What Might Happen in a Big Bank Failure?

Includes: BAC, C, JPM, MBFI, WFC
by: Anthony M. Freed

By Scott J. Wilson

Is 60 Minutes the new propaganda department of the FDIC, or what? Again, they drop the ball in their coverage of the mortgage crisis, leaving viewers more misinformed than ever.

My esteem for the fabled news show is quickly diminishing.

“Reporter” Scott Pelley had a piece on 60 Minutes on Sunday (03/08/09), in which he tries to comfort us by examining a bank being taken over on February 27, 2009, Heritage Community Bank in Chicago.

By showing the inside workings of a take over, “60 Minutes” (I think) was trying to put our minds at ease by showing how smoothly it goes.

But this is a bank of only 5 branches, with a total 12,000 deposits worth only $200 million. Not pocket change, but not any where in the same ballpark or even league as a big bank like B of A (NYSE:BAC) or Citi (NYSE:C).

In the story, they state that when IndyMac went down, it held close to $11 billion. The FDIC levies premiums that they charge banks to insure the deposits, and put the funds into a reserve for such failures.

The FDIC states that there were 25 closings in 2008, but as of the first two months 2009, there have already been 6 closings. The FDIC estimates that they will need $65 billion to cover closings over the next five years.

Let’s do the math:

  • $65 billion over then next five years = $13 billion per year.
  • If Heritage Community Bank is an average bank (don’t think that five branches is that big) = $200 million.
  • That means they can handle 65 closings a year of these small banks.

So that being said, what happens if another Indy Mac goes down?

According to Sheila Bair (Chairman of the FDIC) the FDIC will never go broke. It will always be backed by the government.

What does Bair think? That the fed will just print some more money and give to her? That doesn’t sound so good.

Now I have done some investigating of my own: According to this piece, there are three things that the FDIC can do when a bank fails:

  • They can close the bank and pay the depositors.
  • They can close the bank as it was and run it themselves.
  • They can sell the bank (as was the case in the HCB in this story.)

In the story, Heritage was sold to MB Financial (NASDAQ:MBFI) and things went on as normal the next day (Saturday) after the FDIC take over. The FDIC paid MB $3.5 million dollars to take over Heritage. The FDIC also insures that if any loan by HCB that goes bad in the near future will re-reimbursed up to 80% of the loan loss.

Okay, so this situation seems to have a happy ending.

But let’s say that a bank fails and the FDIC fails to get a suitable buyer, what happens if they don’t want to run it and they close it down.

I brought this question to the attention of my banker at Regions Bank (NYSE:RF). He informed me that the FDIC has up to TWO years to pay depositors their claim. Yes it is insured, but if you don’t have access to your money for up to two years, what good is it going to do you?

What about the people who live pay check to pay check? Or the seniors that have a limited cash flow and everything they own is in that one bank that went under?

Once I heard this from my banker at Regions, my wife and I decided to diversify in three banks. This way if one goes under and no one buys it, I will have a back up. We also took some cash and put it into our safe.

  1. Why, do you say or wonder? Well, let's do some thinking here:
  2. Who, if anybody, remembers what happened during the depression? Who really lived it? Answer: Seniors.
  3. Who has some of the most assets? Answer: Seniors.
  4. If there is a massive scare and there is a run on the banks, who do you think will be the first to come to the bank and withdraw all of their savings? Answer: Seniors.

And last, how many “average Joe” accounts would it take to equal what one senior couple would have in their account? Answer: I don’t know, but I know it is probably at least 10 to 1, probably close to 20 to 1 or higher.

So this is where we and the FDIC must be careful.

Keeping the confidence in the people who have the most at stake…seniors. If there is a run on the banks, you can bet that the seniors will be the first ones in line to get their cash.

In the “60 Minutes” piece, they in fact show a senior citizen come in with an empty brief case in order to withdraw all his money. Nothing in this story examines how seniors can make or break this mess with run on the banks.

I have never been involved with a bank that was being taken over, but I am sure it is not as nice as the way they show it in this piece.

Heritage had been in business for 45 yrs and probably didn’t take some of the most risky loans such as the Chases (NYSE:JPM), B of As and Wells Fargos (NYSE:WFC), but they get bailed out where these small banks seem to be just kicked to wayside.

One other thing that is brought up is when Pelley brings to the attention of Bair about what would happen if a big bank goes under and why they get bailed out and the small banks don’t, she suggests that we need to legislate the size of the big banks.

Make it so that they cannot exceed a certain limit to insure the fact that they cannot get too big and fail.

Bair says that the FDIC can and will not fail, what will happen if a Chase or B of A goes under. I think that the FDIC would have a hard time handling one of those.

They won’t be able to just “print money” to clean up the mess without creating another snowball effect on the value of the dollar, let alone the consumer confidence. That is something that Pelley should have investigated instead of how nice it was when this little five branch bank failed.

Disclosure: Long JPM.