Following is the unofficial transcript of a CNBC EXCLUSIVE interview with FDIC Chairman Sheila Bair today on CNBC's "The Kudlow Report."

All references must be sourced to CNBC.


LARRY KUDLOW, host: FDIC chair Sheila Bair, welcome back to THE KUDLOW REPORT. Thank you very much for your time.

Ms. SHEILA BAIR: Sure. Happy to be here.

KUDLOW: All right, let me begin. Today, as you know, stocks swooned, led down by a big drop in banks. I think the index was off 6 percent, the Dow off close to 200 points. The word on the street is people are worried about a second wave of bank losses and defaults and closures. What can you tell us? What is your outlook?

Ms. BAIR: All right. Well, I think everybody needs to keep their heads. We're still working through some credit losses. And, yeah, now we are getting into the credit losses related to the overall deterioration of the economy. But there's some positive news out there on the economy, and even though banks will continue to work through cleaning up their balance sheet, we saw a few glimmers of hope in the second quarter results. Net interest margins were improving. The rate of increase of noncurrents and charge-offs was slowing. So it's too early to note there's a trend yet, but I see some glimmers of hope there. So I think we just need to say what we've always said, that it's going to take time to work through these credit losses, but we'll get out of this.

KUDLOW: When you announced those second quarter results--it was very interesting--we posted--you posted a $4 trillion--a $4 billion, I beg your pardon--a $4 billion loss. You had a $7 1/2 billion gain in the first quarter, so there was a little bit of a surprise. Going forward, you've got your bank analysts, some of them on the Street, saying we're going to be posting losses in the second and third quarter. Some analysts are saying 150 to 200 banks are going down. The estimates go even higher than that.

Ms. BAIR: Right.

KUDLOW: And people are especially worried about the overhang of commercial loans.

Ms. BAIR: Right.

KUDLOW: What can you tell us about that?

Ms. BAIR: Right. Well, first of all, I would say that operating income remained in positive territory in the second quarter, and we did have a $5 1/2 billion special assessment on banks in the second quarter, which did weigh on earnings. So I think there were some nonrecurring items, and there were a few institutions, large institutions, that had voluntarily brought some exposures back on their balance sheet and had to take some mark-to-market losses on that. So there were some nonrecurring losses in the second quarter I think that need to be adjusted and look into that. So I don't think--you know, again, what I said before, we've got some things that we need to work through, but I wouldn't read too much into those second quarter losses and...

KUDLOW: But how do you assess this commercial loan threat? There's been so much written. There's, what, $1.7 trillion worth of commercial mortgage infrastructure loans outstanding.

Ms. BAIR: Right.

KUDLOW: And in particular, the smaller regional and especially the community banks seem to be the largest holders. They're also refinancings of some of the commercial mortgage-backed securities.

Ms. BAIR: Right.

KUDLOW: What can you tell us about that, from your vantage point?

Ms. BAIR: Well, commercial real estate is a looming problem. It's going to be a bigger driver of bank failures towards the end of this year into next year. As a--as a percentage of losses, the residential mortgages are still driving it.

KUDLOW: You think there will be? No, can I just--just want to qualify that.

Ms. BAIR: Sure. Sure.

KUDLOW: You mentioned that. You think there will be a wave of losses towards the end of the year from commercial loans?

Ms. BAIR: Mm, no. What I said was that I think commercial real estate losses will be more of a driver of bank failures as we're working through the residential mortgages. And residential mortgages are still a bigger percentage of where the credit distress is right now. But commercial real estate is catching up. So I do think commercial real estate is going to be a bigger driver of losses and bank failures. But we've known about this for some time, and it's. again, it's just part of the process that we have to do to clean up the banking system.

KUDLOW: As you go through your rescue missions and closing these banks and reopening them...

Ms. BAIR: Right.

KUDLOW:'ve had a lot of this so-called loss sharing stuff.

Ms. BAIR: Right.

KUDLOW: Do you own these toxic loans? Is that in the fund?

