Deposit Insurance Arbitrage

I'll coin this term in order to explain the travesty that is being
allowed in the banking industry. Institutions are literally paying
little old ladies' less than a half a percent on their life savings and
using said funds to gamble in the risk fraught derivatives market, with
the risk being totally underwritten by the government through the:

1. FDIC (deposit insurance and bond insurance - although to date this
   expense has been born by the industry, the FDIC is insolvent and may
   very well have to tap the Treasury, ie. the taxpayer: see I'm going to try not to say I told you so...),
2. Treasury (via TARP and associate measures, see #87b876;">America, You have been outright lied to! Bamboozled! Swindled! Hoodwinked! The Worst Case Scenario) and
3. Federal Reserve (ZIRP, QE, and a whole slew of programs I only wish I knew about - see The Fed Believes Secrecy is in Our Best Interests. Here are Some of the Secrets).

A perfect example of how the big banks are carrying this arbitrage out is outlined in "The Next Step in the Bank Implosion Cycle???",
but the global economy risking behemoths are not the only one's that
arbitrage bank deposit funds via FDIC guarantees. Earlier this year, I
featured research on a smaller bank, Bank of Oklahoma, which I found
participated in some pretty suspect accounting moves. Despite these
"gimmicks" the stock floated higher with the general market and
particularly the banking sector. OF course, this does nothing to cure
the ills that they have been papering over. Subscribers should
reference:

 BOK 1Q09 2009-05-07 06:34:52 460.74 Kb

 BOK 2Q09 review 2009-08-01 05:04:06 1.05 Mb

 March Actionable Note - Banking Sector BK 2009-03-03 11:58:22 184.25 Kb

 March 2nd Actionable Note Preview - banking 2009-03-02 09:44:20 61.88 Kb

Well, one of my subscribers have pointed out another "gimmick" that
they are into, and that is the FDIC arbitrage thing. That's right, not
the giga-billion dollar Wall Street TARP babies, but the Bank of
Oklahoma. Here's how it works:

1. As a deposit taking
   institution, CDs and savings accounts are insured by the FDIC. The
   banks use the funds from these CDs and savings accounts to fund their
   operations, which use to be primarily loans and checking/cash
   management services.
2. The Fed has enabled expanded margins for
   many of these institutions through ZIRP (zero interest rate policy),
   but that is not enough to help the truly sick banks. See "The Anatomy of a Sick Bank!".
3. Thus,
   many banks have ventured off into the arcane world of derivatives to
   boost earnings, and avoid having to polish all of those toasters to
   offer to Grannie! These banks include JP Morgan, Citibank, and Bank of
   America (see The Next Step in the Bank Implosion Cycle???"), but also much smaller regional and even some local institutions. The Bank of Oklahoma is offering what appears to be option-embedded CDs that sport the FDIC insured moniker on them.
   These instruments allow the owner to participate in the equity markets
   while having the federal guarantee on the principal. So, you ask,
   what's so bad about that? Well, let's walk through what their marketing
   material has to say, "For discussion purposes only", of course...

From this point on, I will split this post into two sections. The first
is the arbitrage itself. The second details the product that the Bank
of Oklahoma is using as an arbitrage tool. If you are familiar with the
banks and their need to raise more capital, then skip down to point 2
to avoid being bored.

Point 1 - The Arbitrage

In "The Anatomy of a Sick Bank!",
I attempted to show in detail, how the dropping of interest rates
didn't necessarily produce the blowout profit margins for banks that
everyone thought they would. The reason, many banks were too sick to
take full advantage of it, hence their version of profit margin (NIM,
net interest margin) remained level in many cases and actually dropped
in more than a few cases - even as the Fed dropped rates like they were
hot! Here's an excerpt from the article penned (actually, typed)
Tuesday, 10 June 2008 (many of these banks have actually went under
since then, and rates have since dropped to effectively zero, or 260
basis points or so):

Bernanke  comes to the rescue that doesn't

Federal Reserve chairman Ben Bernanke has spearheaded the most
aggressive rate cutting and monetary policy action in the history of
this country. He has reduced the effective federal funds rate by nearly
50% in just 5 calendar quarters, from an already relatively low 5.3% to
2.6%. 

