Californians Lose $1 Billion From Unconstitutional Bond Sales

Aug. 26 (Bloomberg) -- With the temperature reaching 100 degrees Fahrenheit on an April afternoon, Alan Polee peers through a window into the locked-up gym at Vanguard Middle School in Compton, California. The cream-colored building is shut because of a decaying roof.

At Vanguard, 15 miles south of downtown Los Angeles, children play outdoors, no matter the temperature, on rutted fields and basketball courts with broken backboards.

“We shouldn’t have these conditions in this day and age,” says Polee, 46, a Los Angeles city truck driver who has sent five children to the Compton schools. “You wonder what’s going on.”

The Compton Unified School District could have repaired the gym. In 2006, the district refinanced $50.8 million in taxpayer- approved bonds, in a move its bankers said would save the district money. In the process, officials took out $6.5 million in cash, which they said would be used for school construction and repairs.

School board member Micah Ali says Vanguard’s gym and rundown facilities at other schools weren’t fixed. A Compton audit couldn’t track how school construction money was spent. In the meantime, total debt owed by taxpayers until 2022, instead of being reduced, has gone up by 15 percent.

Throughout California, the largest and most fiscally troubled state in the U.S., about 200 school districts have done similar refinancing deals -- all of which have been condemned by Attorney General and former Governor Jerry Brown as unconstitutional.

Ban on Deals

The Compton school board didn’t seek voter approval for the deal. From 2002 to 2007, California school districts collected a total of $1 billion for construction during a bond refinancing spree set off by falling interest rates.

None of these deals should have been done, Brown says. The constitution bans school districts from taking on additional debt in a refinancing of taxpayer-approved bonds without a public vote.

In every case, the prohibited transactions added to school district debt and increased property taxes for at least the next decade, bond records show. Banks pitched the deals to schools on the premise that refinancing would save taxpayers money and provide extra cash.

The deals were dominated by UBS AG and Piper Jaffray Cos., which collected fees up to four times the U.S. average for bond sales, public records show.

“This was a hell of a cute scheme,” says Lee Buffington, treasurer of San Mateo County, just south of San Francisco. “These guys had a gold mine going and thought nobody was watching.”

Financing Frills

Some districts spent millions of dollars from refinancing not to upgrade classrooms but to purchase administration buildings and build sports stadiums.

Those decisions overrode requests from school board members and parents to support more urgent needs -- such as fixing leaky roofs, replacing faulty electrical systems, modernizing science labs and increasing security at schools where student violence had flared.

The Moreno Valley Unified School District, a 39-school system in Southern California, used 90 percent of its $6.5 million in cash to build a 3,000-seat outdoor stadium equipped with a wireless videotaping system for football games.

Librada Murillo, a mother of three children in the district, says school officials didn’t ask parents for advice. She blames board members for building a stadium when schools needed new bathrooms and security systems.

“We have a right to know this information,” she told the school board in 2007. “What the school board has been doing is not legal.”

No-Bid Deals

Most districts arranged refinancings without competitive bidding, bond records show. The added taxpayer burdens come as communities across the country try to dig themselves out of debt quagmires brought on by the purchase of exotic financial contracts.

The U.S. Justice Department for the past two years has been conducting the largest-ever criminal investigation of public finance in the nation.

Jefferson County, Alabama, the state’s most populous county, has been on the brink of bankruptcy for more than a year, unable to meet payments on $3 billion in interest-rate swaps sold by a group of banks headed by JPMorgan Chase & Co. JPMorgan declined to comment.

California, where state and local governing bodies issue more bonds than anywhere in the U.S. outside the federal government, has already had its share of debt fiascoes. In 1994, Orange County, home of Disneyland, went bankrupt in what still stands as the biggest municipal failure in U.S. history.

Fiscal Mess

Now, the state is trying to escape from its own fiscal mess. Governor Arnold Schwarzenegger in July closed a $24 billion budget gap with cuts ranging from trims in child welfare services to furloughs for state employees. He faces more reductions unless the economy recovers.

Banks told California school officials that refinancing made sense because the new debt would cost less than the old bonds, according to district documents and tape recordings of school board meetings. Such promises are misleading, says San Mateo Treasurer Buffington.

