The [bank] holiday served its major purposes of keeping any depositors, including Ford, from making withdrawals. But getting the banks open again was another matter.

Independent Man: The Life of Senator James Couzens
Harry Barnard
Charles Scribner's Sons (1958)

In February of 1933, Roy Chapin, trustee of the failed Union Guardian Trust Co, and Arthur Ballantine, Undersecretary of the Treasury, traveled to Detroit to meet with Henry Ford. The great inventor, largely at the behest of his under appreciated son, Edsel, had loaned millions to keep Union Guardian Trust afloat. Ballantine, representing President Herbert Hoover, went to Detroit to convince Ford to make an additional loan or at least put up collateral so that the Reconstruction Finance Corporation could make new loans and thereby avoid disaster.

Ford ultimately refused all appeals, including from his former manager and friend, Senator James Couzens, and threatened to take "his boys" into town that Tuesday after Lincoln's Birthday to withdraw all of his billions in cash from all of the Detroit banks.  Hearing of Ford's irrational position, Governor James Comstock of Michigan declared a bank holiday on February 14, 1933.

Though originally intended to last only eight days, the Michigan bank holiday spread to other cities and became indefinite as federal officials refused to allow undercapitalized bank to reopen.  When FDR took office less than a month later on March 4, 1933, the banks in NY had just closed. The banks in Detroit and in many other parts of the US had been closed for weeks. When FDR spoke of "fear" in his inaugural address, he was speaking to millions of Americans without employment or hope or even access to their own funds.

Imagine how it would be if the banks were all closed, and the credit cards and ATM machines did not work.  Reminding readers of The IRA just how dire were the circumstances in the mid-1930s is our way of telling one and all that the present circumstances are far less threatening.

Yes, we have wagered in the Kotok Economic Prognostication Pool for next year that over 110 banks will fail between now and July 2009 with over $800 billion in assets, a little shy of 7% of the industry's total assets.  

And yes, given the above forecast, we will probably see the FDIC's $50 billion insurance fund exhausted and the Congress forced to finance the triage and sale of insolvent banks. That's the little surprise awaiting the new President and Congress after November.  But even with our worst case analysis, the Credit Crunch of 2008 is still a mild correction compared to the 1930s.

Unfortunately, we have so desensitized generations of Americans to risk that after the past year of ugly headlines and weak financial markets, the mere suggestion that a bank is unsound sends people into a panic. By dumbing down the markets to the point where we believed that banks, companies and structured assets could be described with a single rating, the financial community did our fellow citizens a disservice.  Now we as a society have to re-learn how to assess a bank's soundness.

Most retail consumers of banking services, like the institutional consumers of structured assets, have for years assumed that all banks are commodities; safe, sound and not in imminent danger of failure. But now consumers with liquid funds above the $100,000 Federal Deposit Insurance Corp insured limit are at risk.

Consumers unskilled in financial matters are being asked to make judgments about whether a given bank is a safe place to keep their life's savings. Just remember that truth lies in many perspectives, to paraphrase our friend Alex Pollock in an earlier interview in The IRA ("Conflicted Agents and Platonic Guardians: Interview with Alex Pollock").

As we described last week, dozens of individual bank customers have contacted IRA over the past couple of months. All have the same basic question: How's My Bank? To answer this query, we have two responses.

First, The IRA Bank Cart. Our latest service offering allows users to track the financial performance of individual banks using the same metrics found in the IRA Bank Monitor. For $50 per year, users can track four quarters of an individual bank's financial performance. This is a snapshot meant to quickly get you up to speed on a given bank's capital position, profitability and loss rates, with handy charts showing the institution's historical and peer results.

Click here to go to The IRA Bank Cart to look up the Bank Report for your institution. This is the beta version of this display and it will be evolving like all IRA tools based on your feedback and internal testing.

Second, below we provide a general overview of the factors we believe to be important for monitoring the safety and soundness of your depository institution. Remember that banks historically have been first and foremost depositories for customer funds, not providers of loans and services. Concerns about bank solvency are refocusing consumers on this core role of a bank as a safe repository for assets.

