Anatomy of a Bank Failure – Does FDIC Encourage Excessive Losses?

Okay, by now we’re all pretty familiar with the Troubled Asset Relief Program, right? Can you watch a newscast without some mention of what bank is receiving TARP funds, what they are (or, rather, aren’t) doing with them, who’s criticizing who got them, and who has a better idea about how to end the ‘recession’ whilst dancing around the taboo ‘D’ word decribing our current situation? How about a different look at what’s going on with the banks, namely the ones that fail?

A brief primer: since the beginning of 2008, 46 banks have had their books declared so effed up that the feds have decided to step in and shut them down. That doesn’t include hastily arranged shotgun weddings of drowning institutions, like the one of Wachovia to Wells Fargo. The state with the highest number of failures was Georgia with nine, but don’t worry, California came in nipping at Georgia’s heels with eight. We have, however, been the most expensive state, with our failures (most notably including IndyMac last spring) costing the Federal Deposit Insurance Corp. $13.6 billion. That’s just shy of 70% of the total the FDIC’s reserve fund has been tapped since January 2008, when most people started tracking this sort of thing and the go-forward date to use if you want to compare apples to apples when researching different sources.

FDIC reserves were set up following the last depression to insure individual depositors against loss of their savings if a bank went under. Right now an individual is theoretically covered for their first $250,000 deposited at a bank, that temporary cap expires at the end of this year, when consumer protection drops to $100,000. Of course there are ways around this limit – if you’re lucky enough to have more than $100K sitting around in the bank, you can have several accounts with different institutions. The tricky part comes when institutions are continually merging and/or failing – if you had $100K at Wachovia and another $100K parked at Wells Fargo, you were safe. But now you’ve got $200K at Wells, so far as FDIC is concerned.

Anyway, reserves in January 2008 stood at $52.4 billion. The failures last year sapped that fund by $18.9 billion, and so far this year the 14 failed banks have cost the fund another $1.7 billion. This fund is stocked by charging banks an insurance premium on their deposits. As the costs mount and the fund drains, FDIC is responding by charging member banks increasingly high premiums. Rates in the last quarter of 2008 ranged from 0.05-0.43%, but were bumped to 0.12-0.5% for the first quarter of 2009. The second quarter of this year has seen another increase, as well as the imposition of a 0.2% “emergency assessment.” Show of hands – how many think banks are just writing off these increased fees as the cost of doing business? Now how many believe the extra costs are trickling down to consumers in the form of the return of fees on accounts we’d long taken for granted as free, or as reduced rates paid to end consumers?

But even these extra cash infusions may not be enough to keep the institution that guarantees the safety of using a bank in the US from going bankrupt itself. Sheila Bair, the FDIC chairwoman, was recently quoted as saying “Without additional revenues beyond the regular assessments, current projections indicate that the fund balance will approach zero.” That’s a chilling thought, no?

So where do these losses come from, anyhow? Usually when the feds find a healthy bank willing to take on the sickly one they’ve slated for euthanasia, they enter into a loss-sharing agreement, whereby the acquiring institution agrees to accept a certain amount of losses in exchange for gaining all the customers, assets, and deposit accounts of the acquired one, thereby improving their market share and position in a particular market. Chase, for example, used its acquisition of WaMu to expand into west coast markets – where setting up, staffing, and opening hundreds of banks in California, then attracting customers, would’ve been expensive and time-consuming, whereas telling all the WaMu customers they now bank with Chase and changing the signs out front of existing branches was much simpler. The devil, however, is in the details of a contract called a loss-sharing agreement.

As previously mentioned, the acquiring bank, in exchange for the benefits mentioned above, agrees to accept a certain amount of loss, agreed to at the time of acquisition with the FDIC. Any losses above this amount, however, are split between the new bank and the FDIC, with our insurance funds covering the lion’s share of excess loss – from 80-95%. There is significant concern that banks are strong-arming or duping FDIC officials into setting these caps too low.

How does that hurt us? Easy – suppose Chase is told that it has to eat the first $5 billion of WaMu’s losses from writing crappy interest-only negative-amortization stated-income loans on inflated-value houses all over California during the peak of the housing bubble. Chase figures $5 billion is a decent price to pay for a thousand or so new branches and a few million new customers, so they sign on. But their accountants have done their homework – they know what they’re buying is really worth $10 billion to them, and that they expect WaMu’s idiocy to end up costing upward of $12 billion in the long run. A equitable deal, then, would’ve been for the FDIC to pay Chase $2 billion or so to take over WaMu, figuring the extra losses are offset by their gain from entering the new market. But instead, now the FDIC has to eat 95% of anything over the first $5 billion, meaning Chase makes their purchase for billions of dollars under market value, with FDIC funds essentially subsidizing their venture.

Worse, what incentive is there for an institution to strive to operate efficiently if they’re pretty much assured that if they win, they win, while if they lose, someone else hands them a check to cover their loss? That, amigos, is a point of serious concern, and one that hasn’t been addressed anywhere that I’ve been able to find in underground or mainstream media. We’re busy griping about millions in AIG bonuses while billions in waste slips right under our noses.

Disclaimer: the WaMu/Chase numbers are purely hypothetical, I haven’t researched specifically the value of the deal they struck. I have no evidence, factual or anicdotal, about anyone in a black suit and sunglasses threatening a FDIC negotiator with the business end of a gun, or even a ball-point. These are my conspiracy theories that exist in my own twisted world, but I encourage you to adopt them.

PSD is a new blogger for the OB Rag blog.