How Safe is Your Bank?

Author: David Kotok, Post Date: July 25, 2008
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In 1790, Edmund Burke, the founder of Anglo-American conservatism, waxed eloquently about the power and responsibilities of a government’s agencies in a democracy.  He said: “To execute laws is a royal office; to execute orders is not to be king.  A political magistracy, though merely such, is a great trust.”  This warning came before there were central banks like the Federal Reserve, before there were bank regulators & supervisors, and before there were bank deposit insurers like the FDIC.  Was Burke prescient and thinking about them?

Treasury Secretary Paulson didn’t quote Burke in his speech at the NY Public Library.  Paulson wanted to assure Americans that their banks and banking deposits are safe.  He used his position of “political magistracy” to announce what Burke referred to as the “great trust.”

How do we greet the Treasury Secretary’s remarks, in the face of IndyMac’s failure and the FDIC announcement that uninsured IndyMac depositors may only get 50% of their money?  How do we respond when the Wall Street Journal reports the Federal Deposit Insurance Corporation (FDIC) stayed in the subprime mortgage business after they seized failing Superior Bank FSB?  (See WSJ front-page story entitled “FDIC Faces Mortgage Mess,” July 21, 2008.)

Two hundred and eighteen years after Burke’s admonition, we can ask: Is your money safe in the bank?

We have received that question from clients and journalists on a continuing basis since the IndyMac events unfolded.  IndyMac is a very large bank failure.  On TV it became the American counter-image to the British bank run at Northern Rock.  For an IndyMac analysis, see Bob Eisenbeis’ commentary at www.cumber.com.  Bob notes that in IndyMac’s case the actual run came after the bank failed and was taken over unlike the Northern Rock run which preceded the failure.  We do not know if these folks wanted their insured deposits or their uninsured deposits.

Here is what we know about banks and your bank deposits.  And there is a lot we don’t know, as you will see.

A)    We are told that there are 90 banks on the “watch list” of the FDIC.  This is double the number that were on this list in 2006, the year before the financial crisis began.  Note that IndyMac was NOT on this list at the end of the first quarter of 2008.  It was then called “well-capitalized.”

B)    We are not told who these 90 institutions are.  The federal authorities know that making a name public will trigger withdrawals from that bank, so they keep the list confidential.  That means you, as an uninsured depositor, do not get advance warning from the FDIC that you may be at risk.  Uninsured depositors are supposed to worry about the safety of their own funds.  The system is designed that way.  Whether the federal authorities are doing enough to strengthen the system is a policy question currently open to debate.

C)    We are not told when banks borrow from the Federal Reserve’s Discount Window.  We only see the total borrowings.  They are broken down only as coming out of one of the twelve regional Federal Reserve Banks.  Thus the Fed is of no help in letting you assess the safety of your bank deposits.  We are not told the banks that borrow from the Fed’s Term Auction Facility (TAF).  They are also aggregated, just as with the Discount Window.  We need to use private services for these assessments not the Federal Reserve.

D)   Some riskier institutions are resorting to complex ways to obtain funds.  When they do they often collateralize them and that means less protection for the uninsured depositors.  Covered bonds are an example.  Many are not familiar with the “covered bond” concept.  See www.cumber.com for that recent analysis.  We know that Washington Mutual used covered bonds and denominated them in euros.  One has to wonder how much that contributed to their currently viewed weakened condition.  WAMU was seeking ways to gain funds other than using Federal Home Loan Bank advances.  Note that the covered bonds are collateralized.  That means they have a claim that is ahead of uninsured depositors if the bank fails.

E)    Your bank publishes public reports, and they must make them available to you.  In them you can see some details about your bank’s financial characteristics.  That will tell you part of the story, but only part.  You are able to find out about your bank’s Federal Home Loan Bank (FHLB) advances.  You may be able to find out more details in the footnotes of the bank’s reports.  The rules about what the bank has to tell you and what they don’t tell you are pretty clear.

F)   There is a federal ranking system for banks but a depositor cannot obtain it. The federal regulators rate all banks for safety and soundness.  Those ratings are scored, and the characteristics are known by the acronym CAMELS.  The score is kept confidential; the range is 1 for the best and 5 for the worst.  You do not have legal access to your bank’s score as a depositor.  We can infer that IndyMac had a CAMELS score of 1, 2, or 3 on March 31.  Were it to have been a 4 or 5, it would likely to have been on the FDIC watch list.

OK, so you can only get partial information to assess your risk exposure but is it enough?  And what if you are a lay person and do not have the financial analytical skills to dissect the technical side?

