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Credit Crisis Safety Plays: Banking Ratings Report Can Provide Peace of Mind and Warn You if Your Bank is Weak

Nov 14, 2008
Credit Crisis, Keith Fitz-Gerald

By Keith Fitz-Gerald
Investment Director
Money Morning Investment News/The Money Map Report.

When federal banking regulators last week seized the Houston-based Franklin Bank SSB (FBTX), it became the 18th bank failure this year amid the ongoing credit crisis. With total assets of $5.1 billion and total deposits of $3.7 billion, Franklin wasn’t the largest bank failure this year – that honor belongs to IndyMac Bancorp Inc. (OTC: IDMCQ), which had more than $30 billion in estimated assets when it was seized by U.S. banking regulators in July. At the time, IndyMac was also the third-largest bank failure in U.S. history, reaching all the way back to 1934, U.S. News & World Report said at the time.

That begs the question: Is your bank safe? And perhaps a second question: Why should you care? After all, aren’t deposits guaranteed by the Federal Deposit Insurance Corp. (FDIC)? And weren’t the limits on covered deposits raised from $100,000 to $250,000 as part of the $700 billion banking bailout deal?

Those all are true points. So long as we continue to see a bank failure here and another one there, everything should be copacetic.

But here’s the thing: By the end of 2009, about 110 U.S. banks with assets of more than $850 billion will fail – and that could cost the FDIC as much as $200 billion more than it has, Christopher Whalen, co-founder of the Los Angeles-based Institutional Risk Analytics, a risk-management and consulting firm with an expertise in the financial-services industry.

Most banks are fine, IRA says. But even industry insiders say the banking business is in for some rough times.

“It’s not going to be Armageddon,” Mark Vaughan, an economist and an assistant vice president for banking supervision and regulation at the Federal Reserve Bank of Richmond, told Bloomberg Markets magazine recently. “But it’s going to be bad.”

If bank failures accelerate, and the FDIC insurance fund goes bust, there will probably be a taxpayer bailout. But no one knows what form that could take or what the payout ratio might be. And industry experts do expect dozens of banks to fail in the months to come.

So why take the chance?

You shouldn’t. But how can you tell if your bank could be one of them?

Ironically, if you look to the Federal Deposit Insurance Corp. (FDIC) for guidance – as most investors do right now – you won’t have a clue. That’s because its list of so-called “troubled institutions” is a closely guarded secret. The FDIC will tell you that 117 banks were on the list recently, up 30% from 90 at the end of the first quarter. And, in its desire to be ever so helpful, the agency also will tell you that the combined assets of troubled banks recently rose to $78 billion, a jump of 200% from only $26 billion at the close of the first quarter. Capital-loss provisions rose 240% to $50.2 billion.

But the FDIC won’t tell you – no matter how politely you ask – which institutions are most at risk (nor which are the healthiest) even though the government has this information at its fingertips. The FDIC says that it maintains this secrecy to prevent a run on troubled banks and enhance the overall stability of the banking community.

To me that seems an awful lot like asking investors to buy insurance after they’ve crashed their car.

So, we’ve got to turn to other sources in an effort to protect our capital.

One of our favorites is the IRA Bank Industry Stress Index published by Whalen and his colleagues at Institutional Risk Analytics. What makes the IRA Stress Index so compelling is that it’s based on the FDIC’s own data. That means it’s sort of like a financial X-ray that allows you to see what’s really under the hood – even though the government won’t tell you.

“Problems in the financial industry are of a scale that most people simply can’t imagine,” Whalen says. “Existing ratings and research coverage are clearly inadequate. That means we’ve got to come up with new ways to look at bank safety and soundness – particularly when it comes to increasing consumer awareness of transparency. And safety.”

Martin Hutchinson, a fellow editor here at Money Morning and a 30-year veteran of the banking industry, agrees, noting that “knowledge, after all, is power. Particularly when consumers are caught in the middle like they are now.”

