Sunday, October 18, 2009

Nearly 100 banks have failed so far this year, pushing the Federal Deposit Insurance Corp.’s insurance fund into the red for only the second time since its founding in 1933.

As the worsening commercial real estate debacle continues to ravage the balance sheets of thousands of mostly small and medium-sized banks, analysts expect hundreds more could fail before the problem abates.

“While banks and thrifts are now well along in the process of loss-recognition and balance-sheet repair, the process will continue well into next year, especially for commercial real estate,” FDIC Chairman Sheila C. Bair told the Senate Banking, Housing and Urban Affairs financial institutions subcommittee last week.

“We expect the numbers of problem banks and failures will remain elevated, even as the economy begins to recover,” Mrs. Bair said when she revealed in late September that the insurance fund’s net worth turned negative. Problem banks and bank failures “tend to be lagging economic indicators,” she said.

Mrs. Bair put those failures in perspective on Friday by noting that more than 500 financial institutions collapsed in 1989.

This year’s 99 bank failures have already cost the FDIC more than $25 billion. That’s on top of the nearly $20 billion in costs absorbed by the federal agency from the 25 banks that failed last year.

The recession has so devastated the FDIC’s deposit insurance fund that the agency has had to take the unprecedented step of requiring banks to prepay $45 billion of insurance premiums by the end of this year in order to replenish the FDIC’s coffers. The premiums would cover the fourth quarter of this year and all of 2010, 2011 and 2012.

As recently as May, the FDIC estimated that bank failures from 2009 through 2013 would cost the agency $70 billion. In late September, the FDIC increased that estimate by more than 40 percent to $100 billion.

The $100 billion projection is “about right, unfortunately,” said Scott Talbott at the Financial Services Roundtable, a banking trade group that supports the FDIC’s prepayment plan.

The deposit insurance fund’s balance at the end of June was $10.4 billion, down from more than $45 billion a year ago. It is this balance that turned negative at the end of the third quarter; final figures are not yet available.

Noting that the negative net worth of the insurance fund was “a bad situation,” Mr. Talbott called the FDIC’s prepayment plan “a creative and elegant solution.”

Rob Strand, a senior economist at the American Bankers Association, which also supports the prepayment plan, said the FDIC has devised “an aggressive plan” to generate the needed cash. “We think that will handle the problem,” said Mr. Strand, who doesn’t expect the FDIC will need to tap the U.S. Treasury for a bailout.

Even though the agency’s insurance fund is in the red, the FDIC still has money to absorb losses. That’s because the insurance fund balance is just one part of the FDIC’s total reserves that are available to cover losses. The second part is the agency’s contingent loss reserve, which totaled $32 billion as of June 30.

Just as banks set aside reserves for loan losses, the FDIC sets aside reserves for bank failures. The $32 billion in its contingent loss reserve reflects its estimate of the cost of failures expected over the next year. As of June 30, these funds were available to absorb future losses. It is this $32 billion contingent loss reserve that is expected to be depleted early next year unless the prepayment assessments begin rolling in.

The FDIC has the power to exempt institutions from the prepayment requirement if it would adversely affect the safety of the institution.

In addition to requiring the prepayment of insurance fees, the FDIC, beginning in 2011, will increase the insurance premium that banks pay. Banks pay the FDIC their insurance assessments based on the amount of deposits they hold. Currently, the healthiest banks pay between 12 cents and 16 cents for each $100 on deposit. Beginning in 2011, that annual assessment will rise by 3 cents.

If regulators declare a bank has been pursuing risky practices or is in danger of failing, its assessment is higher.

If the cost of bank failures significantly exceeds the FDIC’s projections, the agency has the option to raise premiums again, Mrs. Bair recently noted. But that decision would irritate many banks.

Earlier this year, the FDIC assessed banks an emergency charge in addition to their regular premiums. The emergency charge brought in $5.6 billion but hit the banks in their profit-and-loss columns.

