Safe Deposits

From time to time, I receive emails from readers of my book and visitors to this blog who are looking for specific investment recommendations or advice regarding their personal finances. My usual response is that I avoid offering opinions on such matters, as I don't think it is appropriate given how little I know about their circumstances and requirements. Occasionally, though, someone raises an issue that is likely to be of interest to many others, and I feel as though it should be addressed in some way.

Well, one question I was asked lately was what someone should do if he (or she) has a substantial sum of money in a small local bank. I said that while I couldn't really comment on the health of any particular financial institution, if he was worried about it, then he should be engaging in some sort of due diligence (like I describe in my book) to see if his concerns were warranted. I also said that, at the very least, he should have no more money on deposit in that institution than would be covered under FDIC insurance guidelines (though, ultimately, that may not be good enough, either, which I also make clear in Financial Armageddon).

As some might recall from a post I wrote last week, "The Time to Panic is When Those in Charge Say 'Don't Panic,'" there was "one thing worth noting about the crisis unfolding at British lender Northern Rock: it could happen here -- or anywhere else for that matter." However, at the time, I didn't really elaborate on the kinds of things depositors should be looking at when it comes to scrutinizing the health of the financial institutions they entrust their money to. Fortunately, in a post for MSN Money, "How Safe Is Your Bank?" columnist Jim Jubak goes some way towards addressing that issue.

Fear about the subprime-lending crisis propelled a run on one of England's banks last week. Could that happen here? Let's analyze the red flags and assess the dangers.

When was the last time you saw a bank run? Unless you're old enough to remember the Great Depression, the answer is probably never. But a lot of worried savers in England got an up-close-and-personal look at a bank run last week.

Hundreds of panicky depositors lined up outside branches of British bank Northern Rock (NHRKF, news, msgs) last week to withdraw their money. Fearing that the subprime-mortgage mess was about to swallow their savings, over three days depositors pulled $6 billion -- about one-eighth of the total deposits -- out of the bank. The run started to taper off only after the British government stepped in to guarantee the safety of depositors' money.

How likely are we to see a bank run in this country? Let me give you my best shot at answering that question.

A problem bigger than borders

Northern Rock, based in Newcastle, England, might seem an unlikely victim of the meltdown in the subprime-mortgage market.

Those of us who live in the United States are used to thinking of the rising default rates and the risky lending practices that have struck mortgage lenders such as Accredited Home Lenders (LEND, news, msgs), Countrywide Financial (CFC, news, msgs) and Novastar Financial (NFI, news, msgs) as "our" problem. But truth to tell, lenders in other hot real-estate markets, such as the United Kingdom's or Spain's, have been just as willing to lend money to all comers.

For example, one of Northern Rock's most "innovative" mortgages combines a mortgage for 95% of the purchase price with an unsecured personal loan for as much as 30% more. It makes the U.S. practice of bundling together first and second mortgages to enable a purchaser to put zero down seem, well, conservative.

Mortgages for 100% of a home's value -- let alone 125% mortgages -- stand a good chance of going bad when home prices start to fall. And that's exactly what has happened in both the United States and the United Kingdom.

A deeper look at banks

But to find the real similarities between Northern Rock and U.S. mortgage lenders you have to look under the hood at how these institutions, be they named bank or mortgage company or savings and loan, raised the money that they lent out as mortgages.Video on MSN Money

In the good old days, the days when Jimmy Stewart ran the Bailey Building & Loan Association in Bedford Falls, S&Ls and banks took in money from depositors and then lent out the cash from these savings accounts as mortgages. And, quaintly enough, the banks even held on to the mortgages, collecting monthly payments for 30 years before retiring the debts.

Writing new mortgages depended on money flowing in from new deposits, from monthly mortgage payments and from the occasional early payoff of a mortgage.

The model at Northern Rock -- and at Countrywide Financial and its U.S. peers -- is very different. Yes, some of the money lent out in mortgages may come from deposits, but most of the cash comes from the capital markets, where mortgage lenders of every stripe tap buyers of commercial paper for new cash. Mortgages don't sit on the books until they mature, and originating companies actually collect very few monthly payments on these debts. Instead, the mortgages are sold off and then turned into asset-backed securities of various flavors.

Lending faster and faster

This system supercharges the returns that financial institutions can make in the mortgage business. A company that originates a mortgage can sell it off in a matter of weeks, regain its capital (plus a fee for originating the mortgage and, if interest rates and the financial markets break right, a profit on the sale of the mortgage) and then, having freed up its capital, originate another mortgage.

That works just fine as long as the capital markets are willing to lend the mortgage companies the short-term funds that they will turn into long-term mortgages, and as long as the capital markets are willing to buy the securitized mortgages so that the mortgage lender can get the mortgages it has written off its hands and free up its capital again.

This system contains the seeds of its own destruction, however. It encourages lenders to run faster and faster. The more money they can put out in mortgages, the more mortgages they can sell or securitize, the more money they can free up for new mortgages, the more mortgages they can write, and on and on. Growth in deposits can't possibly keep up with this growth in the mortgage portfolio. So leverage at the lending institution grows and grows.

Dependence on capital markets

Northern Rock's loan book is 3.1 times its deposit base, for example. And, because loans are growing far faster than deposits, the bank's reliance on the capital markets increases as well. At the end of 2006, about 73% of the funding for mortgages at Northern Rock came from the capital markets. In the first half of 2007, its dependence had climbed to 85%.

