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One of the good things to come out of the Dodd-Frank Act was the permanent increase in deposit insurance protection to $250,000 per account. Typically, Congress increases coverage when the national median household income reaches a level equal to about half of the deposit insurance cap. The current median household income for the nation is about $50,000, which was half the old coverage cap of $100,000 — time to raise the cap.

In 1980, when the cap was raised to $100,000 from $40,000, the median household income across the country was about $17,700. In 1973, when the cap was raised to $40,000 from $20,000, the median household income was about $10,500. In 1968, when the cap was raised to $20,000 from $15,000, the median household income was about $7,700.

Whether it makes sense to tie deposit insurance to median household income is a debatable point. Whatever the cap is, I like to see it tied to real economic data; I really don’t like to see the FDIC and the Deposit Insurance Fund manipulated for political purposes.

The increase to $250,000 may certainly have been the result of political horsetrading. In “On the Brink,” former Secretary of the Treasury Henry Paulson writes about a Sept. 30, 2008 meeting with top Treasury officials. He writes:

“We had a meeting Tuesday morning and then a conference call to discuss raising the FDIC cap on insured deposits from $100,000 to $250,000 per account as part of the TARP sweeteners.”

So the increase in coverage had nothing to do with the economy and appropriate levels of deposit insurance. It was all about getting enough support to pass TARP.

The $250,000 cap is a good thing, even if I don’t really like the way it was achieved.

For as long as I have been covering this industry, bankers have told me that the OCC is really not interested in small banks. “They are focused on the big banks,” I have been told many times. OCC leadership obviously has heard this message and they clearly don’t like it. Many speeches delivered by the Comptroller begin with some clarification about all the community banks under OCC supervision.

“Despite my best efforts, I sometimes still confront the stereotype that the OCC is only concerned about big banks. Let me say again, emphatically, that that’s just not true,” Comptroller John Dugan told community bankers in a speech delivered March 19 in Orlando. He goes on to explain that two-thirds of OCC examiners are focused on community banks. He also noted that the agency reaches out to listen to community bankers through a variety of industry events and meetings. “My over-riding point here is that we at the OCC consider community bank supervision as core to our mission.”

Yet, I wonder whether Mr. Dugan really understands community banking. In the remainder of his speech, he talks about bank failures, emphasizing the disproportionate representation of community banks. “195 banks, nearly all of them community banks, have failed since the start of the crisis in 2008,” he says. Furthermore, he notes an “estimated cost to the deposit insurance fund exceeding $58 billion.”

Any community banker would find that observation a bit galling. Citi and BofA both failed on the OCC’s watch, but Treasury stepped in to prop them up so they were never closed. Had they failed, they would have wiped out the FDIC fund completely. I think it is pretty insensitive to talk to community bankers about the problems in community banking without acknowledging the far more severe problems in a sector of the industry where the OCC has much greater responsibility.

In the speech, Dugan noted four things that he believes regulators need in order to be effective: balanced judgment, to provide appropriate guidance, consistency and forthright engagement with bankers. The irony of his third item — consistency — is inescapable. There is nothing more inconsistent in bank regulation than regulators picking winners and losers. Too-big-to-fail pretty much tells community bankers they are a bunch of losers. Dugan is right to say that one of the most important things regulators can do is be consistent; to me, that means ending too big to fail. Not until this policy is ended will it make any sense to compare community banks with the rest of the industry.

Politicians and pundits criticize bankers for making too few loans, for tightening credit too much. At the same time, most examiners are urging caution on lending. Few examiners are telling bankers to go out and make more loans. Most bankers say that when the examiners come into the bank, they are quick to criticize, even the loans that seem very sound.

The leaders of the regulatory agencies are aware of this dichotomy. FDIC Chair Sheila Bair and Comptroller John Dugan talked about this in Orlando last week. Bair referred to this join statement issued by the regulatory agencies and the Conference of State Bank Supervisors, which encourages banks to make loans to credit-worthy small business borrowers.

