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FDIC Fund Shrinks as Small Banks Fail at Rapid Pace

By , Money Morning •

A mounting number of small bank failures is putting the squeeze on the Federal Deposit Insurance Corp.’s (FDIC) fund, but a new rule that eases capital requirements for those buying bad debt could open the door for private investors.

The balance on the FDIC’s fund that safeguards more than $4.5 trillion in bank deposits dropped to just $10.4 billion in the second quarter, as it seized dozens of small- and medium-sized banks across the country. Eighty-one banks were deemed insolvent in the second quarter, compared to 25 in all of 2008 and just three in 2007.

At the end of the second quarter in 2008, the FDIC’s fund was more than $45.2 billion.

“A decline in the fund balance does not diminish our ability to protect insured depositors,” FDIC Chairwoman Sheila Bair said.

The FDIC’s “problem list,” or banks that run a higher risk of failure, grew to 416 in the quarter, up from 305 in the first quarter. That’s the highest number since the second quarter of 1994, when there were 434 banks on the list.

Total assets for “problem” banks grew to $299.8 billion from $220 billion, the FDIC said, leaving bigger banks like JPMorgan Chase & Co. (NYSE: JPM) and Citigroup Inc. (NYSE: C) off the list. Combined, JPMorgan and Citi have assets of $3.8 trillion.

The agency isn’t ruling out raising premiums on banks for the second time this year, or drawing on its credit line with the Treasury Department, The Associated Press reported. The FDIC can borrow up to $500 billion from the Treasury, but did not say it plans to do so.

"While challenges remain, evidence is building that the U.S. economy is starting to grow again," said Bair. "Banking industry performance is – as always – a lagging indicator. The banking industry, too, can look forward to better times ahead."

But the better times may have to be postponed, as looming defaults in the commercial real estate sector continue to drag down smaller banks. The Congressional Oversight Panel, the watchdog group that was born out of the Troubled Asset Relief Program (TARP), said in its latest monthly report that toxic assets on smaller banks’ balance sheets may require an additional $12 billion to $14 billion in funds and may need a stress test of their own.

While the financial markets are showing improvement, the panel said a "continuing uncertainty is whether the troubled assets that remain on bank balance sheets can again become the trigger for instability."

Part of that uncertainty lies in exactly what amount of toxic assets remain.

“No one has a good handle how much is out there,” panel chairwoman Elizabeth Warren told Reuters Television in an interview. “Here we are 10 months into this crisis…and we can’t tell you what the dollar value is.”

A panel study showed that under a scenario 20% worse than assumptions used by the U.S. Federal Reserve’s stress tests, roughly 719 banks with assets between $600 million and $100 billion would need to raise about $21 billion in new capital to offset loan losses from mounting loan defaults.

Because of the rash of bank failures, the FDIC’s board voted Wednesday to make it easier for private investors to buy failed financial institutions. The new rules require buyers to hold at least 10% of a failed bank’s equity in reserve, down from 15%.

The FDIC will also guard against private equity funds from flipping banks, and will require investors to maintain reserves for three years.

Billionaire Wilbur Ross, whose Invesco Ltd. (NYSE: IVZ) subsidiary WL Ross & Co. LLC buys equity in troubled companies, told Reuters Television he’ll continue to invest in banks, but the FDIC’s new rules are still to tight, saying he would have preferred a 7.5% reserve requirement.

“We will now be able to be a bidder, whereas at the 15% capital level it would have been ridiculous ... We'll be in the game, but not as aggressively as we had been,” Ross said.

An equity ratio of 7.5% would still be 50% more than most banks must have to be considered well capitalized, Ross told Reuters. The new 10% ratio means returns will be about one-third less, he said.

[Editor’s Note: For more insights into the quandary facing the Federal Deposit Insurance Corp., check out this related story that appears in today’s issue of Money Morning. The story, accessible at no charge, can be accessed by clicking here.

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