Ms. BAIR: Well, we do. We do have some assets, but generally what we try to do is sell the whole bank before it is actually closed by its primary regulator. And one of the good things about loss-share is it helps facilitate selling the whole bank to an acquirer who can continue banking services in the community, and particularly when bank customers have both the deposits and their loans with the banks. This is a pro-bank customer effort as well. The loss-share really saves us a lot of money. We think it saved us about 11 billion so far over the past two years. As you know, if you--if you sell these troubled bank assets or failed bank assets, stand alone, for cash only, the market prices are pretty bad right now. But with loss-share, we can get our pricing up, and even though we realize the loss up front, we pay out the cash. We pay out over a period of years as the actual credit losses occur, so it helps preserve our liquidity, too. So we've had some good experience, and the loss-share also puts the assets in private sector management. So that's another positive, from our perspective.

KUDLOW: How do you react? Some people are saying, to avoid more losses on the Federal Deposit Insurance Fund, to avoid more losses, that you're going slow in declaring insolvency.

Ms. BAIR: Yeah.

KUDLOW: That you don't want to take the drong--the strong steps, in particular that you're waiting a bit longer than might otherwise be the case.

Ms. BAIR: Right.

KUDLOW: Is there any truth to that?

Ms. BAIR: Well, no, there's not. I think you need to understand what the bank closing process is. We actually do not close banks. The primary regulator, the chartering the authority, state banking supervisors, or the OTC or the OTS, make the decision to close the bank, then they appoint assets receiver. So this a process. We work with the primary regulator. We do have the authority to self-appoint if we feel we need to, but we almost always defer to the primary regulator to make that decision. And it can be a difficult one. I mean, our resolution process is a very--a very tough one. Shareholders are wiped out, in some instances uninsured depositors--we've been able to cover a lot of the uninsured depositors through bank acquisitions. Some are willing to pay a premium for that, but sometimes we have to oppose lots of uninsured depositors. So we want to make sure that it's the right decision. By the same token, we want a timely resolution. Because if you do wait too long, it can increase the losses. So it's a difficult--it's a balancing act, but again, we work with the primary regulator. But it's the primary regulator's call about when that bank is closed.

KUDLOW: Well, in order to keep our deposit money safe, are you going to have to make a new bank assessment for the funds?

Ms. BAIR: Well, we will decide that toward the end of the third quarter. We'll have a board meeting and review the most recent data we have and make a decision then about whether a seshal--what--if there will be a special assessment and the amount and the timing. We did signal in the second quarter, when we--when we made the spet--announced the special assessment for the second quarter that another special assessment is likely, but we'll review all the most recent data at the end of the third quarter before we make a final decision.

KUDLOW: So what I hear is you're not sure. Is it possible you'd rather tap the Treasury line of credit? I mean, after all...

Ms. BAIR: Right.

KUDLOW: ...a bank insurance premium assessment is kind of like a tax on bank capital, is it not?

Ms. BAIR: Well, it is. It's a balancing act. And I--on the same token, we pride ourselves on the fact that banks pay for deposit insurance. We have not had to go to the taxpayer, and we take a lot of pride in that, and I think if and when we do have to start borrowing from Treasury, that will perhaps open up another host of issues about more bailouts. And we'd like to try to avoid that. I would say, though, that even if we end up having to borrow from Treasury--we did have that once in the early '90s. I think Bill Isaac had a good discussion with you on that on one of your earlier shows. But the FDIC will pay it back. We paid it back in three years in the early '90s, and if that had to happen again, it would be paid back and paid back as quickly as possible.

I'd also like, if I could, to emphasize that the amount of total reserves we have right now is $42 billion. There's been a lot of focus on what we call the reserve ratio, which is really an expression of our net worth, which is about $10.4 billion. But that's what we have left after we reserve 32 billion to cover protective...(unintelligible)...

KUDLOW: Well, that it's 10...

Ms. BAIR: ...over the next 12 months.

KUDLOW: That's 10 billion for 4.5 trillion worth of deposits. I mean, it's a big number.

Ms. BAIR: Well...

