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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. T his 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 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 the Carter Administraion. When Donald T. Regan was appointed the U.S. treasury secretary in 1981 by President Ronald Reagan, Regan also became chairman of the Depository Institutions Deregulation Committee, and helped push through the 1982 Garn-St. Germain Act, which furthered the 1980 act.
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.
Isaac was replaced by L. William Seidman, who ran the FDIC from 1985-1991. Ironically, Seidman later joined the board of a new outfit called Promontory Interfinancial Network LLC.
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:
· Mark Jacobsen, FDIC chief of staff from 1999-2002.
· Eugene Ludwig, comptroller of the currency from 1993-1998.
· And Alan Blinder, vice chairman of the U.S. Federal Reserve from 1994-1996.
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 mimics 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 Style
In 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:
- 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.
- Because they are hot money disguised as core deposits, listing-service deposits can also mask capital-adequacy issues at a bank.
- Failing to distinguish between core deposits and hot money makes it tougher to assess risk at banks that accept those deposits.
- 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.
- 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 Solutions
The 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 to provide insights that just aren't available anywhere else. Check out the entire report. It's available – free of charge – by clicking here.]
News and Related Story Links:
- Money Morning Special Investigative Research Report:
The Cold Truth About 'Hot Money:' How Brokered Deposits Became the Third Rail of the American Banking System. - Federal Deposit Insurance Corp:
Official Web Site. - Investopedia:
Brokered Deposits. - CDARS.com:
Certificate of Deposit Account Registry Service. - SEC.gov:
William M. Isaac. - Wikipedia:
U.S. savings and loan crisis. - Wikipedia:
Deposit Institutions Deregulation and Monetary Control Act of 1980. - WhiteHouse.gov:
Ronald Reagan. - Wikipedia:
Donald T. Regan. - Securities Industry Association:
Official Web Site. - Los Angeles Times Obituary:
L. William Seidman. - Promontory Interfinancial Network LLC:
Official Web Site. - Bloomberg Markets Magazine:
Exploiting FDIC Loopholes Enriches Former U.S. Bank Regulators. - Professor Sherrill Shaffer:
Official Home Page/University of Wyoming. - About.com:
Core Deposits. - Wikipedia:
Too Big To Fail. - The Personal Financier:
Stress Tests and Capital Adequacy Explained. - Atlanta Business Chronicle:
FDIC: Ga. banks lost $3.2 billion in 2009. - MarketWatch.com:
Almost 10% of FDIC-insured banks "troubled;"Agency's Deposit Insurance Fund had a $20.9 billion loss as of Dec. 31.
- MarketWatch.com:
Commercial mortgage failures threaten system: overseer; Losses may range between $200 billion and $300 billion, report says.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
He helped develop what has become known as the Volatility Index (VIX) - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of 10X Trader, Shah presents his legion of subscribers with the chance to earn ten times their money on trade after trade.
Shah is also the proud founding editor of The Money Zone, where after eight years of development and 11 years of backtesting he has found the edge over stocks, giving his members the opportunity to rake in potential double, triple, or even quadruple-digit profits weekly with just a few quick steps.
Shah is a frequent guest on CNBC, Forbes, and Marketwatch, and you can catch him every week on Fox Business's "Varney & Co."
He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.
Are you being dishonest for a reason? You state, "The 1980 Act was shepherded through Congress by U.S. President Ronald Reagan's new treasury secretary, Donald T. Regan". I checked the Wikipedia reference you gave, and indeed, the act was passed in 1980. However, Reagan become president in 1981. Democrats controlled congress and the presidency in the years prior (in the case of congress, for decades). It is difficult to read the remainder of an article such as this. I was interested, but I cannot check all facts. Something as blatant as this, along with the innuendo, suggests you have an… Read more »
The funds d' insurance of Federal Deposit Insurance Corp. who protect your deposits are $20.9 billion in red. I ask: with what protect my deposits are $20.9 billion in red. to say to me or is my /je deposits want refer envoiés with me costs blow costs
sing: mostafa ajjouj morocco
To Jim Brink and WIMC
And the fact that the democrats set up the republicans in another scam by repealing The Glass steagall act Act in 1999. There is a coalition here and or a pattern which the American people need to intellectualize. The two party system is a fascist state designed to usurp the American peoples liberties. Isn't it phenomenal how money can be traded for honesty and integrity even at the expense of "The Great Experiment". The banksters have certainly let the air out of Americas bag.
I am head of public affairs at Promontory Interfinancial Network. The first comment, the one from Jim Brink, pretty well sums up my reaction to this piece, too — it is totally without merit. There are so many mistakes in fact and in interpretation here that you have to assume they are deliberate. It would take far too long to refute the piece point by point, and after the first few examples, no one would care anyway. I need to set the record straight, though, on three quotes. I listened to every conversation between Mark Jacobsen and Mr. Gilani. I… Read more »
FDIC is the root of the moral hazard. What you are describing is the unintended consequences of the moral hazard legislation. Not mentioned here is the additional hazard of depositors not really caring a whole lot about bank soundness, because, after all, their money is insured. So we need *more* regulations to manage the side effects. Those regulations, of course, are guaranteed to be free of their own side effects If you want the end of bank corporatism, you have to get rid of the regulations which were lobbied for those whom benefit from the market distortions. And get rid… Read more »
What am I missing here? If you got rid of the brokers of hot money, wouldn't the depositor just spread his deposits around the different banks himself in order to stay under the FDIC protection limit? Aren't these brokers just providing a convenient service for the depositor so that he doesn't have to have 20 different accounts in order to remain FDIC insured?
