Banks' Next Roadblock: The FDIC

A quarterly report for the FDIC, the government organization that insures bank deposits, shows two less-than-joyous developments:

1. It's running out of money.

2. Demand for money it'll need to cover failing banks is growing quickly.

Before you run to your bank with a wheelbarrow, know that your insured deposits are safe. The Federal Deposit Insurance Corp. has a credit line with the Treasury it can tap when things hit the fan. "We're backed by the full faith and credit of the United States government," says FDIC boss Sheila Bair. Too big to fail, in other words.

And thank goodness it is
The FDIC's deposit insurance fund -- which it relies on to make depositors whole when banks fail -- dropped to $10.4 billion at the end of June, the lowest level since 1993. That's an almost insignificant amount covering its $4.8 trillion in insured assets.

In the past few years, you can see how quickly the fund has diminished:

Source: FDIC.

Such a decline isn't surprising, given the state of the banking industry. This year alone, 81 banks have failed. In 2008, 25 bit the dust. A quick drain of the reserve fund should be expected.

What's scary is that bank failures could just be warming up. You can see this by the ever-increasing number of problem banks the FDIC covers:

Source: FDIC. *Through June 30.

"Problem" banks are those, as described by the FDIC, "institutions with financial, operational, or managerial weaknesses that threaten their continued financial viability." Potential failures, in other words. For obvious reasons, it doesn't reveal the names of these banks until they croak.

What now?
The connection between these two -- falling reserves and rising problem banks -- draws an obvious conclusion: The FDIC is going to need to raise money. Quite a bit of it. Since the Treasury credit line is really a nuclear meltdown scenario backstop, the money is likely to come from a more primary source: Healthy banks.

In good times and bad, banks pay premiums to the FDIC that the agency uses to fund bank failures. When times get tough, it can charge "special assessments," or one-time charges to replenish its coffers. This past May, the FDIC instituted a special assessment with a new calculation targeting total assets, not deposits, hitting big banks like Citigroup (NYSE:C) and Goldman Sachs (NYSE:GS). It's like an insurance policy you have to have that can raise monthly premiums sporadically and at will.

You can see where this is going: As the deposit insurance fund shrinks and the problem bank list grows, the FDIC is going to have to start charging banks a helluva lot more, as well as additional special assessments.

This isn't blind speculation. Sheila Bair herself told Bloomberg, "We will likely have to have another special assessment in the fourth quarter."

Yeah, that is special
And that's going to bite into banks' earnings over the next year or two. Dick Bove, a prominent banking analyst who has been fearlessly bullish on financials this year, had this to say yesterday:

If you estimate what the FDIC premium is going to be for the year 2010, it now looks like it's going to be somewhere, all-in, around $22 billion. If you estimate what the earnings of the banks are going to be, without the FDIC premium, it would be about $80 billion. So roughly 1 out of every 4 dollars of profit is going to go to the FDIC premium. And I don't think that's in the earnings estimates of banking companies.

Wonderful. This includes everyone from regional banks like SunTrust (NYSE:STI), to megabanks like Wells Fargo (NYSE:WFC) and Bank of America (NYSE:BAC). Now that they've elected to become bank holding companies, it also includes the likes of Goldman Sachs and Morgan Stanley (NYSE:MS).

Is it fair that survivors' premiums will pay for the mistakes of failed banks? Sure. That's how insurance works. What's unfortunate are the inequitable premiums survivors will end up paying to clean up banks that paid relatively little during the boom years, when the FDIC was flush.