from Money Morning, my usual "What the hell is wrong with our government, the sky is falling" web site
[Editor's Note: The Federal Deposit Insurance Corp. insurance fund that protects your deposits is $20.9 billion in the red. One of every 11 U.S. banks is in trouble. And it's going to get worse. Neither the FDIC, the Federal Reserve nor the Treasury Department will 'fess up that what's fueling bank failures is a risky form of funding called 'brokered deposits." Industry insiders refer to them as 'hot money." Credit-crisis expert Shah Gilani spent months investigating the often-murky world of hot money. This story is excerpted from an in-depth report, which readers can access by clicking here.]
By Shah Gilani, Contributing Editor, Money Morning
When the Federal Deposit Insurance Corp. (FDIC) released its list of 'problem banks" this week, 702 institutions holding $402.8 billion in assets were found to be in trouble.
That's the longest list in 17 years, and it's only going to get worse. In fact, regulators are expecting the number of troubled lenders to grow at an accelerating rate this year. They claim that an uptick in commercial-real-estate losses will serve as the key culprit.
But the real culprit – the one that regulators won't talk about publicly – is the funding scheme banks employ to load themselves up on speculative loans. This scheme – far removed from most investor radar screens – has played a major role in the banking sector's growing woes, and will continue to contribute heavily to bank failures in years to come.
The centerpiece to this risky funding strategy is a funding vehicle known officially as a 'brokered deposit." However, due to the narcotic-like effects brokered deposits can have on a bank's balance sheet, industry insiders have adopted a more-appropriate moniker – referring to them as 'hot money."
The Birth of 'Hot Money"Brokered deposits have helped banks grow explosively from tame domestic companions into muscular monsters that are capable of ripping the face off of economic prosperity when the lending institutions blow up.
To understand all the forces at play here, we need to look back nearly 50 years.
As far back as the 1960s, depositors searching for high-yielding savings and thrift accounts were matched up by brokers who steered them to banks offering the best yields.
Say, for example, you have $1 million that you want to deposit. A 'deposit broker" would take the cash, and break it up into several smaller portions, each of them below the maximum allowed to qualify for federal deposit insurance. Those deposits would be spread among banks that are customers of the broker.
That cash provides the banks with money that they can turn around and lend. And it also provides the Federal Deposit Insurance Corp. with fees for its insurance fund.
But brokered deposits also have a dark side.
Fueled by hot-money deposits, banks too often shift into a turbocharged growth mode. They expand into markets they don't know and concentrate their loans, instead of spreading their risks. When the music stops, as it did in 2008, these banks crash and burn.
As early as 1963, regulators tagged brokered deposits as problematic. They limited any bank's holding of them to only 5% of total deposits. Regulators were worried that upward pressure on interest rates from banks trying to attract depositors would spread across the economy. Later, some brave and stalwart regulators screamed that these deposits were causing bank failures and threatened the entire banking system.
In 1984, William M. Isaac, chairman of the FDIC, personally identified the origins of what would later become the U.S. savings and loan crisis. He railed about how S&Ls and thrifts were paying high yields to attract brokered deposits and using the money to make crazy, speculative loans and bets. He proposed killing the brokered deposits business altogether.
Banks, of course, loved brokered deposits. And they fought hard against the FDIC's initiative to kill the hot-money juggernaut.
Special interest groups were intent on seeing the brokered-deposit business flourish. And they'd already won some extraordinary trophies.
The Deposit Institutions Deregulation and Monetary Control Act of 1980 proved to be their first bonanza. It removed the 5% limit on brokered deposits imposed by regulators in 1963. It phased out a ceiling on the interest rates that banks could pay. And it raised FDIC insurance from $40,000 to $100,000 (in 2008, insurance was raised to $250,000). The 1980 Act was shepherded through Congress by U.S. President Ronald Reagan's new treasury secretary, Donald T. Regan.
As fate would have it, Regan came to the Treasury Department from Merrill Lynch, which was one of the biggest players in the brokered-deposit business. Back then, it was Merrill Lynch, not Goldman Sachs Group Inc. (NYSE: GS), running on the Washington inside track.