History's most aggressive rate cutting does nothing
to help sick banks. As a matter of fact, some of the banks got sicker
after the rate cuts. For those not familiar with bank numbers and net
interest margins, let's look at it from a manufacturers perspective.
Banks inventory can be equated to capital. Banks borrow to get
inventory, just as manufacturers borrow to get physical inventory. The
banks, and the manufacturers must pay interest on these loans. So,
let's say the manufacturer has to buy inventory (bank's capital) for $5
each to make widgets. The company then sells widget inventory items at
$5.20 each retail. This gives the manufacturer a 4% profit margin (the
manufacturer must turn the borrowed money into product, where the banks
can actually use the borrowed money as product). Now, the manufacturer
runs into trouble because he bought 40 million too many widgets due to
his belief the whole world would go on buying more widgets then it
needed, and could afford, forever. So, the government comes to bailout
out,,, oh, sorry about that, apply monetary policy to the situation and
subsidizes the cost of said widgets to the manufacturer by 50%. That's
right, the government takes 50% off of the manufacturer's widget costs
so the manufacturer will have more profit in order to dig himself out
of this hole from which he so aptly and skillfully dug himself into.

But, guess what's happening? Contrary to all of the "know it all"
pundits, arm chair investors and ivory tower economist's preachings and
teachings (no disrespect intended towards "know it all" pundits, arm
chair investors and ivory tower economists) the manufacturer still can't make money and his profit margins are remaining the same, or even going down in some cases. #ff6600;">Click any graph to enlarge to a full page, print quality presentation.

The primary reason why the Fed's lowering of the interest rates is not
helping the banks is because monetary stimulus via discount windows and
low interest rates can solve liquidity issues, which the banks have -
but the banks liquidity issues stem from INSOLVENCY,
and illiquidity. Thus, all the Fed is doing is taking a pricey, risky
(inflation and weakening currency that pisses off our trading partners)
and volatile band aid and applying it to deep and gushing wound. Those
band aids with the pretty colors do indeed tend to make Mama's baby's
little boo-boo feel better, but from a scientific perspective do very
little in regards to addressing deep puncture wounds.

Well, a lot has happened since then, including a massive bank rally.
But if you look at the those banks whose NIM's remained level or
dropped when rates dropped, you get an interesting list. Let's see
here: Countrywide - gone, Wachovia - gone, Bank of America, soon to be
gone, broken up and/or running back to the taxpayer for the next
bailout, and those other banks such as Marshall & Illsey - keep
your eye out. My thesis still stands. Many, if not nearly half, of
America's banks are sick. What have they done to self medicate? Well,
they are trying to make up for those thinning margins, or even in the
case where margins are thickening they are preparing since they know
and I know and you should know too that the Fed is artificially
suppressing rates in an unsustainable fashion. The only place to go
from zero is higher!

So, banks are now attempting to horde
capital in an effort to cushion shocks coming in the near future, and
most likely cushion the shocks that they expect from their wreckless
lending actions from the recent past. Many have been kicking the can
down the road using various methods as described to my subscribers in
the BOKF earnings opinions linked above and as shown to the public in
posts such as They ARE trying to kick the bad mortgages down the road, here's proof!
As far as I can see, they are trying to kick the can far enough to earn
their way out of the bad balance sheet hole, and appear to have the
explicit OK from the government (see Charting the Truth). 

