IT WAS ENOUGH TO make anyone gasp — at first. NetBank, the oldest nationwide Internet-only savings and loan, was shut down by the Treasury Friday as a result of weak loan underwriting, poor documentation, early payment defaults on the loans it sold and failed business strategies. The bank, which was founded in 1996, had $2.3 billion in deposits, including the life savings of tens of thousands of people.

The shuttering of NetBank is the largest savings and loan failure since 1993, when Western Federal Savings Bank in California closed, says Bill Ruberry at the Treasury's Office of Thrift Supervision (OTS). For those who vividly recall the S&L crisis of the 1980s, that can seem like quite a dubious distinction.

Consumers, however, shouldn't start pulling their money out of their online accounts and stuffing it in their mattresses. There are ways to make sure your money is safe in the virtual world, whether you're dealing with an Internet-only bank, online services of a small regional bank or those of some large global concern.

The NetBank Fallout

What happened at Alpharetta, Ga.-based NetBank, for example, should serve as an interesting lesson for online banking customers.

When the company shut down, ING Direct1 — the online arm of banking behemoth ING Bank — almost immediately stepped in and acquired the accounts of NetBank customers holding checking and savings accounts, CDs and IRAs. (Mortgage accounts were acquired by online bank EverBank).

For customers who had deposits of up to $100,000 (or $250,000 for IRAs and Keoghs) — the insured limit set by the Federal Deposit Insurance Corporation (FDIC) — access to banking services, such as online bill pay, wire transfers and using an ATM, was virtually uninterrupted, says David Barr, a spokesman for the FDIC. "Those people went to bed on Friday night as customers of NetBank and woke up on Saturday morning as ING Direct customers," says Barr.

The rates on NetBank checking accounts and CDs (until they reach maturity) remain the same. However, NetBank money-market accounts, which used to carry a 4.5% APR for the first six months, have converted to ING Direct's interest rate of 4.2% and annual percentage yield of 4.3%. (For more on what former NetBank customers need to know, click here2).

Those who had more than $100,000 (or $250,000 in retirement accounts) aren't as lucky. Some $101 million of NetBank's deposits are considered uninsured, according to Barr, which translates into about 1,500 accounts (a fraction of the company's roughly 160,000 accounts). These account holders have full access to their insured amounts of up to $100,000 with ING Direct, but they'll have to wait before they can gain total access to the portion of their money that wasn't insured. In essence, they've become creditors of NetBank, meaning that NetBank's remaining assets will have to be sold before they can recoup 100% of their deposits. (As of Friday, the FDIC sold roughly $1.4 billion in NetBank's assets, and was able to pay depositors about 50% of their uninsured money, says Barr.)

What Online Bankers Should Know

Online banking has gained significant traction in the past several years. In 2005, the number of households with Internet connections that banked online grew by 27% to 55 million, according to independent research firm Forrester Research. By 2011, Forrester projects that number to grow to 72 million households, or about 76% of the homes with Internet connections.

Part of that uphill trajectory is the attraction to the convenience that online banking offers. Paying bills from the comfort of one's home is much better than having to go to the bank during banking hours. Another selling point: Online banks tend to offer much higher interest rates on savings accounts than traditional banks. After all, online banks such as HSBC Direct and Emigrant Direct offer annual percentage yield on savings accounts of 4.5% and 4.75%, respectively — some of the highest rates out there. Traditional bricks-and-mortar banks, on the other hand, offer average interest rates of just 0.46%, according to Bankrate.com

But should what happened at NetBank make potential online bankers think twice about jumping on the online-banking bandwagon? Consumers don't need to panic, says Lori Jomsky, senior vice president of deposit products at Informa Research Services3, a market research company.

In fact, it's important to remain calm. There are 8,300 bricks-and-mortar and online banks in the U.S., according to Greg McBride, a senior financial analyst at Bankrate.com. "Occasionally one of them will fail," he says. "We'll probably see more of them fail in the next couple of months." But regardless of which banks fail, he says, consumers won't risk losing their money as long as they follow two simple rules: Make sure their bank is FDIC-insured and that their deposits are below the FDIC $100,000 insurance limit. That way, if your bank does shut down, your money — as long as it's not above the FDIC's $100,000 limit — will be safe. To find out if an online bank is FDIC-insured, visit the FDIC web site4.

If you do decide to deposit $100,000 or more in an online account, do some digging first. Jomsky suggests checking with your financial advisor. You can also check online portals like Yahoo Finance for banks' quarterly briefs and reports, as well as recent news about the bank. (In NetBank's case, for example, red flags would have popped up in mid-September when a planned acquisition of the company by EverBank was terminated. In a filing with the SEC, NetBank said the deal was killed because EverBank believed NetBank was "in breach of its representations and warranties." It was a clear indication that something was amiss.) Also, Bankrate.com's free Safe and Sound5 feature lets you print reports that assess the overall financial health of a particular bank. If you see a one-star rating for several quarters on end, you may want to reconsider depositing your money in that bank.

Still, it's probably not worth the risk of exceeding the FDIC-insurance limit, says McBride. The best way to handle a lot of cash is to find the highest-yielding accounts and split your money among them. That way you're fully covered by the FDIC and earning a nice rate on your investments at the same time. You can also consider signing up for a Certificate of Deposit Account Registry Service (CDARS), a program where you can deposit more than the insured limit with one participating bank. Then, that bank will swap the amount in excess of $100,000 to another bank so that you maintain full FDIC protection on your investment, says McBride. Effectively, the money is at multiple banks, but you sign one agreement with the participating bank of your choice, earn one interest rate on all your accounts, and receive a regular statement. To locate a bank that offers this program in your region, click here6.

Ultimately, the decision to choose an online bank "really boils down to the presence of FDIC insurance, a competitive product offering, and the ease of transacting," says McBride. And even though news of NetBank's closure must have been shocking to its customers, because the bank was FDIC-insured very few of them had to endure the shock of losing their entire life savings.

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By AnnaMaria Andriotis

© 2007 SmartMoney. All Rights Reserved.

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