FDIC Procrastination Is The Way Around Pricing The Toxic Assets

The large banks, such as Citi, are not cash flow insolvent and are still in a position to lend. Some are likely book value insolvent or at least capital insufficient if the assets are repriced to market value, but on a cash flow basis, they can continue to operate and lend and honor normal deposit withdrawals.

Deposits are stable. Many of the toxic assets are receiving payments and are cash flow positive. Plus, these banks have liquid securities, such as Treasury securities, that can be converted to cash to further increase lending.

As long as these banks are not seeing a run on its deposits and as long as they can continue to lend, there is no functional need for the FDIC to step in and takeover Citi or the other large banks.

Buying or moving the toxic assets requires a repricing of the assets to a current market value and destroying much, if not all, of these banks' capital base. However, as long as the banks are receiving payments on the toxic assets, despite accounting rules, they can avoid writing down these assets until they default arguing that the assets are more like loans than securities. They may face some future shareholder and SEC lawsuits, but that potential liability will be small in comparison to a FDIC takeover.

Assuming that not all the assets will default at the same time and that Citi and the other banks will have positive earnings from the rest of their lending and investment portfolios, they can survive and come out of this crisis (although bruised) over the next few years. They will write down over the next few years its toxic assets (as they are already currently doing) as they default in their payments and these write downs will be offset by earnings from the remainder of the banks.

30 years ago, the large banks faced a crisis over sovereign debt until the Baker Plan and were technically insolvent, but were not required to write down those assets to a market value. Similarly, 20 years ago, there was a commercial real estate crisis and the banks took loan losses but not market value write-downs.

The current banking crisis with toxic assets is not like the S&L crisis. With S&L's there was a moral hazard because large shareholders controlled the bank and use the delay to take on very high risk as the only hopes of salvaging their wealth and many in effect bet the bank and lost. But many also survived.

Sometimes, banks have to wear the emperor's new clothes. Over time, the toxic assets will disappear through repayments and write-downs. Quick fixes are not always the best solutions. In the case of the large banks, procrastination is possibly the best answer.