By 1984, the party was rocking and no one wanted anyone to take away the punch bowl. The FDIC's Isaac was trying to kill off brokered deposits. So was Edwin J. Gray, chairman of the Federal Home Loan Bank Board, which regulated thrifts.
Both were slammed to the mat.
The Securities Industry Association (SIA), a lobbying powerhouse, joined deposit broker First Atlantic Investment Corporation Securities Inc. (FAIC), and sued to repeal the initiative. The duo won a quick victory. FAIC would later have the dubious distinction of having brokered the second-largest amount of deposits into thrifts that would subsequently fail.
A total of 1,043 thrifts failed during the S&L crisis. Taxpayers were stuck with a $124 billion cleanup bill.
The memory of it still haunts Isaac, the former FDIC chairman.
'The record of the 80's is clear," Isaac told me in an interview. 'We got flat out opposition from Treasury and Congress refused to back the regulators."
Little has changed since then: Special interests continue to steer us straight at the icebergs.
Promontory's business: Brokering deposits.
When Bloomberg Markets magazine asked Seidman about the nature of the company he'd joined, he conceded there would be critics. But he had an answer ready.
'The question can be raised: `Is this what the government wanted when they put in deposit insurance?'," Seidman told his interviewer.
But then he answered his own question by stating that 'one man's loophole is another man's God-given right.''
Promontory Interfinancial is a rising star in the brokered-deposits business and is also a powerhouse special interest machine. Its list of founders reads like a 'Who's Who" of financial-sector regulation, and includes:
They know how the system works.
I asked Jacobsen, Promontory's co-founder, president and chief operating officer, about creating the firm and what it meant to be in the business. His response: 'The fact is, I have a different perspective now than I would when I was a former regulator."
Jacobsen makes an eloquent case for Promontory's business model. Although the firm has a product that mimic's traditional brokered deposits, Jacobsen's brainchild is actually a product called the Certificate of Deposit Account Registry Service, or CDARS.
CDARS are 'reciprocal deposits." They allow local banks to bring in large depositors who might otherwise shop their funds around through other deposit brokers. The large deposits are broken up through CDARS and spread out across Promontory's member network of nearly 3,000 banks.
The bank receiving the large deposit doesn't miss out. It gets back an equivalent sum in small deposits from the network to use to fund its loan book and assets.
Promontory recently persuaded the FDIC to separate reciprocal deposits out from a calculation of total brokered deposits held by any one bank. Brokered deposits are subject to additional FDIC levies when the agency calculates what a financial institution must pay into the deposit-insurance fund. However, in spite of being statutorily defined as brokered deposits, CDARS won't be counted as such when the FDIC calculates those additional assessments.
This exception isn't lost on other banks, says Sherrill Shaffer, a professor of banking and financial services at the University of Wyoming who is also a former chief economist of the New York Federal Reserve Bank – and a one-time head of the Department of Supervision, Regulation and Credit at the Federal Reserve Bank of Philadelphia.
'When losses go up at the FDIC, premiums (on brokered deposits) go up in the next quarter," Prof. Shaffer said. 'So any banks not using CDARS end up cross-subsidizing those that do. To get around that, they have to sign up."
Financial Intrigue – Internet StyleIn the brokered-deposit universe, the deepest black hole exists in cyberspace.
A constellation of special interests is pushing brokered-deposit services. The weapon of choice is a powerful device known as 'listing services."
Listing services are nothing more than a cyberspace bulletin board where banks that advertise the rates on their certificates of deposits (CDs) can be linked up with consumers or institutions searching the Internet for the highest yields for their savings.
But it's also a gravity-free zone where the mere press of a button can cause 'hot money" to jump from one bank to another – effortlessly and instantaneously.
In spite of that reality, listing-service money isn't counted as a brokered deposit. Instead, it's counted as a 'core deposit" – which regulators define as a 'stable source of funding" for lending.
But here's the reality:
1. Listing-service deposits are hot-money deposits advertised by banks that have to be rolled over or replaced when CDs mature. Far from being stable, these deposits actually create liquidity issues for banks.
