Monday, August 24, 2009

Executive Summary

• Guaranty Bank failed on Friday and was sold to a foreign bank.
• Bank assets are undeniably under stress and are deteriorating.
• Given the current trajectories, as many as two thousand more banks may fail.
• The FDIC absolutely must remain well capitalized with liquid cash, or confidence-destroying bank runs will result.
• It was premature of Bernanke to declare victory.
• Choose your bank wisely.

One to two thousand bank failures are on the way. Peak stress has not yet been reached. Nearly every major source of bank loan stress continues to worsen. We’ve not seen any signs of a bottom yet in the most important measures.
 
The key risk here that a gap could develop between the FDIC’s ability to make good on depositor accounts and demand for funds from those accounts.
 
While this stress was significant enough last fall to cause me to issue warnings about keeping some money out of the bank and seeking to move funds from less to more sound institutions, I held back those recommendations once I judged that the risk had passed.
 
But now that risk has returned.

Sunday, August 16, 2009

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.

(Source) 

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

(Source) 

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.   (Source)

Community Bank of AZ: The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $25.5 million.   (Source) 

Community Bank of NV: The cost to the FDIC’s Deposit Insurance Fund is estimated to be $781.5 million.   (Source)  

Colonial Bank: The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $2.8 billion.   (Source)  

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: 

 

(Source) 

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

(Source) 

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.”

(source)  

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.

(source) 

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 23^rd 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.

(source) 

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.

(Source)

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.

Making Matters Worse

An additional pressure on the DIF stems from the fact that losses from prior FDIC enforcements have been dramatically higher than initial estimates. With each new FDIC report, we see less money in the DIF kitty than expected. This next article does a great job of articulating that this is because bank assets are worth a lot less than originally thought:

On January 1 2009 the FDIC reported it had $17,276 million in the DIF and according to press releases for each failed bank, the estimated total costs for FDIC’s DIF during Q1 amounted to $2,146 million, leaving $14,997 million in the fund. However, according to the latest FDIC Quarterly report the fund counted $13,007 million at the start of Q2, – a difference of $1,990 million.

In other words, the estimated spending on failed banks during Q1 was $2,147 million, but the bill ended up around $4,137 million instead (and probably still counting).

This is why Q2 is even more interesting, since the estimated costs are $11,504 million, thus leaving only $833 million in the fund for supporting failing banks in the future. Moreover, the real total cost for the first quarter in 2009 was almost twice the estimates. If Q2 is even close to this figure, the FDIC’s DIF will (very) soon be out of funds.

However, we have detected that DIF costs/bank assets have steadily increased under the period of discussion.

We believe the main reason for this lies in a de facto relaxation of accounting standards, even before the FASB 157 amendment on March 15 earlier this year. Basically the relaxation allows banks to write-off the parts of their losses caused by the slowdown in the market – but it does this by allowing them to decide what a fair price in a ‘normal’ market would be.

Allowing banks to control how they mark-to-market their assets, will likely backfire and when they ultimately end up failing, imply greater closure costs for the FDIC. From the graph above one can infer that the average yearly DIF costs/bank assets have increased at an alarming rate to almost reach 31% in 2008 and 2009.

(Source)    

To review, banks have been granted a waiver by the government to essentially overstate the value of their assets, a convenience that wags refer to as “mark-to-fantasy” accounting.  When the FDIC swoops in on a Friday afternoon and takes over a failed bank, they have to start with the bank’s own estimates of asset values when assessing the possible losses.  To put it bluntly, these are pie-in-the-sky estimates that will only ever disappoint.

Looking carefully at the numbers above, we see that the FDIC estimated $2,147 million in losses, but spent $4,137 million, resulting in losses that were 92% higher than expected (and counting). I don’t know about you, but I happen to think that a 92% variance is a lot. 

