FDIC: Rescuer or Rescuee?

Is Your Bank Safe (part 2 of 3)

Last weekend the FDIC seized three smaller banks. This makes a total of 98 banks that failed this year. The banks were Jennings State Bank (Spring Grove, MN), Warren Bank (Michigan) and Southern Colorado National Bank (Pueblo).

The FDIC is chief savior when banks fail. It monitors the financial health of banks. Whenever a bank collapses, the FDIC moves in to arrange auctions of their assets and debts to other banks and/or hedge funds.

Having been a customer of two early banking failures last year (a bank and a credit union), I can personally attest the FDIC process works well. But can the FDIC keep up it up?

The FDIC Deposit Insurance Fund

The Federal government requires the FDIC to keep $1.15 cents on hand for every $100 of deposits by its approximately 8,000 member banks. At the end of 2008, FDIC members had approximately $4.8 trillion in deposits. But the FDICs deposit insurance fund fell by $16 billion down to $19 billion. The FDIC quickly levied a hefty emergency assessment on its members this spring.

By June 2009 the amount of money in the FDIC’s deposit insurance fund declined to $10.4 billion; down from $42 billion in the previous June. This is the lowest level since the Savings and Loan crisis of the 1980s. As a result, FDIC’s fund had only 40 cents for every $100 of deposits. That’s well below the statutory minimum required.

But bank failures are continuing to grow. Recently, government officials estimated that bank failures between 2009-2013 would cost the FDIC up to $100 billion. Seeing that it was due to run out of funds before the end of the year, the FDIC is now demanding prepayment of several years in fees from member banks.

This, unfortunately, will be likely to have the effect of hastening the demise of some of its members.

How can the FDIC be so broke so fast? Let’s take an in-depth look at the answer and what it means for our futures.

The True Costs of Bank Failures

The FDIC will spend somewhere around $19 billion from its deposit insurance fund this year, but little of that money is going to depositors. That’s because the FDIC has been fairly successful at getting other banks to take over the deposits of failed banks. It is the assets, e.g. property, loans, investments, etc., of failed banks that are costing the FDIC so much money.

The costs to the FDIC for handling the assets from bank failures are mounting up. The FDIC estimated it would pay $293.3 million out of its insurance fund for the three most recent bank failures last weekend. And these are very small banks.

Why is this total so high? In January of this year, the FDIC began using a tool from the savings and loan crisis days. It’s called “loss sharing.” Loss sharing is basically a subsidy to other banks and private equity sources to take over failed banks. It means that FDIC costs for handling bank failures aren’t just bureaucratic ones. The FDIC is taking on the risk of owning toxic assets that may or may not improve in value in the future.

For example, when Colonial Bank of Alabama went under in August it was the sixth largest bank collapse in U.S. history. The FDIC entered a loss-sharing transaction for $14.3 billion of Colonial’s approximately $22 billion in assets. BB&T, a Southern regional bank, took on the remaining $7.7 billion.

When Colonial failed in August, for the first time ever, the FDIC included a clawback provision. The FDIC has agreed to reimburse BB&T for the 80 percent of its first $5 billion in losses (after which the FDIC is pledged to reimburse 95 percent of losses up to a total of $14.3 billion). The FDIC’s clawback provision says if BB&T’s losses from Colonial are less than the first  $5 billion, the FDIC gets some money back. But any return of the FDIC’s funds won’t happen until 2019!

This kind of risk-taking isn’t unusual at the FDIC.

When Corus Bank of Chicago went under in September, the $6.6 billion of its deposits went to another Chicago bank. Regarding the $5 billion in assets (valued now at around $2.5 billion), the FDIC then made a complicated loss sharing deal with a group of private equity companies in a 60-40 split.

The FDIC did ensure that all of the Corus’ debt must be paid off before anyone gets any equity. And the FDIC has an option to take as much as 70 percent of any equity raised from Corus’ assets. Unfortunately, Corus assets were mostly non-performing loans for unfinished building projects.

And here’s the sweetener for the buyers. The winner of the auction for Corus gets a number of goodies from the FDIC. It will get access to $1 billion in interest free loans and a subsidized rate on loans after that. It will also get a revolving line of credit, plus $40 million in management fees.

The FDIC estimates that the Corus Bank collapse will cost its insurance fund around $1.7 billion.

Where’s the bottom line?

At least one WSJ commentator has commented acidly that FDIC loss-sharing deals with buyers of failed banks are similar to the kind of arrangements banks made on subprime mortgages. The FDIC’s deals encourage buyers to overpay, and the results could be just as fatal.

Professor of economics at Boston University, Laurence Kotilkoff, estimates that the FDIC now has more than $6 trillion in contingent obligations against its deposit insurance. By getting prepayment of fees from member banks for up to three years in advance to pay this year’s bills, the FDIC looks to be paying Peter to pay Paul while mortgaging its own future for years.

The obvious questions for our futures? What will happen if the FDIC can’t pay for the equity it’s buying from the failed banks? And what happens when the next failed bank has no buyers?

Next time:  “Who’s The FDIC Gonna Call?”

Copyright © 2009 Nancy K. Humphreys