Are Banks Safe In A Falling Market?

[This post is written and copyrighted by FIRE Finance (]

Are Banks Safe?When the market is a roaring bull, everything is rosy and fine. But when we face a bear market it would perhaps be worthwhile to contemplate on the safety of our hard earned money deposited at various banks. Not all banks are same! Apart from comparing customer service, interest rates, account fees, and other associated perks we should also be concerned about the probability of a bank's chance to fail.

HunchRecently we anticipated that the Fed would cut rates which would lead to lower Annual Percentage Yields (APYs) for a Certificate of Deposit (CD). So, being prudent, we started shopping for banks offering good APYs on a 1 year CD.

We searched for CDs with good APYs at bankrate, money-rates and banx. An interesting observation was that so far as APYs were concerned, Countrywide Bank was way ahead of the pack!

If APY was the sole determining factor for the purchase of a CD one would be tempted to open a Jumbo Countrywide Bank CD. However we should remind ourselves that of late, their mortgage lending wing has been suffering due to the subprime mortgage fiasco.

Intuitively we felt that the failure of its mortgage division may affect its banking division as well. Even though we know that our money in bank deposit accounts are FDIC insured up to $100,000, we stayed away. It is better to be safe than sorry!

TestedA few days ago Jim Jubak in his article at MSN Money described a failure of a bank named Northern Rock in UK. It began with the failure of Northern Rock's mortgage wing which eventually snowballed into a total bank failure!

It took only a couple of days for Northern Rock to witness panic driven withdrawals to the tune of $6 billion! Fortunately the Central Bank of UK stepped in. They gave some money to Northern Rock which provided a temporary stabilization and consequent relief. Else there could have been a mammoth turmoil in the financial markets.

This event corroborated our hunch regarding staying away from banks with troubled mortgage divisions.

Which type of US Banks may have such vulnerability?
Jim Jubak pin points the type of banks which are more susceptible to such failures. We quote him verbatim:
"Jim JubakHaving a big mortgage book and a small deposit base. In the U.S., Countrywide Financial, with $34 billion in time deposits (about $25 billion uninsured) on the books at the end of 2006 and recent monthly mortgage production of $34 billion fits that description. A bank such as Wells Fargo, with $270 billion in core deposits on the books at the end of 2006 and $68 billion in monthly mortgage production, doesn't. Countrywide isn't out of danger, even after Bank of America invested $2 billion in the company, but that deal does increase the odds that Countrywide will be able to tap other sources of capital if it continues to have problems securing financing in the commercial-paper market. In the U.S., though, the companies facing the biggest funding problems are those, like Novastar Financial, that don't have banks at all.

Other possible trouble spots are companies such as E*Trade Financial that dabble in banking and mortgage lending but where neither activity is a core competency. E*Trade announced Sept. 17 that it would exit the wholesale-mortgage business."
Also, it might be worthwhile to stay away from small to medium sized banks which are not big enough to cause widespread havoc in the financial market in the event of their failure. Why?

Federal Reserve BankBecause the Federal Reserve of US (like the Central Bank of UK) is not bound by any legal means to step in and bail out a bank which has failed. It would use it's discretion. In the event of a bank's failure, the bigger a bank is, the larger would be its impact on the financial market. Consequently the chances of the Federal Reserves stepping in to bail it out would be higher.

So what should we do?
After reading Jim's article and doing our own research we came to the following conclusion. While choosing a bank for opening deposit accounts we should:
  1. stay away from banks (for e.g. Countrywide Bank) whose mortgage wing is in trouble.
  2. avoid banks like Etrade whose core competency is not in banking.
  3. do business with big or nation wide banks with significant core deposits. Smaller banks may vanish into thin air in no time due to some correction or market problem.
  4. mitigate risks by spreading our deposits in multiple banks. This is relevant since we cannot peep under a bank's hood to see its true shape.
We made sure that we followed the above steps during our recent CD purchases. It made us feel more comfortable since we factored in the chances of a probable bank failure and did not arrive at a decision based on a good APY alone.

Please let us know if we have overlooked any aspect regarding choosing a safe bank in a bear market. Your suggestions and opinions are always welcome.

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