None of this is the least surprising to those who have been paying attention. It is another shell game, being conducted for the benefit of a very few at everyone’s expense. It works like this:

1. Allow banks to effectively lie about the value of their assets.
2. Let them operate until it is beyond obvious that they need to be shut down.
3. Act surprised when their losses are a lot higher than “expected.” 

Nobody who is paying attention is fooled in the slightest, but unfortunately, very few seem to be paying attention.

Moral Hazard

This is just one more example of where giving banks extra maneuvering room, by allowing them to overestimate the actual worth of their assets, has only made matters worse.

The alternative? Let the bondholders and shareholders of failed banks get completely wiped out.  Let a large number of failed banks go out of business. It is a complete fabrication to suggest that we need anything more than a fraction of the existing banks and financial institutions. Certainly quite a few could go under, and we’d be none the worse for the wear. Then, if there’s any additional exposure left in the remaining banks, have the problem assets be nationalized so that a healthy core remains. 

At the most basic level, the FDIC itself is a very bad idea. While protecting depositors is a good thing, the FDIC also encourages bad banks to engage in risky behaviors, because there’s no detectible reason for depositors to prefer one bank over the other. All pay essentially the same rate of interest, and all the monies are FDIC-insured.  Bad banks that take on a lot of risk make huge profits compared to their more sedate competitors.  Before you know it, perilously risky lending is the new normal.

And then the bad times hit, the bad banks are bailed out, and their safer competitors are left paying for their mistakes. And  here we are, reaping the ‘rewards’ of this well-intentioned – but ultimately destructive – government program. 

Lest you think that this moral hazard is some sort of passive by-product about which I am merely speculating, I offer you this account from March of 2009:

FDIC Criticizes Massachusetts Bank With No Bad Loans for Being Too Cautious

A Massachusetts bank that has defied the odds and remained free of bad loans amid the economic crisis is now being criticized by the Federal Deposit Insurance Corp. for the cautious business practices that caused its rare success.

The secret behind East Bridgewater Savings Bank’s accomplishments is the careful approach of 62-year-old chief executive Joseph Petrucelli.

“We’re paranoid about credit quality,” he told the Boston Business Journal.

That paranoia has allowed East Bridgewater Savings Bank to stand out among a flurry a failing banks, with no delinquent loans or foreclosures on its books, the Journal reported. East Bridgewater Savings didn’t even need to set aside in money in 2008 for anticipated loan losses.

But rather than reward Petrucelli’s tactics, the FDIC recently criticized his bank for not lending enough, slapping it with a “needs to improve” rating under the Community Reinvestment Act, the Journal reported.

Can you imagine?   Even as the credit crisis is savaging the land, the FDIC, lacking more urgent matters we guess, was busy slapping “needs to improve” ratings on the safest and soundest bank in the land. 

We wonder if Citibank got a “needs to improve” rating?   But we doubt it – and that’s the problem.

As an aside, we wonder if Sheila Bair, the current FDIC chairwoman, isn’t already grasping for a rope tied to the wharf:

Friday August 14, 2009, 6:54 pm EDT

FDIC Chairman Sheila Bair said Congress would not go along with expanding the Federal Reserve’s authority to regulate large financial companies or with giving a new consumer protection agency enforcement powers over banks.

Power to enforce rules for banks now belongs to Bair’s agency and other bank regulators.

“There’s a lot of resistance from a lot of different quarters to a lot of the things the administration has submitted,” Bair told the AP on Thursday. “That is a reality the administration needs to deal with.”

(Source)

Given what we’ve reviewed here, that would be our preferred strategy too – find a side issue to create cover for the departure.  Our appreciation for Ms. Bair’s skills just bumped up a couple of notches.  

What this means

To begin with, one thing we can be completely certain about is that the FDIC is going to need a lot more money, and soon.  While there is a bolus coming in on September 30^th from the special FDIC levy, I doubt that it will last more than 2-3 months, given the accelerating rate of failures and the number of banks that have already failed but are still operating.

