The Coming FDIC Crisis

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

I am often asked how I can be positive on the stock market, yet so negative on the economy. As I’ve discussed before, the stock market’s rally is based on liquidity, meaning a tsunami of money flooding the financial system needing to find a home. I absolutely do not believe it’s based on sound and well thought out fundamental policy and systemic changes. This was my main theme in two CNBC interviews. (Click Here to Listen) They are the first two listed on the page.

My ongoing concerns are the same ones I’ve had all along. The global financial system cannot stand on its own two feet without government support, intervention and manipulation. At some point, the free money ride will end without private investment being able to take its place. That’s when the house of cards crumbles again. The Federal Reserve and Treasury used the vast majority of their immense arsenal to stem the tide in 2008 and 2009. I doubt they will be able to have the same affect next time.

One area I want to spend some time on today is the FDIC, the agency that insures member bank deposits, now up to $250,000. Along with Ben Bernanke, I believe Sheila Bair, the FDIC chairman, deserves very high marks for her handling of the financial crisis. When so many “experts” were running around with their heads cut off, she remained firmly in control, offering multiple plans on how to stem the tide and attack the crisis head on. As things began to stabilize her agency also offered some quality suggestions on proposed regulatory reform.

On Nov. 24, the FDIC (Federal Deposit Insurance Corp.) released its Third Quarter Report on member banks. It’s no secret that we are seeing more FDIC-led bank takeovers than at any time since the Resolution Trust Corp (RTC) was created to help solve the S&L Crisis in the early 1990s. So far in 2009, there are 95 insured institutions that have failed in the third quarter alone. Any time the FDIC comes in for a “rescue”, it usually means that its own capital must be employed to shore up the bank’s reserves. With its coffers already stretched to the dangerous level, another major financial problem is brewing.

If I really believed the economy and financial system were healing correctly, I wouldn’t worry so much about the FDIC. But since I don’t, and the number of “problem” banks is up to 552 ($345B) from 416 in June, some drastic measures will likely be taken. First, the FDIC can tap an emergency line of credit with U.S. Treasury, something that Sheila Bair doesn’t seem too keen on doing. Second, the FDIC can issue fixed income instruments, like bonds and notes and borrow from investors.

Currently, the FDIC is requiring banks to prepay the next three years of fees to help shore up the agency’s own capital base without having to resort to more draconian measures. While I applaud Sheila Bair’s efforts at trying to fix this with minimalist intervention, the problem is that the FDIC will take capital from the banks when they can least afford to give it up. The process of recapitalizing banks will likely take a good decade or so, but we’ll continue to see more banks fail along the way. Prepaying fees with so many institutions still capital starved will only make credit harder to come by, which is the perfect segue to the next problem.

Perhaps the most troubling thing about our banking system is that credit continues to shrink at an historic rate. In the very first sentence of the FDIC’s report, they start with the good news that member banks are making a lot of money. How could they not? If you own a bank and can borrow at essentially 0% to either loan out or invest in something paying 2, 3 or 4%, how can you lose? Add leverage into that equation and the banks essentially have a license to print profits in this environment, exactly what the Fed, Treasury and FDIC need them to do.

At the end of the first sentence, they give us the really bad news, “but loan balances declined by the largest percentage since quarterly reporting began in 1984.” According to Casey Research, bank credit has fallen by $500 billion over the past year. Think about it. That’s half a trillion dollars no longer available for lending and growth. It is nearly impossible for the economy to achieve a sustainable recovery without credit flowing freely. Almost every small business I visit or speak to share their frustration in trying to obtain a loan or line of credit. Since small business is the backbone of our economy, this doesn’t speak well for future organic growth.

The FDIC is in a very tough position, but they’re only one of the problems we face. Until we get the financial system stable and entice private capital back in, whatever growth we are currently seeing is only temporary. With state and local tax receipts falling off a cliff, the various governments need to get their own financial houses in order immediately. That means cutting unnecessary spending and keeping taxes as is or cutting them. Raising taxes without real economic growth will have disastrous implications. Tax incentives must be given to small businesses and entrepreneurs to hire workers and encourage growth. With all of our problems, there is one positive thing I am certain about. This country, economy and financial system has successfully emerged from every single crisis in our history. And this one, too, shall pass with time.

I wish you and your family a very happy, bountiful and peaceful Thanksgiving!

Until next time…

Paul Schatz
Paul@investfortomorrow.com

Bernanke & Co. Have Their Hands Full

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

As I begin to write this, the Federal Reserve just announced that the Fed Funds rate (short-term interest rates) will remain as is, in the range of 0% to .25% for an extended period. It’s the same message Bernanke & Co. have sent for almost the past year. Borrowing is essentially free to banks as Japan did for years and years and years, hoping to stimulate loan demand, money velocity and credit growth. As you may know, it’s been 20 years of poor economic growth and deflation in Japan with no end in sight. They are an aging and non growing population with a dim future.

While I totally agree with the Fed on their interest rate position, it’s FAR from enough to get us out of crisis mode for more than a few months or quarters. As I mentioned in a previous post, there have only been two real periods of deflation in the modern world, the 1930s and Japan over the past 20 years. The 1930s were “cured” with the outbreak of World War II as we shifted to a war time economy. In Japan, the government has tried almost everything with no meaningful results and no end in sight.

That’s why the Fed has thrown the textbooks out the window and show almost no concern about any inflation problem. We already have a successful modern day model from the Volcker Fed days to fight inflation. They have nothing to go on to fight deflation.