If there are any savings, they typically wouldn’t occur for 15 to 20 years. In many cases, a district replaced a 23-year general obligation bond -- voter-approved debt backed by property taxes -- with debt of 15 to 20 years.

State law requires lower total debt when school districts refinance old taxpayer-approved bonds. To accomplish this, banks sell bonds at lower interest rates compared with old ones, and for shorter terms.

Tax Hikes

That decreases debt compared with the old bonds because property owners pay less interest over a shorter period of time.

However, that type of financing leads to immediate property tax increases, in many cases for 20 years, because annual payments to bondholders are larger than they had been with the longer-term bonds, transaction records show. Once the refinancing is paid off, if tax rates don’t rise, property owners would see lower real estate taxes.

Attorney General Brown said in a January legal opinion that a possible benefit to taxpayers that could come in about two decades is “irrelevant.” What counts, he said, is that taxpayers have been improperly hit with higher taxes now.

For the Compton deal, county finance officials analyzed the amount property owners would have to pay bondholders after the 2006 school refinancing. In the three years following the transaction, the finance office doubled Compton’s real estate tax rate on those bonds.

More Declines

The economic meltdown that began in 2007 may add to taxpayer burdens of paying off cash-out refinancings. The state Legislative Analyst’s Office has forecast a 3.5 percent decline in property values in California in the next year, which might force counties to increase tax rates.

Attorney General Brown wrote in his opinion that school districts are prohibited from using a refinancing “for any purpose other than refunding the district’s targeted indebtedness.” Brown hasn’t taken any actions against banks or school districts. He said taxpayers could file lawsuits in their communities.

Brown, 71, is campaigning to be elected governor again after holding the office from 1975 to 1983.

Lost Savings

San Mateo Treasurer Buffington says millions of dollars in new debt owed by California taxpayers could have been avoided if Brown or his predecessor Bill Lockyer had moved faster on complaints and halted cash-out refinancings.

Scott Gerber, Brown’s spokesman, says the legal opinion stopped the practice.

“Individual school districts may still take action to address past wrongdoing related to the practice,” Gerber says. “If evidence of widespread wrong-doing emerges, the Attorney General’s office will look into it and determine the most appropriate course of action.”

Lockyer declined to comment.

The rewards to banks for managing cash-out deals trickled down to lawyers and insurers. Total fees paid by schools -- as a percentage of the cash they received -- reached 41 percent in the Acalanes Union High School District, a suburban system east of San Francisco. Fees came to 82 percent in the Ravenswood City School District near Silicon Valley.

In the San Mateo Union High School District, 20 miles (32 kilometers) south of San Francisco, fees totaled 117 percent of the $500,000 the school system got in cash on a $56 million refinancing in 2004. Advisers led by UBS arranged the financing and took $582,747 for their efforts.

‘Very Angry’

“Fees like that make you sad and very angry,” says Christopher Taylor, former executive director of the Municipal Securities Rulemaking Board, an industry-tied regulator in Alexandria, Virginia. “It’s unbelievable greed.”

The public doesn’t know that cash-out refinancings increase tax burdens because of lax notice by school officials, a local government oversight group said last year.

The San Mateo County Civil Grand Jury, which makes recommendations about government improvements, found that student needs were cheated because fees ate up substantial portions of cash proceeds. The jury criticized school districts for giving insufficient notice to the public.

“The main concern was about the notification of voters and the transparency of the process,” says jury foreperson Virginia Chang Kiraly. “Taxpayers wound up on the hook for more than they voted for.”

‘Valid and Binding’

UBS and Piper Jaffray teamed up on at least 32 of the 50 largest refinancing deals in 2004 and 2005 with a single bond lawyer, David Casnocha of San Francisco-based Stradling Yocca Carlson & Rauth. He wrote legal opinions vouching for deals from 2002 to 2007 that brought districts cash windfalls of up to $30 million.

“The bonds constitute valid and binding general obligations,” Casnocha wrote in legal opinions that backed the sale of cash-out deals. Casnocha, UBS and Piper Jaffray declined to comment.

In Compton, no school board member asked for details when a cash-out refinancing came up on a meeting agenda in March 2006.

Compton, a community of 96,000, is struggling to improve schools and public safety. Over a four-year period that ended in 2008, half of Compton’s high school students dropped out, more than twice the state average.