If you have more than $100,000 deposited in a bank, the current FDIC limit for individual coverage (some retirement accounts go up to $250,000), you are a general creditor of that bank. Let's say that again. When you deposit more than $100,000 in a bank, you are effectively lending it your money unsecured. Kind of puts a different spin on the situation, does it not?

Remember that the uninsured depositors and other creditors of IndyMac, the largest US bank to fail so far in 2008, are facing significant losses as that bank's resolution proceeds. The moral hazard of Wall Street structured finance has now become very real financial hazard for the retail bank customer. So what are the factors we think you should look at in assessing bank safety and soundness?  First we start with capital.

Capital

Take Happy State Bank, of Happy TX, a member of the FDIC's agricultural specialization peer group. At the end of March 2008, the $700 million asset subsidiary of Happy Bancshares Inc had tangible equity to assets of $68 million or over 9.7% of total assets.

The Happy State bank reported a whole 6bp of defaults in Q1 2008 and even less in Q2, just $155,000 in charge offs vs. $75,000 in recoveries. That boys and girls is a 50% loss given default or LGD. Large banks routinely report LGDs over 80%. The Risk Adjusted Return on Capital for Happy State Bank calculated by The IRA Bank Monitor was over 40% (annualized) in Q1 2008.

But not all banks are Happy. With many banks at or below regulatory minimums for capital, the key message for large retail depositors over the FDIC insured limit is beware. The simplest benchmark for consumers worried about safety and soundness: Look for institutions with levels of capital well-above the minimum regulatory levels.

If you are a depositor above the $100,000 FDIC limit and want to spread your risk among several banks, subjecting your depositories to a simple test of, for example, using only banks with at least 1.5% or even 2% more capital than the regulatory limit is one possible approach. Applying such tests is one way of filtering out less stable institutions.

Lending Capacity

A second factor we like to monitor closely is lending capacity, an exclusive measure developed by IRA. By looking at the lending, commitments and other factors of a bank, we are able to characterize the posture of an institution in the marketplace. Is your bank aggressively seeking to lend or is it in a defensive posture?

Looking at changes in a bank's lending capacity can provide insights into an institution's overall stance in the marketplace and soundness. For example, look at Happy State Bank and you see an institution with an Exposure at Default, a Basel II expression that in simple terms refers to a bank's unused credit lines, below 40% of existing loans. This means that the bank has $0.40 in unused lines for each $1 of drawn lines. When this figure is combined with existing loans, Happy State Bank's total exposure is just below 100% of total assets.

Look at a larger player like Washington Mutual (NYSE:WM), however, and we see an EAD of 55%, meaning the bank has $0.55 in unused credit lines for every $1 of drawn lines. Total exposure, defined as loans outstanding plus the unused commitment obligations of the bank, come in at 120% of total assets, a fairly aggressive credit posture compared with peers.

Banks like WM with credit card operations tend to have total exposures well-above 100% of total assets, while more conservative institutions tend to come in below 100% exposure to total assets. Maybe that's why Wells Fargo (NYSE:WFC), which over the past decade has consistently has kept unused lines below 60% of drawn lines, is able to manage its higher loss rate portfolio with better overall results than its peers. Compare that 60% EAD for WFC with over 200% for JPMorgan (NYSE:JPM) or Citigroup (NYSE:C).

Efficiency

Another important factor for monitoring bank safety and soundness is the efficiency ratio. This metric, which is calculated by the FDIC at the bank unit level, is a measure of how hard a bank has to work to generate a $1 of revenue. Many banks have recently seen efficiency ratios climb as higher advertising expenses eat into profit margins. 

The efficiency ratio is a number that is particularly monitored by Wall Street because it serves as an indicator of how hard a bank must work in order to maintain the market position of its business case model. Higher numbers indicate that more must be spent to stay in place. In our view, the efficiency ratio is a good metric for consumers to follow to get a sense for how competitive their bank is with its peers in terms of financial strength and expense management, especially when you look at this metric over a period of years.

At the end of March 2008, WM had a bank unit efficiency ratio of 56.5% according to the FFIEC, well below its peers, as did WFC at 50%, and JPM at 43%. C came in at over 70% in Q1 2008, an illustration of just how far C must go in terms of expense reduction to get into line with its peers.

