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Taipan Daily: Three Ways to Tell if Your Bank Is Safe

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Late Friday evening, the Associated Press announced that six banks in Georgia, Ohio, New Jersey and Wisconsin were closed down by regulators:

The Federal Deposit Insurance Corp. on Friday took over the Georgia banks: Bank of Ellijay, in Ellijay, with $168.8 million in assets; First Commerce Community Bank of Douglasville, with $248.2 million in assets; and Peoples Bank, based in Winder, with $447.2 million in assets.

The FDIC also seized ISN Bank in Cherry Hill, N.J., with $81.6 million in assets; Bramble Savings Bank of Milford, Ohio, with $47.5 million in assets; and Maritime Savings Bank, based in West Allis, Wis., with assets of $350.5 million.

When regulators come in to shut a bank down, their assets get handed off to another bank or financial institution. For example, the FDIC and New Century Bank, based in Pennsylvania, agreed to share losses on $64.8 million of ISN Bank's assets.

Customers are covered up to $250,000 at FDIC-insured banks, but the insurance fund has been sagging under the weight of so many bank failures.

So far this year, we've seen 125 banks fail… That's more than the 94 this time last year, and puts us "on track" to see more than last year's 140 banks fail.

At this rate, that's one bank failure nearly every two days!

In all, 2009's bank failures have cost the FDIC $30 billion, and according to the Associated Press, the fund is now in the red $20.7 billion.

"The FDIC expects the cost of resolving failed banks to total around $60 billion from 2010 through 2014," said the AP article.

With these kinds of costs rising, is your bank safe? Is your money safe?

Here are three key factors in determining how healthy your bank is. And they're all found in your bank's annual financial statements.

Wrecking the Yield Curve

The first characteristic of a healthy bank is an "upward sloping" yield curve. A bank's yield curve is determined by the difference between deposit interest rates paid to its customers and loan interest rates paid by its customers.

Here's why an upward sloping yield curve is important.

If a bank has the majority of its liabilities in short-term deposits, and the majority of their loans in long-term loans, the amount of revenue the bank brings in will continue to increase, as it's paying out smaller interest while bringing in steady higher interest.

If your bank's yield curve is flat, that means the cash the bank's getting from its customers will be less and less as time passes. An inverted yield curve could mean the bank is losing money.

Not good for the bottom line.

For example, a bank that has $250,000 in deposits that pay 1.5% a year, and $1,000,000 in long-term loans at 4.75%, is making $43,750 a year. If we switch these numbers, we get a very different picture.

With $1,000,000 in deposits paying 1.5% a year, and $250,000 in long-term loans at 4.75%, the bank is paying out $15,000 and only bringing in $11,875.

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Is Your Bank Getting an Allowance?

One of the reasons why an upward sloping yield curve is important is because banks need to sock away for rainy days.

Because there will always be the risk of defaults, banks create an "allowance" for these bad loans.

Basically this is the bank's piggy bank. It's not money they use every day in typical transactions. This stash is used to cover their losses. And here's where things get interesting. A bank should aim to have enough "allowance" to cover all probable losses.

It's not completely necessary, as these losses can be paid from other piles, like earnings or profits.

But when you have a flat or inverted yield curve, it makes it hard to get ahead of losses, especially in a stressed economy when defaults on loans climb. Not only does the bank have to account for those losses, it has to account for the loss of revenue from interest rates, and the problem can snowball from there.

A well-provisioned bank is much healthier than one that "under-covers" its losses.

Increased Write-offs Could Be a Bad Sign

And that leads us to write-offs. These are the losses that banks incur. Obviously, the larger the amount of write-offs, the worse the health of the bank — especially relative to the allowance.

But you can take this a step further by looking at a bank's asset risks.

A bank's assets are broken into three tiers by value, but it's not a valuation based on amounts as though a $4,000 asset was tiered higher than a $2,000 asset. Rather, these assets are broken down by how measurable their value is.

Tier 1 assets are the cream of the crop, and Investopedia.com that these assets make up at least 6% of your bank's total assets. They have a clear value. It's like, for example, a car. You go into a dealership, and the price for that car is listed right on the window.

Tier 2 assets have more of an associative value. They're not as clearly defined. This would be like the loan for that car. You have one measurable value — the price — but interest rates change and fluctuate. That loan at 7% is clearly worth more (barring default) than the same loan at 4%. The point is, these values aren't set and concrete.

Tier 3 assets are even less so. These are the murky waters where value has more "moving parts" with little to no measurable value. In fact, companies with Tier 3 assets often overestimate these values, and end up taking it on the chin when they don't pan out. This would be like trying to price a car that hasn't even been made yet.

Clearly, Tier 1 and Tier 2 assets are less risky to banks. If you notice your bank's Tier 3 assets climbing as a percentage of its total assets, and Tier 1 assets drop below 6%, you might have cause for concern.

And this goes for both customers and investors, because investors are the "low man on the totem pole." They get paid last. So use these three figures from your bank's financial statements to see just how healthy it is. It could save you a lot of time and stress, not to mention money and security.

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  1. George Fink | September 26, 2010

    The error in the above scenerio is the "convertibility" of the assets. Tier one has to be immediately convertible to raise cash if needed. One factor that is critical is the "provision for loan loss" as noted. Check these against any loans deemed questionable, doubtful or any similar designation. Also look at loans for commercial real estate (particularly anything that is retail oriented as these will have the greatest exposure in the coming years. Next look at the "statement of management" in any reports. Do they recognize potential losses? Finally, the alpha and omega is the "quality of management" a subjective valuation but the most critical. Satisfaction with these will determine whether success is likely. As with any economic circumstances there is opportunity if a detailed valuation based on honest disclosure is made.

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