Barred Windows

While the city homicide rate in 2008 was the lowest in 25 years, Compton battles gang violence that’s been glorified in rap songs about the community. Compton streets are lined with a mix of palm trees and check-cashing outlets, fast food chains and liquor stores with barred windows.

In the early months of 2006, the Compton school system ran into a financial fix. It had nearly exhausted a $200 million construction fund, with many schools still in need of repair. RBC Capital Markets Corp., which had handled four previous Compton debt sales, came up with an answer: refinance old debt and deliver $6.5 million in upfront cash.

New York-based RBC, part of Toronto-based Royal Bank of Canada, managed the transaction. The lead banker, Los Angeles- based managing director Roderick Carter, 54, had experience in such deals. In 2005, he handled four refinancings, of $46.8 million to $75.7 million, that provided districts with a total of $20 million in cash, according to bond documents.

The transactions earned RBC $1.6 million, the records show. At an evening meeting in Compton in March 2006, the seven-member school board took a total of five minutes to approve the refinancing, a videotape of the session shows.

‘In Their Throats’

Just one trustee, Mae Thomas, a financial analyst at a Los Angeles hospital, objected among the six voting members. She said the community hadn’t been consulted about what to do with the $6.5 million.

“Why don’t we have hearings so the community can have input on these bonds?” Thomas asked. “We sit up here and shove it in their throats.”

The new bonds shortened the maturity of the district’s debt by seven years, to 2022 from 2029. The 10-year interest rate on the new bonds dropped to 4.66 percent from 5.25 percent. Still total debt increased to $58.2 million, from $50.8 million. As a result, county officials set higher tax rates.

Compton property owners are being billed a total of $3.7 million for 2009, 46 percent more than the $2.5 million they would have faced for the old bonds, district records show. If the school district doesn’t borrow more money, the public could see a drop in real estate tax bills in 2022, when the new bonds are paid off.

‘Saves Money’

Compton board members didn’t delve into the workings of the refinancing or ask about fees, which totaled $912,126. RBC collected $749,588. David Huff, a Los Angeles lawyer who gives legal advice to the district, recommended that the board approve the transaction.

“This is sound fiscal management,” he said at the board meeting. “As your counsel, I cannot think of a reason why not to do it. It saves money.”

In an e-mail, Huff stands by his statement at the 2006 board meeting. He says taxpayers will save in the long run. Former School Superintendent Jesse Gonzales and former district business manager Teresa Santamaria, who backed the refinancing, declined to comment.

RBC says its fees on the Compton refinancing met market levels for bond sales.

‘Multiple Law Firms’

“Refinancings were completed at client direction by virtually every major underwriting firm, with written legal opinions from multiple law firms affirming their compliance with state law,” spokesman Kevin Foster says.

At the time Compton was scrambling to rescue its construction program, the district moved into a new $10 million administration building. It was funded by lease revenue arranged through the Los Angeles County Schools Pooled Financing Program. When board members attend meetings, they sit in high-backed burgundy leather chairs that cost $750 each, public records show.

While school districts such as Compton did just a single refinancing, the Acalanes district in the San Francisco Bay area was hungrier. The school board used the technique four times in 2004 and 2005. Acalanes, a district populated mostly by white- collar professionals, collected cash totaling $3.8 million.

Its bank, Piper Jaffray, and bond lawyer, Casnocha, assured the district that the transactions violated no laws, according to bond documents.

Increased Debt

In the largest sale in 2005, Acalanes refinanced $46.4 million in 2002 bonds. Yields on the 10-year portion of the new 20-year bonds dropped to 4.45 percent, from 5.62 percent, according to data compiled by Bloomberg. Still, the debt increased to $48.7 million after the district took cash of $1.2 million and paid costs of $663,048, or 55 percent of the new money.

Piper Jaffray collected $450,866, a fee equal to $10 for each $1,000 issued, about three times the national average. The new 20-year bonds required a jump in annual payments to $2.2 million a year from $1.2 million in the first two years of the debt, beginning in 2005, bond documents show.

County tax officials more than tripled the tax rate on the refinancing in the first two years after the transaction. The public could pay out less after 20 years, when the bonds are paid off, if the county holds property tax rates steady.

In the four Acalanes sales, the district spent an average of 41 percent of its upfront cash -- $1.6 million -- on fees, bond documents show.

