The Federal Deposit Insurance Corp. plans to tell an Iowa court today that it will not cover losses by holders of popular short-term investments called retail repurchase agreements that were bought from an Iowa bank that failed last month.
If the court agrees, the holders of these "repos" from the failed Mt. Pleasant Bank and Trust Co. could stand to lose a total of $350,000. While FDIC officials said the ruling applies in only a few other states whose laws are comparable to Iowa's, the FDIC action emphasizes the risks of repo investments.
The FDIC contends that the Mt. Pleasant customers, who had invested between $5,000 and $55,000 apiece to get returns higher than those offered on insured deposits, did not have a secured interest in the government securities used as collateral to back the repos. That means they could not get their money back from the sale of the securities but would have to wait in line with other creditors to get their share of what was left after the bank's assets were liquidated.
After Mt. Pleasant was closed last month it was absorbed by Hawkeye Bank and Trust of Des Moines.
An investor buys a repo by lending dollars to the bank, receiving a specified higher return from the bank after a fixed period of time. The increase is equivalent to an interest payment on the repo. Repos are not considered deposits, but rather debt obligations, and are therefore not insured by the FDIC. The repos are also not covered by the Federal Reserve Board's regulation limiting the interest rates banks can pay on deposits, which explains their popularity both to investors, and to banks in their competition with money market funds, which face no such limitation.
With both the sales of retail repos and the number of bank failures growing, more small investors could wake up to find their money gone. According to the Federal Reserve, the amount of retail repos outstanding has grown from a negligible amount a year ago to $19.7 billion at the end of July.
Although the potential loss in the Mt. Pleasant case is relatively small, it marks the first time the government insurer has failed to include uninsured bank accounts in a merger.
In 26 other cases this year where failed banks have been closed and taken over by healthy ones or merged with government assistance, some $286 million in uninsured deposits over $100,000 has been protected. In other words, the owners of these accounts have benefitted from insurance even though they weren't entitled to it.
In related news, the Securities and Exchange Commission last week issued a memorandum regarding the risk to mutual funds from heavy investment in repos. In response to a letter from Rep. Benjamin Rosenthal (D-N.Y.), the commission said it would study possible solutions, such as requiring funds to evaluate the credit worthiness of repo issuers.
The risk to a mutual fund is that in the event of failure the fund may be subjected to delays in selling the securities underlying the repos and therefore a decline in their value. However, David Silver, president of the Investment Company Institute, the mutual fund trade association, called the issue "somewhat contrived." He pointed out that only one mutual fund has been affected by the bankruptcy of Lombard-Wall, Inc., government securities dealers. A court granted permission to sell the securities after four hours.
In a repo transaction the lender gives money to a securities dealer and receives government securities as collateral. Retail repos and institutional repos are the same basic instrument, except that in the case of retail repos the lender (the customer) does not get possession of the collateral. Therefore, Silver concludes, the general public is better protected by buying shares in a mutual fund that invests in repos than by buying repos directly through a bank.