The Dangers of Deposit Insurance Arbitrage

Oct.29.09 | About: BOK Financial (BOKF)

I'll coin this term in order to explain the travesty that is being allowed in the banking industry. Institutions are literally paying little old ladies' less than a half a percent on their life savings and using said funds to gamble in the risk fraught derivatives market, with the risk being totally underwritten by the government through the:

  1. FDIC (deposit insurance and bond insurance - although to date this expense has been born by the industry, the FDIC is insolvent and may very well have to tap the Treasury, ie. the taxpayer: see I'm going to try not to say I told you so...),
  2. Treasury (via TARP and associate measures, see America, You have been outright lied to! Bamboozled! Swindled! Hoodwinked! The Worst Case Scenario) and
  3. Federal Reserve (ZIRP, QE, and a whole slew of programs I only wish I knew about - see The Fed Believes Secrecy is in Our Best Interests. Here are Some of the Secrets).

A perfect example of how the big banks are carrying this arbitrage out is outlined in "The Next Step in the Bank Implosion Cycle???", but the global economy risking behemoths are not the only one's that arbitrage bank deposit funds via FDIC guarantees. Earlier this year, I featured research on a smaller bank, Bank of Oklahoma (NASDAQ:BOKF), which I found participated in some pretty suspect accounting moves. Despite these "gimmicks" the stock floated higher with the general market and particularly the banking sector. OF course, this does nothing to cure the ills that they have been papering over.

Well, one of my subscribers have pointed out another "gimmick" that they are into, and that is the FDIC arbitrage thing. That's right, not the giga-billion dollar Wall Street TARP babies, but the Bank of Oklahoma. Here's how it works:

  1. As a deposit taking institution, CDs and savings accounts are insured by the FDIC. The banks use the funds from these CDs and savings accounts to fund their operations, which use to be primarily loans and checking/cash management services.
  2. The Fed has enabled expanded margins for many of these institutions through ZIRP (zero interest rate policy), but that is not enough to help the truly sick banks. See "The Anatomy of a Sick Bank!"
  3. Thus, many banks have ventured off into the arcane world of derivatives to boost earnings, and avoid having to polish all of those toasters to offer to Grannie! These banks include JP Morgan (NYSE:JPM), Citibank (NYSE:C), and Bank of America (NYSE:BAC) (see The Next Step in the Bank Implosion Cycle???"), but also much smaller regional and even some local institutions. The Bank of Oklahoma is offering what appears to be option-embedded CDs that sport the FDIC insured moniker on them. These instruments allow the owner to participate in the equity markets while having the federal guarantee on the principal. So, you ask, what's so bad about that? Well, let's walk through what their marketing material has to say, "For discussion purposes only", of course...

From this point on, I will split this post into two sections. The first is the arbitrage itself. The second details the product that the Bank of Oklahoma is using as an arbitrage tool. If you are familiar with the banks and their need to raise more capital, then skip down to point 2 to avoid being bored.

Point 1 - The Arbitrage

In "The Anatomy of a Sick Bank!", I attempted to show in detail, how the dropping of interest rates didn't necessarily produce the blowout profit margins for banks that everyone thought they would. The reason, many banks were too sick to take full advantage of it, hence their version of profit margin (NIM, net interest margin) remained level in many cases and actually dropped in more than a few cases - even as the Fed dropped rates like they were hot! Many of these banks have actually went under since then, and rates have since dropped to effectively zero, or 260 basis points or so.

Well, a lot has happened since then, including a massive bank rally. But if you look at the those banks whose NIM's remained level or dropped when rates dropped, you get an interesting list. Let's see here: Countrywide - gone, Wachovia - gone, Bank of America, soon to be gone, broken up and/or running back to the taxpayer for the next bailout, and those other banks such as Marshall & Illsey - keep your eye out. My thesis still stands. Many, if not nearly half, of America's banks are sick. What have they done to self medicate? Well, they are trying to make up for those thinning margins, or even in the case where margins are thickening they are preparing since they know and I know and you should know too that the Fed is artificially suppressing rates in an unsustainable fashion. The only place to go from zero is higher!

So, banks are now attempting to hoard capital in an effort to cushion shocks coming in the near future, and most likely cushion the shocks that they expect from their reckless lending actions from the recent past. Many have been kicking the can down the road using various methods as described to my subscribers in the BOKF earnings opinions linked above and as shown to the public in posts such as They ARE trying to kick the bad mortgages down the road, here's proof! As far as I can see, they are trying to kick the can far enough to earn their way out of the bad balance sheet hole, and appear to have the explicit OK from the government (see Charting the Truth).

