If you wanted to close your certificate of deposit early, you’d pay a penalty. Unless your CD were callable, your bank can’t close it early with one exception. Fortunately, it’s an exception all banks loathe.

We learned that Certificates of Deposit aren’t risk-free, they are susceptible to inflation risk. Fortunately, they aren’t at risk when a bank fails either. However, should a bank fail, the acquiring bank may not be required to honor existing CD rate agreements.

There are two possible scenarios when a bank “fails:”

• The failing bank actually fails, is received by the FDIC, and subsequently sold to an acquiring bank. In this scenario, the acquiring bank is not required to honor the CD agreements of the failed bank. They can choose to honor them but they are not legally obligated to.
• The failing bank doesn’t actually fail, the FDIC simply helped broker its sale to an acquiring bank. In this scenario, the mainstream media may report a bank as having failed when it fact is hasn’t. The FDIC did step in and assisted with the transition but never took it over. In this scenario, it’s as if the acquiring bank bought the failing bank, perhaps with a loan from the FDIC (or protection against losses). In this case, the acquiring bank is required to honor the CD agreements of the failed bank.

While the fear of major banks failing has, for the most part, passed us; it’s important to understand this distinction (though 32 banks have already failed in 2009, vs. 25 in 2008). One of the telltale signs a bank is in dire straits is when their CD rates are abnormally high relative to their peers. Washington Mutual had an absurd 5% APY CD when other major banks were in the 3-4% range. In that case, JP Morgan honored the 5% APY CDs even though they weren’t required to.

Jim writes at the personal finance blog Bargaineering.

(Photo: spinadelic)

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