raised by Credit Suisse (CS) and by a law firm representing nine financial institutions (Sullivan & Cromwell letter, FDIC website).

Potential participants in the FDIC guarantee programme are taking issue with a number of key terms and conditions laid out in the Interim Rule. But most important of all is the fact that, in its present form, an FDIC guarantee will create more problems than it is targeted to solve. Primarily, the FDIC-backed paper will not be "fully, irrevocably and unconditionally" guaranteed by the US government. Rather, the Interim Rule refers to repayments conditioned by the domestic bankruptcy process, with no specific timing parameters. (The Comment Period on the Interim Rule expired on Thursday.)

Financial institutions correctly point out that the US government must guarantee bank-issued debt regardless of the reason for non-payment of principal or interest, and without any procedural delays. Otherwise, the valuable AAA credit rating will be in doubt, and anything less than AAA on FDIC-backed securities would threaten market perceptions of all US government issued securities. In precise terms, credit default swaps on 10-year treasuries, currently quoted at a spread of 40-45 basis points, could easily widen into the 70-80 basis points range if the format of the FDIC guarantee fails to meet standards of guarantees being offered in the UK, Europe and Australia.

Sullivan & Cromwell, which is representing JP Morgan (JPM), Bank of America (BAC), Goldman Sachs (GS), Bank of New York Mellon (BK), Citigroup (C), Wells Fargo (WFC), Morgan Stanley (MS), State Street (STT) and Merrill Lynch (MER), recommended very significant changes pertaining to costs, maturities and process requirements; however, the primary challenge which the FDIC will be confronted with over the next few days relates to the quality of its guarantee. According to some legal experts, complying with the full-and-irrevocable assurance request from financial institutions might require a change in the FDIC charter.

There is no question that, as investors realize that the bank-debt insurance mechanism is either faltering or is subject to delays into late January, common shares of almost all the potential participants in the FDIC's Temporary Liquidity Guarantee Programme will come under renewed pressure, with Citigroup, Goldman Sachs, General Electric and Bank of America being the most vulnerable at this juncture.

To aggravate the problem for American banks in what promises to be a highly competitive debt-issuance space in forthcoming months, UK banks have already issued $21 billion worth of government-guaranteed bonds, according to Bloomberg (November 13, 2008); at least six European banks are expected to follow suit with another $50 billion-plus debt issuances next week. Furthermore, this weekend's G-20 gathering is bound to generate an entire series of guarantee-related commitments for both bank and corporate debt from governments across the globe.

The sooner the FDIC can remove the uncertainty governing default risk, the better. In the interim, bailout targets will remain short propositions, regardless of any broad rally in the equity indexes.

Stock position: Short C, GE, CS, GS.

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This article has 1 comment:

  •  
    Nov 15 12:24 AM
    >most important of all is the fact that, in its present form, an FDIC guarantee will create more problems than it is targeted to solve. Primarily, the FDIC-backed paper will not be "fully, irrevocably and unconditionally" guaranteed by the US government. Rather, the Interim Rule refers to repayments conditioned by the domestic bankruptcy process, with no specific timing parameters. (The Comment Period on the Interim Rule expired on Thursday.)


    To relieve the pressure on the FDIC in regard to its FDIC-backed paper, what the government needs to do is first to restore the credit-rating of the insurers in the private sector -- especially the monoliners.

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