Bailout's big mistake: Loans to small banks

NEW YORK (CNNMoney.com) -- The last of the big banks have returned their bailout funds, but uncorking the champagne would be premature: taxpayers still have a lot of skin in the game, and getting paid back only gets more difficult from here on out.

There are still 663 banks that have received a total of $58.6 billion in loans from the Troubled Asset Relief Program and have yet to pay the Treasury Department back.

Most of those banks won't pay back their bailout funds for years -- if at all: One went bankrupt. Two of those banks have failed. Dozens are subject to government sanctions. And 56 were unable to pay their quarterly dividends or interest payments last month.

At a quick glance, things are looking up for the bailout: Wells Fargo (WFC, Fortune 500) and Citigroup (C, Fortune 500) announced on Wednesday that they paid back a combined $45 billion in loans. The original eight bailout recipients have now paid back their loans in full, and 71% of TARP's $205 billion bank bailout portion has been returned.

But while the larger banks have been eager to be rid of TARP because of the negative stigma associated with the bailout and the associated executive pay restrictions, most smaller banks have little incentive to quickly pay back their funds. Bailed out banks aren't required to pay back their TARP loans for five years, and smaller banks are happy to sit on the cheap money.

Besides an unwillingness to repay taxpayers quickly, many small banks are simply unable to do so.

The law stipulates that banks who pay back their funds early must replace them with another source of capital, and the big banks have been able to go to the market and issue stock to grow their capital reserves. Small banks, however, don't have the luxury of issuing more stocks, as investors largely remain weary of small banks who haven't yet proven their health.

"Equity markets are not open to smaller banks," said J.P. O'Sullivan, associate director of banks and thrifts at SNL Financial. "Regulators are going to want to see them build up their common equity before they redeem. That means they're going to have to earn their way out."

Other bailed out banks are struggling. A Treasury report issued last week showed 56 banks did not pay their quarterly dividends or interest payments on their bailout funds, up from 33 in August. Only one bank that missed its dividend in August paid it in November, and 12 banks have missed at least three-straight payments.

"Usually not paying a dividend means the bank doesn't have enough capital, or it isn't earning, which is a bad sign if you want to get paid back," said Linus Wilson, professor of finance at the University of Louisiana.

Three banks missed dividend payments because they no longer exist or went bankrupt: Small business lender CIT filed for bankruptcy in November, and though it recently emerged from Chapter 11, it no longer has to pay back the $2.3 billion that taxpayers shelled out to it, and it no longer pays a dividend. Last month, taxpayers lost another $303 million after TARP recipients UCBH Holdings and Pacific Coast National Bank failed.

Additionally, dozens of bailout recipients are subjects of enforcement actions like cease and desist orders from the Federal Reserve and other regulators, a warning sign that the banks are in danger of failing.

The White House last month estimated total losses from the $700 billion bailout will amount to $141 billion, and the Congressional Budget Office lowered its estimate to $159 billion. But experts say that loss could be higher if more small banks fall into trouble.

Some argue that the government never should have bailed out small banks in the first place: Small banks wouldn't have brought the entire industry down if they failed. Many aren't well-capitalized enough to use their TARP loans for lending. And many, like CIT, were troubled at the time of Treasury's investment.

"There's not a whole lot of good economic justification for injecting capital into small banks," said Wilson.

Instead, Wilson and others argue that troubled small banks should have been allowed to go through bankruptcy or fail and be acquired by another bank. That would have cleared away their bad assets and allowed them to lend -- something throwing money at troubled banks doesn't allow for.

"All banks with deficient capital should have gone through a FDIC-type resolution process," said Simon Johnson, professor of global economics and management at MIT. "TARP funds for small banks were a smokescreen for the overly generous bailouts for big banks."

The problem with allowing smaller banks to go bankrupt or fail is that it could have been politically damaging. Letting mom & pop banks fail while bailing out big banks would have looked unseemly.

Another factor was the need for speed. Treasury wanted to quickly rescue the financial sector, and the bailouts offered calm to an unstable market.

"Giving TARP to small banks was a judgment that had to be made quickly, and it gave a lot of comfort to the market," said Lawrence Kaplan, former special counsel at the Office of Thrift Supervision who is now the senior attorney in the financial institutions practice at Paul Hastings. "Investors believed that these banks would survive. Though there were some troubled institutions in the mix, most are fine and still with us."