Deposit Insurance: Keeping Dead Banks Walking

0:00One of the great evils of human history has resulted from attempting to keep dying banks alive. And hundreds, if not thousands, of banks are currently on the ropes and just waiting for regulators to wrap them in yellow tape one of these Friday evenings. However, only 92 have failed. I don't know if you guys keep up on this, but 92 U.S. banks have been seized this year. here. In fact, the latest one, number 92, was right here close to you guys. Venture Bank. Any depositors of Venture Bank? Well, anyway, I don't want to know. Venture Bank in Lacey, Washington, which I understand is down in the Olympia area, was seized last evening. Pretty good sized bank, 18 branches, about a billion in assets was seized last The FDIC has 416 banks as of the end of the second quarter on their problem list, but of course they're not going to tell you what banks those are, so just don't worry about it.

1:16There's 416 problem banks out there, but we're not going to warn you about any of them. The assets of those troubled banks are nearly $230 billion. At the same time, the FDIC's Deposit Insurance Fund has fallen to $10.4 billion. So the assets of the banks in trouble is $230 billion. The Deposit Insurance Fund is $10 billion. But not to fear, the Treasury has increased the FDIC's line of credit to $100 billion in preparation for more losses. So if you include the line of credit from taxpayers, the FDIC has just over two cents of reserves for every dollar it's insuring.

2:08Now sure, the FDIC just isn't staffed up to be taking over these banks as quickly as they'd like to so but it still makes one wonder how how do they stay in business how do they remain liquid enough I mean I'm sure all of you when you're thinking about where to put your money are looking at the balance sheets and income statements of the banks right you go through the call reports you know where their loan concentrations are you know what what their delinquency rates are You know how well they're doing, right? No, of course. Nobody knows that. Nobody pays attention. In fact, Bernard Condon wrote a piece on Forbes.com called The Reverse Bank Run.

3:00And the point of the article is that Americans, as he says, Americans seeking high yields on their money are causing deposits at struggling banks to mount. In other words, if a bank is struggling, they need deposits real bad, so they offer higher rates, and that's where the money is going. The result is that banks that should fail are sticking around longer, making the cleanup more when they do finally fail. Now, like much legislation that we have that is very harmful, deposit insurance, at least on a national level, was born in the Great Depression. It was part of the Glass-Steagall Bill, formerly known at the time as the Banking Act of 1933.

3:45Of course, we know Glass-Steagall is the law that separated investment banking from deposit banking, but deposit insurance actually was very controversial at the time. The big banks were not for it, but the legislators that were for it, They thought it would guard against bank runs and failures. The small banks liked it, as you can expect. They had an opportunity to have deposits insured and they could compete more effectively with big banks. So the big bankers didn't like it. The small banks really liked it. And, of course, congressmen liked it.

4:31So even though FDR was against it, in fact he told his vice president Jack Garner, he said, Jack, it won't work, the weak banks will pull down the strong. But there was so much support amongst congressmen, senators throughout the country that they did pass Glass-Steagall with deposit insurance included. included. In fact, at the time, Time magazine wrote, and of course, Time magazine was kind of the oracle for the big Eastern banks that hated the bill, and they wrote that the big banks would see, quote, Their Deposits, which they had spent a lifetime to build up and protect with their good names confiscated by the government to pay for the mistakes and dishonesty of every small-town bankster.

5:24Wouldn't it be great if Time Magazine was writing like that these days? Gave that up a long time ago. Now the law that, of course this law would create the Federal Deposit Insurance Corporation and in fact some of the employees for the FDIC actually think it is a corporation, which sounds crazy but I know from spending many years with regulators that they would actually refer to their employer as the corporation. And one writer called the creation of the FDIC the New Deal's most important creation. Even Milton Friedman and Anna Swartz praised deposit insurance.

6:12They said the structural change most conducive to monetary stability since the state bank notes were taxed out of existence after the Civil War. FDR was said to have first endured and then embraced deposit insurance. A guy named Raymond Morley wrote a book about the first seven years of the New Deal. He wrote, I'm convinced that finally he made himself believe that he had favored it from the beginning. Now the amount of deposit insurance was originally $2,500. But within seven months, it was increased to $5,000, which is about $80,000 in today's dollars.