One of the cheapest sources of funding for banks is deposits, savings accounts (which can be volatile) and CDs (which are less volatile due to fixed maturation and early withdrawal penalties). In the US, depositors can shop for the best CD rate in an environment where differences of 100% are not unusual, eg, 2.50% vs 5.00%. It should raise eyebrows when one bank offers a 5 year CD at 2.5% and another offers the same product at a 100% premium in the same interest rate environment. Obviously, the latter bank is considerably more desperate for funds. They can make such an offer because whether they offer 2% or 20%, it is all guaranteed by the FDIC (below a limit which the vast majority of Americans rarely pierce) come hell or high water.

Herein lies the arbitrage. Banks are using the FDIC insurance to backstop imprudent and often fiscally irresponsible acts, such as offering a 100% premium to the market average to attract monies, often into an institution that does not deserve to have grandma's often quite conservative funds. If one were to look at who is offering what rate, it is basically a road map leading you to who has the worse balance sheet. Basically, the higher the rate offered or the more arcane the product, the bigger a victim of the Asset Securitization Crisis (go ahead, click the link) the bank is.

A quick glance at bankrate.com's CD page should tell us who's trying to boost the busted balance sheet. For instance AIG Bank (the poster child for the term "busted") is offering 3.11% on a 5 year CD while Waterfield Bank and Salem Five Banks (most likely much smaller, hence should be offering higher rates) are offering 1.98% on virtually the same product. We all know AIG has problems. Is the FDIC funding the difference in risk? Why would AIG offer a higher rate? Because it is more distressed.If you move down to 1 year CDs, you can see differences of up to 400+% in pricing!

The ability to offer rates and products that are imprudent, fiscally irresponsible, and borderline insane are all a result of their ability to draw from the same insured pool of candidates, in effect ongoing moral hazard and the arbitrage of the FDIC insurance system. Without the FDIC guarantee, they would either have to offer rates that truly encompass the risk of doing business with an institution with solvency issues (junk rates), or would not be in the business of offering "safe" products at all. So, what's the point you ask? The point is that the FDIC is not sufficiently penalizing those institutions who are offering products, services, or activities that are sufficiently outside the bounds of what many of us call traditional banking. This accusation ranges from Goldman Sachs, Bank of America, Citibank and JP Morgan (reference again "The Next Step in the Bank Implosion Cycle???"), to the Bank of Oklahoma with their equity embedded CDs. As a result of not having to pay extra insurance to reach for that extra dollar in deposits or extra yield in the trading markets, we have an arbitrage situation that is being abused by banks, both big and small.

Arbitrage, as defined in Wikipedia: In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Point 2 - The Bank of Oklahoma Arbitrage Tool

Click to expand these images, or download the original PDF here.

Click to expand page 1

bokf_stock_cd.png

Click to expand page 2

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So, this product from the financial engineering wizard of Wall Street, Midwest are offering the opportunity to reach for yield in a low interest rate environment, as quoted from the marketing material:

For investors seeking contingent semi-annual income of up to 4.5 - 6.5% (9-13% annual) and FDIC-Insured Return of Principal at maturity (1). Provides contingent semi-annual interest payments tied to the performance of a basket of 10 large cap U.S. stocks, representing a variety of industry segments.

For those not hailing from Wall Street, Midwest, this is most likely accomplished through an OTC swap or option embedded product. The reason why I even bothered to go into its construction is because it is designed to basically sucker conservative CD buyers into buying a product with increased risk and capped upside. Before I go on, let's realize that if you want exposure to the stock market, simply by stocks, an index fund or an option or future on the index. If you want limited exposure to stocks, by the same with limited funds. It really is that simple. You can do that with a small portion of your CD and not pay the bank any of its fees, and get the same result without the added counterparty risk of having to hope scientific whizzes from Wall Street Midwest that bought this product's engine from Wall Street East (let me guess, Goldman sold them the swap, didn't they?) didn't get sold a lemming, or that the Bank of Oklahoma doesn't go belly up. After all, as my subscribers know, these guys are playing it a little more than aggressive with their accounting. In addition, you also preserve your full FDIC insurance protection (we'll get to this point a little later).

bokf_stock_cd_yield_graph.pngClick to enlarge

As you can see, the bank has capped the yield on the product, so it captures any upside past the 6.5% bi-annual observation period (13% annually). This is profit you would not have to give up if you exposed yourself to the market directly. Remember, you can expose yourself as much as you want. Do you want to replicate this product without donating your fair share to the bank? Take out a calculator and see how much of your CD you can afford to lose while still maintaining the minimum income you desire.

