"Banks in Troubled Times"

by Greg Mermel, C.P.A.

Published in the "Money and Taxes" column in PerformInk on August 1, 2008

How did you choose your bank? Convenience? Family or employer connection? Their advertising good interest rates or free checking? Maybe your car dealer or mortgage broker placed your loan with them. Some people select a credit union out of leftist political principles or labor union solidarity.

All of these are appropriate factors to consider, but others matter, too.

What Does Your Bank Do?

People often assume all banks are interchangeable: "they all take deposits and make loans, so what's the difference?"

To me, that is rather like saying all members of Actors' Equity are interchangeable: "they all act, and pay their dues, so what's the difference?" We all know better. Some actors have greater range than others, but clearly there are limits. You won't see Ian McKellen and Idina Menzel up for the same roles.

Same with banks. Does your bank do what you need?

Few banks will turn away the random customer who wants to open a checking account. But some banks see that sort of average "retail" customer as their core business. Others see the checking account business almost as an accommodation for their wealth management, or investing, or commercial lending customers.

Bigger differences abound on the lending side. Car loans, for example, are seen as retail banking much like checking accounts. Some banks eagerly seek that business. Others promote those loans only to their existing customers. And a few will make them, if pushed, but only for their existing customers -- and will even tell them that they can probably get better terms elsewhere. (Mine did.)

Home mortgages and credit cards are similar. Some banks do not do them, and some only to existing customers. Some will lend only to the best quality borrowers. As we have seen in the sub-prime melt down, some will -- or used to -- lend to anyone with a pulse.

That's just the retail side. Banks may also engage in investment brokerage, wealth management, commercial lending, equipment leasing, bond underwriting, construction lending, and other activities too esoteric to describe in two words. Some are safe, some not so safe, and some downright risky.

The Safety Net

Fear that your bank or your money won't be there tomorrow has recently become a factor. Media coverage of the FDIC's seizure of IndyMac Bank has been both breathless and seemingly calculated to create fear. Lists of banks that might also be in trouble are being circulated much like gossip about celebrity drug habits.

This fear-mongering creates a self-fulling prophecy. Fear that a particular bank might go under leads people to pull their money from the bank (or at least reduce their balances to federal deposit insurance limits). Once word gets out, a true bank run can start and put the institution into a death spiral.

Forget the television clips of weepy people in line, wailing that they had lost all of their savings and were desperate for even a bit of money to live on.

Here's what really happens when the FDIC closes a bank.

Before seizing a bank, they try to arrange for another bank to take over some of the failed bank's assets and most, if not all, of its liabilities to depositors. If they can't arrange that, the FDIC creates a new bank of its own, usually with a similar name. Checks will continue to be processed, ATM cards will work, and the same tellers will be behind the counters. The pieces will be sold off later, but the short-term goal is to make it as seamless as possible for most customers, especially those whose accounts were fully insured.

Holes in the Safety Net

What does not happen is that all deposits over the federal insurance limit of $100,000 are immediately and irrevocably lost. Those larger depositors are, effectively, creditors in a bankruptcy and will receive payment as the bank's assets are liquidated. In the IndyMac case, depositors received half of their uninsured balance immediately.

More will likely come. Of the 28 other banks the FDIC has closed since 2000, three eventually paid their depositors in full, and eight more paid more than 90 percent. Only three paid less than half, and there were no cases in which the uninsured depositors received nothing.

Borrowing from a Problem Bank

If a failed bank holds your mortgage or other loan, the situation is definitely "business as usual." You still owe the money, on the same terms, and continue to make payments the same way.

That's fine, as long as you can do business as usual. But if your loan was in trouble -- in arrears, trying to work a deal to avoid foreclosure -- you are in much bigger trouble now, because nobody is going to have the authority to change anything.

Flight to Quality

In nervous times, investors consistently move to safer investments, or at least those perceived as safer. The same is true with banking, and not just on the deposit side. A contact of mine at a mega-bank reports that, with scummy mortgage brokers and dubious lenders folding their tents, he is seeing both more home mortgage loan applications than a year ago, and better qualified borrowers.

Unfortunately, identifying "quality" is tough. (That's one of the reasons I am naming few names in this column.) One can argue with some justification that the true mega-banks are "too big to fail" -- that the government would prop them up if necessary to avoid a tsunami-grade ripple effect in the economy.

You could also seek banks that have very conservative lending practices that do not seek deposits from outside their natural customer base. Those brokered deposits tend to be volatile and their flight was among the triggers for IndyMac's bank's collapse.

Or you can keep less than $100,000 in any bank, and stash the rest either under the mattress in the ultimate federally-guaranteed place: U.S. Treasury securities. The Treasury securities pay better interest.

Free Offer

Every year during the income tax season, I offer free copies of my “Checklist of Potential Deductions...” for those in the arts. Just call my office, or send an email to checklist@gregmermel.com.

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