That dependence is intrinsically dangerous because it is based on a mismatch between the lender's short-term liabilities, its borrowings in the commercial-paper market and other short-term markets, and its long-term assets, the 30-year mortgages that back the lender's debt.

The problem with this mismatch is that long-term-debt securities are much more volatile than short-term instruments. So when the market hits a hiccup, the prices of long-term debt, such as mortgages, move down much further and faster than the prices of short-term debt.

For a company that has used the price of long-term mortgages to back its borrowing of short-term paper, that can be a huge problem, as the price of debt backed by long-term mortgages collapses while the company's need for short-term cash continues. With long-term-debt prices falling, the company has less collateral to offer to back the short-term paper it needs to sell to raise capital.

The Bank of England's bailout

In a worst-case scenario, the company can find itself shut out of the short-term-debt market. If the company can't find bank loans to replace the capital from the debt markets, it has to look for a lender of last resort and hope that one of the world's central banks will decide that letting the company go under would do an unacceptably large amount of damage to the financial markets.

That's exactly what happened at Northern Rock. The company found itself cut off from the debt markets. No private buyer, after looking at the likelihood that the company needed an infusion of $15 billion to keep its business going, was willing to step forward. And so the Bank of England extended a line of credit to Northern Rock, and when that didn't calm the financial markets, announced that it would guarantee depositors' savings. (That last isn't small potatoes in a country where deposit insurance covers only $70,000 of a depositor's money.)

Northern Rock is certainly not out of the woods. It's unlikely that the bank will remain independent, and it's not clear who will buy the business that remains without some further government bailout.

I've gone into so much detail on Northern Rock because I think it gives bank depositors -- and investors -- an outline of what kind of banking institution is most likely to get into trouble. Following the Northern Rock model, a likely candidate for trouble would show one or more of these red flags:

Having a big mortgage book and a small deposit base.

In the U.S., Countrywide Financial, with $34 billion in time deposits (about $25 billion uninsured) on the books at the end of 2006 and recent monthly mortgage production of $34 billion fits that description. A bank such as Wells Fargo (WFC, news, msgs), with $270 billion in core deposits on the books at the end of 2006 and $68 billion in monthly mortgage production, doesn't.

Countrywide isn't out of danger, even after Bank of America (BAC, news, msgs) invested $2 billion in the company, but that deal does increase the odds that Countrywide will be able to tap other sources of capital if it continues to have problems securing financing in the commercial-paper market. In the U.S., though, the companies facing the biggest funding problems are those, like Novastar Financial, that don't have banks at all.

Other possible trouble spots are companies such as E*Trade Financial (ETFC, news, msgs) that dabble in banking and mortgage lending but where neither activity is a core competency. E*Trade announced Sept. 17 that it would exit the wholesale-mortgage business.

Raising the majority of its money from the capital markets.

Northern Rock's ratio in this area is well more than 70%. That's the highest I've been able to find in the United Kingdom. But ratios at Alliance & Leicester (AANCF, news, msgs), the No. 9 mortgage lender in the United Kingdom, and Bradford & Bingley (BDBYY, news, msgs), the No. 10 lender, are up near 50%.That's one reason these stocks have been pummeled in the wake of the troubles at Northern Rock. I have not been able to find a major U.S. banking institution with a ratio of 50% or more.

Not being too big to fail.

The Bank of England stepped in to rescue depositors at Northern Rock because the bank was big enough that its collapse could shake the entire financial system. Part of the worry about Alliance & Leicester and Bradford & Bingley is that, at two-thirds and one-half the size of Northern Rock, they might be small enough to fail. No one knows where the central bank in any specific country will set the bar. In Germany, we've seen the rescue of relatively small but still significant state banks. In England, we know Northern Rock makes the cut, but that's all.

In the United States? I don't know where the cutoff might be, but I'm very certain, after watching the Federal Reserve cave into the financial markets with a half-percentage-point interest-rate cut Sept. 18, that size does matter. If you do business with a good small bank -- and many run a much-better-managed operation than their bigger competitors -- use that small size to your advantage and have a face-to-face talk with a bank officer about your concerns.

Whether your bank is big or small, now's the time to read the fine print and make sure that your account is insured and to find out the limit of the coverage. (Remember that in the United States bank deposits are insured to $100,000 by the Federal Deposit Insurance Corp. The Securities Investor Protection Corp. offers different coverage for accounts at brokerage companies.)

It's a whole lot easier to do your homework now than when you're standing in the street with hundreds of panicked depositors.

Comments

[David Vige]

Fantastic post! I'd like to recommend a resource link where people can find excellent information about how to "go local" for their banking needs: www.solari.com/banks

[Zack S]

Please note that the FDIC has up to 30 years to pay back anyone who lost up to $100,000. If you get one of the brochures on the FDIC at any bank this info in in there.

[Mike Adams]

Where has all the "oversight" gone? The Bush Administration has totally abrogated its responsibilies re the "safeguarding of America" i.e. banking system in a mess; airline services in a mess; FDA inspections of foreign (China) goods in a mess; US Border Patrols (illegals) in a mess; etc etc. And we're being protected? This is the worst administration in my lifetime; combined with a spineless Congress....it can't get any worse!!