Get Ready for More Bank Failures

By most measures, the past year has been the worst financial crisis in a lifetime. But not by one significant measure: Bank failures.

The Federal Deposit Insurance Corp. has closed 92 banks so far in 2009, after seizing 25 ailing banks last year. By contrast, during the last banking crisis, 381 banks were seized in 1990, 268 in 1991, and 179 in 1992. Still, the pace of bank failures is accelerating. In recent days, three banks failed, including Illinois-based Corus Bank, doomed by $3.2 billion in construction loans, mostly to condominium developers.

The relatively slow pace of bank failures during the crisis is partly the result of government decisions to keep ailing banks open for as long as possible, says Louisiana State University banking professor Joseph Mason.

Plagued by Problem Loans Now, it appears, the FDIC is shutting down the bad banks at a faster rate. Since July 1, the FDIC has shuttered 47 banks, amounting to more than half of the FDIC's financial losses on the bad banks this year. The consensus among banking experts is that two to three times more banks could fail during this crisis, for a total of 200 to 300, says independent market strategist Doug Peta.

Put simply, the problem for banks is bad loans. Institutions have been hit by one type of problem loan after another, says Keefe, Bruyette & Woods (KBW) analyst Frederick Cannon. First, it was bad residential real estate loans, including the notorious subprime mortgages. The biggest bank failure of the crisis occurred on Sept. 25, 2008, when the FDIC closed down Washington Mutual and arranged for it to be bought by JPMorgan Chase (JPM). Another big failure was on July 11, 2008, when the FDIC, at a cost of $10.7 billion, took over IndyMac, a specialist in risky, so-called Alt-A residential loans.

Mortgage problems persist, but banks specializing in loans to developers have been hit hard in 2009. KBW data show that, of banks that have failed since 2007, an average of 28.8% of loans outstanding were construction loans, compared to 9.8% for the industry as a whole. At Corus, which failed on Sept. 11, 88% of its lending was construction loans. "This year is dominated by construction lenders," Cannon says.

Good for the Survivors The next problem for banks is likely to be commercial real estate and other commercial and industrial loans, Cannon says. A healthy banking industry is a key ingredient to an economic recovery. Small businesses especially rely on bank financing, which has been hard to get recently.

However, an accelerating cascade of bank failures isn't all bad news for the banking industry as a whole. For one thing, bank "seizures are good for the survivors," Peta says. "[Failures] reduce the number of institutions indulging in 'Hail Mary' banking." In other words, a desperate, troubled bank is likely to offer high rates to attract depositors. That lures customers from strong banks to weak banks.

Also, when banks fail, their stronger competitors can gobble up their branches and depositors "on the cheap," Peta says. For example, BB&T Corp. (BBT) became one of the nation's top-10 banks this month by asset size, according to rankings by SNL Financial. The reason: BB&T acquired Colonial Bank, which has $22 billion in assets, after its closure by the FDIC on Aug. 14.

Complaints about Transparency At the same time, the problems at big banks might be giving smaller institutions a chance to win back market share, says Christine Barry, research director at the Aite Group . In her recent survey of almost 800 community banks, she found that more than half reported adding customers and deposits during the financial crisis. "While a lot of these banks are faced with big challenges, many of them are actually seeing a lot of opportunities," she says.

Since the beginning of the financial crisis, investors have complained about a lack of transparency from banks. Without knowing what bad loans or toxic assets sit on bank balance sheets, it's difficult to assess how risky those banks really are. "The one thing the industry needs is information for investors to sort out who is strong and who is weak," Mason says. Regulators are still reluctant to release this data, for fear of scaring investors, says Mason. But he believes this approach is counterproductive and could prolong the recession.

Still, banking stocks have rebounded strongly this year, with the KBW Bank Index (BKX) up 141% since its low on Mar. 6. (But the index is still down 56% from two years ago.) What has boosted investor confidence isn't information, but the implication that many large banks are too big to fail, Mason says. "They're still living off the life support of various government programs," he says.

Time is Short A cure for ailing banks is time. With interest rates low, this should be a profitable time for many banks, Peta notes. The housing market is showing signs of recovery, with the most recent Case-Shiller Home Price index rising 1.4% from May to June. That's a good sign for a banking industry with many loans related to real estate. "We are making some progress," Peta says.

If they make the right moves, some troubled banks can survive long enough, and earn enough now, to make up for losses of the past few years. But for hundreds of less fortunate institutions, time is quickly running out.

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