2. Because they are hot money disguised as core deposits, listing-service deposits can also mask capital-adequacy issues at a bank.
3. Failing to distinguish between core deposits and hot money makes it tougher to assess risk at banks that accept those deposits.
4. Because listing services are incorrectly classified – despite their risk – banks don't have to pay the higher deposit-insurance premiums assessed on other hot-money deposits. That means the FDIC isn't paid for the additional risk it's taking on by insuring these higher-risk deposits.
5. Because listing services are counted as something that they're not, no one really understands the effect of listing-service deposits on bank operations.
The Search for SolutionsThe argument over brokered deposits, listing-service deposits and reciprocal deposits is a heated one.
While there may be nothing wrong with the public seeking high yields and government guarantees on their bank deposits, there is something wrong with what banks do with the funds they gather. Of course, there wouldn't be any problems if regulators were doing what they were supposed to be doing, monitoring the risks and growth trajectories of the banks that had funded themselves with hot money.
Advocates and the special interest groups that have protected, proliferated and profited from brokered deposits have a long list of reasons that banks should be permitted to continue their use. What's more, advocates say, it's not the brokered deposits that cause banks to fail: It's bad management of those assets that causes such failures.
The University of Wyoming's Prof. Shaffer sees it this way: 'The use of brokered deposits in some cases fund rapid growth, which has its own risks and in some cases substitutes for an outflow of deposits from individual depositors who are becoming concerned about the health of the bank," he said. 'In either of those applications, the use of brokered deposits can permit a bank to take on more risk than it otherwise would and that's the main way in which moral hazard arises."
The question to ask is this: Will the use of brokered deposits and other variable-cost and hot-money funding schemes be promoted as part of a policy to attempt to grow our banks out of this crisis?
Hopefully not: That strategy didn't work in the 1980s, didn't work recently, and won't work in the future.
But there may be a way to save us from more boom-to-bust cycles.
What if we took away the inside track of special interests that profit on the backs of taxpayers by insuring all bank deposits? What if we break up all the 'too-big-to-fail" banks and spread their pieces around the country to place credit closer to folks on Main Street?
What if we rewarded banks that made good loans and financed jobs, manufacturing, product innovation and productive service industries with tax incentives that they could use to lower the cost of credit to deserving borrowers or pass along to public shareholders? What if we facilitated our banks competing with other global players by making them share and diversify the risks and rewards associated with loan origination, underwriting, securitization and product innovation? What if there wasn't more or less regulation, just effective regulators doing the jobs they were supposed to be doing?
Jacobsen, the former FDIC chief of staff and Promontory co-founder, may have cut to the heart of the issue when he stated that no sweeping fix exists.
'Moral hazard is where the money is," he said.
[Editor's Note: This article is excerpted from Shah Gilani's special investigative report,'The Cold Truth About 'Hot Money:' How Brokered Deposits Became the Third Rail of the American Banking System." Among its revelations, the report presents the inside story on how back-dated accounting allowed IndyMac Bank to keep taking in brokered deposits before it failed, costing the Federal Deposit Insurance Corp. (FDIC) $10.4 billion. It portrays how Ally Bank propped itself up with its TV commercials (if you watch TV, you've seen them) and its Internet grab of brokered deposits.
Gilani, the report's author, is a retired hedge-fund manager who is also a well-known expert on the global credit crisis. In researching this report, Gilani conducted hundreds of interviews — which enabled him provide insights that just aren't available anywhere else. Check out the entire report. It's available – free of charge – by clicking here.]
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By Shah Gilani, Contributing Editor, Money Morning
Sooner or later, mounting losses on commercial real estate could crash through the market's 2009 optimism and send the economy and stocks into a double-dip downturn.
The major problem is that lawmakers and regulators are setting up investors into believing that commercial real estate (CRE) losses are being effectively addressed. The truth is that escalating losses are being hidden as part of a campaign of optimism in a desperate gamble that a robustly reviving economy will save the day.
To protect yourself from another investment beating, here's what you need to know.