I assume that the Treasury or the Fed will need to step in by year’s end to provide additional funding. Hopefully the US Treasury can continue to find adequate market demand for its ever-growing debt sales. If not? Then the FDIC will be one of many demands upon an insufficient pool of funding. And who knows how that will play out?

I also fear that this drama is just getting started.  Like an asset bubble, a banking crisis has a trajectory and pace all its own.  In the chart below from Calculated Risk, we can see that the S&L crisis that began in 1980/81 took eight years to peak and another four to subside. 

While it’s possible that this banking crisis will be shallower and shorter than the S&L crisis, I consider it very unlikely. Assuming that this crisis began in 2007/08 and that it, too, will take eight years to peak, we might expect the FDIC to find itself increasingly busy through 2019, with a peak in 2015. 

Too bad the FDIC is completely out of money already, even as this crisis is just beginning.

So how do I protect myself?

My immediate concern, should the FDIC find itself short of cash, is that it will simply turn from dragging its feet on closing banks to dragging its feet on paying out depositor claims. This means that if you have money in a failed bank, it could be tied up for quite some time.

Here’s the advice I gave last year when I wrote about the FDIC:

1. Do not keep more than $100k in any one bank account (okay, no genius insight there…)
2. Always keep 1-2 months worth of basic living expenses, in cash, out of the bank but in a safe place. This way, if the banks close down, the ATMs aren’t working, and checks won’t clear, you’ll still be able to go on with things as the crisis gets resolved. And don’t worry; you won’t be losing much in the way of interest payments on that cash.
3. Be prepared to run, not walk, down to the bank to remove your funds if the bank looks like it’s going down. Being one step ahead of the legal machinery could save you a lot of anxiety, if not your money. Here I would keep a sharp eye on the bank’s stock price, because that will give you the earliest possible warning. The FDIC is notorious (and for good reason) for keeping mum about a troubled bank prior to seizing the assets.
4. All banks are NOT created equal. Only keep your money in a Blue Ribbon bank (as rated by Veribanc in their Blue Ribbon Report ) or in one that is rated “B+” or higher by TheStreet.com. If need be, separate your holdings across several banks to assure your risk is not overly concentrated. Also, just ask around – some banks play a riskier game than their local brethren, and knowing who’s who could be a real life saver.

Another great place to check on your bank is to see if it appears on this unofficial list of troubled banks maintained at Calculated Risk.  If my banks were on that list (I use several, all highly rated, to spread the risk), I would switch to a different (highly rated, naturally) bank. 

You might also want to read my prior report on the FDIC, because it covers the legal language from the FDI Act, which unequivocally states that depositors may only be paid from money that exists within the insurance fund (which is now depleted).

Conclusion

The FDIC Deposit Insurance Fund (DIF), carefully built up over decades, has been completely depleted in the first two years of this crisis. While there’s a special levy on the way on September 30^th that will help the FDIC continue to operate for a while longer, those funds will prove insufficient to last the year.  Funds will have to be found outside of the usual and customary system of assessing a premium on bank assets.

Adding to the FDIC money woes are the already-bankrupt but not-yet-seized banks that are waiting in the wings, the mark-to-fantasy accounting gimmick used by banks to understate the true extent of losses by nearly 100%, and past losses from already-seized banks running out to be much worse than anticipated.

This banking crisis has a long way to go.  And if history is any guide, it may not peak for another 5-6 years.

The FDI Act provides for no additional source of funding to repay depositors other than funds located in the depleted DIF.  The FDIC will need to have that fund restocked by the Treasury or some other source later this year.  Smaller banks are already quite miffed about having been asked to pay higher premiums to pay for the all-too-predictable mistakes of their larger brethren. 

Because of the potential funding problems for the FDIC, I continue to advise that it is prudent to keep some money out of the banking system entirely, avoid troubled banks, and be ready to rapidly withdraw funds from any bank that appears troubled.

Stay calm, be ready; there’s more to come.