KUDLOW: But actually, isn't it true, Ms. Bair, I mean, when you look at this.

Ms. BAIR: Yeah.

KUDLOW: I used to work as a deputy in the Office of Management and Budget.

Ms. BAIR: I know you did. I remember that.

KUDLOW: There is no lockbox for the FDIC. I mean, it was consolidated on to the federal budget back with LBJ.

Ms. BAIR: Right.

KUDLOW: In effect, the Treasury Department stands behind the FDIC. Is that not the case?

Ms. BAIR: Well, that is absolutely--is absolutely the--well, we invest our funds in Treasury securities, that is true, and we are full faith and credit, and we could tap up to 500 billion in a line of credit if we needed to. I can't imagine that would ever be necessary. But it's important for people to understand, we are the government. We're backed by the full faith and credit of the United States government. But, that said, our tradition has been to fund deposit insurance and any losses associated with bank failures through assessments on banks. And I think that's a point of pride at the FDIC and the banking industry. So we have to go to Treasury borrowing, I never say never, but I think that will be a pretty profound decision.

KUDLOW: So, in a sense, the FDIC funds--the federal government guarantees it the way it guarantees Social Security payments. I mean, isn't that fair?

Ms. BAIR: It is full faith and credit, that's absolutely right.

KUDLOW: And so why not tap down 10 or $25 billion just to reinsure bank-to reassure depositors that everything's going to be safe and sound?

Ms. BAIR: Well, I guess--I know that that's been out there as a-suggested in The Wall Street Journal. Actually, though, the Deposit Insurance Fund, the reserve ratio, the number that everybody focuses on, is an expression of our net worth. So if we borrow a 25 billion, that really doesn't do anything if, you know, if our Deposit Insurance Fund goes into negative territory, the fact that we have now borrowed 25 billion and put it in our kitty, before we actually need to do that. really doesn't impact what the reserve ratio will be. So those lines of credit are there anytime. The agreements are in place. They can be tapped immediately. It's there if we need it. We don't need it right now, and I'm not sure we will ever. But it's important for people to understand it is there.

KUDLOW: So in effect what you're telling is this, for those people who own these deposits that are now guaranteed up to $250,000, I guess, through 2013...

Ms. BAIR: Right. Right.

KUDLOW: ...maybe forever, as far as I know, if you believe in the full faith--if you believe in the full faith and credit of the US government, then the deposits are safe. Is that about the size of it?

Ms. BAIR: I think the deposits are as safe as they can be, and it is backed by the entire banking system as well as the full faith and credit of the United States government. So it's hard for me to see any guarantee that could be stronger. So I think it's important that people understand that. Nobody's ever lost a penny of an insured deposit. No one ever will.

KUDLOW: All right.


KUDLOW: Let's move on to the regulatory issue. You have a major editorial op-ed piece in today's New York Times...

Ms. BAIR: Right.

KUDLOW: ...called "The Case Against a Super Regulator."

Ms. BAIR: Right.

KUDLOW: What is your beef against a super regulator, which would be the Fed?

Ms. BAIR: Well, I don't know if it would be the Fed. I think there's discussion now that some have suggested moving all the bank regulation, as well as the holding company regulation, into--to some type of new agency. And I do fear that. I think a monopoly regulator like that could make things worse, not better. There hasn't been a great experience in Europe with these--with these monopoly regulators, and I think there is a tendency for them to become even more dominated by very large institutions, which I think would help--hurt the smaller institutions.

It would also undermine--we have a 150-year-old system of both state and federal chartered and separately regulated institutions. I don't think the dual banking system would survive if we did that. And, I guess, more importantly, why? The ability to choose between the federal charter and a state charter really have nothing to do with the current crisis. You know, there were a lot of other things that had a lot to do with the current crisis: the shadow banking system, arbitraging capital standards, lack of regulation of OTC derivatives. The need for a greater systemic risk oversight as well as, we've discussed before, a meaningful resolution authority that will work for large institutions, those are things that would fix what went wrong with the current system. The ability between--choose between the federal and the state charter, I don't see, really had any role at all in this.

