Obama's banking end around

President Obama wants to close a loophole regulators have been trying to plug for years.

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NEW YORK (Fortune) -- One road to regulatory reform runs through Detroit and Utah -- and there are signs the ride could get bumpy.

The Obama administration's financial oversight reform program would force industrial loan companies, or ILCs -- banks owned by the likes of retailer Target (TGT, Fortune 500) and carmaker Toyota (TM) -- to submit to Federal Reserve rules and regulations.

Because Fed rules limit bank ownership, the plan could force big commercial firms to sell their banking arms. Doing so would close a regulatory loophole that has long chafed the Fed, which has no authority over nonbanks.

But the fight over the ILCs is just beginning. Any changes in the law must be enacted by Congress, and Sen. Bob Bennett, R-Utah -- where many of the biggest ILCs are based -- has fought previous efforts to close the loophole. Bennett claims ILCs haven't been a problem during the recent crisis and says eliminating them will make credit less available to consumers.

Meanwhile, Ford Motor (F, Fortune 500) has sought federal permission to turn its Ford Motor Credit unit into an ILC in a bid to cut its borrowing costs as it competes with its government-backed Detroit rivals GM (GMGMQ) and Chrysler. Neither Ford nor the Federal Deposit Insurance Corp., which supervises ILCs, returned calls seeking comment.

Critics of industrial loan companies argue that strengthening the separation of banking and commerce would be a good thing at a time when the federal deposit insurance fund is under pressure.

"The taxpayer subsidies the ILCs have received are just enormous," said Art Wilmarth Jr., a law professor at George Washington University. "The government has to stop the proliferation of these entities."

The case against ILCs, Wilmarth said, can be summed up in four letters: GMAC, a troubled finance company once owned by General Motors that now lists the government as its biggest shareholder.

GMAC "is the poster child for why we shouldn't have commercial ownership of banks," said Wilmarth.

Policymakers frown on commercial ownership of banks because it can lead to poor credit decisions and create more risks to the taxpayer-funded federal safety net.

Even so, ILCs started cropping up as niche lenders in a few states more than 20 years ago. Regulatory changes a decade ago led to the formation of some giant ILCs, including ones run by Merrill Lynch (now part of Bank of America (BAC, Fortune 500)) and General Electric (GE, Fortune 500).

But among the larger ILCs was a Midvale, Utah-based company called GMAC Automotive Bank, part of GMAC.

For years, GMAC was a profitable part of General Motors. In 2006, though, GM sold a 51% stake to private equity firm Cerberus as it raised cash to restructure.

Since then, the picture has darkened at both GM and GMAC. GM filed for Chapter 11 protection June 1, after receiving billions of dollars in bailout funds and spending months on the brink of bankruptcy.

Meanwhile, GMAC -- the biggest provider of financing to the carmaker's dealers and customers -- was struggling to raise capital to qualify for its own federal aid.

At the end of December, the Fed cleared GMAC to become a bank holding company, while exempting it from Federal Reserve Board rules that govern a bank's dealings with its affiliates. Since then, GMAC has received some $21 billion in taxpayer support, including Treasury funds and FDIC loan guarantees.

The government justified the move by citing "emergency conditions." It forced GM and Cerberus to sharply reduce their stakes in the company and said the conversion would allow GMAC, the main lender to customers of the troubled domestic automakers GM and Chrysler, to continue to extend credit to consumers.

But not everyone was persuaded by that logic. Taxpayers, Wilmarth said, are now bearing the costs of what is essentially a commercial failure -- the collapse of GM after years of poor strategy and product decisions.

He said the poor results in recent years at GM and GMAC show the two were "propping each other up." GMAC then compounded its auto-lending errors by making a big bet on residential housing via the purchase of lender ResCap, he said.

"Everything they said wouldn't happen with the ILCs has happened at this one institution," said Wilmarth. "Massive conflicts of interest, spreading subsidies from banks to commercial firms -- all of it has come to pass."

In a prepared statement, a GMAC spokesperson said its Ally Bank unit, formerly known as GMAC Bank, is "well capitalized."

While its Detroit rivals GM and Chrysler have taken tens of billions of dollars in federal funding, Ford has declined to take bailout money.

But if Ford wants no part of the unpopular Troubled Asset Relief Program, the company has signaled it would like to join GMAC in raising low-cost funds by taking bank deposits. Ally Bank has raised more than $20 billion in deposits, in part by offering above-market certificate of deposit rates.

That's why Ford's credit arm has been seeking industrial loan company status. Getting it would allow the company to borrow more cheaply -- though an approval could complicate the lives of policymakers set on closing the ILC loophole.

"I think they may have a battle on their hands here," said Raymond Gustini, a partner at law firm Nixon Peabody in Washington. "But for now, those who want to eliminate the loophole have the moral high ground."