‘Absolutely Ludicrous’

“That’s absolutely ludicrous,” says Ken Hambrick, chairman of the Alliance of Contra Costa Taxpayers, a county organization that watches local government spending. “No one was apparently aware of this.”

Christopher Learned, who handled all of the transactions as the district’s chief financial officer, declined to comment.

In Southern California, the Moreno Valley Unified School District needed improvements ranging from upgraded roofs to new security systems in 2006, according to school records.

Moreno Valley, a community 75 miles east of Los Angeles, has a violent crime rate that’s increased each year since 2005, according to Federal Bureau of Investigation statistics. In 2007, a student was shot and killed within a block of a city high school.

The district, with 35,000 students, decided on a refinancing for upgrades, which allowed it to get $6.5 million from Kansas City, Missouri-based bank George K. Baum & Co., records show.

School officials decided to use most of the cash from the transaction -- $5.8 million -- to build the new stadium at a district high school.

‘Extreme Violence’

Chris Huhs, a former parent-teacher association president at a Moreno Valley school, says security and academic needs overrode the need for a sports stadium.

“Providing the high school with a stadium is ludicrous,” she told the board before it voted on the deal in 2007. “We have extreme violence at that school.”

During school deliberations about the deal, advisers told school officials that Attorney General Brown was considering the legality of cash-out refinancings. Moreno Valley’s lawyers, Newport Beach, California-based Bowie Arneson Wiles & Giannone, said Brown’s opinion wouldn’t jeopardize the debt.

“The bonds are valid, binding and enforceable,” the lawyers wrote.

The board approved the deal, refinancing $43 million in bonds issued in 2004. Three of the five board members backed it.

‘A Loophole’

“I felt it was a loophole,” says Victoria Baca, a trustee who balked. “You get free money without voter approval and without taxpayer knowledge? It’s crafty, and no one understands it.”

Robert Crank, head of business services at Moreno Valley Unified, says the district’s legal counsel approved the deal and taxpayers weren’t kept in the dark because all school board meetings are televised.

“We have funds in the pipeline to complete the other projects,” Crank says.

Moreno Valley homeowners today are paying $1 million more on the district’s debt compared with the original bonds, according to an analysis prepared for the district by Causey Demgen & Moore Inc., Denver-based financial consultants.

$1 Million More

Instead of owing just under $2 million in annual taxes, property owners are on the hook for $3 million, the firm found. The interest rate on a new 10-year bond is 3.91 percent, down from the 4.15 percent on the old debt, Bloomberg data show.

Property owners have to wait until 2029 to learn if the deal then decreases their taxes.

The board paid the bank and advisers fees totaling $725,104, which equaled about 11 percent of the upfront cash and $17 per $1,000 of bonds sold. Baum’s cut was $481,139, and the rest went to attorneys, credit-rating companies Standard & Poor’s and Fitch Ratings and bond insurers.

Charles Youtz, senior vice president and manager of Baum’s California public finance practice who worked with Moreno Valley on the deal, didn’t respond to messages seeking comment.

In Northern California, 15 miles from San Francisco, the 21-school San Mateo-Foster City Unified School District came up with a novel maneuver to raise construction cash from a refinancing in 2006.

Old Grocery Store

The district, home of the headquarters of Franklin Resources Inc., manager of the Franklin and Templeton mutual funds, has a median home value of $469,200.

That’s more than twice the national average. The district moved its executive offices out of an old grocery store it was renting for $300,000 a year to a 34,000-square-foot (3,160- square-meter) building in Foster City, on San Francisco Bay.

San Francisco-based Orrick Herrington & Sutcliffe LLP, the nation’s leading legal adviser on municipal debt, had concluded that the cash-out financings of the type done by Acalanes and Compton were illegal, says John Hartenstein, a lawyer at the firm.

So the firm devised a technique to avoid a district’s direct receipt of cash. Working with school systems such as San Mateo-Foster City, Orrick created a public entity affiliated with a district, known as a joint powers authority, or JPA, to provide cash through a bond swap to use for school projects.

$30 Million More

In 2006, the San Mateo-Foster City district sold $76 million in bonds to refinance old debt. The so-called San Mateo School Facilities Financing Authority, created by Orrick, purchased the securities with money the authority raised from selling $83 million in revenue bonds.

