New recession worry: Bank failures

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Recession Watch 2008

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NEW YORK (CNNMoney.com) -- As if the economy wasn't already fighting enough strong headwinds, the risk of capital shortfalls and outright failure of the nation's banks is rising.

The Federal Deposit Insurance Corp., the federal agency that backs bank deposits, last week reported the biggest jump in "problem institutions" it has seen since the savings and loan crisis of the late 1980s. While the extent of the problem is still low by historic standards, it identified 76 banks as in trouble - a 52% increase from a year ago.

FDIC Commissioner Sheila Bair among regulators set to testify Tuesday at a Senate Banking Committee hearing on the state of the banking industry.

Experts say the 76 banks now under scrutiny are likely only a small part of the problems now looming over the banking sector.

Jaret Seiberg, the financial services analyst for policy research firm Stanford Group, said it appears that regulators are expecting about 200 bank failures in the coming year or two. If that occurs, it could rival the flood of bank failures seen during the S&L crisis. In 1989, the nation saw a post-Depression era record of 206 bank failures.

And Seiberg says even more than 200 troubled banks are likely to be purchased before they reach the point of failure.

"Many of these banks are highly dependent on construction lending, and that's the area of lending that is likely to come under the most stress," he said.

The FDIC stresses that not all those banks will fail. In fact in 2007 only three banks failed, even though 50 were on the watch list at the end of the previous year. So far this year, one bank - Douglass National Bank in Kansas City, Mo. - has failed.

Still, the head of the FDIC is looking to hire 25 staffers to deal with an anticipated increase in failures, a move that would increase its staff by 11%. Among those it hopes to hire are recent retirees who worked through the S&L crisis.

The banks most at risk for failure are generally smaller ones, not the huge global banks hit by billions in writedowns from subprime mortgage problems.

Smaller banks are big players in the business of construction loans made to homebuilders - loans that were backed by new homes now worth a fraction of the original estimated value.

In the past six months, the number of construction loans that are 30 days or more delinquent has spiked, according to Foresight Analytics, an Oakland, Calif., economic- and real-estate-research company. Its figures show 7.5% of single-family construction loans were delinquent in the fourth quarter of 2007, more than double the 3.1% rate as recently as the second quarter.

Matt Anderson, a partner with Foresight Analytics, said that it is the small- and mid-size banks, those with assets of $10 billion or less, that find themselves most at risk. Their construction loans outstanding equaled about 115% of their primary supply of capital as of Dec. 31, compared to the big banks for which construction spending represents only 43% of capital.

Anderson said even non-residential developers who have not been hurt by the downturn in housing could see their funding spigot turned off.

"The demise of smaller lenders probably won't have as noticeable impact on the national level, but in a lot of local markets around the U.S. it will be felt," Anderson said. "In the short-run, for folks that may have a viable projects, it could mean those projects will go under as well."

Dean Baker, co-director of the Center for Economic and Policy Research, agreed that it will be the smaller banks in markets with the greatest economic weakness that will fail, and that will only compound the troubles in those areas, even if customers don't lose their deposits.

"It's one more downdraft," he said. "For certain areas, Detroit, Cleveland, some of the areas where the housing bubble burst, it could be real bad news. I don't see the bigger banks rushing into those areas to provide credit."

But even if the big banks are somewhat protected from problems with construction loans and the risk of failure, it doesn't mean their balance sheet problems don't pose a threat to the economy.

In fact, Seiberg and some others say that tighter capital among the nation's major banks poses an even greater economic threat than hundreds of small bank failures.

Huge writedowns have caused losses at No. 1 bank Citigroup (C, Fortune 500), No. 1 thrift Washington Mutual (WM, Fortune 500) and leading mortgage lender Countrywide Financial (CFC, Fortune 500) in the fourth quarter.

Federal Reserve Chairman Ben Bernanke told a Senate panel last week that while he doesn't expect the rising tide of bank failures to reach the major banks, he is worried about the need they face to raise additional outside capital.

"They have enough now certainly to remain solvent, and to remain well above their minimum capital levels," he testified. "But I'm concerned that banks will be pulling back and not making new loans and providing the credit which is the life blood of the economy."

Seiberg agreed that potential tightening of capital among the major banks is a far more serious threat to the economy than even hundreds of small bank failures.

"This economy lives and dies on credit," he said. "If the megabanks are stuck with billions in leveraged loans eating up precious space on their balance sheet, they won't be able to originate new loans. That's bad for everybody."