Two weeks ago, a bipartisan group of 79 members from the U.S. House of Representatives sent a letter to U.S. Treasury Secretary Timothy F. Geithner and Federal Reserve Chairman Ben S. Bernanke. The lawmakers want the public to know that they are concerned that the "commercial-real-estate industry has the potential to infect our economy and slow a recovery," according to Rep. Paul E. Kanjorski, D-Pa.
Kanjorski, the chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises (GSEs)- which includes the likes of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) – says it's the administration's responsibility to make sure that happens. "The Treasury and Federal Reserve now must take needed and urgent action to stave off a potentially devastating wave of commercial real estate foreclosures and bank losses," Kanjorski said.
So in keeping with how effectively overseen and transparent our capital markets, insurance industry and GSE institutions are, the lawmakers want more accounting gimmickry to be made available to banks that hold commercial-real-estate assets. The lawmakers are concerned that banks may be forced by some regulators to write down the value of performing loans, even when payments are current. And these elected officials want more latitude for banks to manipulate recently issued CRE loan-modification guidelines.
Just what recently issued CRE loan modification guidelines are we referring to?
The tooth fairy commeth. On Oct. 30, bank, thrift and credit-union regulators very quietly gave lenders flexibility in how they classify distressed commercial mortgages. Banks can now slice distressed loans into performing and non-performing loans, and institutions will magically be able to reduce the total reserves set aside for non-performing loans.
For example, let's assume that a developer borrowed to build a shopping mall, but only one tenant leased space in the finished project. Cash flow from the project would be insufficient to service the loan, meaning the lending bank would have to set aside reserves against the total loan. Under the new guidelines, however, the mall loan actually could be carved into two loans – a performing loan representing the rented space, and a non-performing loan that represents the empty space.
Theoretically, with fewer reserves having to be set aside, bank balance sheets would look better, leaving lenders with more cash available for loans. But the reality might be very different. Granted, this accounting hocus-pocus might well stave off some bank failures. But with the overhang of non-performing loans still on their books, will those banks really be eager to lend out their precious cash?
That's not the only concern, either. The fact that lawmakers don't want to force banks to write down "performing loans" should be a cause for concern among investors. It's like the riddle: If an airplane crashes exactly on the border of two states, where do you bury the survivors? Hint … you don't bury survivors. And, you don't have to write down performing loans – unless, of course, they're not really "performing."
What's really happening with performing loans is a game called "extend and pretend." When most banks make commercial loans they include an "interest reserve." The reserve amount is part of the total loan, and it is there so that banks can pay themselves their interest until the project generates enough cash flow to start paying interest and principal.
The unvarnished truth is that innumerable commercial loans are in distress right now because projects aren't being finished. And if they are , tenants aren't leasing. So rather than write down the loans, banks are extending the terms of the debt with more interest reserves included so they can continue to classify the loans as "performing."
Hiding behind the extend-and-pretend game is the dark reality that property values have declined at an alarming rate – racing ahead of the rate at which banks are writing down these loans.
Nor is that the only concern. Because interest reserves do not repay any of the loan principal, there is no amortization on these debts. In other words, banks are extending loans that they would never make now, because borrowers are already grossly upside-down.
But let's be real: There isn't enough time on any clock to ever win that race.
Why do I say that? Because, in order for the United States to rebound to a full-employment rate of at least 5%, the nation's economy would have to create 200,000 jobs per month – for seven years.
Although all the big banks hold significant amounts of underperforming-commercial-
Regional and local community banks have as much as 80% of their balance sheets tied up in commercial real estate, and very few other sources of significant fee income to offset CRE losses.
It's not the too-big-to-fail banks that are lending to consumers; they're too busy catering to huge corporations, enslaving the credit card borrowers they pressed into servitude with low teaser rates, and pandering to lawmakers to preserve their monopolies and their outrageous executive compensation packages.
It's the regional and community banks that lend to individuals and small businesses that are sinking fast under the weight of CRE. How are they going to be the credit providers to consumers and the backers of the small businesses we are counting on to create jobs for the country's 18 million unemployed?
Lawmakers and regulators expect to buy time for the economy to grow in order to drive up commercial-real-estate prices and save the banks that are threatened. But their rescue vehicle of choice is the banking sector that is foundering because of the growing gale of commercial-real-estate losses. So please forgive me if I label these Washington insiders as grossly incompetent, self-serving and deluded.