Although this financial intelligence originally was designed for institutions trying to make sense of the FDIC’s database, IRA recently created a personal report that allows individual investors to X-ray their own banks. Available for $50, the report classifies data into six broad categories at combine to create what IRA calls the “Key Safety and Soundness Indicators:”

  • An overall “Stress Rating.”
  • Return on Equity (ROE).
  • Loan defaults.
  • Capital.
  • Lending capacity.
  • Efficiency.

In contrast to other free services that simply provide a numerical grade or a star ranking without much in the way of helpful context, IRA provides an industry benchmark for each category so that investors can make “apples-to-apples” comparisons between banks. It also helps investors judge for themselves how risky any U.S. financial institution tracked by the FDIC actually is – or isn’t.

Whalen notes that the IRA model frequently provides early warnings, too. In the early months of 2006, for instance, he noted that the “Overall Industry Banking Stress Index began climbing at a time when most of Wall Street was in denial.”

Pointing to a sample report on Washington Mutual Inc. (OTC: WAMUQ), which he shared with Money Morning, Whalen said that, “in June 2008, just before Uncle Sam crashed WaMu’s party, the beleaguered bank had an Overall Stress Rating of 21.6 – versus an industry average of 1.4.”

In other words, according to IRA’s calculations, WaMu was more than 10 times riskier – which equates to more than a full order of magnitude – than the average bank. WaMu has since been purchased by JPMorgan Chase & Co. (JPM).

Obviously, WaMu is hardly alone. And it won’t be the last bank to fail.

According to Whalen, the IRA Overall Industry Banking Stress Index is still rising, which is why as many as 110 banks are at risk of failure.

But individual investors no longer have to fly blind, for they now have a tool to gauge whether their bank is likely to be on the FDIC’s watch list.¦lt;br /> To find out more, please click here.

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Four Ways to Sidestep the Damage Wall Street’s Big Money Movers are Inflicting on Main Street

Oct 28, 2008
Credit Crisis, Keith Fitz-Gerald

By Keith Fitz-Gerald
Editor, Geiger Index
Investment Director
Money Morning Investment News/The Money Map Report

As the worst financial crisis in recorded market history rocks Wall Street, millions of investors on Main Street keep asking a single question.

When will this end?

The market volatility is unprecedented: Where professional traders once ranked a day as “wild” if we witnessed a 300-point swing, in recent months we’ve seen 600- and 700-point swings on a regular basis. On Oct. 9, a Thursday, we rode out a record-setting swing of 1,000 points.

That wild backdrop is bad enough. At the same time, however, the major market indices are heading lower – at times with a speed and ferocity never before seen. But the real killer is that there is seemingly nowhere to hide.

This is what Wall Street’s Armani Army doesn’t tell you about traditional diversification: It doesn’t work when everything goes down at once. (The one exception is the specialized inverse investment vehicles that we’ve repeatedly counseled you to employ precisely to prevent this kind of total freefall. Two examples that we’ve mentioned numerous times were the Rydex Inverse S&P 500 Strategy Fund (RYURX) and the ultra-aggressive “2X” ProShares UltraShort Financials (SKF) exchange-traded funds).

Most noticeably, of course, was last Friday’s trading, which began after an overnight bloodbath in the markets overseas. A notice from the CME Group Inc. (CME) that stock index futures contracts were “limit down” – meaning they’d achieved their maximum allowable downward move before  U.S. stocks even started trading for the day – didn’t help much.

While much of this is commonly explained away as economic panic, the reality is that it’s primarily a financial panic that’s driving this market action lately. And, just in case you recall my comments a few weeks ago about not having seen the hair on fire selling I thought lay ahead, this is exactly what I was referring to.

This time around, ironically, it’s not panic from normally flighty retail investors that’s causing the markets to go haywire. Instead, it’s the big boys that are apparently panicking.

My experience suggests that one or more hedge funds have imploded. Whether by margin call or redemption proceedings is a moot point. We won’t know for sure until much later next week when the newspapers finally catch up, but the massive swings we saw in currencies, gold and other commodities are certainly consistent with an unprecedented liquidation – and a forced one at that. Perhaps even more than one.