I fail to see how any of this "hot money" business is relevant. The banks would still have the same liability whether the depositor deposits directly to the bank, or through a broker.
Despite the criticisms of this article, which may or may not be fair or accurate, i found this description of hot money and brokered deposits not just interesting, but rather eye-opening. I had actually never even heard these terms described before, though I have heard both terms used by writers who never actually described what these terms meant. This article suggests or implies that all this hot money is really the root cause, or one of the major root causes, of our current economic crisis. If so, it is my opinion that this crisis may well re-emerge from time to… Read more »
It is unfortunate that Gilani's article may not be totally accurate relative to who said what/when. I was a privately owned mortgage banker in the 1980's and observed first hand how many of the S&L's used brokered deposits in a variety of risky ventures in an attempt to save them selves.Much the same as a person drowning grabs for anything floating.The current situation with many of our banks is the same.They will and do engage in most any approach to try and save themselves.The fed is assisting them by maintaining rates at artifical levels thereby providing the carry trade.The substance… Read more »
Gentleman, Lets get some things straight here. What we are now experiencing are the after effects of deregulation and increased spending on the part of the controlling political party without an requisite increase in taxes. In my opinion, his started in the Reagan years and went through Bush I and Bush II when the party in control cut taxes to some of the wealthiest people in the country, while repeatedly increasing spending. Now we are faced with many of the same consequenses that the Hoover Administration faced from 1929 until they where voted out of office in 1932. However, because… Read more »
At first I was skeptical, but managed to hold it at bay. When I got to the Reagan and Regan thing my skepticism won the day. Three minutes of Googling confirms what others have already found: The bill was signed by Jimmy Carter on March 31, 1980, while Ronald Reagan was still running for president in his first election, and Don Regan was busy running Merrill. With such a glaring error I didn't bother to read any further and skipped to the comments.
From Shah Gilani Mr. Brink, thank you for your comment. You are correct that the 1980 act was passed during the Carter administration. However, Don Regan did help push through the act, as it was in Merrill's interest as well as in the interests of all the S&Ls and thrifts. When Regan became Treasury Secretary in 1981 he also became Chairman of the Depository Institutions Deregulation Committee, and helped push through the 1982 Garn-St. Germain Act, which furthered the 1980 act. As Ronald Reagan's champion of deregulation, Regan pushed the envelope wherever he could. Almost all legislation results in "unintended… Read more »
Excellent post Shah.
I had always wondered how these newer banks were able to run so many advertisements on television.
It was quite obvious that something was up. After all, how could the smaller banks offer bigger deposit returns than larger banks?
Only by taking more risk.
Thanks for this report!
In your response to the challenge that the Deposit Institutions Deregulation and Monetary Control Act of 1980 was passed during the Carter administration, not the Reagan, you said:
"You are correct that the 1980 act was passed during the Carter administration. However, Don Regan did help push through the act, as it was in Merrill's interest as well as in the interests of all the S&Ls and thrifts." Please explain how Don Regan had any position or power to push this through while Carter was president. Was this in the capacity of a lobbyist?
Thanks
Capital shifted to hot markets that couldn't generate it themselves – higher interest rates paid, must push it out the door, make all possible loans. Everything is insured – who cares what your money does when you aren't looking. How much outside money is too much? What percent? Situationally we'll know – after the fact. Can't tolerate any arbitrary ounce of prevention number that limits speculation and protects savers at large.
It is the FDIC insurance that is the fundemental driver. There is a saying here in UK "Governments should never throw money at a problem that the do not want to see increase." Sadly the UK administration frequently demonstrates the truth of this but rarely learns the lesson. Without a Federal back stop S&Ls would have to buy insurance against their loans going sour on the open market. With AIG around I cannot be positive the price charged would have reflected the risk, but I suspect it would have been closer. I also believe the shutters would have come down… Read more »
Thank you Mr. Gilani for an insight we lay folks rarely receive. Despite any real or perceived errors in the article, several truths are exposed. Free markets are less and less free as government grows and grows. Moral hazard is always backed by the innocent taxpayers who are being duped twice; by the original transaction in good faith and the last transaction in good fear. Neither the banks nor politicians face the consequences of their failed intended actions while the taxpayer faces the unintentional consequences of trusting the fascist and unholy alliance of business and government. The only true solution… Read more »
We were interviewed during Shah's investigative process. An interesting thing I found was he spent 13 1/2 pages berating brokered deposits and one of his last statements is brokered deposits weren't the problem. You certainly wouldn't come to that conclusion without reading the whole article. For the record, we are one of those companies that acts like a rate service. And I am one of those that don't believe the deposit itself is the problem, but what is done with it. Yes, a large number of banks that have failed had brokered deposits, but also a large number of them… Read more »