A Broke FDIC Expands Checking Account Insurance From $250,000 To Infinity

A few days ago, the FDIC, broke as ever, with a Deposit Insurance Fund that was well south of zero at last check, announced, with delightful irony, that it was expanding its insurance on non-interest bearing checking accounts from the current $250,000 to, well, infinity. As in there is no upper limit on how much the FDIC would insure - the fact that it has no money at the FDIC to begin with being completely irrelevant. That's right, the broke FDIC basically said that it would guarantee up to $480 billion currently sitting in US checking accounts between December 31, 2010 and December 31, 2012. Yet is this nothing less than another Volcker-inspired plan to get capital out of multi-trillion money market industry and into consumer hands via easily accessible transaction accounts, and to encourage spending on useless trinkets like iPads? This could very well be the case.

As many will recall, earlier this year the Group of 30, headed by Volcker, came out with a recommendation to allow money market to suspend redemption without prior notice. We, along with many others, speculated that this was merely an attempt to spook MM investors into stocks. Well, it succeeded... half way. Investors did indeed take out money from mutual funds, whose current after-fee 7-day simple yield on prime funds is just 7 bps. However, they then used that money to buy not stocks, but fixed income, instead focusing on such securities as Investment Grade bonds and Treasurys. As a result the much expected ramp in stocks never really occured, and it was up to the Fed and the HFT mafia to keep ramping stocks as ever more outflows exited dometic equity mutual funds.

This latest action by the FDIC, as Barclays' Joseph Abate speculates, is nothing less than a comparable attempt to get Americans to take out theyr cash from money market funds and, now that the whole equity investment avenue is closed, to put it into checking account instead, hoping that once the money is one step closer to the end consumer (as it will reside in non-interest bearing transaction accounts), and easier to withdraw, the psychological element will be one of spurring consumption. Yet will this latest scheme to impact mass consumer psychology work? If past experience is any indication, the desired outcome will once again fall well short of the actual.

More details from Joe Abate on this latest scheme by the FDIC:

The FDIC recently released details about the Dodd-Frank financial reform bill’s requirement to provide temporary unlimited deposit insurance coverage. Unlimited deposit insurance would apply only to non-interest-bearing transaction (checking) accounts. It would be provided to all depositary institutions – there would be no opt-in – and importantly, there will be no explicit charge to the banks for the extra insurance. That is, unlike the similar Transaction Account Guarantee (TAG) program, there would be no special assessment or insurance premium for the coverage assessed on quarterend balances over the current $250,000/account limit. Instead, the FDIC will price its regular risk-based quarterly assessments to account for the additional insurance. But assuming the FDIC proposal goes through without major changes, the entire $480bn currently sitting in US checking accounts would be fully covered for the period between December 31, 2010, and December 31, 2012.

No discussion on just how the FDIC will insure not just all this capital, but all continue with its $100,000 insurance of traditional interest checking accounts, considering that the FDIC is broke. After all, if it gets to insurance getting actually paid out, it will be game over.

But of course, it is all about expectations. Which is why Abate believes this is merely a ploy to get money market holders to transfer their money from MMs to checking accounts, after conducting an appropriate cost-benefit analysis.

Unlimited transaction account coverage – even if temporary – poses a challenge for money market funds. At current levels, the average after-fee 7-day simple yield on prime institutional money funds is just 7bp. Thus, besides the insurance coverage, there is little difference between money fund accounts and checking account balances. Traditionally, this has not been the case, as money funds typically yielded more than bank deposits in order to compensate depositors for the absence of (limited) deposit insurance. On the surface, then, the provision of unlimited deposit insurance on a close substitute that also yields (close to) nothing could encourage institutional investors (those most likely to exceed the current $250,000 deposit insurance limit) to shift their balances back into banks.

Despite these super-low rates, money fund balances have held fairly steady since late spring. We suspect that part of the stability may reflect the fact that among institutional investors, the current amount of deposit insurance coverage ($250,000) is not sufficiently high to shift their cash allocation to banks. With only that level of coverage, institutions may feel more secure holding their multi-million dollar cash deposits at money funds, where the fund manager’s commitment to a stable net asset value acts as a weak form of insurance.

It is possible that unlimited transaction account insurance might tip the balance sharply in favor of checking account balances over money funds. If institutional investors prefer the FDIC’s explicit guarantee to the money fund sponsor’s promise to maintain a stable NAV, then money fund redemptions could increase. The pace of redemptions – if any – would ultimately depend on what value institutional investors place on having explicit principal protection. If this isn’t worth the 7bp they earn after fees on money fund deposits, they may stay put. But according to a recent Federal Reserve working paper, institutional money fund investors tend to be fairly flight prone – pulling their deposits quickly at the first sign of financial distress. (“The Cross Section of Money Market Fund Risks and Financial Crises,” P. McCabe, Federal Reserve Board working paper, September 2010.) This suggests a fairly strong sensitivity to principal protection over yield among the $1.2trn in institutional money in stable net asset value funds. As a result, some portion of these balances could leave for bank checking accounts. Of course, the value of insurance becomes apparent only in a crisis. As a result, with financial markets stabilizing, it’s possible that institutional money has become less flight prone. If true, the value of the FDIC’s insurance coverage might not be worth much for institutional investors. Until the insurance coverage takes hold at year-end, though, it’s not clear how much of the $1.2trn in institutional money fund balances could depart for banks.

We continue to be surprised by the eagerness of the administration to forcefully evacuate prime money market funds. The aggressive insistence to make life for MM investors a living hell, can only mean that should the true NAV of the majority of money markets be disclosed it would make the "breaking the buck" incident which nearly destroyed the system more than anything else in the days after the Lehman collapse a daily event. We hope we are wrong about this.