FDIC Insurance and Structured CDs

As a continuation of our structured CDs week here on the SLCG blog, today we're going to discuss one of the biggest selling points for these products: FDIC insurance. FDIC insurance mitigates most of the credit risk found in structured products, but it may not be as significant a factor as the marking materials for structured CDs may suggest.

Structured products, the debt analog of structured CDs, are often maligned because of their exposure to credit risk. If the issuer of a structured product is unable to pay their obligations as they become due, investors could realize substantial losses. This is precisely what happened when Lehman Brothers went bankrupt, as Lehman was at the time one of the largest issuers of structured products -- see our paper on the subject .

FDIC insured deposits, on the other hand, are backed by the full faith and credit of the US government if the issuing bank goes under. There are of course limits to the amount covered by FDIC insurance. The Emergency Economic Stabilization Act of 2008 (PDF) temporarily increased the maximum deposit insurance amount from $100,000, established in 1980, to $250,000 per account (see 136(a)(1)) and the Helping Families Save Their Homes Act of 2009 (PDF) extended this increase through December 31, 2013 (see 204(1)(1)(A)). This new limit was made permanent by the Dodd Frank Act of 2010 (PDF).

One thing investors should appreciate is that FDIC insurance covers only the principal repayment at maturity, not interest payments (unless the interest payments are guaranteed). In a structured CD, that means any market-linked payments, which are the interest generating part of the investment, are not insured and are therefore exposed to the issuer's credit risk. According to the FDIC warning issued in spring 2012:

If the bank has guaranteed that the principal will not go down in value, the FDIC will cover both the principal and any accrued interest, up to the federal insurance limit. But if interest is only credited at maturity [as in structured CDs], and if the bank were to fail before the CD matured, no interest would be insured because no interest had accrued.

For example, yesterday we covered an HSBC structured CD issued in May 2012 that has payment at maturity with a guaranteed minimum component and a contingent component. Should HSBC default prior to maturity, the FDIC would cover the principal investment, but no interest contingent upon market performance since this is not due to the investor until maturity.

The implication of FDIC insurance is that a structured CD will be slightly more valuable than an exactly equivalent principal protected note on the same underlying issued on the same day. However, it is unlikely that such an exact pair would exist in the market. In our experience, structured CDs are typically longer term (have a longer time to maturity) than similar principal protected notes, which decreases their value to investors.

The realization and accrual of interest is another complication of structured CDs. The FDIC warns that although some structured CDs -- see, for example, the following JPM market-linked CD -- do not credit interest during the CD's term, you may be required to recognize interest income for tax purposes at a "comparable yield" for the product. This results in a phenomenon commonly known as "phantom income" and we'll have another post later in the week discussing the tax consequences of market-linked CD investing.

So while FDIC insurance does partially address one important criticism of structured products (namely, credit risk), it does not completely protect investors from issuer default. The value of FDIC insurance can be mitigated by the issuer adjusting other product parameters (more volatile market indexes, longer term, etc.), and leads to other complications of which investors should be fully aware.