Every once in a while a decision made in a boring meeting at an unglamorous, fluorescent-lit federal agency signals that historic upheaval is underway for the world outside.
At 6 a.m. on Monday, Sept. 29, when it was clear that Wachovia, the enormous U.S. bank, couldn't open its doors to customers due to a lack of funds, the board of the Federal Deposit Insurance Corporation (FDIC) voted for the first time since its creation during the Great Depression to take a "systemic risk exception" to the rules that usually limit what it can do. The exception allowed the FDIC to cover some of Wachovia's potential losses, enabling the bank's sale to Citigroup and its continued operation.
Doesn't sound like much, but let the language sink in for a second. The fiscally conservative organization charged with guaranteeing American bank deposits found that, for the first time ever, the economy of the United States of America was at risk. Not just one bank, but the whole financial system. If Wachovia failed to open, or did open but blocked depositors from continuing the run on cash that had begun the previous Friday, panic could have spread to other banks, big and small. The crisis could have become a financial catastrophe in a matter of hours.
The FDIC's concern about the fragility of the system extends to other agencies. On Sept. 23, while lobbying Congress for $700 billion to lift bad loans out of the financial system in hopes of restarting lending between banks, Treasury Secretary Henry Paulson downplayed another, more extreme approach to shoring things up. "Some said we should just stick capital in the banks, take preferred stock in the banks," Paulson said. "That's what you do when you have failure. This is about success."
Well, last Friday Paulson embraced sprinkling banks with billions of dollars, announcing at a press conference that he intended to pursue this plan "to promote financial market stability." Which leads to an obvious question: Are banks failing now?
The obvious answer is yes. Banks are failing 13 have gone under so far this year and they're going to continue failing. One hedge-fund star said the markets are now pricing the chance of a default in the next five years by Morgan Stanley or Citigroup at 45% and 21%, respectively.
The FDIC has a clear message for Americans who are beginning to awaken to the size of the problem: Don't panic. Banks will fail, but it is highly unlikely that depositors will lose their money. The FDIC now guarantees up to $250,000 in individual deposits at the banks it insures. And by law it gets its hands on a failed bank's assets before any other creditors do. FDIC chair Sheila Bair is eager to talk about how no insured depositor has ever lost a penny of his or her deposits.
But experts in and out of government expect bank failures to accelerate. Banks that are too big to go under, like Citibank and Bank of America, could fail but will stay alive in one form or another through a bailout or government-backed sale, for example. But plenty of medium and smaller banks are going to disappear or be divvied up by creditors. And the longer Paulson's new capital-infusion plan takes to get up and running, the higher the likelihood of failure will be.
That worries economists, as bank failures exacerbate the already bleak situation by decreasing the amount of lending in the system. That's one reason most now predict the country will sustain a protracted recession even if it manages to avoid the kind of systemic risk the FDIC feared a disorderly and public Wachovia failure might have brought.
And bank failures are likely to keep worrying the markets too. Some traders were hoping for two potentially positive events this weekend, after the worst week in the history of the New York Stock Exchange came to a close on Friday. The first was that the meeting of the G-7 whose finance ministers and central bankers were set to convene in Washington would unveil details of a plan to inject capital into banks worldwide. The second was that the G-7 would commit to a coordinated guarantee of interbank lending.
The G-7 did produce an action plan, but it was light on specifics; all member countries will inject capital into banks as needed (Britain has already committed to doing so), but they didn't announce amounts or timing. It was hardly the explicit, "show us the money" announcement many investors hoped for. Similarly, the G-7 pledged to unfreeze credit markets but didn't say how or mention interbank guarantees.
Markets may feel better about a joint European commitment announced Sunday to guarantee certain bank loans and recapitalize banks. Unfortunately, disappointment in the markets, the failure of another major bank or other dramatic events may yet produce another early-morning FDIC board determination that the American financial system as a whole is at risk.