One of the cheapest sources of funding for banks is deposits, savings
accounts (which can be volatile) and CDs (which are less volatile due
to fixed maturation and early withdrawal penalties). In the US,
depositors can shop for the best CD rate in an environment where
differences of 100% are not unusual, eg, 2.50% vs 5.00%. It should
raise eyebrows when one bank offers a 5 year CD at 2.5% and another
offers the same product at a 100% premium in the same interest rate
environment. Obviously, the latter bank is considerably more desperate
for funds. They can make such an offer because whether they offer 2% or
20%, it is all guaranteed by the FDIC (below a limit which the vast
majority of Americans rarely pierce) come hell or high water. Herein lies the arbitrage.
Banks are using the FDIC insurance to backstop imprudent and often
fiscally irresponsible acts, such as offering a 100% premium to the
market average to attract monies, often into an institution that does
not deserve to have grandma's often quite conservative funds. If one
were to look at who is offering what rate, it is basically a road map
leading you to who has the worse balance sheet. Basically, the higher
the rate offered or the more arcane the product, the bigger a victim of
the Asset Securitization Crisis (go ahead, click the link)
the bank is. A quick glance at bankrate.com's CD page should tell us
who's trying to boost the busted balance sheet. For instance AIG Bank
(the poster child for the term "busted") is offering 3.11% on a 5 year
CD while Waterfield Bank and Salem Five Banks (most likely much
smaller, hence should be offering higher rates) are offering 1.98% on
virtually the same product. We all know AIG has problems. Is the FDIC
funding the difference in risk? Why would AIG offer a higher rate?
Because it is more distressed.If you move down to 1 year CDs, you can
see differences of up to 400+% in pricing!

The ability to
offer rates and products that are imprudent, fiscally irresponsible,
and borderline insane are all a result of their ability to draw from
the same insured pool of candidates, in effect ongoing moral hazard and
the arbitrage of the FDIC insurance system. Without the FDIC guarantee,
they would either have to offer rates that truly encompass the risk of
doing business with an institution with solvency issues (junk rates),
or would not be in the business of offering "safe" products at all. So,
what's the point you ask? The point is that the FDIC is not
sufficiently penalizing those institutions who are offering products,
services, or activities that are sufficiently outside the bounds of
what many of us call traditional banking. This accusation ranges from
Goldman Sachs, Bank of America,  Citibank and JP Morgan (reference
again "The Next Step in the Bank Implosion Cycle???"),
to the Bank of Oklahoma with their equity embedded CDs. As a result of
not having to pay extra insurance to reach for that extra dollar in
deposits or extra yield in the trading markets, we have an arbitrage
situation that is being abused by banks, both big and small.

Arbitrage, as defined in Wikipedia: In economics and finance, arbitrage
is the practice of taking advantage of a price differential between two
or more markets: striking a combination of matching deals that
capitalize upon the imbalance, the profit being the difference between
the market prices. When used by academics, an arbitrage is a
transaction that involves no negative cash flow at any probabilistic or
temporal state and a positive cash flow in at least one state; in
simple terms, a risk-free profit. A person who engages in arbitrage is
called an arbitrageur—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Point 2 - The Bank of Oklahoma Arbitrage Tool

Click to expand these images, or download the original PDF here:  09_10_bok_2_pg_fact_sheet_10_stock_cd 28/10/2009,15:43 44.49 Kb

Click to expand page 1

  Click to expand page 2

So, this product from the financial engineering wizard of Wall Street,
Midwest are offering the opportunity to reach for yield in a low
interest rate environment, as quoted from the marketing material:

"For
investors seeking contingent semi-annual income of up to 4.5 - 6.5%
(9-13% annual) and FDIC-Insured Return of Principal at maturity (1).
Provides contingent semi-annual interest payments tied to the
performance of a basket of 10 large cap U.S. stocks, representing a
variety of industry segments."

For those
not hailing from Wall Street, Midwest, this is most likely accomplished
through an OTC swap or option embedded product. The reason why I even
bothered to go into its construction is because it is designed to
basically sucker conservative CD buyers into buying a product with
increased risk and capped upside. Before I go on, let's realize that if
you want exposure to the stock market, simply by stocks, an index fund
or an option or future on the index. If you want limited exposure to
stocks, by the same with limited funds. It really is that simple. You
can do that with a small portion of your CD and not pay the bank any of
its fees, and get the same result without the added counterparty risk
of having to hope scientific whizzes from Wall Street Midwest that
bought this product's engine from Wall Street East (let me guess,
Goldman sold them the swap, didn't they?) didn't get sold a lemming, or
that the Bank of Oklahoma doesn't go belly up. After all, as my
subscribers know, these guys are playing it a little more than
aggressive with their accounting. In addition, you also preserve your
full FDIC insurance protection (we'll get to this point a little
later).

