This week in The Institutional Risk Analyst, we feature a conversation with FDIC Chairman Sheila Bair as she nears the end of her term. Bair has been in and out of public service for three decades, including working for Congress, the Treasury and lastly the FDIC. She spoke to IRA co-founder Chris Whalen before the July 4th break. 

The IRA: That you for taking time to speak with us Chairman Bair. You have been working in Washington for 30 years on and off. What was your favorite assignment during that time? Was it working on the Hill or the FDIC?

Bair: This job as FDIC Chairman has been my favorite, both in terms of the challenge and being fulfilling. I think at FDIC I have had the opportunity to make a difference. The other time would be my years with Senator Robert Dole (R-KS). That was a very special time, a less economically challenging time. The Republicans had just taken over the Senate and the Presidency. The 1980 election was the game changer because the GOP had been in the minority for so long.

The IRA: When you went to work for Bob Dole, I was just going to work at the Heritage Foundation. A year later ended up working as a staff writer for Legislative Digest at the Republican Conference Committee under Congressman Jack Kemp (R-NY).

Bair: Another old timer. You remember that period, then.

The IRA: A question we hear constantly from bankers and other clients is that the regulators are "clamping down" on lending. Is the FDIC and other agencies actively discouraging banks from making loans?

Bair: We have been clamping down on bad lending, but we are not discouraging prudent lending, well underwritten loans, at all. That is the policy direction that we have provided. Even on CRE exposures, we've said via the guidance that you can have a concentration if you manage the risk appropriately. We have also said that the commercial loan does not have to be classified merely because the collateral has gone down in value so long as the credit is performing and the borrower is creditworthy. Even if the loan is under water.

The IRA: That is fine with existing credits. To that point, we hear a lot of comments in the marketplace from people who own commercial properties. The good news is that these properties can be refinanced, The bad news is that lenders often require commercial borrowers to put cash into the new deal, even class A properties that are fully leased. We are talking about quality locations up and down the northeast corridor, but the decline in collateral is making lenders demand more cash. Is this being driven by the regulators? Or by the reality in the market?

Bair: If the banks are doing that, it is for their own credit risk management purposes. I don't believe that more equity in refinancing deals is something the regulators have demanded. Certainly, it is not something demanded by the FDIC. In terms of refinancing CRE, we have told the banks that they don't even need to get an appraisal if the credit is current. If you are extending additional credit then you obviously need a new appraisal, but if you are just rolling the existing loan then we have guidance in place that says you don't need a new appraisal. Now if the bankers think that asking for more cash down is prudent, then they can do that but I have not heard of examiners telling bankers to ask for more equity in refinancings That is contrary to the guidance we have out there now and we certainly have no policy to seek additional cash down in commercial real estate deals for creditworthy borrowers.

The IRA: We have not heard that allegation, but the banks do seem to be taking a hard stance on valuations. Loss given default has improved for the industry over the past couple of quarters, but we remain bearish on housing prices in 2011 and 2012. You saw that Congressman Scott Garrett's (R-NJ) covered bond proposal passed out of the House Financial Services Committee, but the banking industry is awash in deposits. Funding is not the issue at the moment as we argued in an comment on Reuters.com, "Did the FDIC really kill the repo market?," regarding the impact of the FDIC assessment change on the fed funds market.

Bair: Well, even if the change in the assessment had an effect, is that a bad thing?

The IRA: No, well our colleague David Kotok of Cumberland Advisors is a thoughtful man and has written about this issue. He asks why does not the FDIC exempt reserves at the Fed from the FDIC assessment because the fee is cutting down on interest rate arbitrage for the banks, but there is no problem with funding in the industry at present, is there?

Bair: We are up to $6.5 trillion in insured deposits. We have funding as far as the eye can see. To the extent we have shifted the assessment base to all assets only means that deposits are becoming more attractive. But remember that when we only assessed domestic deposits, investors gamed the system because they knew we were required to protect certain creditors of the bank as well. Secured creditors, ring-fenced foreign deposits...

The IRA: And repurchase agreements...

Bair: Yes, if fully collateralized which they generally are. None of these asset categories was assessed insurance premiums in the past. As conservatives, if we believe that government services should be paid for, then the cost of the government-backed protection given these bank creditors by the FDIC guarantee should be assessed.

The IRA: You have talked in the past couple of press conferences for the release of the quarterly data for the industry that banks cannot continue to enhance income by reversing loan loss provisions. What is the business prospects for this industry which, even with extraordinary actions such as pulling money out of loan loss reserves, is still in mid-single digits in terms of equity returns? What should we expect for the next couple of years?

Bair: I think it is a real issue. A couple of things come to mind. The uncertainty on a number of fronts such as the economy and real estate is hurting. It is making banks more risk averse and borrowers less willing to make new commitments. The uncertainty about the direction of the economy and particularly what Congress is going to do about the budget, debt ceiling, etc. is another factor. Investors still don't know what the game plan is for dealing with fiscal issues. We need to have some confidence that the political system can work before you see business really start to commit to supporting a recovery. The lack of confidence in the political process is hurting the economy and the willingness of borrowers to take new loans.