From the "Investment Risks to Consider" section:

  • There may be no active secondary market for the CDs. Hmmm! Does this mean that you may not be able to sell these"securities" before the bank is willing to redeem them at maturity? I am considerably better versed at things financial than the average CD investor, and even I am not clear on exactly what they are trying to disclaim here. Sounds like a warning bell for lack of liquidity for 5 years, through! Again, wouldn't be a lot easier to just buy a CD with 97.78% of your money (subtract CD yield offered from principal) and put 2.22% (the yield you are willing to risk) into an ETF (I personally don't like ETFs), index fund, SPDR (or similar product, not my cup of tea either, though), index future or option, or better yet and most simply, just buy the stocks in question, directly? If the Bank of Oklahoma were acting in your best interests and had a calculator handy, I am sure the latter option would yield the best result from a fiduciary responsibility perspective, but banks don't get paid for that, now do they?
  • Investors have no rights in the basket securities and will not receive cash dividend payments or other distributions that holders of the securities may be entitled to. Again, why give this up to the bank unnecessarily? You are not getting a deal on the upside because the upside is capped. You are not getting income because the bank is trying to keep that as profit from the deal - your contingent profit! You are not getting added safety, because your principal is FDIC protected up to ($XXX,000) anyway.
  • Offers principal protection if the CDs are held to maturity, subject to the credit risk of the Bank of Oklahoma for amounts invested beyond FDIC insurance limits. Now,I'll admit that I didn't look at the prospectus, and don't know a lot about this particular product, but when you add this bulleted disclaimer point with the first one, it becomes obvious that your funds are at risk (all of your funds, principal and yield) if not held to maturity. This is in addition to the liquidity risk quoted above. So, I ask, why in the world would one by this product, when you could just by a plain vanilla CD and stock??? One should also keep in mind that you are exposed as a counterparty to BOKF directly (as opposed to the FDIC) for funds above the insured limit. BOKF is certainly not as conservative in their accounting as they could be (just as they are not as generous in their product offering as they may seem), and it is most likely that it will catch up to them in the upcoming quarters. They skated this far, but we shall see if they pay the piper or not. Subscribers, again reference - BOK 1Q09 2009-05-07 06:34:52 460.74 Kb and BOK 2Q09 review 2009-08-01 05:04:06 1.05 Mb.
  • Investing in the CDs is not equivalent to investing in a conventional CD or any of the securities underlying the 10 stock basket. This is the kicker here, and was most likely insisted upon by their lawyers. This is a derivative product, not a true, plain vanilla CD! As a derivative, it is most likely prone to tracking error. That means that the returns on the derived basket of securities may not accurately or even tightly track the basket of 10 securities. This is one of my biggest problems with the way many ETFs are put together. In addition, you do not have actual ownership in the stocks themselves - no voting rights, no dividends, and I am assuming no tax loss credits in case things don't go your way. You also don't have the safety of a traditional CD: no guaranteed active secondary market (meaning you may not be able to sell it before your 5 years are up, even back to the bank), no guarantee of principal before the maturity date, etc. So what do you have???

A monster. Why a monster, you ask? See "Welcome to the World of Dr. FrankenFinance!".

So, what happens if BOKF goes belly up, and you have $500,000 invested in this thing? What happens if they go belly up and you have $3,000 invested in this thing and you pull out before your 5 year period is up? You are a direct counterparty to a derivatives dealer in a derivatives transaction if you buy this so-called CD, did you know that? Try explaining that to grandma. Better yet, let the FDIC explain whether or not BOKF would be able to sell this product to grandma's at all without the umbrella arbitrage of the FDIC insurance system - despite the fact that it appears that that insurance coverage of this product is spotty at best and probably untested in a sharp downward spike of both the banking sector and the equity markets, you know - considering "There may be no active secondary market for the CDs."

You guys at the FDIC need to tighten up on this stuff!!! Make banks get back to being banks again. More loans, less baloney, please!

Disclosure: bearish positions held on BOKF