“The statement recognizes the importance of small businesses and the fact that some are experiencing difficulty in getting credit,” Bair said. “It clearly states that financial institutions that extend credit using prudent lending standards will not be subject to supervisory criticism. I know that there are concerns about examiners being overzealous in adversely classifying loans and applying capital requirements … What I want you to understand is that we hear your concerns. We are trying very hard to achieve a balanced approach to supervision during these challenging times.”

Dugan also acknowledged tension between advocates of increased lending and those focused on safety and soundness. “These hard times have produced a very difficult regulatory climate, for both community banks and their supervisors,” Dugan said. “A number of bankers and their trade associations … have complained that regulatory measures have been too stringent … At the same time, others have criticized regulators for being too lenient with troubled banks …”

Dugan said he has given his examiners a four-part message for dealing with this dilemma:

First, it is critical that examiners strive continually for professional judgment that is balanced.

Second, as significant issues arise, we can and should do more over time to provide appropriate guidance.

Third, in the expectations we communicate to banks and the actions we take, we need to be consistent.

Fourth, our examiners and their supervisors need to engage bankers forthrightly and address the specific concerns that [bankers] raise. Read the entire speech here.

It is difficult to argue with these four points, although the third point is a little hard to swallow. Certainly as long as too-big-to-fail is the official policy of the Treasury Department, action by regulators will not be consistent across the industry. Bair in her speech made a big deal out of the too-big-to-fail problem. Although Dugan mentioned too-big-to-fail in his speech, he did not go into depth about it.

More from the Sheila Bair speech in Orlando:

“Job number one must be to level the playing field once and for all and to put an end to the doctrine of too big to fail,” she said to applause. “Too often in the past … we saw large, systemically important institutions exempted from the type of supervisory sanctions that community banks face very day.” Listening, I got the sense that this really ticks her off.

In “On the Brink,” Henry Paulson described some of the conversation surrounding the rescue of Citibank in November of 2008. In his entry for Saturday, Nov. 23, he writes:

No one seemed more frustrated than Sheila, who at first suggesting using the FDIC’s normal procedure for handling Citi … That morning she said she wasn’t sure that Citi’s failure would constitute a systemic risk. She felt that Citi had enough subordinated debt and preferred stock to absorb the losses. She spoke as if Citi were just another failing bank and not a world leader. “So” she said, “why not let them go through the receivership process?”

Paulson said the suggestion made his jaw drop; of course, they didn’t go that route.

A year and a half later, clearly, Bair still doesn’t like the idea that some banks get special treatment. “It is time to get serious about establishing a credible, pre-funded resolution authority for giant banks and non-bank financial institutions,” she said in Orlando. She said she likes the provisions in the House bill and the Senate proposal for dealing with too-big-to-fail institutions. “We would finally have a mechanism under which large, complex institutions could be closed if necessary without wreaking havoc on the rest of the financial system,” she said.

A three-judge panel for the U.S. Court of Appeals for the Seventh Circuit has over-ruled a Jan. 15, 2009 Tax Court ruling regarding the tax treatment of qualified tax-exempt obligations held by subchapter S banks. The ruling is good news for subchapter S banks. About a third of the banks across the country have subchapter S incorporation status. Read the decision here, issued March 17.

Jerome and Doris Vainisi, owners of the First Forest Park Corp., in Forest Park, Ill., were the petitioners. The holding company owns First Park National Bank and Trust Co., in Forest Park. The bank owned qualified tax exempt obligations that generated more than $600,000 in income in 2003 and 2004. When computing their interest expense deduction for their federal income tax returns for those years, the bank did not take a TEFRA disallowance because it had obtained subchapter S status more than three years earlier. The IRS cried foul, saying the bank should have taken a disallowance.

Prior to the IRS determination and its Tax Court ruling, it was widely believed that subchapter S banks did not need to take a disallowance if they had been a sub S bank for three years or more. The Tax Court Judge, Maurice Foley, ruled that since the provision in the tax code regarding the TEFRA disallowance does not make reference to S corporations or S subsidiaries, they need to take the disallowance.