Long the domain of hedge funds and their uber rich clientele, many hedge funds were over-weighted in these categories in recent months in an attempt to chase performance. Overweighting, in case you’re not familiar with the term, means they’ve made excess investments in those areas. And chasing performance means they’re trying to create higher returns by making disproportionately larger bets than they would otherwise. Part of this could be from simply trying to generate larger performance fees, but it could just as easily be attributed to anxious managers placing ever-larger bets in an attempt to make up losses (most hedge funds are under water this year).

Where this gets fund managers in trouble is when they make these over-weighted bets by using leverage. You’ve probably heard this term a lot lately. In case you don’t understand what it really means, let me digress for a moment to explain it. Leveraging up (or simply “levering” to those in the industry) means using borrowed money to control a huge pile of assets that you wouldn’t otherwise be able to control.

In recent years, for instance, it wasn’t unusual for a hedge fund to lever up 30 to 1, meaning for every $1 dollar they invested they borrowed $29. As a result, a fund with $10 million under management could control $300 million or more of investable assets. I’ve heard of some funds running 50 to 1, while currency traders routinely run 100 to 1.

While using other people’s money dramatically enhances the potential for higher returns, it really enhances the potential for massive losses. Where this gets them into trouble is that a fund running 30 to 1 only has to lose 3% of the $30 worth of equity to get wiped out, as in kaput.

Somewhere along the way, as bad turns to worse and performance deteriorates, a hedge fund’s creditors will place a margin call, meaning they want the hedge fund to pony up more collateral or return the money it was loaned. Or, investors will place redemption requests meaning they want out. Either way, this forces the operator of a hedge fund to raise money any way it can.

If a given hedge fund does not have enough cash to meet the margin calls or redemption requests, they have to raise cash by selling assets. And they typically start with the most liquid stuff like gold, currencies and commodities. At first, the sales progression will be orderly, but as I suspect was the case last Friday (and on many big down days recently where chaos ruled), it will rapidly deteriorate into a fire sale where the hedge funds involved dump everything they can at any price just to get out.

And that’s where their problems affect you and me.

As scores of highly leveraged hedge funds dump billions of dollars worth of holdings at once, they effectively “flood” the markets with whatever the asset is that they are trying to sell. In doing so, they push the values down for the rest of us. For an example, imagine a house in your neighborhood selling for 50% of its appraised value. Upon completion of the sale, all “comparables” in the area, including your own home, will likely take a hit as a result. So it’s in everybody’s interest to keep prices as high as possible.

But nobody can do that when there are more homes than buyers – even in the best neighborhoods.

So when is it going to stop?

We don’t know. No one does. Hedge funds are notoriously secretive in their reporting, so even though there are estimates as to how much they own and (by implication) how much they owe, it’s hard to gain perspective on how much leverage is actually being used. Nor do we really know who holds what asset – especially as it relates to potential liquidations.

Over the weekend, rumors were flying that U.S. Federal Reserve examiners are hounding Citadel Investment Group LLC regarding “counterparty risk” and its exposure to debt. Citadel, naturally, vehemently denies this, but lately where there’s smoke, there’s certainly been the potential for fire.

Then there’s Europe. Despite the fact that many Europeans find it fashionable to blame the whole financial-system meltdown on the United States, mounting evidence suggests they may be the biggest hypocrites of all.

Data from the Bank of International Settlements shows that Western European Banks may hold as much as $4.7 trillion in cross-border bank loans to Eastern Europe, Latin America and emerging Asian markets, which means, as London-based financial expert and Chartered Financial Analyst Nicholas Vardy described it as “the exposure of continental European banks to a whole set of ‘sub-prime’ nations in the form the former Communist bloc may be the Achilles heel of the European banking system.”

That means that “the elephant in the room is that while public sector debt was held in check by policymakers, private debt as a percentage of GDP exploded, as that was not part of convergence criteria to join the Eurozone.”

