FDIC and Rewarding the Risky Banks. How a Safety Net Hides the Risk in Banking. When Your Bank is Failing or is Emerging from Failure Offer Good CD Rates.

There is a fascinating phenomenon that occurs in the banking system when capital is running short.  At least, this was the case before the government decided to be the ultimate financial backup for the entire banking structure of our country.  Places like Washington Mutual or Countrywide were offering stellar rates on various savings vehicles only days before their demise.  How can this be?  How can it be that a bank with a horrible balance sheet flooded with overpriced assets that have lost most of their value be offering above market interest rates?  Well for one, banks are allowed to chase public capital and realize that the public will put money into a bank so long as the FDIC backs up the bank.  As a saver, what do you care if the bank is insolvent so long as you don’t put more money over the insured deposit maximum which currently stands at $250,000 per account?

And this is the crux of the issue.  Only a tiny fraction of Americans even have $250,000 in savings but putting this implicit guarantee on banks even those that are failing creates the incentive for banks to offer higher rates even if their balance sheet isn’t so sound.  Let us look at some current examples:

Source:  Bankrate.com

I sorted out a list of high 5-year CD rates at current institutions.  Those that rise to the top have had their issues to say the least.  OneWest Bank is the new name of former toxic mortgage lender IndyMac that failed miserably during the crisis.  This bank ended up costing the FDIC billions yet here they are offering one of the highest CD rates.  What about Lone Star Bank in Texas?   Let us look at their track record:

“WASHINGTON – It would seem hard for a bank to falter in Houston, a city where jobs and purchasing power rose in recent years as energy prices spiked and construction boomed.

But Lone Star Bank, which opened in 2006, has rung up losses in every quarter since it started making loans. Now the U.S. government is an investor, having put $3 million into the bank last month through its $700 billion bailout fund known as TARP.

Lone Star’s chief executive acknowledges the bank got off to “a bad start” but insists it could turn a profit this year if Houston’s economy escapes the worst of the national recession. Without the public money, Lone Star might have lost some of its best customers as it pulled back to preserve capital.

The bailout “provides us the ability at a minimum to grow with our customers who are currently growing,” chief executive Bill Wilcock said. “To me, that is still loan growth in the TARP sense. But it does not mean we are going to go out to beat the bushes for as-yet-unknown customers.”

Now this is my question.  Do we even want these kind of banks to grow?  Clearly there are many other banks around the country that made prudent and intelligent bets on the economy and yet they are the banks with no bailout money.  The FDIC is rewarding failure by continuing to back up insolvent banks.  Of course, the biggest failures are the giants like Bank of America, JP Morgan, Wells Fargo, and Citi that just announced a $7.6 billion loss.  But what does the stock do?

The stock manages to pull off a 3.5 percent gain even with the horrible news.  Why?  Because the market is already factoring in that the government will do whatever it takes to keep the bank from failing.  It is a one sided bet.  If the company fails, the stock only costs $3.54 a share.  But if goes up?  The upside is enormous.  The government has effectively created the biggest call option on the banking sector.  And to be even more detailed about the issue the bondholders have yet to face any major haircuts.

Now in the next two years $134 billion in option ARMs will recast and will lead to additional foreclosures and banking losses.  You would think that this would put a damper into how things are going but instead, the market keeps moving forward disconnecting from reality on the street.  The reward system is unfortunately not serving the people.  If for example people knew that banks weren’t going to get bailed out, they would be more cautious as to where they put their money.  Instead, the message they get from Wall Street and the government is put your money in the biggest banks that actually created the crisis and forego some of your local banks that might have been diligent over the decades.  You might even get a solid interest rate.

Now I understand that we need some basic amount of insurance in banks.  That is understandable.  After all, the FDIC came about during the Great Depression when people feared all banks and would rather keep money in their mattress.  Yet to simply say this for all banks regardless of their behavior is simply an invitation for more bailouts.  The FDIC insured banks carry roughly $13 trillion in assets yet the FDIC reserve fund is insolvent.  Now how are they planning to back up all that money if banks have additional problems?  They are essentially strapping onto the Federal government and any issues that may come about will be paid out by taxpayers.  That is why Citi went up in a day it announced billions in losses.  We already backup over $300 billion in questionable assets in this bank.

So what is the ultimate cost?  At the end of this all is the banks are going to slowly crush the dollar with their improper handling of the economy.  More and more money is required to bail out banks with their bad bets.  The bad bets are still there.  They just don’t disappear.  The fact that the FDIC is backing up $13 trillion in assets with nothing should tell you everything you need to know about where we are heading.

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