The Impact of the Wall Street Bailout on Bank Deposit Insurance

October 2008Alerts Focus on Banking Advisory

The traditional United States financial underpinnings have been upended by unprecedented events in the credit and equity markets that began several weeks ago and continue to unfold as this article goes to press. As the final details of the bailout bill emerge (officially known as the “Emergency Economic Stabilization Act of 2008”), it is an especially appropriate time for you to review your banking relationships as you begin to assess the effect of theWall Street meltdown on your overall financial health and liquidity.

As the nation anxiously anticipates the new financial paradigm, a few questions may be on your mind relating to the impact of the bailout on the security of your bank deposits.

What is FDIC Insurance? The Federal Deposit Insurance Corporation (FDIC) is a corporation chartered by the federal government pursuant to its powers under the Glass-Steagall Act which was enacted in 1933 in the wake of the Great Depression. Among its other functions, the FDIC insures accounts held by depositors in FDIC-member banks.

What accounts are covered? The FDIC takes a broad view of the meaning of the term “deposit.”This term includes, among other types of accounts, all manner and type of savings accounts, checking accounts, demand deposits, money market deposit accounts (although not money market mutual funds), time deposits, certificates of deposit, cashier’s checks, certified checks, escrow funds, trust funds and letters of credit.

What accounts are not covered? Stocks, bonds, mutual funds (including money market mutual funds) and other products in the nature of securities are not covered by FDIC insurance. 1 These assets, if held by a customer at a financially troubled brokerage firm, are protected by the Securities Investor Protection Corporation (SIPC). It is important to recognize that SIPC protection does not work the same way as FDIC insurance in terms of blanket protection of losses. While SIPC protection is beyond the scope of this client alert, its essence is that investors will be protected against the credit risk of the brokerage firm with whom the custodial and fiduciary relationships are maintained. Investors will remain at risk for the underlying solvency and creditworthiness of the issuer of the securities in which they have invested.

How much will the FDIC cover? Most people are familiar with the FDIC’s basic coverage limit of $100,000 per depositor.This amount was increased temporarily (through December 31, 2009) to $250,000 with Congress’ enactment of the bailout bill. However, the basic coverage limit is only the starting point for determining actual coverage. Individual depositors may obtain substantially more than the basic per depositor coverage limit if they understand how to structure their accounts across various ownership categories that the FDIC recognizes as separately insurable, including, among others, jointly-owned accounts, trust accounts, IRAs and deferred compensation plans. 2

For example, if Anthony has $100,000 in an individual account and, together with his wife Cleo they have $200,000 in a jointly-titled account, the couple will have obtained coverage of the entire $300,000. Anthony will enjoy $200,000 of coverage representing full insurance on his individual account plus another $100,000 which insures his portion of the joint account. Similarly, the couple’s insurance will include any additional amount (up to $100,000) held in an individual account in Cleo’s name.

Separate coverage of up to an additional $250,000 per depositor is available for individual retirement accounts and eligible deferred compensation plan interests. If appropriately structured trust accounts are included, a family or other group of related depositors might accumulate significantly in excess of $1 million in insurable depository accounts.

Are accounts held at separate banks by one depositor separately insured? Yes. If the banks are FDIC-insured depository institutions, accounts held by a single depositor in separate banks will be separately insured even if the banks are under common ownership by the same holding company.Many financial institutions are now promoting an investment strategy whereby the institution opens accounts in multiple banks for the same depositor to take advantage of the separate insurance limits for each bank account. For example, Sam deposits $1 million with financial institution ”X”. Institution “X”, in turn, opens separate accounts in Sam’s name in 10 different FDIC insured banks and deposits $100,000 in each account. Sam now has total insured deposits of $1 million.

When will multiple accounts held at the same bank be combined for coverage purposes? Under the law, the FDIC will aggregate all deposits which are maintained by a depositor “in the same capacity and the same right” regardless of how the accounts are titled. The FDIC will look to the beneficiaries, not merely the type of account or the name on the account, in determining what amount of coverage applies.

Consider the following example. Dad opens a $25,000 account “in trust for” son. Mom wins $100,000 in the lottery and puts the lottery proceeds in a certificate of deposit “in trust for” son. Since son is the sole beneficiary of each account, the two accounts will be combined and son will have maximum coverage of only $100,000.

How does the FDIC treat trust accounts for purposes of deposit insurance? Trust accounts may be insurable separately from, and in addition to, other insured deposit accounts. In the previous example, if Mom and Dad had created a traditional trust account where they maintained joint control during their lives, to be passed to son upon the last to die, then the entire $125,000 would have been covered because the FDIC regulations provide that certain trust accounts are insurable up to $100,000 per trust creator per beneficiary.

Can the FDIC offset insured deposits against loan obligations owed to the bank? Many clients maintain their primary depository accounts at the same banks where they have a borrowing relationship. This can occur by virtue of enforceable covenants in the loan documents themselves or simply as a matter of mere convenience. In either case, clients should be aware that the FDIC only covers “insured deposits” which is the net amount due to any depositor for amounts in an insured institution. The FDIC may withhold payment of deposits to the extent necessary to provide for the payment of any obligation the depositor owes to the bank if that obligation is in default. Even though the FDIC’s right of offset is limited to defaulted obligations, if loan balances exceed the amount of deposits, clients may be safer if their accounts are maintained at separate institutions from those where the primary borrowing relationship is maintained.

Can a depositor offset loans against deposits? Occasionally clients are in a situation where deposit balances exceed loan obligations outstanding and also exceed FDIC insurance coverage limits. In this context, the question arises whether the depositor can seek to offset deposits against outstanding loan balances to bring deposits within insurance limits. While there is no such right expressly written into federal law in favor of depositors, applicable state law may provide such a right.

What should you do? These scenarios are merely a few among the myriad possible circumstances that can arise. They are intended to illustrate the complexity inherent in the FDIC insurance regulatory framework. For clients that maintain substantial balances in FDICinsured depository institutions, we recommend that you contact your legal and financial advisors to conduct a thorough review of your holdings.Only a careful analysis of the structure and interrelationship of all accounts will yield valid conclusions regarding the scope of deposit insurance coverage.

For more information about this issue, contact David Jaffe at [email protected] or 412.391.6410.

1 - On September 19, 2008, the U.S.Treasury Department announced a temporary guaranty program that will insure the holdings of certain money market mutual funds for up to $50 billion backed by the assets of the Exchange Stabilization Fund.
2 - The examples assume that the standard maximum deposit insurance amount in effect is $100,000. Until final regulations are written regarding the bailout bill, it is unclear whether the increased maximum of $250,000 will apply in all cases.