As Bank Failures Increase In The US, FDIC Has Only Two Options Left

The Federal Deposit Insurance Corp. (FDIC) will likely have tap its credit line with the U.S. Treasury or impose more special premiums on banks, to ensure U.S. banks are fully supported.

While FDIC-insured banks reported a net income of $2.8 billion in the third quarter, bank lending fell by 2.8%, the most since records were first kept in 1984 and the fifth consecutive quarter loan balances declined. The FDIC’s Deposit Insurance Fund (DIF) went into the red at the end of September and the bank insurer today (Tuesday) revealed just how steep the loss it was when the quarter ended: $8.2 billion.

“A few very large banks are making a pile of money, and the rest of the industry is hurting,” Westwood Capital LLC Managing Director Daniel Alpert said in an interview with The Associated Press. Alpert points to a variety of government subsidies, including capital injections, asset guarantees and low-cost borrowing that are costing taxpayers without improving the economy.

“We’re creating riskless profits for the big banks,” he said.

The number of banks on the FDIC’s “problem list” in the United States grew to 552 in the third quarter, up from 416 in the previous period. That’s the largest number of banks on the list since December 1993, when there were 575. For the first nine months of 2009, a total of 95 banks failed at a cost of $25 billion to the DIF.

Since the end of the third quarter, an additional 34 banks have failed, bringing the year’s total to 124, almost five times more than the 25 banks that were deemed insolvent in 2008.

The FDIC’s has set aside $38.9 billion in provisions for failures in 2010, and it will get an additional $45 billion by Dec. 30 from three years’ worth of prepaid assessments, giving the DIF $83.9 billion.

However, FDIC officials anticipate bank failures will cost the DIF $100 billion in the next five years, leaving the FDIC with two options:

• Draw on its credit line of up to $500 billion from the Treasury.
• Levy a special assessment on banks.

Have Credit, Will Borrow

Although the FDIC won’t need the full $500 billion in credit from Uncle Sam, any borrowing from this line will mean drawing funds the U.S. Federal Reserve doesn’t have on its books. In other words, the Fed would need to print this money, which would put further pressure on inflation and correctly be perceived as another taxpayer bailout.

In his 2010 Outlook for the banking sector, Money Morning’s Martin Hutchinson said soaring commodity and oil prices all but ensure the Fed will raise interest rates some time in 2010. But doing so will affect the very banks the FDIC insures, reducing the profitability of lending and undermine the prices of assets like houses and commercial real estate, thus causing larger bad debts.

Then there’s the political firestorm that will result from the FDIC borrowing money from the very people that own the bank deposits it protects.

“Calling on taxpayers to bail out the FDIC’s insurance fund is like asking your parents to support your crack habit,” said Money Morning Contributing Editor Shah Gilani. “There’s only one direction that moral compass will take you: down.”

If the FDIC does tap its credit line with the Treasury, it wouldn’t be the first time. It turned to the line during the saving-and-loan crisis of the early 1990s. But absent from that crisis was the $750 billion the U.S. government has already loaned to banks through the Troubled Asset Relief Program (TARP).

The American public, which struggled amid a credit crunch last fall, has already expressed rage at the Treasury’s unwritten “too big to fail” policy for certain banks such as Bank of America Corp. (NYSE:BAC) and Citigroup Inc. (NYSE:C).

More Unforeseen Premiums Would Weigh Heavily on Troubled Banks

Should the FDIC’s allotted $83.9 billion not be enough, it could once again impose more special assessments on banks as it did last spring, generating $6.2 billion for the DIF.

As the FDIC’s list of “problem banks” continues to grow, some may not be able endure the sudden decline in earnings that would come from a special assessment by the FDIC.

Banks’ income statements already have other pressures to contend with. Loan losses continued to gain in the third quarter, rising 80.5% to $50.8 billion, led by commercial real estate, the FDIC said.

Not only could a special assessment hurt banks, but it could also be counterproductive to the FDIC as it rescues the banks that can’t afford any extra expenses. The hundreds of troubled banks on the FDIC’s “problem list” won’t be able to contribute any more to the insurance fund, says Money Morning’s Gilani.

“Demanding that remaining problem banks pay higher premiums could easily force them over the brink,” Gilani said, adding that although this scenario would be problematic, “at least it attaches a much-needed dose of reality into the risk formula banks all but have abandoned in years past.”

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