The authority then provided the $5.7 million for the administration building and school repairs. Piper Jaffray collected $600,000 to underwrite the bond deal. Paying off the new bonds will cost taxpayers $30 million more by 2023 than it would have if the old debt hadn’t been refinanced.

The interest rate on a new 10-year bond is 3.8 percent, down from 5.1 percent on the debt it replaced. If the district issues no other debt before 2031, the deal would save taxpayers $3.1 million over 33 years.

“The district received an unqualified legal opinion from Orrick Herrington & Sutcliffe in regards to the bond issuance,” says Micaela Ochoa, chief business official at San Mateo-Foster City Unified.

‘Scheme is the Same’

In his January opinion, Brown said the JPA approach isn’t justified under the law. Such transactions violate California’s constitution and tax laws, the attorney general said.

“The JPA scheme is the same as a cash-out,” Brown said.

San Mateo Treasurer Buffington says he’s disturbed that advisers who supported the deals have collected extraordinarily high fees with impunity.

“I don’t think they should be allowed to just walk away,” he says.

Before California school districts succumb again to these kinds of transactions, officials need to better scrutinize bank pitches and taxpayer costs, says Robert Brooks, a finance professor at the University of Alabama.

“Issuers have to wake up to their fiduciary responsibility to manage the public money responsibly,” he says.

Polee, the truck driver in Compton, stands on a grime- crusted breezeway near the closed Vanguard gym. He compares the school’s condition to the new $10 million school administration building with leather seats.

“The community gets short shrift,” he says. “The bureaucrats live high on the hog.”

Banks 'Too Big to Fail' Have Grown Even Bigger

Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard

When the credit crisis struck last year, federal regulators pumped tens of billions of dollars into the nation's leading financial institutions because the banks were so big that officials feared their failure would ruin the entire financial system.

Today, the biggest of those banks are even bigger.

The crisis may be turning out very well for many of the behemoths that dominate U.S. finance. A series of federally arranged mergers safely landed troubled banks on the decks of more stable firms. And it allowed the survivors to emerge from the turmoil with strengthened market positions, giving them even greater control over consumer lending and more potential to profit.

J.P. Morgan Chase, an amalgam of some of Wall Street's most storied institutions, now holds more than $1 of every $10 on deposit in this country. So does Bank of America, scarred by its acquisition of Merrill Lynch and partly government-owned as a result of the crisis, as does Wells Fargo, the biggest West Coast bank. Those three banks, plus government-rescued and -owned Citigroup, now issue one of every two mortgages and about two of every three credit cards, federal data show.

A year after the near-collapse of the financial system last September, the federal response has redefined how Americans get mortgages, student loans and other kinds of credit and has made a national spectacle of executive pay. But no consequence of the crisis alarms top regulators more than having banks that were already too big to fail grow even larger and more interconnected.


"It is at the top of the list of things that need to be fixed," said Sheila C. Bair, chairman of the Federal Deposit Insurance Corp. "It fed the crisis, and it has gotten worse because of the crisis."

Regulators' concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government's backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess.

This problem, known as "moral hazard," is partly why government officials are keeping a tight rein on bailed-out banks -- monitoring executive pay, reviewing sales of major divisions -- and it is driving the Obama administration's efforts to create a new regulatory system to prevent another crisis. That plan would impose higher capital standards on large institutions and empower the government to take over a wide range of troubled financial firms to wind down their businesses in an orderly way.

"The dominant public policy imperative motivating reform is to address the moral hazard risk created by what we did, what we had to do in the crisis to save the economy," Treasury Secretary Timothy F. Geithner said in an interview.

The worry for consumers is that the bailouts skewed the financial industry in favor of the big and powerful. Fresh data from the FDIC show that big banks have the ability to borrow more cheaply than their peers because creditors assume these large companies are not at risk of failing. That imbalance could eventually squeeze out smaller competitors. Already, consumers are seeing fewer choices and higher prices for financial services, some senior government officials warn.

Those mergers were largely the government's making. Regulators pushed failing mortgage lenders and Wall Street firms into the arms of even bigger banks and handed out billions of dollars to ensure that the deals would go through. They say they reluctantly arranged the marriages. Their aim was to dull the shock caused by collapses and prevent confidence in the U.S. financial system from crumbling.