6:58In 1950, the amount was raised to $10,000, $66,000 to $15,000, and $69,000 to $20,000 and $74,000 to $40,000. And then there was a big change. 1980 was the year, and FDIC insurance went to $100,000, which was a big jump. Now, and this increase in deposit insurance really exacerbated problems with moral hazard. The increase to 100,000 was essentially to benefit the SNL industry, was to make them more competitive. In fact, in the absence of deposit insurance, the SNLs would have had trouble attracting deposit dollars. Thus, it was a provision of deposit insurance to institutions that they pursue these risky the activities that was and indeed still is the root cause of the problem.

7:51So rather than enclose, closing insolvent thrips, this policy of regulatory forbearance is put, was put in place. Insolvent institutions were put on life support, created these zombie firms, these zombie SNLs. Every incentive to take high risk, high return, strategies to try to earn themselves out of problem, and they were pressuring healthy intermediaries by bidding up deposit rates and lowering returns for commercial ventures. So with that all, the result was that in January 1986 through the end of 1995 was that the number of SNLs was essentially cut in half.

8:37The FSLIC, anybody remember them? Anybody remember that they had their deposits insured by the FSLIC? Well, they were declared insolvent in 1986. The FSLIC insured the SNL deposits. And as was typical of the case, the government underestimated what the amount of the problem They estimated that four hundred-fifths were going to go under, and that the cost of the taxpayer was going to be $50 billion. Bill Seidman, who died recently, said in his memoirs, only three months after the cleanup started, it was already evident that the problem was far worse than anyone in government had envisioned, including me.

9:29me, and it was getting worse every day. The economy was beginning to slide into recession. And ultimately, we were forced to take, faced with taking the most politically unacceptable action of all, having to admit that we had all made a big mistake. Cost of the SNL crisis was $130 billion. 1,043 SNLs failed. And the entity that, of course, insured those deposits was abolished, only to be taken over by, or at least the duties of insuring those deposits by the FDIC. The FDIC does that through its deposit insurance fund with the mandate that they have 1.25% of insured deposits.

10:22So every insured deposit out there, they're supposed to hold 1.25% in their deposit insurance And of course when banking was going good, banks were earning money and they were paying their dues to the FDIC and by 1996 this deposit insurance fund reached 1.25%. So what did the FDIC do? They quit charging premiums. By 2005, 94% of the banks paid no insurance premiums, because they already had enough. I mean, they already had a percent and a quarter, you know? They were fine. But of course, as I said before, as of June 30, this deposit insurance fund had dropped to $10.4 billion, and of course they're only insuring $4.8 trillion in deposits, and so So when you don't include the line of credit, they only have two-tenths of one percent of the money they need to back these deposits.

11:35And that's after they've collected $5.6 billion in a special assessment charge to the banks earlier this year. So they've taken in $5.6, they still only have $10.4, and they're insured $4.8 trillion. The math doesn't work out very well. Now Randall Krosner, and he used to be on the board of the Federal Reserve, and William Melick, they wrote a chapter in a book recently about deposit insurance, and academics have kind of a funny view of deposit insurance. They say, although the journey has been slow and at times quite painful, bank regulation has come full circle since 1933. and they essentially make the case that no limitations on branching, there's no wall separating commercial and investment bank, and so they say in such an environment and complemented by risk-graded premiums and prompt corrective action, deposit insurance is unlikely to be needed to protect the medium of exchange.

12:40Constraints on regulatory forbearance make it unlikely that the moral hazard associated with Deposit Insurance will again manifest itself in a large crisis as in the 1980s. Of course, they wrote this prior to last year, of course. So the belief of many academics is that, you know, banks' deposits had to be insured because they could only land locally, and if the local economies went down, then the deposits wouldn't be any good because the loans would be uncollected. So if banks could just be able to diversify their holding, if they would be able to engage in business, in many lines of business, in a diverse geographic area, the deposits would be protected by this diversification.

