Zombie banks walk among us

ROAD TO RESCUE

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• 7 regional banks fail
• Banker: "TARP helped avert a global calamity"

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Where the banks are failing

Bank failures and foreclosures keep mounting

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NEW YORK (CNNMoney.com) -- Maybe the so-called "zombie" banks didn't die after all.

As recently as two months ago, many on Wall Street speculated that the nation's largest financial institutions -- banks like Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) -- were only operating as a result of extensive aid from the U.S. government.

Now, many experts wonder how so many small regional and community lenders that are capital starved and overwhelmed by escalating loan losses are able to stay in business.

In metropolitan Atlanta and the state of Florida, for example, more than 50 banks reported non-performing asset levels of 10% or more of total assets as of the end of March, according to the Raleigh, N.C.-based investment bank Carson Medlin.

Non-performing assets are loans that are not collecting interest or principal payments. In more normal economic times, non-performing asset levels remain below 1%.

Up to this point, small lenders, which serve as the primary source of credit for large parts of the country, were considered a picture of health in the banking industry. Most avoided the toxic mortgage products that ruined so many of their big bank peers.

Experts note that the majority of the 8,000 small banks are still thriving. But the outlook for this corner of the nation's banking industry has been tempered in recent weeks as small lenders endure rising losses, partly as a result of exposure to areas like commercial real estate and small business loans.

Next Wednesday, Wall Street will get a clearer sense of what kind of shape the industry is in when the Federal Deposit Insurance Corp. publishes its first-quarter assessment of the industry. One closely-watched part of that report is the agency's so-called "problem bank" list.

As of the end of 2008, that number stood at 252 institutions and it is expected to have climbed even higher during the first three months of 2009.

So far this year, the government has closed 34 banks, including the FDIC's takeover and subsequent sale of Florida-based lender BankUnited (BKUNA) late Thursday to a group of private equity investors.

While only a fraction of the institutions on the problem bank list typically reach the point of failure, experts contend that regulators have been unable to shut down some "zombie" lenders, in part, because they are still scrambling to catch up with the variety of ills affecting the sector.

Consider the case of Citizens Community Bank, a New Jersey-based lender located a little more than an hour's drive northwest of New York City. Federal regulators seized control of the bank earlier this month after the firm became overwhelmed by problems in its construction loan portfolio.

Nick Ketcha Jr., a former director of supervision at the FDIC who now serves as a managing director at the New Jersey-based financial services consulting firm FinPro, said that the company could have just as easily have been shut down at the end of last year.

"They were ready to be taken over," said Ketcha. "The fact that [regulators] didn't get to them may suggest that others are out there."

Two reports published earlier this month by the FDIC's Office of Inspector General charged that the agency was "not timely and effective" in addressing the most significant problems affecting Bradenton, Fla.-based lender Freedom Bank and Alpha Bank & Trust of Alpharetta, Georgia. Both banks failed late last year.

Unprepared for the crisis much in the same way the private sector was, the FDIC has been ramping up efforts since late last year to try and stay ahead of troubles.

In its annual budget for 2009, for example, the agency increased funding for its receivership division, which oversees bank failures, nearly tenfold from $150 million to $1 billion.

But even with that funding increase, it will take time for the FDIC to boost its staff levels enough to be capable of keeping up with all the troubled banks.

In the meantime, regulators may have little choice but to focus their attention on those institutions which are in the most dire shape. As a result, other less-troubled lenders are allowed to live on for another day, notes FinPro's Ketcha.

"Right now they are looking at which [banks] are the biggest problem and prioritizing," he said.

Still, experts like Joshua Siegel, managing principal at StoneCastle Partners, whose firm focuses on investing in small-cap banks, suspects there could be forces other than staffing levels at work.

Regulators, he notes, may postpone a bank's downfall especially if the region in which its resides could enjoy an economic recovery in the coming months.

There is also speculation that industry regulators have resisted closing some banks because it may be tough for the FDIC to find buyers for them -- even after they have been seized and scrubbed of their troubled loans.

Despite some interest in failed banks from private equity firms, Jeffrey Adams, managing director at Carson Medlin Co., said many banks are unwilling to buy struggling peers.

"They are battling their own fires if you will," said Adams. "There is just not a natural supply of parties to take over deposits."