The FDIC considered - but rejected - another emergency charge to replenish its insurance fund in the fourth quarter. To pay the charge, banks would have had to record the expense on their income statements, reducing their profits or increasing their losses.

Some banks likely would have had to dip into their capital reserves, which regulators have been encouraging banks to build up. Reducing a bank’s capital limits the amount of loans it can extend, something policymakers do not want to do as the economy slowly emerges from its deep recession.

Compared to an emergency charge, requiring banks to prepay $45 billion in assessments has several accounting benefits for the banks’ balance sheets.

“Cash goes out but doesn’t hit earnings, which is crucial,” said Mr. Talbott.

While banks are relatively flush with cash, and thus able to prepay the assessment, the banking industry’s overall profit performance has been abysmal in recent quarters. After posting net losses of more than $37 billion during last year’s fourth quarter, the banking industry eked out a net profit of just $1.8 billion during the first half of 2009, according to FDIC data.

In this environment, huge expenses from emergency charges would not be welcome.

The FDIC had a third option to rebuild its insurance fund - borrowing directly from the U.S. Treasury. The FDIC has authorization to tap the Treasury for up to $100 billion and has access to an additional $400 billion from the Treasury with the approval of the Federal Reserve and the Treasury secretary.

Independent banking analyst Bert Ely said tapping the Treasury would have been a better option than the prepayment plan. The FDIC could have repaid the Treasury loan from the bank fees it collects. By publicly signaling she was loath to tap the Treasury, “Sheila Bair unwisely stigmatized borrowing from the Treasury,” Mr. Ely said.

FDIC officials acknowledged they did not want to incur the stigma of yet another taxpayer-funded bailout in the wake of the bailout fatigue that has pervaded the nation.

“It’s clear that the American people would prefer to see an end to policies that look to the federal balance sheet as a remedy for every problem,” Mrs. Bair said Sept. 29 when she announced that the insurance fund’s net worth had turned negative. “In choosing this [prepayment] path, it should be clear to the public that the industry will not simply tap the shoulder of the increasingly weary taxpayer.”

In its background paper on prepaid assessments, the FDIC pointedly answered “no” to a question asking whether the plan would “constrict lending.” Some bankers disagree.

“Certainly, it’s going to limit lending,” said Mr. Strand of the ABA. Prepaid expenses “will be a non-earning asset and will not be used to build capital,” which is the foundation for loans, Mr. Strand explained.

Mr. Talbott expected the prepayment plan would have a “negligible” impact on lending. In an interview Friday on MSNBC, Mrs. Bair acknowledged that “premiums impact banks’ ability to lend.”

Even as the economy recovers, the FDIC’s finances could remain precarious for years.

By the end of June, losses had whittled the insurance fund to 0.22 percent of the $4.8 trillion in deposits that the FDIC insures. By the end of September, that percentage turned negative. Congress has mandated a minimum level of 1.15 percent, which the FDIC does not expect to reach until 2017.

Meanwhile, the FDIC’s list of “problem” banks increased to 416 at the end of the second quarter, rising from 305 at the end of March and reaching a 15-year high. Analysts expect that the list almost certainly increased during the third quarter.

Mrs. Bair put that problem in perspective in testimony before the Senate banking panel on Wednesday.

“The number of problem institutions is still well below the more than 1,400 identified in 1991, during the last banking crisis, on both a nominal and percentage basis,” she said, adding that “most [problem banks] do not fail.”

Mr. Ely is confident that banks will be able to cover all of the FDIC’s losses, but it may take seven years to rebuild the FDIC’s insurance fund. Mr. Strand of the ABA agreed.

Mrs. Bair also agrees, but she has not closed the door on tapping the Treasury.

“While we’re optimistic on the economy, if conditions unexpectedly worsen, we could reach a point when we would have to tap our Treasury line” of credit, she said late last month. “But today is not that day.”

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