Is The FDIC Understating The Cost Of Bank Failures?

When a banking failure occurs, the FDIC’s goal is to protect depositors and seamlessly arrange a transfer of deposits and a sale of assets to a healthy institution.  To enhance the attractiveness of a closed bank to a potential buyer and to reduce the FDIC’s immediate cash needs,  the FDIC has made extensive use of loss-share agreements (LSA) when a failed bank’s assets are sold.

According to the FDIC:

Acquirers of failed institutions view the LSA structure as attractive because the FDIC’s loss coverage provides substantial downside protection against losses on covered assets.  When the FDIC calculates the estimated cost of a failure, it takes into account all expected losses on the assets covered in loss share agreements (LSAs). These current market assumptions are built into the cost of failure at resolution. Thus, the cost of all expected future payments are recognized at the time of bank failure and no losses are deferred.  Loss sharing also reduces the FDIC’s immediate cash needs.

As the number of banking failures has increased dramatically over the past two years, the FDIC’s immediate cash needs have become an increasingly important issue.  At the end of 2009, in order to bolster the Deposit Insurance Fund (DIF), the FDIC required insured institutions to prepay 3 years of FDIC insurance premiums which raised about $46 billion.   Despite this additional assessment, as of the latest reporting period at March 31 2010, the Deposit Insurance Fund (DIF) reserve ratio was -.38 percent (negative $20.7 billion), the lowest ratio in the history of the FDIC.

Despite no announced changes by the FDIC in the method of computing losses for a failed institution, three of last week’s bank closings had unusually low loss estimates.

If the estimated future losses on the sale of a failed bank’s assets are lowered, the loss to the DIF fund will decrease.  Protecting the Deposit Insurance Fund (DIF) from further losses is an important issue to the FDIC.

The FDIC believes that it is important that the fund not decline to a level that could undermine public confidence in federal deposit insurance. A fund balance and reserve ratio that are near zero or negative could create public confusion about the FDIC’s ability to move quickly to resolve problem institutions and protect insured depositors.

Is the FDIC using overly optimistic estimates of losses on failed banks?  Three of last week’s banking failures were highly unusual since the estimated losses to the DIF were exceptionally low.  During 2009, the average loss to the FDIC for bank failures amounted to 22% of total assets of the failed banks.  For 2010 to date, the ratio of total estimated losses to total failed bank assets was approximately 23%.  The three failed banks on August 20 with very low loss ratios are listed below:

SONOMA VALLEY BANK $337.10 $10.10 3.00%
LOS PADRES BANK $870.40 $8.70 1.00%
BUTTE COMMUNITY BANK $498.80 $17.40 3.50%

Using Sonoma Valley Bank as an example, a review of the company’s financial position portrays a very troubled bank with a large amount of nonperforming loans.  In addition, Sonoma’s loan portfolio was overly concentrated in commercial real estate (42.9%) and development loans (13.2%) as discussed by management in the Sonoma 10-Q.

Like many community banks, the Bank does have a significant concentration in commercial real estate loans. At the present time, due to severe economic recession, significant decrease in real estate values, and the lack of available financing options, local commercial real estate values have declined considerably. This severely impacts the Bank’s commercial real estate portfolio causing additional provisions for loan losses.

Although the economy has shown some signs of stabilization, conditions in the commercial real estate market are anticipated to worsen further which may result in additional provisions for loan loss throughout 2010. The non-performing assets to total loans ratio was 16.27% as of June 30, 2010 compared to 4.09% as of June 30, 2009.

As of June 30, 2010, commercial real estate properties were identified as a concentration of credit as it represented 42.9% ($108.5 million) of the loan portfolio.

Management believes that the adverse impact on the collectability of certain of these loans will continue in 2010, as the combined effects of declining commercial real estate values and deteriorating economic conditions will place continued stress on the Bank’s small business and commercial real estate investor borrowers.

The severe decline in commercial real estate markets suggests that banks with a heavy concentration of commercial real estate loans not yet marked down to market values may face further significant losses.  Moody’s Commercial Property Price Index shows a stunning decline in value of 41% from the peak of October 2007.  Banks with commercial loans on their books backed by inflated asset values will avoid further large writedowns only if property values recover.

The troubled asset ratio of Sonoma Valley Bank was 138% compared to a national median of 15%.

Considering the comments by Sonoma Bank’s management and the amount of losses historically taken on failed banks, the FDIC’s estimated losses on Sonoma Bank, Los Padres Bank and Butte Community Bank seem unusually low. The FDIC did not respond to emails and phone calls requesting comment.

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