KUDLOW: Have you talked to President Obama about your reservations? I mean, it's his team pushing this. Did you actually talk to him?

Ms. BAIR: Well, yeah. Well actually, on this question, the president and the Treasury and all--everybody in the administration agrees with this, and the white paper did maintain separate regulation of federal and state chartered depository institutions. So on this issue is was very much the...(unintelligible)...

KUDLOW: Yeah, but aren't they...

Ms. BAIR: ...administration.

KUDLOW: As I understand it, though, the proposal on the table is that the Federal Reserve, presumably, would be the uber, what...

Ms. BAIR: Yeah.

KUDLOW: ...systemic risk regulator. And that's not what you want.

Ms. BAIR: Right. Right, well, that, we do. That's a--that's a somewhat different issue. And, yes, but for the same reasons, we do worry about too much regulatory power concentrated in any individual entity. It's not really about the Fed. It's about how much power you want to concentrate in one place. You know, our whole system is based on checks and balances, and I think having some checks and balances and some sharing of responsibility, with definitive accountability, I think that's really the way to go. You know, the FDIC was alone for a while there in delaying implementation...(unintelligible) advanced approach capital standards, and I'm glad we did. Because if those had been--those standards had been implemented earlier, large banks going into this crisis would've had less capital.

KUDLOW: Well...

Ms. BAIR: And so I think--or having--letting other--multiple voices in the process I think was helpful.

KUDLOW: You know, just to wind this up on this policy point, I mean, it's a bit in the weeds.

Ms. BAIR: Sure. OK.

KUDLOW: I'm not sure the average person understands this stuff. But, look, as I understand it, from your writing and your article and things that you've said, and we've had this conversation...

Ms. BAIR: Right.


We need more capital in the banking system, that's the ultimate benchmark. Probably need less leverage in the banking system. How can these things be achieved, and what about too big to fail?

Ms. BAIR: Right.

KUDLOW: I mean, that is the great moral hazard of our time. Smaller banks are not too big to fail, but the big banks are. They're running the system. How do we get out of that, Sheila Bair?

Ms. BAIR: Well, again, I think you need a meaningful resolution authority that would apply to large financial organizations. Right now we only have it for insured depository institutions. It works for insured depository institutions. Yes, it's a painful process, a harsh process, but you get market discipline back into the system. If the public and, most importantly, investors and creditors know that there is a facility that will be used to close a very large financial organization if it becomes nonviable. And, again, we're very much with the administration on that issue, and I'm very, very hopeful that that will be a key part of whatever type of reform package that Congress creates.

KUDLOW: At the end of the day...

Ms. BAIR: Mm-hmm.

KUDLOW: ...when you look at this whole banking crisis, all right...

Ms. BAIR: Yes.

KUDLOW: ...we're a year after the worst of it last September 2008.

Ms. BAIR: Yes.

KUDLOW: Are you confident that we are going to recover? Are you confident we are going to recover?

Ms. BAIR: Yes, I am. Because it will be a painful process and it will take some time, but we will recover. You know, I deeply believe in this country. I believe in our commitment, our entrepreneurship, our innovation, our tenacity and our hard, tough work ethic, so we will get through this. We will work through this. Regulators, I think there are going to be some positive things coming out of this. I think getting more back to basics in terms of how financial institutions run themselves, and the extent to which they take imprudent risk. I think there are strong market disincentives for that now, but more can be done. I think regulators are learning again that they need to be tougher, that we need--you know, there's a difference between free markets and free-for-all markets.


Ms. BAIR: And we need to set some basic rules. So we're learning those lessons, we're learning them the hard way. But those are positive things that will come out of this. So, yes, we are going to get out of this. And we'll be stronger at the process--at the end of the process.

KUDLOW: All right, Ms. Bair, we appreciate your optimism on that. I appreciate your time here in the late summer interview. You're terrific to help us out. All the best to you, Miss Sheila Bair.

Ms. BAIR: Thanks.

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