Deadly Assumption #5: My Bank Accounts Are Fully Insured

July 21, 2008

[This is a re-run of an article I posted on this website in the this site's first month, in 2005: Article 91. I reprint it here without changing a word.]

When you open an account at a bank, you are told in writing that your account is insured by the FDIC. What is the FDIC? It's the Federal Deposit Insurance Corporation.

What is a corporation? It is a legal entity that is created specifically to insure its owners from bankruptcy. If the corporation goes bankrupt, the owners (investors) will be protected from further lawsuits. They lose only the money they invested in the now bankrupt corporation.

Is the FDIC a private corporation? No. It's a government corporation. So, does this make it more reliable? More reliable than what? It is as reliable as the U.S. government.

If you go to the FDIC's Website, you learn the following:

The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions for up to $100,000; by identifying, monitoring and addressing risks to the deposit insurance funds; and by limiting the effect on the economy and the financial system when a bank or thrift institution fails.

This sounds good. Depositors want someone to supervise banks. No one wants his bank to go bankrupt (bankrupt = bank + rupture).

There is another crucial question: What is the ratio between deposits and FDIC reserves?

The FDIC receives no Congressional appropriations -- it is funded by premiums that banks and thrift institutions pay for deposit insurance coverage and from earnings on investments in U.S. Treasury securities. With insurance funds totaling more than $44 billion, the FDIC insures more than $3 trillion of deposits in U.S. banks and thrifts -- deposits in virtually every bank and thrift in the country.

Let's see: $3 trillion divided by $44 billion. That tells us that the reserves are a little less than 1.5% of the money value of the insured accounts. For every dollar in an account, there is a penny and a half in the FDIC.

Or is there? If you go to the Bank Insurance Fund, Balance Sheets, June 2004, you will find that there were not $44 billion in assets, but rather $34.7 billion. Of this $34.7 billion, only $12.3 billion is classified as "Available-for-sale securities." These were U.S. government securities. Most of the portfolio ($19.4 billion) is invested in "Held-to-maturity securities," meaning U.S. government bonds: high interest rate assets.

As to where the missing $6.3 billion in assets ($44b minus $37.7b) are, the balance sheet does not say.

So, to insure $3 trillion in deposits, the FDIC has in ready reserve about $12 billion in government T-bills. To get its hands on this money during a banking crisis, the FDIC must sell these T-bills for cash. To whom? At what discount? Where will buyers get the money?

At some point, the Federal Reserve System would step in and buy the FDIC's liquid assets. But how long would $12 billion, or $37.7 billion, or even $44 billion last in a true banking panic? Not long.

The bottom line is this: your bank accounts are insured unless there is a banking crisis. Then, you must hope for the best.

The greatest threat is a gridlock in the payments system. Bank A cannot pay bank B at the end of the day because bank C has not paid bank A. How could this happen? Think of what happens to banking if a terrorist group releases anthrax into a major city, killing a million people in three days, and then announces that it has targeted another city. How long would your local ATM have money inside?

It would not take an act of terrorism. It came close in the summer of 1998, when the hedge fund, Long Term Capital Management, almost went bankrupt. The New York Federal Reserve Bank intervened. An officer called major American banks and suggested a meeting in which they would extend billions of dollars of extra credit to LTCM. In justifying this decision to Congress in October, 1998, FED Chairman Greenspan said this:

It was the judgment of officials at the Federal Reserve Bank of New York, who were monitoring the situation on an ongoing basis, that the act of unwinding LTCM's portfolio in a forced liquidation would not only have a significant distorting impact on market prices but also in the process could produce large losses, or worse, for a number of creditors and counterparties, and for other market participants who were not directly involved with LTCM. In that environment, it was the FRBNY's judgment that it was to the advantage of all parties--including the creditors and other market participants--to engender if at all possible an orderly resolution rather than let the firm go into disorderly fire-sale liquidation following a set of cascading cross defaults.

Notice his phrase, "cascading cross defaults." This is another phrase for "payments gridlock."

The FDIC will be helpless to deal with such a scenario.

This is why wise investors are not totally dependent on insured bank accounts to provide their liquidity -- money -- in a banking crisis. They have other strategies: the kinds of strategies that are discussed on this website. That is why I created this website.

Meanwhile, don't forget to subscribe to my free Tip of the Week report, which is sent every Saturday morning. The sign-up box is on the Home page.