The FDIC Is Broke. Now What? (Part I)

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Executive Summary

  • With the most recent bank failures, the FDIC is out of funds.
  • The FDIC is levying a one-time fee on member banks to cover the shortfall, but it will not be enough and it punishes the prudent.
  • The FDIC has been suspiciously slow at shutting down banks that have admittedly already failed.
  • Banks have been allowed to overestimate the actual worth of their assets using "mark-to-fantasy" accounting.
  • Hundreds of banks are likely already mortally wounded and set to fail.
  • The FDIC means well, but creates a moral hazard the effects of which now haunt us.
  • Take prudent action: Choose only high-rated banks, and keep cash out of the bank.

Five more banks failed this week, resulting in a long weekend for the FDIC (see below). The largest of these, by far, was Colonial Bank, which will cost the FDIC some $2.8 billion. And that's assuming that their loss estimates pan out as expected and that the $15 billion in shaky assets on which the FDIC will share future losses do not turn into larger-than-expected losses.

SAN FRANCISCO (MarketWatch) -- Colonial BancGroup Inc. became the largest bank failure this year after the Federal Deposit Insurance Corporation seized the struggling Alabama-based lender Friday and sold it to BB&T Corp.

The Colonial BancGroup deal will knock roughly $2.8 billion off a pool of money, known as the Deposit Insurance Fund, which the FDIC maintains to guarantee bank customer deposits.

The FDIC and BB&T will share losses on $15 billion of Colonial's assets. Loss-sharing deals have become common since the financial crisis struck last year, as the FDIC tries to encourage more stable banks to take over failing institutions.

Here is the list of failed banks for the weekend of August 15/16, 2009:


Let's add up the estimated costs to the Deposit Insurance Fund (DIF), which is the FDIC pool of money toward which banks pay a premium and out of which all bank failure costs are covered.

  • Union Bank: The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $61 million.
  • Community Bank of AZ: The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $25.5 million.
  • Community Bank of NV: The cost to the FDIC's Deposit Insurance Fund is estimated to be $781.5 million.
  • Colonial Bank: The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $2.8 billion.

All together, that adds up to $3.67 billion dollars in new costs to the Deposit Insurance Fund. The problem is that this turns out to be $3 billion more than currently exists in the Deposit Insurance Fund:


The incredible shrinking balance of the DIF is best viewed on a chart comparing it to total insured deposits:


With this latest series of bank closings, the DIF ratio is now solidly in negative territory. Interestingly, we might also note that insured deposits have declined for the first time since at least 1999, which is as far back as I have found data.

I suspect this deposit decline reflects the fact that people who are out of work are drawing down their savings, but I lack the data to confirm it at this time. Regardless of the cause, declining deposits are a significant threat to the banking system, which is only ever stable and happy when it is continuously growing.

Okay, so the FDIC is out of money. Now what?

Punishing the Prudent

In March 2009, Sheila Bair, head of the FDIC, announced that the FDIC intended to levy a one-time fee on member banks to cover the looming shortfall.

Small and regional banks protested vigorously, noting that they were effectively being punished for remaining sound while Wall Street and a few notorious banks played with fire. They have an excellent point. Note the strong language used by ICBA president Camden Fine:

The group — made up of mostly small town, rural banks that never traded in exotic mortgage-backed securities — is outraged [by the proposed levy].

[Independent Community Bankers of America] ICBA President Camden R. Fine compares the FDIC to Japan’s attack on Pearl Harbor. He calls the special assessment on the nation’s 8,000 community banks “crippling,” and blamed “greed, incompetence and sins of the Wall Street firms that so crippled this nation’s economy.”

“We have now come to the point where the ‘systemically unimportant’ banks of Main Street must, along with the nation’s taxpayers, bail out the ‘systemically important’ Wall Street firms,” Fine said. “Not only are a handful of Wall Street CEOs holding a gun to the taxpayers’ heads, they have the banks of Main Street America looking down the barrel as well.”

Fine said it is ironic that on the day the special assessment was announced, struggling CitiGroup received another government bailout. He says community banks are strong and are doing the economic work the bigger banks should be doing.

“During the fourth quarter of 2008, community banks had the largest percentage increase in lending across the industry,” Fine said. “For every dollar paid in premium assessments, a community banks’ ability to make loans and support economic recovery will be reduced at least eightfold.”

His point, besides being asked to shoulder the burden for irresponsible banks (which is galling enough in itself), is that every dollar sucked out of a small bank represents eight dollars of loans that cannot be made into local communities. It bears noting that recoveries are mostly made due to small business expansion and hiring, yet the effective result of the FDIC levy will be to siphon recovery fuel from small communities and transfer it to the big players.

This is not a small point. It is a big deal.