Officials waived long-standing regulations to make the deals work. J.P. Morgan Chase, Bank of America and Wells Fargo were each allowed to hold more than 10 percent of the nation's deposits despite a rule barring such a practice. In several metropolitan regions, these banks were permitted to take market share beyond what the Department of Justice's antitrust guidelines typically allow, Federal Reserve documents show.

"There's been a significant consolidation among the big banks, and it's kind of hollowing out the banking system," said Mark Zandi, chief economist of Moody's Economy.com. "You'll be left with very large institutions and small ones that fill in the cracks. But it'll be difficult for the mid-tier institutions to thrive."

"The oligopoly has tightened," he added.

Consumer Choice

Federal officials and advocacy groups are just beginning to study the impact of the crisis on consumers, but there is some evidence that the mergers are creating new challenges for ordinary Americans.

In the last quarter, the top four banks raised fees related to deposits by an average of 8 percent, according to research from the Federal Reserve Bank of Dallas. Striving to stay competitive, smaller banks lowered their fees by an average of 12 percent.

"None of us are saying dismember these institutions. But you do want to create a system that allows for others to grow, where no one has an oligopolistic power at the expense of others who might be able to provide financial services to consumers," said Richard Fisher, president of the Federal Reserve Bank of Dallas.

Normally, when faced with price increases, consumers simply switch. But industry officials said that is not so easy when it comes to financial services.


In Santa Cruz, Calif., Wells Fargo, Bank of America and J.P. Morgan Chase hold three-quarters of the deposit market. Each firm was given tens of billions of dollars in bailout funds to help it swallow other banks.

The rest of the market, which consists of a handful of tiny community banks, cannot match the marketing power of the bigger banks. Instead, presidents of the smaller companies said, they must offer more personalized service and adapt to technological changes more quickly to entice customers. Some acknowledged it can be a tough fight.

Wells Fargo is "really, really good at the way they cross-sell and get their tentacles around you," said Richard Hofstetter, president of Lighthouse Bank, whose only branch is in Santa Cruz. "Their customers have multiple areas of their financial life involved with Wells Fargo. If you have a checking account and an ATM and a credit card and a home-equity line and automatic bill payments . . . to change that is a major undertaking."

Wells Fargo, J.P. Morgan and Bank of America declined to comment for this article.

Last October, when the Fed was arranging the merger between Wells Fargo and Wachovia, it identified six other metropolitan regions in which the combined company would either exceed the Justice Department's antitrust guidelines or hold more than a third of an area's deposits. But the central bank thought local competition in each of those places was sufficient to allow the merger to go through, documents show.

Camden Fine, president of the Independent Community Bankers of America, said those comments reveal the government's preferential treatment of big banks. He doubted whether the Fed would approve the merger of community banks if the combined company ended up controlling more a third of the market.

"To favor one class of financial institutions over another class skews the market. You don't have a free market; you have a government-favored market," he said. "We will never have free markets again if you have the government picking winners and losers."

Moral Hazard

Before the crisis, many creditors thought that the big institutions were a relatively safe investment because they were diversified and thus unlikely to fail. If one line of business struggled, each bank had other ventures to keep the franchise afloat. And even if the entire house caught fire, wouldn't the government step in to cover the losses?

With executives comforted by that thinking, risk came unhinged from investment decisions. Wall Street borrowed to make money without having enough in reserves to cover potential losses. The pursuit of profit was put ahead of the regard for safety and soundness.

The federal bailouts only reinforced the thought that government would save big banks, no matter how horrible their decisions.

Today, even with the memory of the crisis fresh in their minds, creditors are granting big institutions more favorable treatment because they know the government is backing them, FDIC officials said.


Large banks with more than $100 billion in assets are borrowing at interest rates 0.34 percentage points lower than the rest of the industry. Back in 2007, that advantage was only 0.08 percentage points, according to the FDIC. Such differences can cause huge variance in borrowing costs given the massive amount of money that flows through banks.

Many of the largest banks reported a surge in profit during the most recent quarter, including J.P. Morgan Chase and Goldman Sachs. They are prospering while many regional and community banks are struggling. Nearly three dozen of the smaller institutions have failed since July 1, including Community Bank of Nevada and Alabama-based Colonial Bank just last week.