The fear shared by my professional trading colleagues is that this exposure may trigger a second credit crisis, and more market mayhem similar to that of 1931, when Credit-Anstalt failed and set off a global banking crisis.

If true, that suggests the market drops we’ve seen so far may be only the tip of the iceberg when it comes to a whole set of “sub-prime” nations in the former Communist Bloc, which has been the stomping grounds for Austrian and German banks in recent years. And it’s very personal as millions of adventurous capitalists there took out loans in Swiss francs, U.S. dollars and even Japanese yen – only to find that their repayment terms in local currencies are soaring as each of these currencies has.

Evidently, nobody told them the “carry trade” works in reverse.

Russia is particularly hard hit and the cost of Russian sovereign-debt-insurance using credit default swaps surged 1200 basis points last week, which makes it higher than the cost of Iceland’s debt before Götterdammerung hit Reykjavik. According to the UK Telegraph, the foreign debt of the oligarchs ($530 billion) has surpassed Russian foreign reserves.

The bottom line is this: What should we do for now?

That’s actually the easy part even though it may not feel like it.

1. If you’re retired, take a good hard look at how much money you really need for the next five to 10 years. Talk to your financial advisor and, if needed, take some risk off the table. Move what you need into cash, or such safety-first choices like the American Century Capital Preservation Fund (CPFXX). Do not own anything you would not want to have in your portfolio if the stock markets were to be shut down for a short time.

2. If you’re not retired – but are close – and have properly diversified your money to something akin to the 50-40-10 structure we advocate (50% base-builders, 40% global growth and income, 10% speculative), hang in there. And remember, this is exactly why we diversified our holdings in the first place – to get through the rough spots. It’s just that this is perhaps the roughest most of us have ever seen.

3. Stick to your plan. Hopefully that includes the disciplined use of trailing stops to capture gains and minimize losses, as well as specialized inverse holdings that profit with each further decline. And don’t forget options to hedge existing risks.

4. Above all else, make sure you have a plan – as we do – for re-engaging the markets when the coast is all clear. It may be awhile before we reach that point, but it’s important to maintain your upside potential in a down market. When the train leaves the station, the one place you don’t want to be is left behind on the platform. Studies like those from Standard & Poor’s show that investors can typically make up 80% or more of bear market losses within the first year of a recovery, once that recovery actually arrives.

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Credit Crisis Update: Rising LIBOR Hints at Bigger Problems to Come

Oct 7, 2008
Credit Crisis, Keith Fitz-Gerald

By Keith Fitz-Gerald
Editor, Geiger Index
Investment Director
Money Morning Investment News/The Money Map Report

More than a year ago, even before the subprime-mortgage crisis had revved itself up into the full-fledged credit crisis that’s now threatening global growth, we pointed to the London Interbank Offered Rate (LIBOR) and other interbank rates that suggested that the worst was yet to come.

The Money Morning team has continued to watch this important risk indicator, and has regularly reported our findings to you. Each time, we’ve preached caution, even though the pundits were telling the masses that the bailout plan was a panacea for what’s actually a financial mess whose fallout continues to spread.

So what is LIBOR telling us now?

Unfortunately, the worst is still yet to come. That’s it. No sugar coating. No rose-colored glasses.

Yesterday (Monday), the spread between Overnight Indexed Swaps (OIS) and the three-month LIBOR rose to an all time high of 2.94%. The LIBOR/OIS spread measures the amount of cash available for interbank lending and is used by banks to determine interest rates. The wider the spread, the less cash there is to go around. This is telling us that banks, despite billions of central-bank support in recent months, are still cash-strapped and are disinclined to lend money either to each other or to consumers.

Then there’s LIBOR itself, the rate that banks charge each other for overnight dollar loans, which rose to 2.37% yesterday, the British Bankers’ Association said. The three-month LIBOR rate has retreated only slightly from a nine-month high of 4.33%, set last January.

