Community Associations are established to protect and maintain the mutual investment of homeowners. Community association reserve funds collected through homeowner assessments are typically deposited into FDIC insured banks, CD’s and money market accounts: what are conventionally considered the safest, low-risk option possible
Most associations’ governing documents restrict boards of directors from depositing association funds in unsecured or high risk investments. Ideally an association collects adequate reserves in advance of major repairs or replacements of common area assets to avoid special assessments to cover those costs in the future. In the meantime, an association’s financial health and the resell-ability of its units is dependent on those funds’ safety.
What if, however, the FDIC were just as risky as the stock market or any other uninsured market investment tool?
The 2008 financial crisis exposed cataclysmic weaknesses in the U.S. and international banking systems. The idea of “too big to fail” collapsed and some banks went under while others were bailed out by governments and taxpayers.
Subsequent changes in banking regulations have created a more dangerous potential for those individuals and entities whose assets are cash based.
Bail-Ins and Depositors’ Funds Redefined
In order to maintain financial stability in the next financial collapse and as an alternative to a taxpayer funded bail-out, the G20 Financial Stability Board and the Dodd-Frank Act redefined the way in which banks would be “bailed-out” in the next financial crisis. Effectively they call for a “bail-in”: a mechanism whereby the bank converts its shareholder and depositors’ funds into an equity line item instead of a liability. Depositors then become creditors and are far down the line of creditors, particularly behind the banks’ derivatives holders, which account for $300 trillion of bank investments. In an April 2013 Huffington Post Article by Ellen Brown entitled “It Can Happen Here: The Confiscation Scheme Planned for US and UK Depositors”, she explains:
Few depositors realize that legally, the bank owns the depositor’s funds as soon as they are put in the bank. Our money becomes the bank’s, and we become unsecured creditors holding IOUs. But until now, the bank has been obligated to pay the money back as cash on demand. Under the FDIC-BOE [Federal Deposit Insurance Corp. and the Bank of England] plan, our IOUs will be converted into “bank equity.” The bank will get the money and we will get stock in the bank.
Of great importance is the fact that as bank stockholders, depositors’ funds would no longer be insured by the FDIC (not that the FDIC has the liquidity to make good on depositors’ losses, as we will discuss later).
A November 2015 article written for Money Morning by former hedge fund manager Shah Gilani entitled “Why I’m Closing My Bank Accounts While I Still Can” explains further.
Your deposited cash is an unsecured debt obligation of your bank. It owes you that money back.
If you bank with one of the country’s biggest banks, who collectively have trillions of dollars of derivatives they hold “off balance sheet” (meaning those debts aren’t recorded on banks’ GAAP balance sheets), those debt bets have a superior legal standing to your deposits and get paid back before you get any of your cash.
A January 2015 Before It’s News web article entitled “New Banking Rules Will Devastate Depositors As Your Money Becomes Theirs In The Next Crisis” describes it this way:
During the recent G20 meeting (mid-November), the member nations decided that your bank deposits will become property of the bank if a crisis takes it down.
This means that the bank will be able to pay off their creditors first (if there’s any left to pay) and the money will no longer be yours. The new rules essentially change the status of you as a depositor (of your money) to that of an investor in the bank. And as with any investor in the stock market (for example) you will be subject to losing your money.
The rules have completely changed…
The power is statutory. Cyprus-style confiscations are to become the law.
The 2005 Bankruptcy Act and the Dodd-Frank Act give derivatives claims the super-priority lien over all other claims, insured or otherwise. And derivatives (mortgage-backed securities) are still the most popular investment tool for banks today.
Under the Trump administration, discussion over repealing the Dodd-Frank Act could include a repeal of Title II’s Orderly Liquidation Authority (OLA). A February 14, 2017 Wall Street Journal article entitled “The Dodd-Frank Rule Banks Want to Keep”, Ryan Tracy reports:
“Orderly liquidation authority,” or OLA, was an answer to the 2008 bailouts of Wall Street firms during the financial crisis. It empowers the federal government to take over and wind down a failing financial firm.
Later in the article he continues: (emphasis added)
This “orderly liquidation fund” has become the most controversial part of OLA. Supporters say the temporary loans aren’t a bailout. The failing firm’s shareholders would be wiped out, management would be fired, and lenders to the failing company would lose money, they say.
Whether or not the OLA is repealed, the funds from a bail-out or a bail-in would go first to the banks’ largest creditors instead of to its depositors.
FDIC Solvency and Role
Now let’s consider the role and capacity of the Federal Deposit Insurance Corp. [FDIC]. The purpose of this article was to draw attention to the risk that association funds may be exposed by the lack of solvency of the FDIC, whose purpose it is to insure deposits in the banking system up to $250,000 per institution. I will provide that research below but, as was just stated, the FDIC could be irrelevant.
The 2016 Annual Report issued by the FDIC states that its insurance fund only accounts for 1.18% of all insured bank deposits in the United States. As of December 31, the FDIC Fund Balance was about $83 billion (of which only 1.3 billion was cash and another $73.5 billion was invested in US Treasury Securities). This means total insurable consumer deposits were approximately $7 trillion. The total derivatives contracts held by US banks at the end of 2016 were $165.2 trillion, according to the Office of the Comptroller of the Currency Fourth Quarter 2016 report on Bank Trading and Derivatives Activities, over 23 times insurable consumer deposits.
