At the heart of Island County’s latest $1 million budget hole crisis is Treasurer Linda Riffe’s inability to find banks willing to deal with the county, mainly because of a 1969 state law that few people were aware of before the economic crisis.

With no banks bidding on the county’s investments, Riffe was forced to put the county’s money into the Local Government Investment Pool. She said the interest rate is pretty lousy, currently below 1 percent, so the county’s investment income will be $1 million less than anticipated this year.

“I had expected an uptick in the third quarter, but now I don’t think that will happen until 2010,” she said.

Jack Wagner, president of Whidbey Island Bank, said the bank used to bid on all of the county’s certificates of deposits, partly as a way to support the local treasurer. The return was usually more than 2 percent. But Whidbey Island Bank officials recently let Riffe know that they couldn’t do that anymore.

“It’s not a risk we’re willing to take,” said Rick Shields, vice president and chief financial officer of Whidbey Island Bank.

A hidden problem came to light when the Bank of Clark County in Vancouver, Wash., was shut down earlier this year. The bank had $15 million in uncollateralized public deposits, which are investments from public entities that weren’t backed up with collateral in the form of securities.

It turned out that the other banks with public investments were on the hook for the $15 million, under the state’s Public Deposit Protection Act. Wagner said nobody was really aware of the law, which had never been applied before.

Under the law, the other banks had to pay the $15 million. The bill for each bank was based on a percentage of deposits in public investments over a year-long period.

For Whidbey Island Bank, the bill was $138,000.

With the possibility of more bank failures‚ and more large bills‚ Whidbey Island Bank and other financial institutions in the state are getting out of the business of taking investments from local governments.

“It’s not a good result for anyone,” Shields said.

Wagner said state officials are talking about requiring that banks have to collateralize 100 percent of all public funds, instead of the current 10 percent requirement. The majority of the other states require 100 percent collateral.

“We could do that, but other banks around the state are really struggling,” Wagner said.

A requirement for 100-percent collateral would discourage most banks from taking on public deposits, Shields said, because they either don’t have enough cash for collateral or don’t want to tie up their money.

“It’s a real crisis,” Wagner said. “I’m not really sure what’s going to happen. It’s a bad situation for banks as well as treasurers.”

Nonetheless, Whidbey Island Bank remains one of the most profitable among banks based in the state. Washington Banking Company, the holding company for Whidbey Island Bank, reported a profitable fourth quarter of 2008, while most other banks lost money. Washington Banking earned $1.7 million, or $0.18 per diluted share, in the quarter compared to $1.9 million, or $0.19 per diluted share, in the fourth quarter a year ago. In 2008, net income was $8.3 million compared to $9.4 million in 2007.

In January, the bank received $26.38 million from the federal government Capital Purchase Program, which is part of the controversial $700 billion Troubled Asset Relief Program. Shields said a small amount of the money went into investments that can be used as collateral for public funds, but most of the money will be loaned out, as it was intended.

Shields said the bank is dealing with a lot of borrowers in trouble because of the economy, but bank officials are doing everything they can to work with the clients.

“We don’t want to foreclose on a home,” Shields said. “That’s our last option.”