If the government continues to back big firms over small, regulators worry that reckless behavior could return to Wall Street.

The administration's regulatory reform plan takes aim at this problem by penalizing banks for being big. It would require large institutions to hold more capital and pay higher regulatory fees, as well as allow the government to liquidate them in an orderly way if they begin to fail. The plan also seeks to bolster nontraditional channels of finance to create competition for large banks. If Congress approves the proposal, Geithner said, it would be clear at launch which financial companies would face these measures.

Economists and officials debate whether these steps would address the too-big-to-fail problem. Some say, for instance, that determining the precise amount of capital big financial companies should hold in their reserves will be difficult.

Geithner acknowledged that difficulty but said the administration would probably lean toward being more strict. Taken together, the combination of reforms would be a powerful counterbalance to big banks, he said.

"Our system is not going to be significantly more concentrated than it is today," Geithner said. "And it's important to remember that even now, our system remains much less concentrated and will continue to provide more choice for consumers and businesses than any other major economy in the world."

FDIC: Number of troubled banks rises to 416

The Federal Deposit Insurance Corp. reported Thursday that the number of distressed banks rose to the highest level in 15 years as its insurance fund continued to shrink.

More lenders ran into financial trouble during the second quarter with recession saddling banks with soured loans, according to the report.

The FDIC said that the number of troubled banks rose to 416 at the end of June from 305 at the end of March. This is the largest number of banks on its "problem list" since June 30, 1994, when 434 banks were on the list, which isn't disclosed by the FDIC.

Assets at troubled banks totaled $299.8 billion, the highest level since Dec. 31, 1993, the agency said.

Banks insured by the FDIC swung to a total quarterly loss of $3.7 billion from last year when they reported a total profit of $4.8 billion.

Reuters
Sheila Bair.

Total reserves of the Deposit Insurance Fund stood at $42 billion, with the contingent loss reserve falling to $10.4 billion from $13 billion over the second quarter. Some analysts have been warning that growing bank failures could put pressure on the FDIC fund.

"While challenges remain, evidence is building that the U.S. economy is starting to grow again," said FDIC Chairman Sheila Bair in a press release.

"The banking industry, too, can look forward to better times ahead," she added. "But, for now, the difficult and necessary process of recognizing loan losses and cleaning up balance sheets continues to be reflected in the industry's bottom line."

Bair said the FDIC has "ample resources" to protect depositors. "No insured depositor has ever lost a penny of insured deposits ... and no one ever will," she asserted.

More than 28% of all insured institutions reported a net loss in the second quarter, compared with 18% in the year-ago quarter.

"Deteriorating loan quality is having the greatest impact on industry earnings as insured institutions continue to set aside reserves to cover loan losses," Bair said.

The quarterly report "makes clear that banks are neither at the beginning or the end of the problems presented by a difficult economy," said James Chessen, chief economist at the American Bankers Association. "They are in the middle and significant challenges still remain."

The FDIC's insurance fund balance has dropped from over $50 billion to around $10.4 billion over the past year, according to Mark Calabria, director of financial regulation studies at the Cato Institute. "With further losses in the construction lending and commercial loan sector, it is almost certain that the remaining insurance fund balance will be depleted," he said.

1,000 Banks to Fail In Next Two Years: Bank CEO

The US banking system will lose some 1,000 institutions over the next two years, said John Kanas, whose private equity firm bought BankUnited of Florida in May.

“We’ve already lost 81 this year,” Kanas told CNBC. “The numbers are climbing every day. Many of these institutions nobody’s ever heard of. They're smaller companies.” (See the accompanying video for the complete interview.)

Failed banks tend to be smaller and private, which exacerbates the problem for small business borrowers, said Kanas, who became CEO of BankUnited when his firm bought the bank and is the former chairman and CEO of North Fork bank.

“Government money has propped up the very large institutions as a result of the stimulus package,” he said. “There’s really very little lifeline available for the small institutions that are suffering.”

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This comes at a time when the FDIC has established new rules on bank sales. Private equity, for instance, would have to hold double the capital of their competitors in order to buy such an institution, said Kanas.

“This will have somewhat of a chilling effect on our participation,” he said. “As a result of having to keep higher capital levels, we’ll see lower prices coming from that sector.”