13:27And of course, we know that, you know, anything but has been the case. The failure of large geographically diverse banks and savings and loans like Washington and Mutual, Indy Mac, Colonial Bank, they prove that diversification doesn't protect bank deposits. Bankers are pressed to earn returns to shareholders, and if they're protected by FDIC insurance, they're going to lend more of their deposits, and they're going to lend them on riskier projects. Jim Grant, who writes, Grant's Interest Rate Observer, was reminiscing about National City Bank recently, and he wrote that back in 1954, National City only lent out 41% of their deposits, and they had less than 1% of their portfolio in real estate loans. Now, by the middle of this year, the total loan deposit ratio of U.S. banks was 84%, and 61% of all loans are are classified as real estate secured.

14:36So what banks have done, as FDIC insurance has increased, they've lent more of their deposits and they've lent them on riskier, more long-term projects. But there's no incentive for bank depositors to go to the trouble of determining bank soundness if the government's going to guarantee deposits. Not to mention that most folks just aren't equipped for the job anyway. Murray Rothbard pointed out in the case against the Fed that the problem with deposit insurance is that it's a fraudulent application of the honorific term insurance to schemes such as deposit guarantees. I mean, insurance, when it's applied properly, it works to control risk against failure of unknown calamities.

15:30And it's where the incidents can be predicted accurately in advance. In other words, there's insurance underwriters who are able to analyze large pools of insured and determine that, you know, a certain number of people's houses are going to burn down or a certain number of people are going to get cancer or whatever they may be. They don't know who it's going to happen to, but they know a certain number of these calamities are going to happen. and they can pay out on these premiums once these calamities happen. But the insureds must be divided into separate risk classes. That's based on the information about the insured. Those insured who are more likely to have a claim, they need to be charged higher premiums. Those that are less, they are charged less.

16:18Now if the law requires that the premiums be the same, this isn't insurance. It's coerced redistribution of income and wealth. This might apply to something else that's been talked about this week. Also the calamities must be beyond the control of the insured, otherwise there's a moral hazard problem. Insurable risks such as death, accidents, health emergencies, they're homogeneous, replicable, random events that can therefore be grouped into homogeneous classes. But actions and events on the market are not. They're heterogeneous. And they're not random, but influencing on each other. Therefore, they're inherently uninsurable. And it's for the entrepreneur to assume those uninsurable risks in the marketplace, not for some insurance character. If no business firm can be insured, Rothbard writes, then an industry consisting Banking of hundreds of insolvent firms is surely the last institution about which anyone can mention insurance with a straight face. Deposit insurance is simply a fraudulent racket, and a cruel one at that since it may plunder the life savings and the money stock of the

17:42entire public." So, you know, one wonders when FDIC Chairwoman Sheila Baer had a straight Face when she wrote the conclusion of the FDIC's Depositor Bill of Rights. She writes, the banking system in this country remains on solid footing through the guarantees provided by FDIC insurance. The overwhelming majority of banks in this country are safe and sound, and the chances that your own bank could fail are remote. However, if that does If this happens, the FDIC will be there, as always, to protect your insured deposits." Just like FSLIC was, right? Sheila Baer makes it sound like bank failures happen at random.

18:36Every once in a while, one's going to happen. She should go to Atlanta sometime, where I I think 20% of the bank failures have happened. Now, a legitimate banking system would begin and be based on honoring property rights. Customers making a deposit in a bank would expect that the bank to guard its deposits, protect it, return his or her money at a moment's notice in the case that the man deposits. After all, the person has not traded a present Good for a Future Good. When you put money in the bank, in a deposit account, demand deposit account, you assume you can go get that money the next day. And they should keep it there and make sure that it's there. That's not what a bank does. Put a dollar in the bank, they loan out 90 cents of it right away. They assume that not everybody's going to show up at once to get their money. When everybody does, it's called a bank run, the bank's out

19:36So the average depositor believes that the bank is warehousing the money and it's available for a many time. A deposit's not a loan. You don't make a deposit and the bank says, okay, you can have it till next week and then I want it back. It's available all the time. Now some people that are sympathetic to fractionalized banking say that while CDs are in for a certain amount of time. That's like a loan. And that's true. I mean, if you put money in a bank for six months or a year in a CD, then that is a loan to the bank. But I don't think you're giving the banker, I don't think it's your intention to say, well, lend it to ex-real estate developer to build a high-rise condo project that may take five years to complete.

