The Other Cliff Event

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A few weeks back I penned a discussion entitled "Cliff Notes for 2013 - What Lies Ahead." Naturally the commentary centered on what is to come January first of next year with the expiration of the Bush tax cuts in addition to the automatic Government spending cuts. Personally I expect some type of legislative intervention to soften or phase in what would otherwise be a cliff event potentially capable of knocking roughly 2% off annual GDP growth. The trick, of course, is anticipating the interim reaction of not only the investment community, but also real business decision making as the chances of reconciliatory legislative action prior to the election are small. That leaves seven to eight weeks post the election to address these twin issues as well as current interim estate tax legislation that likewise sunsets at year end. And what has become eleventh hour just-in-time legislative decision making of the past few years will not fray a nerve or two? Good luck with that.

To add just a bit more fuel to the fire, there is yet another expiration event at year end 2012 that is receiving little to no attention that I believe will have some impact on either the bond market or what supposedly seems to be the recovering fundamentals of the big banks. That event is the expiration of FDIC insurance for all bank deposit amounts above $250,000. Here’s my bottom line. If the Government allows the excess FDIC insurance coverage to expire, they will implicitly be helping out Ben Bernanke and the merry pranksters at the Fed. If they extend the insurance coverage, they will implicitly be supporting the banks. Which will it be? Given the more than close relationship between the Administration and the US financial sector, it should be quite the interesting choice, no? Just remember, in the endgame the Government will always and everywhere vote for self preservation.

Some very short background. On November 9, 2010, the FDIC issued a Final Rule implementing section 343 of the Dodd-Frank Wall Street Reform and Consumer Protection Act that provides for unlimited insurance coverage of noninterest-bearing transaction accounts. Beginning December 31, 2010, through December 31, 2012, all noninterest-bearing transaction accounts are fully insured, regardless of the balance of the account, at all FDIC-insured institutions. The unlimited insurance coverage is available to all depositors, including consumers, businesses, and government entities. This unlimited insurance coverage is separate from, and in addition to, the insurance coverage provided to a depositor’s other deposit accounts held at an FDIC-insured institution. Importantly, note that Money Market Deposit Accounts (MMDAs) and Negotiable Order of Withdrawal (NOW) accounts are not eligible for this unlimited insurance coverage, regardless of the interest rate, even if no interest is paid on the account.

Although what was essentially unlimited deposit insurance coverage was extended in late 2010, it was not until one year Treasury rates nose dived to near 10 basis points that money really started flowing into the banks on a rate of change basis.

money desposits

1 year u.s. treasury rate

And certainly this cheap money has been a boost to bank bottom lines via the interest margin spread. Was this a minor earnings/balance sheet support mechanism for the banks, in addition to TARP, QE, etc.? You bet. Although it’s clearly not the end of the world, if excess FDIC coverage sunsets as now planned at year end, a piece of support for still recovering banks will be removed. I suggest this will be a bigger issue for the large banks who can deploy capital (earn spread) in a much broader array of investment venues than their regional and community bank brethren. The fact is that for many regional and community banks, deploying excess deposits productively over the last few years has been very tough without meaningful investment risk extension (the last thing many of them need while still nursing open balance sheet wounds).

Before thinking about this issue from the standpoint of the Federal Reserve, a bit more quick background. The following chart is absolutely clear in its message.

u.s. federal budget deficit

We’re now coming up on the three year anniversary of the current cycle economic recovery. (The red bars mark official recessionary periods.) What is certainly disturbing is that three years into recovery, the US Government is still running an absolutely massive federal deficit, clearly without historical precedent. As of now, we’re on a run rate for a $1.4 trillion 2012 deficit. From mid-2009 through year end 2011, the Federal Deficit grew by approximately $3.3 trillion. Nominal GDP growth over the similar period? $1.47 trillion. You’ll remember that year over year GDP growth in 2011 was the lowest number in a non-recessionary period since 1947. We have one of the most shallow economic recoveries on record while simultaneously running what only a number of years ago would have been considered unthinkable levels of Federal deficits. Quite the juxtaposition. But as I have suggested many a time, some sector of the economy needs to be the credit provocateur if we are to have any GDP growth. Net credit expansion is the oil that makes the economic engine run. In a period of private sector deleveraging that is still incomplete, by necessity the Government must continue to borrow or face moribund economic expansion. This is not about good, bad, right or wrong, it’s simply a fact. In the absence of private sector releveraging, the Government must and will continue to borrow. In fact as suggested above, if indeed we see reconciliation of the "fiscal cliff" that awaits at yearend, Government borrowing next year will be "better than expected" (oh wait, that only works with lowered corporate earnings estimates).

Of course it has been the Fed that has accommodated a very large amount of additional Federal borrowing over the last year plus. Although I cannot personally corroborate the number, it has been estimated the Fed purchased 61% of net Treasury issuance over the last year. Regardless of the exact numbers, the pressing question is can the Fed continue to monetize historic Federal debt issuance that by necessity must continue if we are to realize nominal economic expansion? Enter excess FDIC coverage.

Let’s get right to the numbers. As of the fourth quarter of last year, according to the folks at the FDIC, there existed $1.4 trillion in US commercial bank deposits above the $250,000 FDIC insurance threshold. Here’s the breakdown by size of institution directly from the FDIC Quarterly Banking report. This is exactly why I suggested above that this will be an important issue for the big (protected) banks.

bank asset fdic coverage
Data Source: FDIC

You can see this one coming, can’t you? If excess FDIC coverage expires at year end 2012, we’ll potentially have $1.4 trillion castaways looking for a home. And would not short term Treasuries be that home if risk is still a primary consideration for these depositors? Just imagine, this number happens to be the current Federal deficit level. Worried about the Fed monetizing US Treasury debt after Operation Twist and into the new year? As "Chuck" would say, just relax. We may indeed have a natural buyer if excess FDIC coverage is no more. But again, as the table above clearly shows us, the money will come from the big banks, not the regional or community banks.

How it all ends up I have no idea. My personal bet is excess insurance coverage expires in the hopes this money finds its way into Treasuries to support continued Federal debt issuance, especially if there is some legislative reconciliation of the twin "fiscal cliff" issues. Not a horrible negative for the banks, but certainly not a positive. Very much a positive for Federal funding and Federal Reserve "appearances". Is this why Janet Yellen is so confident rates will remain low for years to come? Again, my intent here is not to make a fiscal or monetary judgment call, but rather to address an issue it seems no one is talking about at present.

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About Brian Pretti CFA

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