The IRA: Are you worried about the negative trends in terms of net interest margin? Do you think that the Fed needs to raise interest rates to prevent banks from losing too much of the cash flow from core earning assets?

Bair: I was asked at the National Press Club luncheon if the Fed should start raising rates as several observers have argued. I believe you have also had an interesting proposal to force excess reserves back into private assets and thereby help lending. I think the Fed is aware of all of these concerns but it may be time to start thinking about the consequences of low interest rates more carefully. Clearly what we have been doing is not giving the economy the forward impetus that we want to see. We can't put it all on the Fed and monetary policy. Maybe we need some new thinking, some experimentation in terms of policy because what we have done so far has not helped the economy as much as we would like.

The IRA: We don't necessarily put the deficit debate and the debt ceiling first on the list of worries.Professor Steve Hanke wrote an important comment for CATO Institute urging the Fed to raise interest rates, which seems more on point. Do you think that the low level of interest rates and the troubles in Greece is contributing to a reluctance by banks to lend to one another, especially across borders?

Bair: There probably is some of that. Markets can be mercurial so it is hard to predict what the markets will be doing tomorrow or six months from now. Anecdotally we do hear reports that suggest that low rates are affecting risk appetites, so it is true that in the minds of some in the industry low rates are a concern. That's true.

The IRA: Another comment we hear a lot is that the increased "friction" created by increased capital requirements. You heard this with JPMorgan CEO Jaime Dimon complaining about the regulatory burden threatening the economy. But didn't the fact of a leverage ratio and other conservative capital requirements in the US help the industry deal with the crisis? Is excessive regulation hurting the recovery?

Bair: No, I thank my stars that we had the leverage ratio in the run-up to the crisis. I think the leverage ratio was one of the reasons that insured banks, despite some capital challenges, were in a much better position in terms of capital than the shadow banking sector. So no, I am glad that we had the leverage ratio. We had a leverage ratio before the crisis and we saw some pretty robust lending, so I don't think that capital per se is a restraint on growth. Strong capital supports growth.

The IRA: We have long advocated a more public and comparable approach to risk-weighting assets. The current Basel framework for rating sovereign credits makes no sense if you look at the situation in Ireland and Greece. Is this unfair?

Bair: There are sovereign credits and then there are sovereign credits. If your models are giving a country a zero or near-zero risk weight for capital purposes, but the markets say otherwise, then I think we have to look at this issue again. The leverage ratio provides an over-arching constraint on bank risk taking.

The IRA: You and your colleagues at the FDIC were early in terms of warning about the subprime bubble and then trying some solutions to deal with the large number of mortgage delinquencies. You tried to experiment with loan modifications at failed institutions such as IndyMac. There now seems to be renewed interest inside the Obama Administration at looking at some of these efforts as home prices continue to fall. What is your view of how the industry is dealing with modifying loans that can be saved and dealing with defaults and foreclosures?

Bair: On the commercial real estate side, we have seen a lot of progress in restructuring. The process works pretty well and with relatively little political controversy, which is always amazing to me...

The IRA: Well, you have professionals on both sides of the table. Doesn't this help the process move forward?

Bair: That is true, but this is still restructuring and in general somebody is usually pushing back. To the industry's credit, when we told banks to be aggressive in restructuring commercial exposures, we just did not see the push back. Part of the reason that we have not made more progress with residential loan modifications and we are paying for it now is that there was an understandable visceral reaction against modifications for troubled borrowers by others who were making their mortgage payments. You know better than I that there is a strong business case to be made for modification in terms of mitigating losses to the institution or an investor who holds the loan. It helps from a macro standpoint by keeping additional inventory off the market. My frustration is that we did not make the business case for modification and other creative solutions early enough. We kind of missed our window in 2007 to do home mortgage modifications in a large scale way.

The IRA: Well, precisely. Once the banking industry and the Fed realized that the $700 billion appropriated through TARP was not enough money to fix the problem, then the exercise shifted from restructuring to increasing capital. We are still talking about increasing capital with no real restructuring of balance sheets. In terms of getting the economy moving, we've always believed that the banking industry should have been compelled to charge-off bad assets equal to the TARP funds instead of paying it back.

Bair: Some of the things that are politically salable and some of the polices that might have worked better in terms of economic outcomes are two different things. We need to simplify the restructuring process both for government programs and non-government programs. We need to streamline the process and be realistic about the volumes of distressed assets you are dealing with. Unfortunately the low level of resources available to handle modifications is another concern. The second point is that we need to change our strategy to meet changing economic conditions. There have been some programs for the unemployed but we may be able to do more here. Also, deeply underwater mortgages and resetting option arms are going to mean a growing number of people will be in too much house. We need to first qualify these borrowers for loan mods, but if that does not work then we should immediately look at short sales, cash for keys and other methods. These programs need to be very simple, but unfortunately with the dysfunction we see in the servicing sector this is not happening. Banks have not spent the money on capacity, training and other areas to enable us to work through the problem.