First, one must become familiar with the FDIC insurance rules.  Follow them carefully.  Insured deposits will be paid if a bank fails.  The US government has committed itself to this liability.  It makes no difference if the insurance fund is sufficient.  If it is not, we fully expect and the public will demand that the Congress fund any deficiency.  Current law gives the FDIC a claim on the entire equity of the banking system.  If that isn’t enough, the FDIC can draw on the Treasury.  Most analysts believe other steps would be taken long before that extreme action is required.  At Cumberland, we consider an insured CD or insured bank deposit to be just as safe as a US Treasury bill or note.  Note that the $100,000 limit is a cap but there are ways to obtain $200,000 through strategic use of joint accounts.  Remember the limits are per bank so use of multiple banks raises the total insurance coverage.  Many folks use CDs of $98000 or $95000 so that the accrued interest is also insured.  Some details about the FDIC insurance rules are at the bottom of this commentary.

As presently structured under 1991 law, the FDIC is actually first and foremost a mutual insurance company.  It must fund any deficits by levying premiums on the remaining insured banks.  The FDIC has indicated that those premiums are going to rise.  Only after equity in the banking system is exhausted can the FDIC turn to the federal government.  This is not widely understood, and it also means that the FDIC is not an agent for the Congress but for the banks to which it must turn if there are losses.

While this is a serious issue for the remaining banks because it increases their costs, this doesn’t jeopardize the insured depositor.   In the end you are backstopped by the pledge of the federal government to pay you when all other administrative systems fail.

Let’s go to the uninsured depositor.

“What if I have a deposit in my bank and it is above the insurance limits?”  This is really quite a common question.  Many operating businesses face this issue, since they need to keep larger amounts on deposit for operational purposes. These may be uninsured, and thus the depositor faces a risk of loss if the bank is seized.  That is what may happen with IndyMac.  The first $100,000 is insured.  For the IndyMac customers, the problems started with the $1 billion plus uninsured money.

It is important to understand the pecking order of claims when a bank is seized.  If the bank had collateralized loans, those bank assets which were used for that collateral come ahead of you as an uninsured depositor.  An example is a Federal Reserve Discount Window loan.  The Fed is secured by a claim on the bank’s pledged collateral.  The Fed gets paid before any of the depositors.  The same is true for the FHLB.  It is also true for numerous state and local government funds.  For example, in NJ there is the New Jersey Governmental Unit Deposit Protection Act (GUDPA).  New Jersey banks have pledged certain securities to collateralize governmental deposits.  That claim comes ahead of the other depositors who do not have collateral security.  In effect, the collateral turns an otherwise uninsured depositor into a 100% secured one.

Once all these claims are met, the FDIC then looks to the remaining bank assets of the seized bank in order to pay the uninsured depositors.  The FDIC pays the insured depositors and then stands in their place.  The FDIC then get itself repaid from the assets before any money is made available to pay the uninsured deposits.  The uninsured depositors are at the end of the list.  They will get paid before anything gets to any bank holding company bondholder or shareholder, but they are behind all the other competing claims on the specific bank that was seized.

Clients ask us if this is a serious problem.  Facts: there are 8500 banks in the US.  There are 90 banks on the FDIC “watch list.”  We do not know if they are large banks or small banks.  We do not know who they are.  We do know that this is about double the number that were on the list before all the housing finance and financial market turmoil started.  The FDIC estimates that 13% of the banks on the watch list will fail.  I guess that means the FDIC thinks the odds of an uninsured depositor being hurt are small.   But we must remember that IndyMac wasn’t on this list on March 31, 2008.

The trend in bank failures does not give any comfort.  IndyMac is the fifth failure in 2008 and it is big.  The other four are much smaller.  They are First Integrity Bank, ANB Financial, Hume Bank, and Douglas National Bank.  In all of 2007 there were three failures; none in 2006 or 2005. 

But there are only 90 banks on the watch list, and so we have been asked, “What’s the big problem?”  We put this question to Chris Whalen, whose service we will describe in the next paragraph.  Chris answered, "You need to remind your clients that the FHLB and Fed are likely to be supporting troubled banks and getting paid at PAR in the event of a closure, the assets available to repay uninsured depositors are less and less.  In the case of IndyMac, we estimate that uninsured depositors could take a 50% haircut if losses go as high as 25% of total assets.  This is an institution that was considered well-capitalized at year-end 2007.  While the FDIC had 90 institutions on its problem list as of Q1, we identified 8% of all banks, or around 700 institutions as troubled."