The Vainisis appealed the Tax Court ruling and now the Appeals Court has overturned the decision to the previous, generally-held interpretation of the tax code. In the Appeals Court case, argued Feb. 23 in Chicago, the U.S. government argued that Congress did not intend for bank holding company subsidiaries with sub S status to enjoy this tax advantage.

“We cannot rewrite statutes and regulations merely because we think they imperfectly express congressional intent or wise social policy,” circuit judges Richard Posner, Diane Sykes and William Bauer write in their ruling.

“Of course, unless abrogated, the privilege conferred by section 1363(b)(4) will perpetuate a competitive advantage enjoyed by S or QSub banks that have never been C corporations or that converted from C to S earlier rather than later. Later converters — not to mention all existing C corporation banks — may be gnashing their teeth in fury at the additional interest deduction that many of their S or QSub bank competitors can take. But the difference in treatment, and whatever consequences flow from it, are built into section 1363(b)(4),” the judges write.

“The regulation was promulgated a decade ago and the Treasury Department has thus had ample time in which to decide whether the favored treatment of S and QSub banks is a bad idea. The Internal Revenue Service thinks it is a bad idea, the Tax Court thinks it a bad idea, but the institutions authorized to correct the favored treatment of these banks — Congress by statute, and the Treasury Department, as Congress’s delegate, by regulation — have thus far left it intact. True, the Treasury has proposed to subject all subchapter S banks, no matter now long they have enjoyed that status, to section 291… But the proposal has been in limbo for years … Unless and until such a regulation is adopted or the statute amended, the distinction stands, and exempts the Vainisis from section 291. The judgment of the Tax Court is therefore reversed.”

More from Hank Paulson’s book, On The Brink.

His entry for September 25, 2008 gives us a glimpse of what happened when Washington Mutual failed. It was the biggest bank failure in history. Paulson explains that through an FDIC-facilitated transaction, JPMorgan paid $1.9 billion for WaMu which had $307 billion in assets. The condition of the bank had deteriorated rapidly, with depositors withdrawing $16.7 billion during the 10 days prior to closing.

Here’s the really interesting part. Paulson says six month earlier JPMorgan had wanted to buy WaMu, which was known to be having trouble even then. The Office of Thrift Supervision, WaMu’s regulator, declined JPMorgan’s overtures and worked out a deal with a private equity firm for a $7 billion capital infusion. “This decision proved to be a mistake: an acquisition by JPMorgan would have stabilized the bank,” Paulson writes.

This kind of guidance is a big black mark against OTS, and maybe a few lawmakers are keeping this in mind as they work on the industry reform legislation to merge the agency out of existence.

Here is how Paulson concludes his thoughts on WaMu:

JPMorgan’s purchase cost taxpayers nothing and no depositors lost money, but the deal gave senior WaMu debt holders about 55 cents on the dollar, roughly equal to what the securities had been trading for. In retrospect, I see that, in the middle of a panic, this was a mistake. WaMu, the sixth-biggest bank in the country, was systemically important. Crushing the owners of preferred and subordinated debt and clipping senior debt holders only unsettled the debt holders in other institutions, adding to the market’s uncertainty about government action. Banks were even less willing to lend to one another. In the future, I concluded, we were going to need to go beyond the standard FDIC resolution process for a failing bank.”

So is a $300 billion bank too big to fail? Paulson would seem to suggest it is. Later in the book, when regulators are discussing Citigroup, Paulson reports that FDIC Chairman Sheila Bair suggests they let the bank fail and handle it through the normal failed bank resolution process. Of course, they don’t take her advice. Clearly, there is tension at all levels between those who would give the largest banks special treatment and those who would treat them like any other bank.

I am finding it very instructive to think about what happened to our financial system in 2008-2009. Next week, a book called “Panic: The betrayal of capitalism by Wall Street and Washington” will be released. Written by a friend of mine, Richard Vigilante and his colleague Andrew Redleaf, this book really puts the events of the last two years into perspective.

