'Hot Money' Tactic to Raise Funds Creates Risk

By David Cho

Washington Post Staff Writer

Tuesday, July 15, 2008; A01

Banking stocks suffered some of their worst losses in a generation yesterday as investors' confidence in the U.S. financial system continued to erode despite the dramatic initiative by the federal government Sunday evening to bolster mortgage giants Fannie Mae and Freddie Mac.

Some banks have become increasingly vulnerable because of the risky approach they have used to raise money after traditional sources of finance on the credit markets evaporated last summer, according to banking executives and regulators.

Outside branches of California-based IndyMac Bancorp, people lined up as early as 4 a.m. yesterday to withdraw money after the bank shuttered its doors last week, becoming the third-largest bank in U.S. history to fail.

Federal regulators said yesterday that IndyMac's predicament was not widespread and that most banks remained financially stable.

The concerted effort to calm the public came as shares of Washington Mutual, the country's largest savings and loan, tumbled 35 percent, its biggest decline ever. Trading in National City, a large, Ohio-based bank, was briefly suspended during a panicked sell-off, its shares sinking to a 24-year low even as it issued an urgent statement that it was experiencing no unusual activity by depositors or creditors.

Concerns about the health of the country's financial firms spiked Friday after federal regulators seized IndyMac, which had relied on brokered deposit accounts -- high interest rate paying accounts, normally certificates of deposit, that are offered by a bank to brokers who represent large investors.

Some banks are keeping themselves afloat by turning to such "hot money" sources, in which a cash-hungry bank quickly raises large sums of money by promising to pay depositors a high interest rate. But such funds can disappear just as rapidly in a crisis.

At IndyMac, $1.3 billion in deposits vanished during the days before the bank failed. Bank branches closed hours earlier than usual Friday to prevent more withdrawals.

"The IndyMac situation was unique and does not signal a direction for the industry as a whole," said John M. Reich, director of the Office of Thrift Supervision.

But before IndyMac failed, it was not even on a list of troubled banks closely watched by the Federal Deposit Insurance Corp. That list includes 90 firms, a relatively small number within the U.S. banking system. FDIC officials acknowledged yesterday that other banks could also fail.

FDIC Chairman Sheila Bair warned recently that new banks that rely on hot money from brokered accounts would be examined more carefully. The agency is also exploring ways to restrict banks from offering these accounts.

These accounts are not necessarily illegal or unwise, federal regulators said. They can help small rural or regional banks rapidly raise money to pay depositors who want to withdraw their money.

"There's nothing bad or wrong with broker deposits; we just have to be sure as regulators they are used in a safe and sound manner," said Scott Polakoff, chief operating officer of the Office of Thrift Supervision. "The risk is adopting a too-aggressive growth strategy that is funded by broker deposits. Because it's a very fast way to grow, it has to be done in a safe and sound fashion."

Since last summer, banks have faced a daunting predicament. Borrowers are defaulting in droves on all kinds of commercial real estate loans, home mortgages and consumer debt and can't pay the banks back.

That leaves the banks without the cash to pay back depositors who want to withdraw their money. In addition, they are struggling to sell their loans on the credit markets because investors know that the quality of the debt has deteriorated.

During the boom years of 2003 to 2006, banks used this hot money to fuel excessive growth, according to banking regulators. Now these banks are facing the consequence of their aggressive tactics. Five of the past six banks to fail heavily relied on brokered accounts to raise funds.

"Obviously with all that's gone on in the industry, there are a lot of concerns right here," said Timothy Long, senior deputy comptroller at the Office of the Comptroller of the Currency. "The use of brokered deposits -- all of the regulators are looking at this and reviewing it. It can be a potential source of problems for banks to get themselves in trouble. It does have me concerned in certain situations."

At IndyMac, for instance, 37 percent of all its deposits were in brokered accounts. Just a few weeks before it collapsed, IndyMac advertised a 4.35 percent interest rate for opening an online, one-year certificate of deposit.

"The banks are paying the highest rates in the country for these deposits," said Peter G. Fitzgerald, chief executive of Chain Bridge Bank in McLean. "And that hot money can dry up in a nanosecond because there is a whiff that the bank is facing trouble."

The risks are spread throughout the financial system. Today 3,334 institutions reported brokered deposits totaling $602 billion. Eight years ago, the amount was minuscule, FDIC analysts said.

Separately, banks are heavily leaning on the Federal Home Loan Banks, which may be putting tax dollars at risk, lawmakers said. That banking system, which includes 12 privately funded institutions around the country and carries an implicit backing by the federal government, had loaned $621 billion to banks in the beginning of 2007. By the end of March, that figure had risen 36 percent, to $842 billion.

Some Democrats blamed regulators for not being vigilant enough. Sen. Charles E. Schumer (D-N.Y.) said he had been sounding the alarm for weeks on the over-reliance of high interest rate brokered deposits, a main source of hot money.

"Profligate practices, combined with lax oversight, are what got us where we are today," Schumer said. "Brokered deposits and home loan bank advances exist in order to provide important liquidity to our banking system. But more and more, it appears they've been abused by some institutions to bankroll shoddy lending practices while the regulators turned a blind eye."

Some federal regulators said Friday that IndyMac was the second-largest U.S. bank to fail but revised that ranking to third after taking into account a savings and loan that closed in 1988.

The FDIC announced yesterday that it would freeze foreclosures on bank-owned loans in IndyMac's portfolio to see whether the mortgages could be modified, which would allow homeowners to stay in their homes.