User 277429

FDIC Insurance Limits: Eating My Humble Pie

I feel that all the news and discussion on the topic of FDIC Insurance is ignoring the significant loophole in FDIC's insurance construct that might have a significant impact down the road. As you know, the insurance limit applies on a per bank basis. So if you had $500k, you could go to 2 banks and get your money fully insured. Similarily, if you had $50mm, you could go to 200 banks and be fully insured.

There are several middlemen in the market place that exploit this construct to profit themselves. Examples are the brokered CD desks of several investment banks, The Reserve (whose money market funds were the first to break the buck), and Promontory Interfinancial Network.

These middlemen's business model arbitrages the credit rating of a US Government Agency (FDIC) and increases FDIC's overall liability by increasing the size of insured deposits in the banking system. Wealthy and institutional customers benefit immensely because they are able to obtain Bank CD type rates on up to hundreds of millions of their money while taking US Government credit risk. Indeed, historically they have been able to pick up hundreds of basis points over Treasury rates.

The increased liability to the FDIC is paid for by the banks in the form of higher FDIC premiums. Banks, in turn, pass on the FDIC premium cost as well as the cost that the middleman charges to their customers in the form of lower interest rates and/or fees. Again, wealthy and institutional customers have more leverage with banks and are more sensitive to rates and fees, therefore the cost is disproportionately transferred to the average customer. And if FDIC runs out of its fund, then the taxpayer will be stuck with the cost.

The net result is that these middlemen significantly increase the liability of FDIC as well as transfer wealth to wealthy and institutional investors from average bank customers. Given that there are hundreds of billions of dollars in these programs, it is significantly increasing FDIC's liability and creating a substantial burden for average bank customers that don't keep more than $100,000 at banks.

The middlemen also have a significant 'moral hazard' problem because they are likely to provide funding for banks that are most desperate and thus willing to pay highest rates in the market place. However, unlike normal credit extension, there are no credit checks or collateralization because the risk is borne by FDIC. Promontory sells funds in an auction where the highest bidder is awarded the funds. And it boasts on its website that there are no credit limits and no credit checks or collateralization is required. It also charges $30 annualized per $10,000 for a 4-week CD, a maturity where it does the majority of its business. Astonishingly, these entities (except for brokered deposit desks) are not even regulated by any banking regulator. And you frequently find Alan Blinder on CNBC and other media trying to shape the policies of FDIC as an unbiased commentator when he is pitching CDARS on Promontory's web site.

This is another clear cut case of "Public Risk, Private Gain". Anyone remember Fannie, Freddie?

I wish this issue would be brought up in the discussions now because it has the potential to grow into a huge problem down the road.