The authors write about securitization, noting that one of the significant features of a pool of mortgages is that it free investors from having to consider the individual merits and demerits of particular mortgages. “The investor in a mortgage-backed security, in theory, does not need to know anything about Bill’s mortgage or Bob’s mortgage or whether Bill drinks or Bob is about to lose his job. Mixed into a pool, Bill’s and Bob’s mortgages simply become part of an ‘asset class.’ The creation of a class of investments that will behave in statistically predictable ways excludes the need for judgment of particular cases.”

The authors go on to explain how such thinking led to big problems. Even more importantly from my perspective, is the way in which this kind of securitization attempts to minimize the need for human judgment. In my opinion, the very essence of successful American capitalism is the careful judgment exercised by great entrepreneurs since the advent of the Industrial Age.

I was further intrigued recently reading Henry Paulson’s new book, “One the Brink: Inside the race to stop the collapse of the global financial system.” Paulson, the former U.S. Treasury Secretary, shares his account of the events of 2008 in an interesting book released Feb. 1. Here is what he writes on pages 68-69:

Lacking the ability of traditional lenders to examine the credit quality of the loans underlying these securities, investors relied on rating agencies — which employed statistical analyses rather than detailed studies of individual borrowers — to rate the structured products…

The drive to make as many loans as possible, combined with the severing of the traditional prudential relationship between borrower and lender, would prove lethal.

The lesson? No matter how you package a loan, you still have to assess the quality of the borrower. Ability to repay is important no matter how many times you slice and dice, sell and resale the loan.

A bit of a brawl that pretty much captures the tone of the times.

Jim MacPhee, chairman-elect of the Independent Community Bankers of America, shared a couple of interesting stories in Lincoln, Neb., on Friday, where he was attending the annual meeting of the Nebraska Independent Community Bankers. MacPhee is the chief executive officer of the $78 million Kalamazoo County State Bank in Schoolcraft, Mich.

He explained that last October, he and other ICBA leaders (including Cindy Blankenship of Bank of the West, Irving, Texas, and Mike Menzies, Easton Bank & Trust Company of Easton, Md.) met for 30 minutes with then-Secretary of the U.S. Treasury, Henry Paulson. The Troubled Asset Relief Program had just been announced. MacPhee described the following exchange.

Secretary Paulson looked at me and said, “Jim, are you going to take some of this TARP money so we can get business moving again in this country?”

“No sir,” I said. “My bank has 14.1 percent Tier 1 capital and 20 percent liquidity. I really don’t need any of the TARP money.”

Then he looked over at Cindy and Mike and said “What about you two, are you going to take TARP money?”

Mike said, “Well sir, we’re both sub S.”

He looked at them and nodded. One of his aids said, “Sir, a sub S doesn’t issue stock.”

Point is, Treasury really didn’t understand our model. They don’t understand how we function under sub S or as a highly capitalized bank.

In contrast, MacPhee told this story about a regulator who seems to understand the community bank model.

Last March at the ICBA convention, we had breakfast with Chairman of the FDIC, Sheila Bair, and Chairman of the Fed, Ben Bernanke. It was about a 45 minute breakfast. We could ask them anything we wanted. They were very candid with their answers.

 

That was the time that the 20-basis-point special assessment had been proposed. At the time, my bank is being examined. I asked Sheila Bair this question.

 

“The ‘E’ in CAMELS stands for earnings,” I said. “That E could be taken down fairly substantially, based on this special assessment. Is there any opportunity for you to consider not further reducing our CAMELS rating based solely on the special assessment? Examine my bank on its merit; you give me a 3 on earnings, I accept that. But if I had a 2 in earnings, don’t take it down to 3 just because of the special assessment.”

 

She said, “Jim, I see your point.”

 

She turned to her aid and said “I want a memo to go out on that. Tell our field supervisors not to lower the CAMELS rating based on the special assessment.” 

Look for coverage of the NICB convention in the November 15 edition of NorthWestern Financial Review magazine.