Even under the old banking regulations, the FDIC is not nearly solvent enough to pay all of its insured members in the event of a banking collapse (although its fund balance is higher and their derivatives exposure is much lower than even three years ago).
The FDIC insures funds deposited into FDIC insured banks’ checking, savings, CD’s and money market accounts. Again, the FDIC’s insurance fund only has enough to cover 1.18% of those deposits.
However, by redefining a depositor as an unsecured creditor of a bank and providing the bank with the power to convert those funds from a liability (cash owed and belonging to the depositor) to an equity (cash owned by the bank), the insurance coverage that may have been afforded by the FDIC is virtually irrelevant.
Implications for Condominiums and Home Owners Associations
Cash depositors in FDIC insured institutions have little hope of recouping their funds in the event of another financial system crisis. Conventional opinion is that another crisis is imminent and could begin at any time. Unlike the previous banking collapse when taxpayer funds were used to supplement the banks’ failure, cash held by the banks from their depositors will supplement the banks’ failures.
Higher end communities may rely less on reserve funding and instead plan on special assessments when big ticket expenses are needed. However, most associations do not fall into that category and rely heavily on the funds set aside over time to avoid special assessments for pre-planned expenses.
In a worst case scenario entire bank account balances could become unavailable or disappear altogether. Homeowners would have an extremely difficult time selling their units, unit values would fall, associations may not be able to fund their daily operations, maintenance of the community would falter, over time larger repairs would be deferred and delinquencies and foreclosures would increase. By default, a market failure would cause foreclosures to increase, but the funds associations had to carry them through the last downturn may not exist.
Alternative Considerations for Association Fund Deposits
Few options exist outside of traditional FDIC banking institutions. Some countries have healthier bank fund ratios and attract high value cash depositors interested in protecting their funds in legitimate offshore accounts. For those who are uncomfortable with the idea of offshore banking, credit unions are a domestic option and may or may not be more secure.
Credit unions are not-for-profit, unlike their for-profit bank counterparts. Additionally, credit unions are owned by their depositors and, by the nature of their structure, put the members’ interests ahead of the institution. Credit unions are insured by the National Credit Union Administration (NCUA), a Federal insurance institution similar to the FDIC. The failure rate of credit unions during the last financial crisis was less than traditional banks.
While some experts suggest credit unions are a safer alternative to banks, I am inclined to be more cautious based on further investigation. The NCUA insurance reserves are funded by all federal credit unions. It operates as a cooperative and the burden of one failure is spread across all credit unions. This means a loss covered by the NCUA is taken from the pooled funds belonging to the remaining banks.
In addition, the failure of just two credit unions in 2009 during the banking crisis reduced the fund to below the mandatory 1.2% fund equity ratio, nearly the same ratio as the FDIC. Credit unions do have advantages for personal banking but are not necessarily a safe alternative for large cash depositors.
Are any conventional banks less risky? Maybe. But here’s a few that aren’t.
The major risk in big banks is the same as it was ten years ago: mortgage backed securities or derivatives. The top five banks in derivatives ownership in the United States are JPMorgan Chase, Citibank, Goldman Sachs, Bank of America and Morgan Stanley. Also included at the top of the Financial Stability Board’s G-SIB list (Global Systemically Important Banks or “too big to fail” banks) are Bank of New York Mellon, State Street and Wells Fargo. And all of these banks are also listed on the Office of the Comptroller of the Currency’s (OCC) National Amount of Derivative Contracts Top 25 Holding Companies in Derivatives, along with the following names: HSBC, RBC Bank, PNC, Suntrust, Northern Trust Corp, US Bancorp, GE Capital Global Holding, TD Group, MUFG, Capital One, Regions Bank, Keycorp, BB&T, Fifth Third Bankcorp, Citizens, Santander Holdings and Ally Financial.
If these 25 banks are the largest derivatives holders in the US, perhaps the first step is to consider minimizing obvious risk by removing reserve funds from these banks and investing them into smaller federal or community banks. Credit Unions may still be a better option than big banks, but watch the liquidity of their insurance fund.
Many community associations bank with BB&T, a specialized association services bank and one of the banks on the top 25 list of derivatives holding companies. Because we are discussing the protection of reserve funds, there is an investment tool by which accounts can continue to be maintained by BB&T for management and board convenience but invested in safer locations.
CDARS – Certificate of Deposit Account Registry Service – are considered a very convenient way to maintain FDIC insurance on multi-million dollar deposits. Funds are managed by one primary bank and invested in a variety of banks’ insured investment tools up to the maximum insurable value per institution.
The CDARS agreement signed with your primary bank provides the option to keep your funds from being invested in banks you specify. This means your reserve funds could be managed by BB&T, PNC or Regions Bank, for example, but deposited into banks that are not listed on the above list of 25. Operating funds are typically well below the insurable limit and changing banks all together should be considered on a case by case basis, weighing the advantages of consistency, cost and convenience.
Banks not included on the list of 25 may still be high risk and should be evaluated before considering a depositor relationship.
Consult with your financial professional. They may have knowledge of other options not considered here. Keep in mind though, it is in the banking and financial industry’s best interest to protect itself.
While we can’t predict what will happen in the future, recent history gives a good preview of the outcome of the current and precarious state of the global banking system.
Be aware of the state of your association’s reserve funds, educate yourself and develop an investment plan with your management, legal and financial team.