  As you can see, the bank has capped the yield on the product, so it
captures any upside past the 6.5% bi-annual observation period (13%
annually). This is profit you would not have to give up if you exposed
yourself to the market directly. Remember, you can expose yourself as
much as you want. Do you want to replicate this product without
donating your fair share to the bank? Take out a calculator and see how
much of your CD you can afford to lose while still maintaining the
minimum income you desire.

From the "Investment Risks to Consider" section:

• There may be no active secondary market for the CDs. Hmmm!
Does this mean that you may not be able to sell these"securities"
before the bank is willing to redeem them at maturity? I am
considerably better versed at things financial than the average CD
investor, and even I am not clear on exactly what they are trying to
disclaim here. Sounds like a warning bell for lack of liquidity for 5
years, through! Again, wouldn't be a lot easier to just buy a CD with
97.78% of your money (subtract CD yield offered from principal) and put
2.22% (the yield you are willing to risk) into an ETF (I personally
don't like ETFs), index fund, SPDR (or similar product, not my cup of
tea either, though), index future or option, or better yet and most
simply, just buy the stocks in question, directly? If the Bank of
Oklahoma were acting in your best interests and had a calculator handy,
I am sure the latter option would yield the best result from a
fiduciary responsibility perspective, but banks don't get paid for
that, now do they?

• Investors have no rights
in the basket securities and will not receive cash dividend payments or
other distributions that holders of the securities may be entitled to.
Again, why give this up to the bank unnecessarily? You are not getting
a deal on the upside because the upside is capped. You are not getting
income because the bank is trying to keep that as profit from the deal
- your contingent profit! You are not getting added safety, because
your principal is FDIC protected up to ($XXX,000) anyway.

• Offers
principal protection if the CDs are held to maturity, subject to the
credit risk of the Bank of Oklahoma for amounts invested beyond FDIC
insurance limits. Now,I'll admit that I didn't look at
the prospectus, and don't know a lot about this particular product, but
when you add this bulleted disclaimer point with the first one, it
becomes obvious that your funds are at risk (all of your funds,
principal and yield) if not held to maturity. This is in addition to
the liquidity risk quoted above. So, I ask, why in the world would one
by this product, when you could just by a plain vanilla CD and stock???
One should also keep in mind that you are exposed as a counterparty to
BOKF directly (as opposed to the FDIC) for funds above the insured
limit. BOKF is certainly not as conservative in their accounting as
they could be (just as they are not as generous in their product
offering as they may seem), and it is most likely that it will catch up
to them in the upcoming quarters. They skated this far, but we shall
see if they pay the piper or not. Subscribers, again reference - BOK 1Q09 2009-05-07 06:34:52 460.74 Kb and  BOK 2Q09 review 2009-08-01 05:04:06 1.05 Mb.

• Investing in the CDs is not equivalent to investing in a conventional
CD or any of the securities underlying the 10 stock basket.
This is the kicker here, and was most likely insisted upon by their
lawyers. This is a derivative product, not a true, plain vanilla CD! As
a derivative, it is most likely prone to tracking error. That means
that the returns on the derived basket of securities may not accurately
or even tightly track the basket of 10 securities. This is one of my
biggest problems with the way many ETFs are put together. In addition,
you do not have actual ownership in the stocks themselves - no voting
rights, no dividends, and I am assuming no tax loss credits in case
things don't go your way. You also don't have the safety of a
traditional CD: no guaranteed active secondary market (meaning you may
not be able to sell it before your 5 years are up, even back to the
bank), no guarantee of principal before the maturity date, etc. So what
do you have??? 

Why a monster, you ask? See "Welcome to the World of Dr. FrankenFinance!".

