Jay A. Brett, one of Craig Hersch’s law partners, writes the second and final portion of his articles on FDIC Insurance (last week) and bank failures. Today’s article focusing on what happens when the Feds take over a Bank like what occurred at IndyMac. Jay has practiced in Lee County over 35 years, with an emphasis on real estate transactions and banking law. Mr. Brett sits on the Board of Directors of Florida Gulf Bank, in Fort Myers.

Last week we discussed the concept of FDIC insurance and how it might apply to different types of deposit accounts.  First, note that I use the term “deposits” to distinguish what is at risk and what is not.  In short, assets held in deposit accounts become assets of the bank.  As such, deposits create a debtor/creditor relationship between the bank and the depositor. 

In essence, the bank creates a liability in exchange for the money it receives from the depositor which constitutes the bank’s promise to pay the amount to the depositor.  The bank then “uses” the deposits for its business purposes.  These are the “deposits” which are insured by FDIC. 

Escrow or fiduciary accounts, however, are a different animal and are not “deposits”.  They do not become assets of the bank and are segregated from the bank’s other assets.  For those, the bank is merely acting as a trustee or fiduciary, providing such services as custodianship investment management, and advice.  Ownership of these accounts remains vested in the individuals or entities for whom the bank is acting as a fiduciary, and the assets are thus not subject to the claims of the bank’s creditors. 

In the event of a bank failure, it follows that since none of the escrow or fiduciary accounts are subject to the claims of the bank’s creditors, a failure of that bank will have no adverse affect on these accounts, and they will remain the property of the account owner.

Closing the Doors

So what actually happens when a bank fails?  First, some background.  Regulatory bodies make a decision to close a financial institution when its capital levels fall below stated minimums, or it is determined that the bank has an inability to meet its next business day obligations. 

IndyMac Bank, a California bank which failed several weeks ago, was the third largest bank failure in U.S. history.  Although banks, in general, are suffering, there is no reason for anyone to lose confidence in the financial health of most banks.  Although, FDIC keeps a secret “list” of problem banks, unfortunately consumers don’t have access to it.  Generally, the first notice a consumer would have of a bank’s failure is when FDIC makes an announcement that the bank’s charter has been revoked and FDIC is appointed as the bank’s receiver. 

Usually, the chartering authority (the State, the Comptroller of the Currency, or the Office of Thrift Supervision) makes an announcement of why the bank was closed, and that the FDIC has been named receiver.  No prior notice is given that a bank is scheduled to be closed.  Closure notices are typically posted on the door of the bank, usually late on a Friday afternoon.  News releases are then released to the wire services so that word begins to “get around”.

Typical Scenario: Business As Usual

So what happens next?  In most cases, the closed bank reopens as a “new” bank the following Monday morning.  Typically, the bank reopens on Monday under the auspices of another healthy bank which has “purchased” the assets of the failed bank over the weekend. 

FDIC acts as a “broker” for the purchase and can be quite dictatorial in how the terms are structured, at least for the failed bank.  This is generally good news for the shareholders of the acquiring bank and bad news for the shareholders (and management) of the failed bank.  Over the past weekend, two banks operating in the western United States, First National Bank of Nevada and First Heritage Bank, N.A., were closed on Friday by federal regulators. 

A deal for the takeover of each bank was already in place, and those banks are to be reopened on Monday morning (as I write this article) as branches of Mutual of Omaha Bank.  So you see, the system does actually work.  When a bank is “sold” to another bank as a result of its failure, the effect on depositors is minimal, if there is any at all.  Although the bank may be physically closed during the weekend, customers typically have access to their insured funds by check, debit card, or ATM card.  As soon as the bank reopens on the following Monday (or shortly thereafter), checks will clear and can be used up to the FDIC deposit limit (same for debit and ATM cards). 

The important thing here is that depositors who have accounts that exceed FDIC insurance limits still have full access to their funds under the auspices of the new bank.  In other words, “no harm, no foul”, at least as far as the depositor is concerned, except for the psychological stress and the minimal inconvenience of not having access to accounts over the weekend (when the bank is closed in any event).

When No Buyer Is Immediately Found

A far more disruptive process occurs if the FDIC has not located a buyer for the failed bank by early the following week.  In that event, ATM and debit cards will be deactivated and checks not already clearing the system will not clear.  They will be returned stamped “bank closed”. 

