Can the FDIC Weather the Financial Storm?

| Wed Sep. 17, 2008 1:01 PM PDT

The federal bailout of American Insurance Group (AIG) is like putting a finger in the dike. Next to potentially require government intervention is Washington Mutual, the nation's sixth largest bank with some $143 billion in deposits, which hangs by a thread. When—not if—it goes, the government is committed to protecting its depositors through the Federal Deposit Insurance Corporation. According to one estimate in The New York Timeson Wednesday morning, paying off Washington Mutual depositors could eat up half the FDIC's reserves, which currently stand at $45.2 billion. In August, the FDIC identified 117 banks and thrifts that could be in trouble. "A few more IndyMacs or 20 or 30 smaller collapses will wipe out [FDICs] reserves," predicts Dean Baker of the Center for Economic and Policy Research. That means the FDIC could bottom out, unless Congress steps in.

Commercial banks, already straining from the crisis, are now being encouraged by Treasury Secretary Henry Paulson, to take on crumbling Wall Street investment companies. That was the message in the Bank of America's recent takeover of Merrill Lynch. One of Washington Mutual's oft-mentioned suitors is Chase. That means that bank portfolios could become swollen with the junk bonds, lousy mortgages, and other speculative investments held by the unregulated collapsing investment banks on Wall Street. The already weakened commercial banks will find it difficult to survive with this additional load. If they fail, the FDIC's reserves are not big enough to cover the deposits of their customers.

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With an election approaching, politicians in Congress can't possibly allow widespread banking failures. The crisis right now may seem abstract to many, but when Americans finally get the picture that their checking and money market accounts could be in jeopardy, then candidates for the presidency and other offices will have to come up with something beyond the empty rhetoric that passes for proposed policy to date. (Obama has promised leadership; McCain has promised a commission.)

Congress isn't likely to let the FDIC go down the drain. But how to save the day?

Inevitably, there will be a deal, which is likely to mirror some version the savings and loan bailout of the 1980s and 1990s, with the creation of an institution like the Resolution Trust Corporation into which the banks can dump subprime mortgages, junk bonds, and other speculative holdings. The RTC seized the assets of more than 700 S&Ls, worth some $400 billion, then sold them off to private investors. Far from a perfect solution, it was plagued by charges of contract corruption and mismanagement. On Tuesday, Rep. Barney Frank (D-Mass.), who heads the House Financial Services Committee, raised the possibility of a creating an RTC-like entity to handle the current crisis. In an interview with the New York Times, Frank said such an agency would need "tough new regulations" to prevent risky investments, but he did not delve into specifics.

Meanwhile, the AIG takeover opens another can of worms for unprepared federal regulators. The insurance industry has long fought successfully to avoid federal regulation. Currently, the industry is nominally regulated by weak state commissions, which can easily be bullied into submission by the big insurance firms. For years the insurance industry's point man on the Hill was Senator Thomas Dodd. Now, his son, Connecticut Senator Chris Dodd, who's also viewed as an ally to the insurance business, is the chairman of the Senate's banking committee.

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