If we continue to chart this course, we're headed right for a double-dip downturn in the economy and in the stock market.
But there is a way out.
First, break up all the too-big-to-fail banks into "bad banks" by saddling them with all the bad bank loans. Don't worry: It won't take long for those institutions to discover how to make money from these non-performing loans.
Let these "new" institutions keep their proprietary trading desks so they can steal money from the big corporations and investment banking clients they front-run.
Cap all compensation for the top 25% of earners at those banks. And make these top-tier executives stay and work at their new employer for seven years, which is the same amount of time it takes to discharge a bankruptcy. That's only fair since bankruptcy is where these institutions force credit-card borrowers after ripping them off with hidden, retroactive fees and usurious interest rates. Phase out all taxpayer backing over the same seven years. Limit each bank's leverage and require them to add equity capital on a pre-set ratio relative to balance-sheet risk.
Spin off all big-bank credit-card operations into four regionally based trusts and make them operate as not-for-profit entities. Cap interest rates at some nationally set level above the prime rate, and make credit limits a function of income, assets and credit history. While we're at it, only charge merchants and credit-card users 50 cents each per any transaction.
Make community banks "good banks" by spreading the big banks performing loans across their balance sheets so banking is more "localized" and community-centric. Limit the size they can grow to – period. If there's additional business to be had in a particular locale, let another bank open up and help drive down the cost of services.
Create a compensation arrangement for bankers that rewards them generously for creating jobs, improving standards of living in their communities and running their banks profitably relative to standardized risk metrics.
As far as big loans and securitizing and selling asset-backed pools, make the banks syndicate and spread risks between themselves, all of them. They'll actually become experts in risk management as opposed to paying lip service to schemes like Value at Risk.
I'd like to say that I'm kidding, and that everything will work out just fine if we do nothing. But the reality is that only a comprehensive overhaul of banking regulations will save the U.S. economy and stock market from significant pain. Hiding behind accounting gimmickry is just another tarp being thrown over our problems by same special interests that got us into this mess in the first place.
This is an interesting story about the latest financial crisis, aka Mortgage Meltdown, Credit Crisis, the Day the Music Died…
Just last week, the House Committee on Oversight and Government Reform held a hearing on the U.S. Federal Reserve’s decision to directly pay billions of dollars to banks as part of its scheme to bail out insurance giant American International Group Inc. (NYSE: AIG).
According to committee Chairman Dennis Kucinich, D-Ohio, the testimony that congressmen heard just didn’t “pass the smell test.”
What really stinks about the whole mess is not only the cover-up of what really happened and why, but the inability of anybody in Congress to actually do their homework and be able to frame pointed questions and get to the truth.
It’s not complicated, but it is convoluted. Here are the facts and some questions that Congress needs to ask – and that the American people deserve straight answers to.
America’s Founding Fathers were afraid of any concentration of power in the republic. They were particularly afraid that banking interests could hijack our fledgling democracy.
And yet today, 234 years later, our Founding Fathers’ worst fears have come true. Wall Street’s stranglehold on the economy threatens our very prosperity, and the future of a truly democratic republic.
It’s high time we address the truth about Wall Street’s tyranny and set a course for a more secure economic future – one that’s anchored by a safe banking system, not a system rigged by banks.
This is a good article that delves into the banking and financial system crisis a little deeper than most I’ve seen. It’s a bitingly sarcastic look at what has happened over the past decade (or so).
This one hits close to home. I was a WaMu employee for a total of 5 years, finally losing my job as fallout from the WaMu "bank failure" that occurred in late 2008.
This video points out that, quite possibly, WaMu could have survived on its own and implies that perhaps the FDIC wanted JPMorgan Chase to take over WaMu.
I've had similar suspicions myself, thinking that there was some sort of grudge between Sheila C. Bair of the FDIC and somebody at WaMu. Was it Killinger? Rotella? Who? Anybody?
Who knows? When will the tell-all book come out? After all, this was the biggest bank failure in US history. Somebody smart should have something to say about it.