A way to protect yourself is to obtain good information about your bank from an independent research source.  At Cumberland, we have utilized the services of Chris Whalen’s firm, a custom analytics provider: Institutional Risk Analytics (www.institutionalriskanalytics.com) .  Their services range from an automated report showing the bank’s financial and credit performance ($50) to a detailed profile of an institution prepared by one of their analysts.  That costs $1,000.  For additional information, contact Christopher Whalen (914) 827-9272 or cwhalen@institutionalriskanalytics.com .

Our advice is that depositors should try to lower that risk as much as possible.  Here is one idea.

After you have spread your insured deposits around and IF you still have uninsured deposits that need some liquidity placement, consider placement of the funds in a state or local governmental weekly reset variable-rate demand note (VRDN).  For an example see www.cumber.com.

The rationale is that you can get the same claim on a bank liquidity provider for a VRDN as you get from being an uninsured depositor in that bank.   But you also get the obligation of the municipal issuer.  If the bank fails, the Muni issuer will be replacing it with another bank.  Meanwhile the Muni issuer is the primary obligor.  If the bank doesn’t fail, you still have the bank credit as backup for liquidity.

Lastly, we must remember that the financial landscape in the US is rapidly changing.  Many of Treasury Secretary Paulson’s proposals are altering the risk profile that we were previously accustomed to.  And there are issues of systemic risk that must not be forgotten.  The array of changes seems to be transferring more and more risk to the uninsured depositor.

The great sage Will Rogers gave some sound economic advice.  He said: “It’s not the return on the money; it’s the return of the money that counts.”  Had they met, Will Rogers and Edmund Burke may have liked each other.

The following is excerpted from the FDIC rules:

How much insurance coverage does the FDIC provide?

The basic insurance amount is $100,000 per depositor, per insured bank.

The $100,000 amount applies to all depositors of an insured bank except for owners of certain retirement accounts, which are insured up to $250,000 per owner, per insured bank.

Deposits in separate branches of an insured bank are not separately insured. Deposits in one insured bank are insured separately from deposits in another insured bank.

Deposits maintained in different categories of legal ownership at the same bank can be separately insured. Therefore, it is possible to have deposits of more than $100,000 at one insured bank and still be fully insured.

The following sections describe the eight ownership categories recognized by FDIC regulations and the requirements that must be met to have coverage beyond the basic $100,000 insurance amount.

Single accounts: A single account is a deposit owned by one person. The following deposit account types are included in this ownership category:

      Accounts held in one person’s name alone

      Accounts established for one person by an agent, nominee, guardian, custodian, or conservator, including Uniform Transfers to Minors Act accounts, escrow accounts, and brokered deposit accounts

      Accounts held in the name of a business that is a sole proprietorship (for example, a "DBA account")

      Accounts established for a decedent’s estate, and

      Any account that fails to qualify for coverage under another ownership category.

All single accounts owned by the same person at the same insured bank are added together, and the total is insured up to $100,000.

If an individual has a deposit account titled in his or her name alone but gives another person the right to withdraw deposits from the account, the account will be insured as a single account only if the insured bank’s deposit account records indicate that:

      The other signer is authorized to make withdrawals pursuant to a power of attorney, or

      The account is owned by one person, and the other person is authorized to withdraw deposits on the owner’s behalf (for example, a convenience account).

If the insured bank’s account records do not indicate that such a relationship exists, the deposit would be insured as a joint account.

Single Account Example

Account Title Deposit Type Account Balance ($)
Marci Jones NOW

5,000

Marci Jones Savings
20,000
Marci Jones CD
100,000
Marci’s Memories (a sole proprietorship) Checking
25,000
Total Deposits  
150,000
Amount Insured  
100,000
Amount UNinsured  
50,000

Explanation:

Marci Jones has four single accounts at the same insured bank: three accounts held in her name alone and one account held by her business, which is a sole proprietorship. Deposits owned by a sole proprietorship are insured as the single ownership deposits of the person who owns the business. Thus, the deposits in all of these accounts are added together, and the total balance, $150,000, is insured for $100,000, leaving $50,000 uninsured.

A final item: as we were about to release this tonight a Wall Street Journal news alert arrived.  It said: “Federal regulators shut down two national banks, First National Bank of Nevada, based in Reno, Nev., and First Heritage Bank of Newport Beach, Calif., in the latest chapter of the credit crisis. Both banks were units of First National Bank Holding Co. The Federal Deposit Insurance Corp. successfully protected all depositors by selling the accounts to Mutual of Omaha Bank.”

This means seven banks have now failed this year.  Three of them had more than $1 billion of assets.

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