Of the 81 failed banks this year, two have been successfully acquired by private equity, he said. Kanas’ private equity firm bought UnitedBank, the failed Florida-based bank, from the FDIC in May. Regulators also allowed the sale of IndyMac Bank of California earlier this year.

* Check Out World Markets & Futures Trading Now

“We are seeing more people step up and lobby bids in this situation,” he said. “We’re seeing more players mostly as a result of being attracted to the sector. I’m not so sure that will continue now that the rules have been ratchet it up.”

Meanwhile, much of the commercial realty problem resides in the regional and small community banks, said Kanas, because larger banks haven’t fueled that sector in the past.

“The market is expecting about the way we were expecting,” he said. “Unfortunately, we’re not seeing any evidence of a recovery in the real estate market in the southern Florida market,” he said.

The Secret That Will Destroy the World's Financial System

There's a secret out there.

A secret so incredible, so horrifying, so toxic that if the public ever heard about it, it would destroy the world's financial system.

* bink's diary :: ::
*

That sounds like a big claim.

Who's making it? Not some scary Chicken Littles in the Daily Kos diaries. Not some Doomer site. Not wacked-out gold bugs. Not Ron Paul.

This claim is being made by a consortium of the world's biggest and most powerful banks.

What's the secret they don't want you to know?

It all starts here:

In November of last year, the Bloomberg news organization sued the Federal Reserve bank of the United States. The goal of the suit was to force the Fed to disclose information on the alphabet soup of lending programs it created in 2008 to help prop up Wall St. banks:

Bloomberg News asked a U.S. court today to force the Federal Reserve to disclose securities the central bank is accepting on behalf of American taxpayers as collateral for $1.5 trillion of loans to banks.

The lawsuit is based on the U.S. Freedom of Information Act, which requires federal agencies to make government documents available to the press and the public, according to the complaint. The suit, filed in New York, doesn't seek money damages.

"The American taxpayer is entitled to know the risks, costs and methodology associated with the unprecedented government bailout of the U.S. financial industry," said Matthew Winkler, the editor-in-chief of Bloomberg News, a unit of New York-based Bloomberg LP, in an e-mail.

The suit sought to reveal which banks were getting which part of the $1.5 trillion dollars and what assets the banks were putting up as collateral for the loans.

The Federal Reserve fought the case and ...

They lost it:

The Federal Reserve must for the first time identify the companies in its emergency lending programs after losing a Freedom of Information Act lawsuit.

Manhattan Chief U.S. District Judge Loretta Preska ruled against the central bank yesterday, rejecting the argument that loan records aren’t covered by the law because their disclosure would harm borrowers’ competitive positions.

The Fed has refused to name the financial firms it lent to or disclose the amounts or the assets put up as collateral under 11 programs, most put in place during the deepest financial crisis since the Great Depression, saying that doing so might set off a run by depositors and unsettle shareholders. Bloomberg LP, the New York-based company majority-owned by Mayor Michael Bloomberg, sued on Nov. 7 on behalf of its Bloomberg News unit.

The Federal Reserve has to identify the companies to whom it gave the $1.5 trillion dollars and it has to list the assets used as collateral for the so-called "loans."

The Federal Reserve says that this might "unsettle shareholders."

OH MY GOD NO, NOT THE SHAREHOLDERS, NOT OUR PRECIOOUSSS SHAREHOLDERS!

Apparently, that is the standard these days.

And since when has the government felt obligated to protect the share prices of certain private businesses over others? Is that role in the Constitution somewhere?

Anyway, an industry group representing the biggest and most powerful banks on the globe, including British, French, Dutch and German as well as American banks, have issued a warning about the disclosure:

If you tell who got the $1.5 tril, you're gonna destroy the world financial system.

The secret is just that big.

(Note that I'm linking to Zero Hedge here, not because I endorse the editorial theme of the blog at all, but because they are the only place I could find that carries the original document in toto.)

The world might "get destroyed."

But we've also got to have access to this information.

For the simple reason that, if we don't, we're going to see a repeat of this in a couple of years with even bigger numbers, bigger handouts from the Fed and the Treasury, bigger payouts to Wall St. executives and other insiders ...

And even bigger secrets that the public can never know.