20:31that maturity doesn't necessarily match up with the deposit. And what's happened with legitimate banking is that we now have what's known as fractionalized banking that I think Walter referred to earlier in the day, combines deposit banking with loan banking. In other words, as I described, you put money in the bank, they turn around and lend it out to somebody else. So instead of guarding the safety deposits, banks embezzled the deposits and lent them out. The 92 recently failed banks lent their deposits primarily on construction projects or other real estate projects, and they turned out to be duds. Yet as these banks spiraled toward failure, most were still attracting lots of deposit dollars. In fact, the Forbes The fourth article cites three banks where their brokered deposits doubled or tripled in the months leading up to them being seized.

21:29And that's all because of FDIC insurance. Problem banks desperately need these deposits unless they pay the highest rate. And as the author of the Forbes article writes, and many people apparently either don't know about the bank's troubles or more likely they don't care because the FDIC is committed covering the deposit within its insurance limits. RBC Capital's Gerald Cassidy, he's predicted there's going to be 1,000 bank failures. He says that he scans bankrate.com to identify the banks paying the highest rates to determine who's going to fail next. And of course, high on this list is Chicago-based Corus Bank shares. And up until today, they were paying a half and half a point higher for deposits than their competitors.

22:20But as of last night, Corus Bank was seized by the regulators in Chicago. They failed last night. They're one of the biggest failures of the year, $8 billion in assets and 70 branches. So, anyway, Corus was finally taken down last evening. During the boom, Coors was an aggressive high-rise condo construction lender. They lent in Miami, in Las Vegas, wherever it was hot, and now it's not, they were lending on high-rise money. Actually, half their loan portfolio was on non-accrual. That means they weren't collecting interest on half their loan portfolio. That will not work out very long.

23:10So it's no wonder that when banks have failed here recently that the cost to the FDIC fund has been much greater than it was during the S&L crisis. It's equal to about a third of the seized assets. And again, the reason is the higher FDIC insurance rate creates a situation where they're paying out higher and higher losses. and there's many analysts that say because of that the FDIC is in trouble and the pure numbers would would bear that out and to keep keep today's zombie banks alive massive amounts of bank intervention has been required. Last year's panic the Fed wheeled out the money market investor funding facility the asset commercial paper money, money market mutual fund liquidity facility, it raised the ceiling on deposit insurance from $100,000 to $250,000 for interest bearing deposits.

24:18The insurance for non-interest bearing deposits is unlimited and the Treasury also provided to Blanket Guarantee for Money Market Funds. So since the downturn last fall, we've had a huge intervention, and again, the moral hazard problems that appeared in the S&L crisis is going to appear again. Jesus Forto de Soto explains in his book Money, Bank Credit, and Economic Cycles that ultimately Every fractional reserve banking cannot survive economically on its own. It must be supported by government force in the form of a central bank, which institutes the regulations and supplies of liquidity necessary at all times to prevent the entire apparatus from collapsing.

25:16When loans are made that are not backed by real savings, but by just appropriating deposits, That fosters the foolish investment of resources that give rise to unwisely invested business assets which are either worthless or of limited value and therefore incapable of balancing the corresponding deposit accounts on bank balance sheets. Thus, bank insolvencies are always going to tend to occur with fractionalized banking. Now every time you read about a bank failure, the regulators are going to say three words.

26:01They're going to accuse failing banks of operating in an unsafe and unsound manner. But what is really unsafe and unsound is fractionalized banking. The lending out of embezzled deposits with the state's permission under the cover of the fraudulent racket known as deposit insurance. Thank you.