The IRA: The Mortgage Bankers Association just put forward a new pricing scheme for servicing troubled credits to provide some of the resources needed to do the work you are describing. But going back to the letter on mortgage servicing that Josh Rosner and I helped to organize last year, there still seems to be a lack of alignment in interests between the servicers, borrowers and investors. One area that we at IRA hear a lot about from our friends in the public sector is about efforts to keep people in homes, things like the "rent to own" pilot progams from Fannie and Freddie. There is even talk about creating structures such as REITs to own and manage residential properties. Have you or your colleagues at the FDIC had any discussions with the industry about creating new vehicles to own and manage residential properties as rentals?

Bair: We are going to be launching another securitization of non-performing loans later this year. We are going to provide broad flexibility to the servicer to maximize recoveries for us. On rent-to-own I have always been a big fan. If a home owner cannot even make a market-based rent payment, then it may not help. But I think rent-to-own does have a role to play in terms of fostering home ownership for low income people. It allows tenants to build up a little equity, effectively the down payment for an eventual purchase. They build up a credit history and show that they can make a payment every month. I love that idea.

The IRA: It is the old fashioned forced savings model. Our friend Rosner has written about this, about turning the interest deduction for mortgages into a home equity tax credit.

Bair: Well, Josh Rosner should try to get some investors together and create a securitization market to fund it. I think it is a fabulous idea. The IRA: You have managed the cash needs of the FDIC very adeptly during the crisis. You did not need to go to Treasury to use the existing credit line or the other facilities put in place by Dodd-Frank. You have not actually taken any cash out of the industry in several years since the special assessment, correct?

Bair: No we have not. We did the special assessment with a three-year prepay to raise $45 billion in cash. In addition to the pre-pay, the use of loss-share agreements - which both reduced our outlay up front and maximized our recoveries for the loans - kept us liquid and enabled us to avoid going to the taxpayer for help. Some people were critical of the loss share agreements, mostly because of poor information, but I cannot imagine a worse outcome for the FDIC and the public than a cash liquidation of failed bank assets.

The IRA: Going back to the real estate sector, Fannie Mae and Freddie Mac have 95% market share in the mortgage sector. What can FDIC do to create structures that will enable smaller banks to compete with the large bank cartel that controls sales of loans to Fannie and Freddie? Most smaller banks are forced to sell conforming loans to the top four banks servicing released instead of submitting the loans directly, losing the relationship with the customer and half of the origination spread. How can we create a more competitive marketplace to spur lending by smaller banks? Are we doomed to see a more centralized, European-style mortgage market?

Bair: I hope not. I would encourage research in this area. I am going to be working on housing issues after I leave the FDIC and will be joining a foundation in the Fall. The mortgage origination process has been so heavily concentrated I do think it is important for the smaller banks to participate. We need a more diversified market to protect the banks and this also benefits the consumer. Smaller banks like the high touch model of customer service. They want to keep the servicing on loans. Any strategies we can come up with to enhance competition and help banks to diversify their business models is good.

The IRA: Going back to the earlier point about FDIC assessments being a drag on Fed monetary policy, in fact the FDIC has been extremely accommodating in terms of minimizing the amount of capital drain on banks to fund resolutions.

Bair: No, we have not taken more money. The $45 billion was paid up front and accrued over three years. It comes down to about $12 billion per year under the new rules. The banks fortunately had plenty of cash and could help us to fund our needs, but asset sales are also a big part of managing our cash needs. This saved us from having to go to taxpayers for help. I think it is important that the banking industry funds this activity. Maintaining the integrity of the industry commitment to the deposit insurance fund was very important from the standpoint of industry discipline and public perception as well. The industry has largely supported us on this, not everybody, but I appreciate their support when it comes to our funding strategy. They can still say that taxpayers have never had to directly support the FDIC or our guarantee to the public.

The IRA: What advice do you have for Marty Gruenberg as he takes over the leadership at the FDIC?

Bair: They key thing I have learned in dealing with all of the constituencies that we serve is to communicate. People need to understand what we are doing and why we are doing it. It is a constant, non-stop process. I do a lot on interviews, on and off the record. A lot of what we do can be subject to misconstruction. The prime example was that terrible YouTube video about IndyMac.

The IRA: We corrected that item at the time.

Bair: All of the strategies that we follow are designed to maximize recoveries. But if you don't know what we are doing, then it sounds horrible. People said: "80% loss share!" But when we explained to people that we owned the asset and that avoiding a liquidation sale was a far better outcome for the FDIC, then people calmed down. We estimate that FDIC saved $40 billion in losses by selling failed assets to investors vs. the liquidation value of these assets. These types of innovative approaches by the people of the FDIC are what is needed to address the housing crisis. But the key part of the job is just getting the information out there is a consistent and comprehensible way.

The IRA: Thank you Chairman Bair.

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