So, what happens if BOKF goes belly up, and you have $500,000 invested
in this thing? What happens if they go belly up and you have $3,000
invested in this thing and you pull out before your 5 year period is
up? You are a direct counterparty to a derivatives dealer in a
derivatives transaction if you buy this so-called CD, did you know
that? Try explaining that to grandma. Better yet, let the FDIC explain
whether or not BOKF would be able to sell this product to grandma's at
all without the umbrella arbitrage of the FDIC insurance system -
despite the fact that it appears that that insurance coverage of this
product is spotty at best and probably untested in a sharp downward
spike of both the banking sector and the equity markets, you know -
considering "There may be no active secondary market for the CDs."

You guys at the FDIC need to tighten up on this stuff!!! Make banks get
back to being banks again. More loans, less baloney, please!

Comments

[Anonymous]

Reggie,

I enjoy your posts very much. Great attention to detail and the facts.

[Anonymous]

You should check out kasassa checking accounts. This is the latest game i have found where i am making 4.44% on a checking account up to to 50k. It's a silly game where you make 10 debit card purchases, an online bill pay and log into your account or you get 0%. Business wise it makes no sense and if not for fdic I wouldn't put my money any where near them. It does get very confusing when you have multiple accounts. I can think of no other way that first arkansas bank and trust would get my money. What a mess.

[Anonymous]

Bank of Oklahoma is a relatively healthy institution. They declined TARP, as did CFR based in San Antonio. The Texas and Oklahoma economies are not suffered anywhere near as much as the rest of the country, nor did they experience "California-level" property appreciation. BOKF has issues in Arizona, but it is an incredibly small portion of their operations.

Three months ago I was short BOKF, but not because there is any chance of failure. Rather I simply thought provisions would eat into profitability, as the allowance was inadequate.

Remeber also that George Kaiser owns more than 60% of the bank, as well as has debt extended to them...They are well capitalized and if problems arose, could recapitalize privately very quick.

It is a healthy bank (relative) and will survive. Cannot fault them for offering a product.

[Shamwow]

I used to see garbage like this come across my desk on an almost daily basis.  Thanks to the large .pdf sheets, we'd just toss them in the garbage. 

Funny that you decided to look into it a little deeper.  My first mentor made me read a prospectus for one of these things my first week on the job to teach me that no matter how safe something like this seems, once you've read the legal copy, you realize the only person making money is the offeror.

Agree with an above statement that 'joe sixpack' cannot reasonably replicate this.  Theoretically yes, but transaction costs do make this palatable to smaller, less sophisticated investors.

[Reggie Middleton]

I disagree. Realize that I am using straight line interest and simple calcs for the sake of simplification.

Joe six pack has a $100,000 CD, being offered 2% interest for a 2 year lockup. Joe is offered the derivative above, but decides to put $96,000 into the CD and buy 2 year SPX calls for as much as $4000 will buy him, as close to the money as he can get (probably just one near ATM).

Joe Sixpack foregos $160 due to the interest income delta between his $100k cd and his $96k cd, plus the round trip (assuming it was in the money) cost of the option trade (using a decently priced broker such as IB, around $15.  So, for $175, Joe Sixpack replicated this product and got full FDIC insurance, superior liquidity, and the ability to kepp all of the upside he generated. What are the chances that the bank is charging more than that in adminsitrative, sales and management fees for this product? Pretty damn good if I were a betting man... And yes, the bank does profit from upside above the cap unless they somehow gave that up contractually through an OTC swap or option with a counterparty that was smarter than they were (why do those 85 Broad guys keep popping up in my head???).

Let's run through and example of Joe Sixpack putting this together in February, where those options were dirt cheap. He would have had at least a 4x to 6x increase, which would have yielded 10% to 20% yield in less than a year, which easily would have bested the Oklahoma bank deal, would have been much cheaper, much more liquid and much safer.

Trust me, the vendors of these BS products want everybody to believe that joe sixpack couldn't do this at home, but it is not that hard for something simple like this.

In a previous incarnation, it was my goal to create things that had the mythos of being impossible to reconstruct, but the reality of the situation is there are few things that can't be figured out with a calculator, a pencil and a piece of paper - and if it can't be figured out with those basic tools, chances are it is not worth figuring out!

