How bank failure affects your savings rate

Question: Can the rate you’re getting on CDs be lowered if your bank fails and your CD is transferred to another bank? I have a Washington Mutual CD that pays 5% and matures in September 2009 and I’m wondering whether I will continue to earn that rate now that WaMu has failed and JP Morgan Chase has acquired its deposits. If that’s not the case, what can I do? —Katherine, Houston, Texas

Answer: It’s never pleasant for anyone to be swept up in a bank failure. It’s an inherently unsettling situation. And given the extra level of anxiety created by the current financial crisis, the news that your bank has failed or may go belly up is likely to be even more nerve-wracking today.

But as these things go, Washington Mutual depositors have fared relatively well (emphasis on relatively) in at least two respects.

First, when the FDIC announced last week that JP Morgan Chase would acquire WaMu’s banking operations, the agency assured WaMu customers that all WaMu deposits, insured and uninsured, would be fully protected. (The FDIC gave the same assurance this week when it said that Citigroup would acquire the banking operations of Wachovia, although Wachovia did not actually fail.)

So even if you have WaMu deposit accounts that exceed the FDIC insurance limits, you’re not going to take a hit, although the same can’t be said for WaMu stock and bond holders.

Second, although it was initially unclear just how long JP Morgan Chase would continue to honor rates on WaMu CDs, a JP Morgan spokesperson has since confirmed to me that JP Morgan will keep paying the rates WaMu CD owners were getting at the time of the failure for the remainder of the CDs’ terms.

So to answer your question, if you have a WaMu CD that was scheduled to pay 5% for another year, you will continue to get that rate until your CD matures. By the way, that rate looks pretty attractive now, considering that the average rate on one-year CDs is now less than 4%.

There is absolutely no guarantee, however, that this sort of outcome - both insured and uninsured deposits being protected and no cut in CD rates - will be repeated in the event of future bank failures.
Given the possibility that more banks may fail in the near future, it’s important you understand the rules that come into play if your bank goes under.

When your bank fails…

The first thing you need to know is that when a bank fails, the FDIC is legally obligated to cover only insured deposits. That doesn’t mean if you have deposits at a failed bank that aren’t insured that you would automatically lose all your uninsured money. After sorting out a bank’s assets and liabilities, the FDIC often ends up making what it calls "dividend payments" to uninsured depositors.

But why risk losing even a cent in a bank failure when there are so many ways to avoid it? That’s why I recommend that you familiarize yourself with the federal deposit insurance rules immediately if you haven’t already done so. You can do that by checking out an earlier column I wrote on that subject. It’s also a good idea to check out the Deposit Insurance section of the FDIC’s site. (If you keep your money in a credit union, you’ll want to visit the National Credit Union Administration’s site to check out what’s covered by the National Credit Union Share Insurance Fund, which is the credit unions’ version of the FDIC.)

As for what happens to the interest you earn on deposits you have in a failed bank, that depends first on how the failure plays out. If the FDIC can’t find another bank to acquire the deposits of the failed bank, then the FDIC will assure that you will receive principal and interest on insured deposits up to the FDIC insurance limits through the date of the bank failure. After that date, your accounts would no longer accrue interest.

The more likely situation, however, is that the FDIC will transfer your deposits in the failed bank to another bank, as was the case with WaMu. If that happens, the acquiring bank has the option of continuing to pay the same rate you were getting at the failed bank or it can change the rate. If it chooses to lower the rate, you would have the option of withdrawing your money without penalty. If the bank continues to pay the same rate you were receiving or a higher one, you could still withdraw your money, but the bank would have the right to charge any applicable early withdraw penalty.

CD rates

This situation applies for the most part only to CDs. Banks can typically change rates on savings accounts, money-market deposit accounts and the like at any time since they’re not guaranteed for a certain term, and you can withdraw your funds any time without penalty.

With a CD, however, the rate is contractually guaranteed for a given term - typically anywhere from three months to five years - and you incur a penalty for early withdrawal. But if your bank fails, you essentially no longer have a contract with your original bank, which is why the acquiring bank can choose to honor the CDs terms or not.

Of course, if you have a CD with a bank that doesn’t fail but merges with another bank - or, its banking operations are acquired by another bank as was the case with Wachovia - then your CD contract is still in effect. That means the acquiring bank must honor the rate for the remainder of the term, and any early withdrawal penalties would remain in effect.

How likely is it that bank that acquires the deposits of a failed bank would cut the rates CD holders with the failing bank thought they had locked in? Well, it’s not a matter of altruism. It depends largely on how interested the bank is in keeping the failed bank’s deposits on the books. In the case of WaMu, JP Morgan Chase is eager to expand its customer base, so it doesn’t want to do anything at this point that will chase WaMu CD holders away.

But if an acquiring bank isn’t so keen on taking on new customers - or if the failed bank had been paying particularly lofty CD rates that would be expensive to maintain - then it may be more likely to scale back rates, in which case you can either accept the lower yield or withdraw your money without penalty and shop around for a new bank.

If you’re a WaMu customer and you haven’t done so already, I suggest you check out this Q&A the FDIC put together that covers topics ranging from deposits and loans to safety deposit boxes and debit cards.

If you’re not a WaMu customer but would like to know more about what occurs after a bank failure, you can learn more on this FDIC Web site fact sheet.

Who knows, maybe the bailout plan will bolster confidence in our financial system so that our worst fears about bank failures won’t be realized. But if that turns out not to be the case, better to know your options and prepare yourself ahead of time.