As you might imagine, this will cause great disruption to the depositors.  If no buyer is found, FDIC begins mailing checks to the customers for their insured deposits together with a bank statement, so that they will be able to reconcile their records to determine which checks have not cleared.  For checks that have “bounced”, a depositor will have to contact the merchant to make “other arrangements” (not a pleasant scenario). 

All depositors, whether insured or uninsured, would have immediate access to the insured portion of their accounts.  However, as to any deposits which exceed FDIC insurance limits (i.e. uninsured), the depositor literally becomes a “creditor” of the failed bank’s receivership.  This means that as FDIC sells off the assets of the failed bank, periodic payments will be made to the depositors as a “class”. 

The only good news here is that depositors are top-tier creditors (along with the FDIC insurance fund).  As assets are sold, top-tier creditors must be fully satisfied before money flows down to lower tiers.  The amount uninsured depositors eventually receive will vary, but it has been estimated to range from 40 cents on the dollar to 100 cents on the dollar.  On average, it is around 72 cents on the dollar.

Even FDIC Has Unclean Hands

A shocking story appeared in The Wall Street Journal on Monday, July 21, 2008.  The FDIC, it seems, seized a bank in 2001 called Superior Bank FSB based in Hinsdale, Illinois.  Rather than simply selling off Superior’s assets as it normally does with failed banks, FDIC continued to run the bank’s mortgage department, which included making subprime mortgage loans.  This went on for months while a new buyer was being sought.  With FDIC people supervising day to day operations, Superior then proceeded to fund more than 6,700 new subprime loans worth more than $550 million dollars!! 

These loans were then sold by FDIC to other banks, and the loan pool was afflicted by the same problems for which regulators have faulted the entire industry: lending to unqualified borrowers, inflated appraisals, and poor verification of borrower’s incomes.  This begs the question, are the inmates running the asylum?  Is it any wonder that FDIC does not plan to originate any new mortgages as it operates IndyMac Bank while searching for a buyer?  By the way, IndyMac’s depositors currently have access to roughly 50% of their uninsured deposits.  Perhaps they will fare better when a buyer is found.

Is Your Bank Healthy?

So how can customers find out if their bank is at risk?  One way to track that is through the free “Safe & Sound” bank rating feature at www.bankrate.com.  This service is a proprietary system designed to provide information on the relative financial strength and stability of U.S. commercial banks (including savings institutions and credit unions).  A rating system is employed to measure the relative strength and weaknesses of a bank which is similar to the system employed by bank regulators. 

This system is generally referred to by its acronym “CAMELS” rating.  The “C” stands for capital (i.e. adequacy of capitalization of bank); the “A” stands for asset quality; the “M” stands for management quality; the “E” stands for quality of earnings; the “L” stands for liquidity; and the “S” stands for sensitivity to market risks. 

Unfortunately, these ratings cannot be applied very well to new or relatively new (”de novo”) institutions, since they have not had enough operating time to build up ratings.  Each of these CAMELS categories is then given a rating from 1 to 5, with 1 being “superior”, 2 being “sound”, 3 being “performing”, 4 being “below peer group”, and 5 being “unacceptable”.  In this current banking environment, 1’s are nearly non-existent and there are very few 2’s, although many banks do meet that criteria in selected categories.  (The Feds are hard to please, it seems.) 

Typically, if your bank has an overall 3 rating, it is considered “safe and sound”.  Anything below a 3 would be cause for concern.  If your bank rates a 5, better start lining up at the door.  While all of these factors are critical and important to a bank’s health, the one that stands out the most, and the one to which consumers should pay the most attention, in this writer’s opinion, is “M” for management. 

Although evaluating the management of a bank can be a very subjective task, businesses and consumers are advised to independently evaluate their financial institution’s senior management team to determine whether the bank is employing prudent practices and whether the management team has both experience and vision.  While it is relatively easy to guide a bank through calm waters in boom times, it takes real pros to navigate a bank through the rough waters of recession and troubled times. 

It should be noted that ratings from Bankrate are provided on an “as available” basis, and no representations or warranties of any kind as to a bank’s condition are made.  These ratings are provided only to assist customers with evaluating any given financial institution.

Although bank failures, even some on a local level here in southwest Florida, may be part of the financial landscape for the next several years, the Feds believe that there will be far fewer failures during the current crisis than the 834 institutions that failed (mostly thrifts) from 1990 to 1992.  In retrospect, it seems that we all survived nicely both during and following those times, and there is no reason to believe that we will not survive this crisis as well.