LIBOR actually is a set of rates, and is calculated for several currencies based on periods ranging from overnight to 12 months. That, in turn, determines prices for financial contracts valued at $393 trillion as of Dec. 31, or $60,000 for every person in the world, and helps set consumer interest rates on everything from home loans to credit cards, Bloomberg News reported. The BBA compiles the dollar rate every day from data submitted by 16 banks, including Deutsche Bank AG (DB) and Royal Bank of Scotland Group PLC (ADR: RBS). There are also rates for the euro, Japanese yen, British pound, Swiss franc, and Australian and Canadian dollars.

During the past week, as U.S. lawmakers tussled over a bailout plan and governments in Europe were forced to intercede to rescue five banks, the cost of one-month bank loans in euros and overnight dollar loans soared to records. That basically means banks are hoarding cash, a reality that raises borrowing costs and causes economies worldwide to slow.  Yesterday’s three-month LIBOR for loans in dollars jumped to 4.33%, Bloomberg reported.

Meanwhile the so-called TED spread or the difference between three-month LIBOR and what the U.S. Treasury pays for a three-month loan hit an all-time high of 3.93%, before pulling back slightly. The TED spread provides a gauge of how likely banks are to lend to each other, rather than to the Federal Government.

Under normal conditions, the banks charge each other premiums that are historically not much higher than government Treasuries. The fact that the spread is at all-time highs seemingly confirms that banks don’t want anything to do with one another, and would rather deal with the government.

Here’s what to do now:

  1. Make sure you have your cash tucked away in ultra safe T-bills or funds that invest exclusively in short-term Treasury securities.
  1. Make sure you own at least one of the specialized inverse investments we’ve recommended throughout this crisis. That way you can turn what will be a monster loss for most into major profit opportunities.
  1. Make sure you combine downside hedges in your portfolio with choices that don’t dismantle your upside potential. This includes hard assets and other inflationary hedges, as well as plain-old-fashioned balanced funds and even income-oriented investments.

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Credit Crisis Safety Plays: Three Steps to Take to Make Sure Your Bank is Safe

Oct 6, 2008
Credit Crisis, Keith Fitz-Gerald

By Keith Fitz-Gerald
Editor, Geiger Index
Investment Director
Money Morning Investment News/The Money Map Report

Seeing banks such as Wachovia Corp. (WB) get sold or Washington Mutual Inc. (WM) fail is scary for retail banking customers. But there are simple steps you can take to protect your bank assets.

A Money Morning reader recently wrote to say:

“I’m panicked. After watching the news and several banks fail, how can I know if my bank is safe? I’m retired and can’t afford to ‘lose it all’.”

With about 120 banks on the Federal Deposit Insurance Corp.’s troubled list and rumors swirling that as many as 200 more are in deep kimchee, we don’t blame you for asking – particularly since the FDIC doesn’t publish the names of the banks on its watchlist.

Credit Crisis Safety Plays

Here are three quick and easy steps you can take that may help you determine if your bank is safe or not.

  1. Click over to Bankrate.com’s Safe & Sound ratings page. There you can plug in your bank’s name and see how it scores on the basis of 22 objective measures designed to gauge the capital adequacy, asset quality, profitability and liquidity of thousands of banks. If your bank doesn’t make the cut with a higher rating, then switch to one that does.
  2. Use the FDIC’s electronic deposit insurance estimator to see if your assets are covered in full. With the recent signing of the bailout legislation into law, the FDIC now covers accounts up to $250,000 at any one bank in any single account or $250,000 per co-owner for joint accounts. Traditional and Roth IRAs, SEPS and other retirement accounts on deposit at an FDIC-insured bank or savings institutions are insured up to $250,000 separately from any other deposits you may have at the same institution. But this is mainly deposit accounts and doesn’t include stocks, bonds, mutual funds or life insurance policies.
  3. Double-check your ownership. If a portion of your assets is uninsured, getting full coverage may just be a matter of changing ownership or spreading out your accounts to different banks. (But keep in mind, like most things the government doesn’t make this easy so that means more paperwork.) If you’ve got the big bucks, visit the Certificate of Deposit Account Registry Service, or CDARS, and learn how you can obtain full FDIC insurance on deposits up to $50 million – with a single interest rate on a single statement at a single bank. Ironically, a former U.S. Federal Reserve employee – someone who must have gotten “fed” up with the complicated FDIC insurance requirements and ownership restrictions – started this innovative service.

