Thursday, April 22, 2010

The FDIC's Recalibrated “Loss Calculator”

In the past week we have seen more and more optimistic reports about the direction of the US economy. Some, once spurned, CRE asset classes may be finding a “price floor” (there were anecdotes about sales of Miami Condos and the rising prices of Finished Lots in the Western US).

As bank failures make up a very large portion of the commercial and residential asset transfers occurring today, another possible economic inflection point worth watching may be the FDIC’s “DIF Cost Ratio”.

DIF stands for the Deposit Insurance Fund, and the “DIF Cost” is an estimate by the FDIC, at the time of the failure, of what a bank failure may cost the deposit insurance fund (funded from insurance premiums paid in by FDIC member banks). The DIF Cost is the first “mark down” of these assets by the FDIC (nearly $30 billion of failed bank assets in 2010 so far) as they are moved into the private sector via whole bank sales or taken into FDIC’s inventory to be sold individually or bundled up and sold or securitized at a later date.

The DIF Cost Ratio, when viewed as a function of the total assets of failed banks, measures the level or rate of the initial asset “ mark down”. Last week alone there were 8 failed US banks and the DIF Cost to Total Failed Assets Ratio dropped dramatically. In the first quarter of 2010 the DIF Cost Ratio had been running approximately 30%, meaning that the FDIC estimated that the losses of asset value and the cost to the fund was 30% of total failed bank assets in a total of 41 bank failures. In the month of April 2010, on a smaller sample of only 9 failures, the ratio had dropped to 16% of assets and in one instance this month the DIF Cost was just 2% of the asset total.

Multiple factors may be at work here. This month, the strategic desirability of three Florida institutions may have resulted in heated competition for these three failed banks that might provide a unique opportunity for rapid regional expansion into the desirable Florida market. In general, "whole bank" bidding has heated up for this once-in-a-generation chance to expand deposits and branches quickly. And, as a result, the FDIC now has the opportunity to write new loss share agreements more in the FDIC’s favor: in one case last week lowering the FDIC's coverage of future shared losses to 50% from the 80% coverage seen in most previous loss sharing agreements.

The FDIC may be recalibrating its “loss calculator” to reflect the perception of improving economic conditions. We will continue to watch activity to determine if this is indeed a turning point. Such a change will alter the failed bank bidding environment as well as expectations of future FDIC losses, a huge potential impact on the US banking system.

Don’t get us wrong. In the coming year there will continue to be failed orphan banks in regions or economies holding toxic assets that no institution will be willing to buy, at any subsidy level.

If, however, rosier economic forecasts prove to be correct and lasting, the FDIC is smart to capitalize on this trend sooner rather than later.