[Anonymous]

Sounds somewhat like an offering made by the credit union i use, except principal is insured by NCUA instead of FDIC: https://www.ncsecu.org/Investments/BridgeAccount.html

[Gwynplaine (not verified)]

Thanks for the great article Reggie.

The FDIC has no business backing bets in the stock market.  It's like heading out to a craps table with the guarantee that the house will refund any of your losses - while you get to keep up to a 13% gain on your money.  How long would it be before that casino would go bankrupt?

The biggest risk someone runs in buying this product is the 5 year lock up.  I think you're exactly right to view "lack of a secondary market" in that way.  Five years from now, the FDIC may be repaying depositors on an installment plan. What will they eventually get back?

The worst part of it is that banks are seemingly encouraged to help the FDIC get the average investor back into the stock market!  No mistake of this size could have been done innocently by the FDIC.  Although you and I see that deposit insurance arbitrage is horrific, I suspect it may be part of an overall strategy to backstop the market.  They may have no other choice at this point, since a Dow 6000 could pull down the rest of the financial industry.

[Anonymous]

Reggie,

BBVA (was Compass) started offering similiar cd's tied to S&P performance almost a year ago. Would love to know your take on BBVA?

Thanks for your work,

[Reggie Middleton]

I covered BBVA (the Spanish bank) in a full forensic analysis on my blog (subscriber material - don't be stingy). I was bearish on the over building on the Spanish coast. Imagine a humongous Miami Beach condo project that stretched on for the better part of a portion of a country...

[Anonymous]

And do not forget about this....about the widower....

Remember...since she is 80 years old....she cannot
afford to lose her money.....that her husband left her...

After all....she has to live off the interest ....

Oh....what interest ????? 0 to 1% ?

GOVERNMENT ENFORCED ?

You mean no reward for hard earned dough ?

Awe....that's ok....maybe the 80 year old
widower will find the fountain of youth
and get a job.....

Again...

Here is my "3 finger salute" to the big banks....

And there has to be one for the US Govt. as well....

[Anonymous]

As usual this is a common sense problem.....and as usual
the whores in DC are living it up in Whoredom....

Look....here it is....

The big banks lost the equivalent of all US domestic deposits via stupidity....

THEY should be in jail....

Why ? Here it is....

What if I owned a bank....and a little innocent widower
listens to my stupid "safe" TV commercials....and when she sits down to sign up....I actually tell her what I am going to do with her money....

The first thing I am going to do is lever 30 to 60 to 1 ....which means that if the price of the asset moves 5%
against me....this wipes both your retirement money and my bank away....

What do you think that the widower would do ?

In addition to the flawed financial US model....there is a very basic "disclosure" violation to all depositors....
ie "what they actually do with the money"....

And what is even further amazing is the total lack of morality....even withan 80 yr old widower....treated like a cow for slaughter....

Someone enlighten me....

And call a spade a spade....

And as of today....the US Govt. has become the enemy of the widowers.......by siding with the "those in the wrong"....

This is sooooo simple.......

[deadhead]

beautiful job reggie.

keep at it and thank you very much.

[KidDynamite]

Your Point 1 is the real problem - a travesty.  Chris Whalen wrote about it yesterday as well.

regarding your Point 2:  this is nothing new - they just buy a 5 year zero coupon bond (at a discount) that will pay you your principal back at maturity - and use the leftover money to buy an options package to try to get some upside.  I'm not saying it's a good deal for retail purchasers, but it's a product that Joan SixPack in Missouri probably can't duplicate easily at home.

I got a proposal for one of these from Citi last week that was linked to the R2000 index.

Also, Reggie, i don't think the bank "captures any upside" past the capped rate.  they just have fat margins built into the front end.

[McGriffen]

+1, nicely summarized.  I'd personally view these products as pushing the margin on what could / should be offered.  The retail folks at Merrill or MS can sell em, so smaller banks basically must have a comparable offering (under the guise for private banking clientele).

Most likely, joan sixpack in missouri has zero business pursuing these, under any guise.  but that's a judgment call from me, for what it's worth.