 

But what ever you do, do it quickly.

That way you won’t be one of hundreds who will probably be camped out at the front doors of the next IndyMac Bancorp Inc. (OTC: IDMC) when it hits.

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Credit Crisis Safety Plays: How to Make Sure That Your Bank Deposits are FDIC Insured

Oct 3, 2008
Credit Crisis, Keith Fitz-Gerald

By Keith Fitz-Gerald
Editor, Geiger Index
Investment Director
Money Morning Investment News/The Money Map Report

With evidence mounting by the day that the banking industry may be in deeper than it admits, many investors are wondering what the Federal Deposit Insurance Corp. (FDIC) actually does and how it will protect them.

This question becomes even more crucial now that, under the proposed banking-sector rescue legislation that was passed by the Senate Wednesday night, the individual cap on the level of government-guaranteed deposits would be raised from the current $100,000 to the new level of $250,000.

Let’s take a look at what the FDIC is and does, and outline how it’s supposed to function. There are also two steps folks can take to ensure the safety of their deposits.

The 4-1-1 on the FDIC

The FDIC is an independent government agency formed by Glass-Steagall Act of 1933, as a response to the runs on banks that took place during the Great Depression.

In 2005, the Federal Deposit Insurance Reform Act increased the amount of insurance coverage for an Individual Retirement Account (IRA).

Ostensibly, federal deposit insurance was created to protect depositors from the loss of deposits at FDIC-insured banks and savings associations. And the good news is that the FDIC has done so remarkably well over the last 75 years, that no depositor has lost a single penny of insured deposited assets.

FDIC insurance covers checking accounts, savings accounts, money market deposit accounts and certificates of deposit.

It does not, however, cover so-called “non-deposit products,” such as stocks, bonds, mutual funds or life insurance, even though many of those products are offered through FDIC-insured banks.

As you might suspect, there are limits as to what is insured at any given institution. In general, deposit insurance covers:

  • Single accounts owned by a single owner: $100,000
  • Joint accounts with two or more owners: $100,000 per owner
  • Revocable trusts: $100,000 per owner per qualifying beneficiary subject to specific limitations (check with your tax advisor or accountant)
  • IRAs and select retirement accounts: $250,000

It’s important to note that the FDIC individual limit applies separately to different banks. That means if you have $100,000 in each of two separate accounts at different banks – one at each bank – you’re actually insured for the full $200,000.

Credit Crisis Safety Plays

As we mentioned, under the proposed banking-sector rescue legislation that was passed by the Senate Wednesday night, and which is supposed to head to the House of Representatives for a review and possible vote sometime today (Friday), the individual cap on the level of government-guaranteed deposits would be raised from the current $100,000 to the new level of $250,000. But that new coverage will not take effect until the bill passes the House and is then signed into law by U.S. President George W. Bush.

Until that happens, there are still a couple of “action items” worth pursuing to protect and help yourself. They are:

  1. Call your bank and make sure it’s FDIC-insured. If it isn’t, consider switching to a bank that is.
  2. If you’re unsure about your own assets, and whether or not they are covered, check out the FDIC’s electronic insurance estimator.

But do it sooner rather than later. There are a record 117 banks on the FDIC’s troubled list and our own estimates suggest that at present rates we could easily see that number rising to more than 200 in the next six months. That means the agency could be dumping dollars in the near term, so it’s only logical to make sure your money is covered.

[Editor's Note: "Credit Crisis Safety Plays" is a new Money Morning series that will detail strategies that investors can use to insulate themselves and their finances from the ongoing credit crisis. These personal finance missives will draw upon the experiences of such experts as Money Morning Investment Director Keith Fitz-Gerald. Next up: How to be sure that your bank is safe.]

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