“Who gets the money when a bank fails?” That was the innocent question of one of my friends tonight as I prepared to write about this week’s bank failures. I realized many people must have this question.
The simple answer is that money simply vanishes on the day of a bank failure. Deposit insurance provides replacement money, to an extent, but roughly a third of the money it replaces is actually destroyed.
The law of conservation of matter and energy clearly has made an impression on people, and as most people visualize economic matters, they imagine that a similar law applies here. Common sense supports this view. In a successful commercial transaction, a certain amount of money goes in, and the same amount goes out, in different hands. But that is not a law of science, and not all economic events are perfectly efficient when it comes to money. Money is created and destroyed on a daily basis, but most dramatically in bank failures, where deposits in excess of the insurance limits may simply be wiped clean.
I must hasten to add, however, that more than few banks in history have been set up for the express purpose of funneling money out to other parties, usually disguised as borrowers, and in recent years, usually as real estate developers. These banks were made to fail and are founded on false financial statements, and this possibility is one of the reasons that regulators have to keep a close eye on banks. It is the exception, though, when a bank fails under a cloud of suspicion and a criminal investigation. Most bank failures occur as the simple result of bad decisions or sloppy work. Bank failures can also occur as the result of horrendous economic conditions surrounding the bank — but it is important to note that all the banks in the United States have participated in the same national economy, and more than four out of five will survive the current bank failure cycle.
Observers in the White House and elsewhere who are waiting for a real estate rebound to help bring the banks back may have to wait for years. Fannie Mae revealed in its latest financial statements that it has been selling foreclosed homes at a rate of more than 500 per day, yet its inventory keeps rising. The inventory should easily reach 200,000 by the end of the year and 300,000 at some point early next year. That’s more houses than people own in Washington, DC. And that’s just Fannie Mae.
Nor will this problem, known in banking as REO (real estate owned), improve immediately when the job market improves. In a historically normal job market, the rate of workers moving to new jobs would be 5 to 10 times what it is now, and many of these workers will be moving out of houses with underwater mortgages, where they owe more than the house is worth. If those houses cannot immediately be sold, the banks will end up stuck with them, and though the losses may be smaller, that could end up being a larger number of houses than the banks are dealing with now.
You might imagine that many of these workers moving out of the underwater homes will buy other homes in the cities they move to, but in most cases, they won‘t be able to. New mortgage market rules this month will effectively prohibit anyone whose mortgage failed from taking out a new mortgage for a period of about 7 years. Based on that rule, at least 20 percent of current homeowners will be turned into renters before this is all over.
With banks selling homes as fast as they can, and with more than 20 percent of current homeowners prevented from buying a house the next time they move, it will be impossible for housing prices to remain at their current levels. For banks, this assures that losses will continue.
The one bank failure tonight occurred in Chicago. The two branches of Ravenswood Bank were closed. Northbrook Bank is paying almost a 1 percent premium for the deposits and is also purchasing the assets.
Ravenswood Bank had $270 million in deposits and slightly less than that in assets. Its deposits included campaign funds of former governor Rod Blagojevich, who is currently on trial for racketeering and other political misconduct. If Blagojevich is convicted, prosecutors have indicated that they will ask for the campaign accounts to be forfeited. In case you were wondering, even accounts that are frozen by court order are protected by deposit insurance.