After listening carefully to these concerns, the FDIC voted on May 22, 2009 to go forward with the special levy:

The Board of Directors of the Federal Deposit Insurance Corporation today voted to levy a special assessment on insured institutions as part of the agency's efforts to rebuild the Deposit Insurance Fund (DIF) and help maintain public confidence in the banking system.

The final rule establishes a special assessment of five basis points on each FDIC-insured depository institution's assets, minus its Tier 1 capital, as of June 30, 2009. The special assessment will be collected September 30, 2009.

This is where the real test of the FDIC begins. Long an underused form of bank insurance, it is now being severely tested.

You might note in the quote above that the levy will not be collected until September 30, which is 45 days away. Yet the FDIC is already out of money.

Ah. Now we have a reasonable explanation for why the FDIC has been dragging its feet and not shutting down the numerous banks that are already bankrupt, yet still operating.

It can't afford to.

Dead Banks Walking

It has seemed quite the puzzle to many financial observers that some effectively-bankrupt banks have been allowed by the FDIC to continue operating.

For example, there's the second-largest bank in Texas, Guaranty Bank, which practically begged to be taken over by the FDIC earlier this year. When that failed, they submitted a filing with the SEC on July 23rd 2009, which read:

Based on these adjustments, the Bank’s core capital ratio stood at negative 5.78% as of March 31, 2009. The Bank’s total risk based capital ratio as of March 31, 2009 stood at negative 5.52%. Both of these ratios result in the Bank being considered critically under-capitalized under regulatory prompt corrective action standards.

In light of these developments, the Company believes that it is probable that it will not be able to continue as a going concern.

That's about as clear as things can be, except for the case where the filing uses the phrase "critically under-capitalized," when the more common, and accurate, term is "bankrupt." Also, when a bank notes in its filing with the SEC that it probably will "not be able to continue as a going concern," you can be all but certain that it is truly and utterly bankrupt.

A similar story can be told for Corus Bank, which announced on June 30, 2009 that it, too, was "critically undercapitalized" and that things are growing worse because two-thirds of their loans are non-performing. In their filing, the Corus officers even went so far as to remind the FDIC of its regulatory obligations:

[T]he Bank reported negative equity capital as of June 30, 2009. As such, the Bank expects to be notified by the OCC that it is “critically undercapitalized” within the meaning of PCA capital requirements.

Under the FDI Act, depository institutions that are “critically undercapitalized” must be placed into conservatorship or receivership within 90 days of becoming critically undercapitalized, unless the institution’s primary Federal regulatory authority (here, the OCC) and the Federal Deposit Insurance Corporation (“FDIC”) determine and document that “other action” would better achieve the purposes of PCA.

If such a depository institution remains critically undercapitalized during the last quarter ending one year after the institution became critically undercapitalized, the appropriate Federal banking agency must appoint a receiver for that institution unless it and the FDIC affirmatively can determine that, among other things, the institution has positive net worth and the agencies can certify that the depository institution is viable and not expected to fail.

Luckily for the FDIC's dwindling DIF account, the law gives them 90 days after the filing to act, during which time they will still remain in compliance. Since Corus filed on June 30, that gives the FDIC until September 30.

But that's adhering to the letter of the law. In times past, the FDIC moved promptly to shut down insolvent banks, because waiting only makes the problem grow larger. So why has the FDIC been dragging its feet here?

The answer, quite probably, is because the FDIC does not have the funds it needs to shut down these banks, and so it is buying whatever time it can.

The Pressure Mounts

The two examples of failed-but-operating banks, above, are merely the tip of the iceberg. According to a Bloomberg article, even with the relaxed mark-to-fantasy asset rules in place for banks, there are hundreds of banks flashing bright red warning signs:

Toxic Loans Topping 5% May Push 150 Banks to Point of No Return

Aug. 14 (Bloomberg) -- More than 150 publicly traded U.S. lenders own nonperforming loans that equal 5 percent or more of their holdings, a level that former regulators say can wipe out a bank’s equity and threaten its survival.

The number of banks exceeding the threshold more than doubled in the year through June, according to data compiled by Bloomberg, as real estate and credit-card defaults surged. Almost 300 reported 3 percent or more of their loans were nonperforming, a term for commercial and consumer debt that has stopped collecting interest or will no longer be paid in full.

The biggest banks with nonperforming loans of at least 5 percent include Wisconsin’s Marshall & Ilsley Corp. and Georgia’s Synovus Financial Corp., according to Bloomberg data. Among those exceeding 10 percent, the biggest in the 50 U.S. states was Michigan’s Flagstar Bancorp. All said in second- quarter filings they’re “well-capitalized” by regulatory standards, which means they’re considered financially sound.

Imagine how many more would appear mortally wounded if realistic mark-to-market asset valuations were used? One shudders to think of it.

Part 2 >>

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