FDIC Conducting Stress Test Exams - "Shock Testing 400 Basis Points Up and Nothing Down"

In response to The Next Borrow-Short Lend-Long Guaranteed to Blow Up Bank Lending Scheme; Citigroup, Chase, Bank of America CD Ripoff I received an interesting Email from "ABO" a Bank Owner and CEO regarding new FDIC shock testing exams.

ABO writes ...

Hello Mish

You nailed it on the CDs. I just got done with an FDIC exam and they requested shock testing 400 basis points up and nothing down. Hard to go below zero.

In terms of 5 to 7 year CDs a 15 year GNMA is probably a better way to go. Don't buy them at a premium and look at average life of 4 to 5 years. They are zero risk based as well.

Anyway nice job I could not agree with you more.

Here is a snip from my post regarding new borrow-short lend long schemes. Refer to the link at the top for a discussion of absurdly low CD rates offered by Bank of America and Citigroup, or for the full discussion about the duration mismatch problem banks are getting themselves into.

The Next Borrow-Short Lend-Long Guaranteed to Blow Scheme

.... With the discussion about duration mismatch out in the open, please consider Banks Go Straight to Public Borrowers

Banks are setting aside billions of dollars to do something that until now was rarely heard of: making big loans to cities, states, schools and other public borrowers that otherwise might have turned to the bond market.

When Riverside, Calif., was ironing out a bond offering recently to expand its performing-arts center, several banks pitched a radical idea: Why not take out a loan instead? The city scrapped the bond plan and borrowed $25 million from City National Bank in Los Angeles.

"This was a method we'd never even heard of before," says Scott Catlett, the city's assistant finance director. He says Riverside now intends to seek a bank loan for a conference center that it had planned to build with bonds.

J.P. Morgan Chase & Co. is devoting billions of dollars to direct loans this year to both refinance deals and for new projects, according to a bank official. Last year, the bank made a few hundred million dollars of direct loans to municipalities. Now, the bank would consider making a single loan for hundreds of millions of dollars, the official said. It also is dispatching teams to explain the concept to wary public borrowers.

Citibank also is courting municipal borrowers with direct loans, according to several bond issuers. A spokesman for the Citigroup Inc. unit declined to comment.

"This used to be unheard of," says Eric Friedland, managing director of public finance at Fitch Ratings, noting that in the past, banks would occasionally loan a municipality less than $1 million to finance projects too small for a bond offering. For bigger loans, they would form a syndicate with other lenders.

It remains to be seen what land mines may be lurking for lenders and borrowers. Some municipalities are going through significant struggles, raising questions about whether they will prove good credits. And direct loans are less liquid, meaning banks can't sell them as easily as bonds.

For banks, this is a potentially lucrative business at a time when they are sitting on cash that isn't earning huge interest and are reluctant to make loans for mortgages and other areas they see as risky.

In the event of a bankruptcy, analysts say, it is unlikely that a bank extending a direct loan would be given priority over bondholders.

The city saved hundreds of thousands of dollars in issuance costs, says Mr. Catlett, the assistant finance director. Plus, he says, the interest rate is 3.85% versus at least 5% if it had floated a public offering. The term is slightly lower�21 years versus perhaps 30 years in the bond market.

"This was all new to us," he says. "I don't know now when we'll go back to the bond market. This is easier."

Fed or FDIC Should Stop this Fraudulent Scheme Now

The Fed or FDIC should step in right now. There is no way banks can secure cost of funds for 21 years for 3.85%. Moreover, the risk of default is hardly zero, and banks will not be first in line should default happen.

I think borrowing-short and lending-long is fraudulent. How can you lend something for 21 years when you only have the right to use it for 3, 5, or 7?

Want to know what those banks thinking? This is what ....

• They are too big too fail
• The Fed will bail them out
• Cities won't default but who cares anyway because the Fed will bail them out
• They have a hot pile of cash the Fed crammed down their throats at 0% and they want to put it to use
• They got burnt badly on mortgages and home equity loans so they need to find something new
• One idiot bank made an absurdly risky deal so like sheep they all want to do it
  

Right now they are all thinking there is nothing to lose from this. The Fed or Congress will bail them out at taxpayer expense if they get in trouble.

Then, when this does get out of control and blows sky high, they will all scream, "no one could possibly have seen it coming".

For a follow-up post with further discussion including an email from a reader about someone being taken advantage of by B of A, please see Bank of America Preys on Elderly Depositors; Culture of Greed, Arrogance, Incompetence.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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