What is and isn’t protected from bank failure

July 17, 2008

What is and isn’t protected from bank failure
 Money Megazine.

Despite the recent headlines, bank failures are extremely uncommon. But if you’re concerned, here’s what you need to know.

Question: If you have $100,000 in a checking account and also have a $200,000 CD with the same bank how much of your money is protected by federal deposit insurance? How much would you receive if the bank failed? –Walter Matthews, Savannah, Georgia

Answer: Talk about déjà vu all over again. When hundreds of customers lined up to pull their money out of IndyMac, the failed bank that federal regulators seized last week, my mind instinctively flashed back to the S&L crisis of the late ‘80s and early ‘90s, when at one point banks were dropping at a rate of more than one a day.

I don’t think anyone envisions a replay of that era. So far only five banks have failed this year and only three went belly up last year.

Still, given the weakness of the economy overall and the financial sector in particular - not to mention the still very much unresolved problems in the housing and mortgage markets - you want to be sure that the money you put in a bank to keep it safe doesn’t take a hit should that bank happen to fail.

So here’s a rundown on what’s covered - what’s not covered - by the FDIC, or Federal Deposit Insurance Corp.

You’ve no doubt already heard that the FDIC generally insures deposits of up to $100,000 in FDIC-insured banks. (If you’re not sure whether your bank is FDIC-insured, you can find out on their Web site.

But, not surprisingly considering that FDIC insurance is a government program, the regulations regarding this coverage are actually a bit more involved than the oft-repeated $100,000 figure suggests.

What’s covered

Basically, the FDIC provides coverage by what it calls “ownership categories.” Single accounts, which are one category, are covered for as much as $100,000. Joint accounts are a separate category and also receive $100,000 of insurance protection per account holder, assuming each owner of the joint account has equal rights to withdraw funds from the account.

In calculating joint-account coverage, the FDIC takes into consideration all the joint accounts each account holder has at that bank. So, for example, if you and your spouse have a joint checking account with $150,000 in it and you also have a joint savings account with a nephew that has $100,000 in it, you would have $125,000 in deposits in this category (half the $150,000 account and half the $100,000 account), which means $25,000 of your money would be uninsured.

Retirement accounts are another category, and they receive their own $250,000 of insurance coverage per person at each bank. Now, by retirement accounts, the FDIC means deposits held in actual retirement accounts, such as IRAs, SEPs, Keogh plans and self-directed 401(k)s. So, for example, if you have money that in your mind is earmarked for retirement but is being held in a regular savings or CD account in your name, that account would fall into the single account category, not the retirement category.

There are a few other ownership categories that don’t come into play for most people, but that you should be aware of nonetheless, including revocable trust accounts (which include “payable-on-death” and “in trust for” accounts), irrevocable trust accounts, employee benefit accounts and certain types of business accounts.

Even if you exceed the insurance limits, however, you won’t necessarily lose all your money that isn’t insured. Depositors often end up getting back at least some of their uninsured deposits via what the FDIC refers to as “dividend” payments. For example, the FDIC has already said it will reimburse depositors at IndyMac 50% of uninsured funds, and depending on how the bank’s assets and liabilities sort out, it’s possible they could receive more later on. In some failures, however, uninsured depositors receive much less and wait years to get it.

What’s not covered

It’s also important to understand what’s not covered by the FDIC. FDIC insurance applies only to bank deposits, which would include money in checking accounts, savings accounts, NOW accounts, money-market accounts and CDs.

But this insurance does not cover investments that are not deposits, such as mutual funds, stocks, bonds or Treasury bills or annuities, even if you bought these investments at the bank. (You especially don’t want to confuse money-market funds, which are a type of mutual fund and thus not insured, with money-market accounts, which are a bank deposit and thus eligible for insurance.)

So, for example, if you invested $250,000 in mutual funds in an IRA account that you bought through a financial adviser at your local bank, that money would not qualify for deposit insurance in the retirement category. Similarly, if you invested $100,000 in an annuity you bought at the bank, your $100,000 wouldn’t be covered in the single-account category.

This doesn’t mean, however, that you would lose any of that money if the bank fails. When you invest in mutual funds, annuities, stocks, bonds or even Treasury bills through your bank, you’re not making a deposit in the bank as you are when you put money in a checking account or CD. You’re making an investment through a broker that has a working relationship with the bank. The money you invest in such cases is not considered part of the bank’s assets or liabilities, even though you invested that money at the bank. Such holdings are separate assets held outside the bank.

So when regulators tote up a failed bank’s assets and liabilities, your accounts that hold mutual funds and the like aren’t even part of the equation. Regardless of what happens to the bank, you still own those mutual funds or other non-deposit investments, and the value of those holdings is determined by their current market value.

It’s possible that in the immediate aftermath of regulators closing the bank that you could briefly lose access to mutual funds or other investment accounts you acquired through the bank. But even that’s unlikely, as the FDIC tries to assure that in the immediate wake of a failure bank customers have access to insured deposits as well as non-insured accounts like mutual funds and annuities.

Protect yourself

So what’s the best way to insure that you don’t lose money in savings accounts, CDs and other deposit accounts if your bank goes down?

Well, since each ownership category qualifies for its own insurance coverage, it’s possible that you can arrange things so that you have several hundred thousand dollars of insured deposits in a single bank.

If you keep $100,000 in savings account, $200,000 in a joint bank money-market account with another person and $250,000 in an IRA CD, you would have $450,000 in coverage right there, without getting into any of the other categories.

But does it really make sense to try to maximize your insurance protection at one bank?

Granted, you don’t want your savings to be vulnerable, but I think there’s an easier way to protect yourself: just spread your money among a few different banks so you’re well below the insurance limits at each institution. After all, it’s not like there’s a shortage of banks in this country, so why push it?

Diversifying especially makes sense if you’re at or close to the insurance maximums for a given account, as the interest you earn could easily push you over the limit. Buy a $100,000 CD that pays 5% a year, for example, and by the end of the year you would have $5,000 that’s not covered by insurance.

Another advantage to this diversification approach is that, in the event a bank you use does fail, all your money won’t be swept up in the shutdown process.

I think it’s fair to say that the FDIC tries hard to make these situations as painless as possible for bank customers. Regulators usually try to take over the failed bank on Friday and find (or, as in the case of IndyMac create) another institution to acquire the bank or certain operations over the weekend. The goal is that, come Monday, customers would have access to their money at the same locations as before. Regulators also try to avoid disruptions in checking and ATM service.

Still, the mere fact that your bank has failed can be emotionally upsetting. Witness the hordes of anxious customers that descended on IndyMac. And while the transition from a failed bank to a healthy one usually goes relatively smoothly, there’s always the possibility for snafus. In a minority of cases, the FDIC must even resort to doing a “payout” - that is, simply shutter the old bank and mail insured funds to depositors. Waiting even a few days for the mail carrier to deliver savings or CD money that you may need for living expenses would be enough to make anyone uneasy. But the ordeal would certainly be a lot less nerve wracking if you at least had other savings you know you could easily tap.

So by all means if you have the slightest doubt, find out whether the deposits you have at a bank are covered by insurance. You can check out this FDIC calculator to see whether that’s the case.

But my advice is that if you keep significant amounts of money in CDs, savings accounts and such, spread it among a few different banks, especially if there’s even a remote chance of bumping up against the insurance limits.

With any luck we won’t see a big uptick in bank failures. But better to be prepared just in case.