Profitability

The fourth factor we monitor is profitability, expressed as asset and equity returns. Strong earnings allow a bank to maintain adequate capital and reserves necessary to protect depositor funds. In particular, it is important to watch for changes in a bank's profitability.

For example, in Q1 2008, Bank of America (NYSE:BAC) swung from above-peer asset and equity returns to half a standard deviation below peer. BTW, we like to use statistical measures like standard deviations ("SDs") rather than Chinese-menu lists of rankings to describe a bank's financial performance vs. its peers. Gives you more information about just where your bank stands vs. its peers.

The charts in the IRA Bank Report allow users to inspect five years of quarterly results for each bank and its peers. Suffice to say that, in the current economy, if your bank has seen a significant negative change in its financial performance vs. its peers, then it's time to start moving your money -- at least sums above the $100,000 FDIC insured limit. All banks will see profits and loss rates affected by the slow US economy over the next year or more. The trick for large depositors is to pick institutions that are doing better than average.

Default Rates

The fifth factor we like to watch carefully is the bank's loan default or charge-off rate. When a bank realizes a loss on a loan, it subtracts the amount "charged off" from the bank's capital and reserves. Recoveries, conversely, are added to reserves, which is why the Loss Given Default or LGD of a bank is so important. Tracking your bank's loss rate, in historical terms and vs. its peers, is an important indication of safety and soundness. Indeed, we believe that the loan default rate, when converted to a bond-equivalent rating, gives you a pretty good indicator of a bank's internal "target" loss rate for customers.

For example, in Q1 2008 BAC's subsidiary banks had an aggregate loss rate of 136.18bp (annualized) vs. just 74bp for its peers. A loss rate of 136bp equates to a "BB" ratings using industry breakpoints. This loss rate for BAC's subsidiary banks was a full SD above the large bank peer group - and we haven't even started to see the tens of billions of dollars in losses to come from the Countrywide acquisition. While BAC has historically reported above-peer loan loss rates, the percentage increase in losses observed in Q1 and Q2 2008 by BAC's subsidiary banks was also above peer.

Home Loan Bank Advances

A sixth factor that we think jumbo depositors must watch very carefully is advances from the Federal Home Loan Banks. If you want to see a large subset of the list of the 8% of US banks identified as being "under stress," then subscribers to The IRA Bank Monitor should start with the screen of large percentage users of FHLB advances.  The example in the link uses year-end 2005 data.

In view of bank resolutions like IndyMac, where the FHLB advanced were 32.6% of total assets at the end of March, we view any institution with excessive use of FHLB advances as suspect in terms of protecting uninsured depositors.  Because the FHLBs and the Fed stand ahead of depositors in line and get repaid at par when an insolvent bank is closed by the FDIC, in our view, depositors above the $100,000 insured limit should be wary of maintaining deposits in institutions that make excessive use of FHLB advances.

The six metrics we have outlined above are just some of the dozens of classical financial benchmarks and measures defined by US regulators and analytics over the past century that we include in The IRA Bank Monitor.  We believe that if you follow the financial performance of your bank and pay attention to issues such as capital and profitability, you greatly improve your changes of avoiding a loss in a bank closure.

None of these metrics alone are sufficient to monitor the safety and soundness of a given bank, but taken together a few carefully selected metrics and tests can give you, the banking consumer, the knowledge to make better informed decisions about where you keep your money for safekeeping. Setting deposit allocation rules using criteria such as capital levels, profitability or loan loss rates, is one way in which jumbo depositors can limit their risk in bank depositories.

The Institutional Risk Analyst is published by Lord, Whalen LLC (LW) and may not be reproduced, disseminated, or distributed, in part or in whole, by any means, outside of the recipient's organization without express written authorization from LW. It is a violation of federal copyright law to reproduce all or part of this publication or its contents by any means. This material does not constitute a solicitation for the purchase or sale of any securities or investments. The opinions expressed herein are based on publicly available information and are considered reliable. However, LW makes NO WARRANTIES OR REPRESENTATIONS OF ANY SORT with respect to this report. Any person using this material does so solely at their own risk and LW and/or its employees shall be under no liability whatsoever in any respect thereof.