People have been outraged at the profits being reported by some of the financial companies. But in the Fed’s eyes, giving them free money to either loan out or buy low risk, higher return securities was the only way to help them repair their decimated capital bases over a period of time without injecting another trillion dollars directly into the banks. It’s no secret that the Federal Deposit Insurance Corp. is essentially broke and Bernanke & Co. couldn’t let any of the major banks force the FDIC to make emergency arrangement with U.S. Treasury. It’s bad enough now that the FDIC is going to force banks to pre-pay future fees; can you imagine the cost of bailing out Citibank and/or Bank of America?

Over the years, I’ve written my fair share of critical articles on the Fed, especially Alan Greenspan who I believe was a major contributor to the stock market crash of 1987. For all his supposed brilliance, from my seat, he left rates way too low for too long and choked off growth for too long on the opposite side. In less than 15 years, the Greenspan Fed presided over the crash in 1987, Long Term Capital debacle in 1998 and the dot.com bubble/bust in 2000.

Anyway, not to let you think I can only be critical, I think Sheila Bair, chair of the FDIC, has done an absolutely outstanding job and continues to offer creative, non partisan solutions to some of our financial woes. And since January 2008, I give Ben Bernanke et al very high marks for their handling of one of the worst financial crisis’ in history. I don’t agree with everything they’ve done, but it’s not like there’s a roadmap to follow. Prior to January 2008, I often referred to Bernanke as Rip Van Bernanke, as I was convinced the man was asleep at the switch during the very early stages of the crisis when sub prime was the main issue. I still remember his 2007 commentary about sub prime being contained and no recession was on the horizon.

Getting back to the current Fed’s behavior, it’s unlikely that rates are going up any time soon, but remember that the Fed only controls very short-term rates and affects products like your home equity line. Longer-term rates are a function of supply and demand along with inflation and are determined by the “free” market. In normal times, mortgage rates are a function of the 10 year treasury note, however, the Fed has been buying all kinds of mortgages during their quantitative easing process to put more money into the financial system.

While I would love to have been a fly on the wall during all those scheduled and emergency Fed meetings from 2007 through today, I certainly don’t envy the position they are in. They have been forced to pick their poison in what is almost guaranteed to be a very rough and rocky road for the foreseeable future. But it almost feels like this is why he was put on earth, for his lifelong academic study of the Great Depression to be put to use. I often wonder if Ben Bernanke would have taken the job had he known beforehand what he was awaiting him.

FDIC Seeks Buffer for Deposit Insurance

The Federal Deposit Insurance Corp. will require banks to prepay premiums that support insurance on depositors’ funds, due to staff projections that bank failure provisions have forced the insurance fund’s reserve ratio into a deficit as of today.

FDIC Chairman Sheila Bair is pictured at right.

But consumer deposits are still protected by cash and marketable securities that can be sold off and those assets "remain positive," FDIC staff reported Tuesday in a Board of Directors meeting.

No banks have failed in Connecticut at this point in the calendar year, according to FDIC records, but slightly under half of the 95 failures that have occurred were spread across California, Illinois and Georgia.

The FDIC insures up to $250,000 per account, but Tuesday was the first time in the organization’s 75-year history that it decided to collect fees early from banks. As of December 30, institutions would have to pay the assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012.

That is the time banks normally would pay insurance premiums only for the third quarter of 2009.

The FDIC projected that the fund will need $100 billion through 2013, an increase from the staff’s May 2009 estimate of $70 billion over the same period. "Projected failures have increased due to further deterioration in the condition of insured institutions, as reflected in the increasing number of problem institutions. Asset quality problems among insured institutions are not expected to abate in the near-term," Arthur Murton, director of the FDIC’s Division of Insurance and Research reported, to the board.

Approximately $25 billion of the $100 billion in projected failure costs already has been incurred this year and the FDIC anticipates that the majority of costs are likely to occur in 2009 and 2010.

The prepaid assessments are expected to bring in about $45 billion from affected institutions.

"We haven’t analyzed it fully yet, and at this point, it is still a proposal. But we understand it is in our interest and the industry’s interest to support the FDIC, and this looks like the best option," said Ed Steadham, vice president of public affairs for Webster Bank in Waterbury.

The FDIC imposed an emergency insurance fee on banks earlier this year which brought in about $5.6 billion. The industry opposed any additional assessments, saying that would likely do more harm than good. Such a move would directly reduce bank income, hinder capital growth, and make lending much more difficult, the American Bankers Association said in a statement.

"The pre-paid assessments represent money that the FDIC expects to receive from banks anyway over the next several years, but having the cash on hand sooner rather than later provides more flexibility for dealing with any contingencies over the foreseeable future. The bottom line is that customer deposits remain safe in banks and the FDIC has the resources needed to meet its responsibilities," ABA Chief Economist James Chessen said.

Matthew Breese, a research associate with the firm Sterne, Agee & Leach, Inc., said that from a liquidity standpoint, institutions will lose a lot of cash and cash equivalents, but on the upside, they will know what to expect, rather than the uncertainty of repeated special assessments going forward.

"We believe it was the FDIC’s best option," Breese said. "During a time when profitability is important to banks and to the economy, you can’t have this big question mark hanging over the industry."

John Carusone, president of the Bank Analysis Center, said banks will have to set up prepaid asset accounts and put capital against them for the next three years. A pay-as-you-go system would be more prudent, he said.

"There’s no assurance for the banks that paying the money upfront is going to relieve them a later burden," Carusone said. "There’s no consensus from Congress on what the new regulatory landscape will look like and we still don’t know the magnitude of future bank losses."

FDIC Chairman Sheila Bair did not rule out another option of tapping into the agency’s $500 billion line of credit with the Treasury Department, if circumstances worsen. "But today is not that day," Bair said.

There will be a 30-day comment period before the policy goes into effect.