(FORTUNE Magazine) – THOMAS LABRECQUE, chief executive of Chase Manhattan Corp., looks as though he just stepped out of the pages of a magazine. Every hair is in place; the crease in his trousers is crisp and fresh. His demeanor is calm and confident, even after a third quarter when Chase recorded a $623 million loss. Labrecque announced the bank was cutting its quarterly dividend in half, to 30 cents, and preparing to fire some 5,000 of its 42,000 workers. In such straits, a little more emotion might seem in order. But he doesn't think so: ''What good would it do if I were slamming around here, picking up a desk and throwing it across the room, or if I looked like I were going to collapse?'' If Labrecque is suppressing the urge to throw a desk, then John Reed, chief executive of Citicorp, must be fighting the urge to heave something larger like, say, the Brooklyn Bridge. Weighing down Citi's balance sheet are many of the same risky loans that Chase has -- loans to Brazil, to leveraged buyouts, and to shaky real estate developers. The stock is at an eight-year low, and Citi recently had to bribe investors with an extortionate 13% to get them to buy its adjustable-rate preferred stock. Then, to quiet the markets, it had to purchase $275 million of the issue. With too little capital, too many bad debts, and a minimal reserve for problem loans, Citi is a stock few analysts are recommending. This is a tough time to be chief executive of a bank. Confidence in the industry is at its lowest ebb since the Great Depression. Bank stocks are trading at record discounts, with price/earnings ratios of about 4.5, compared with the S&P 500's 12. Worried talk of a government bailout of the Federal Deposit Insurance Corp. fund is widespread. And the economy is on the edge of recession. Labrecque does not mince words about Chase: ''We have nothing we can say about our performance over the past five years that is positive.'' As for the industry, he says, ''the shareholder has every right to bitch and moan and say, 'You guys have all lost your credibility.' '' Bull's-eye, Tom. Investors aren't just angry with bank managers, they are astounded by them. Okay, so maybe anyone could have misread the risks in Latin America or failed to notice the problems with Texas real estate. And, yes, Arizona was an unexpected disaster. But don't bankers ever learn? There they were doing business as usual in New England and New York and all along the Eastern seaboard, re-creating the disastrous conditions they fostered in the Southwest. There they were tripping over each other to finance LBOs. They even queued up to lend to Donald Trump's Taj Mahal. It would be bad enough if banks had injured only themselves, but their excesses could well play havoc with the economy. After a lending binge that helped drive real estate prices sky-high, many banks have cut commercial builders off cold turkey. Prices on some uncompleted Manhattan office towers have plunged 40% or more, in part from a lack of financing. Tight new regulatory standards stanched the flow of cash to the leveraged buyout business, with dire consequences for stock prices, which often rise in anticipation of buyouts. What's happening to the banking industry could mean a bumpy road for the economy in the next few years, and that will affect millions of Americans: -- Real estate prices are likely to be under pressure for some time. Chase's Labrecque looks for two to five more years of depressed values in Manhattan. Others see a seven-year down cycle just beginning in California. With few lenders eager to finance real estate -- banks are making some loans but very grudgingly -- prices around the country may fall further, especially if the Resolution Trust Corp. sells its holdings too rapidly. Says William * Bahrenburg, chairman of Morgan Stanley Realty: ''What makes me think the light at the end of the tunnel is an oncoming freight train is that the Japanese have stopped propping up our market artificially.'' Not only are most Japanese banks cutting back lending, but many Japanese investors are staying home as well, licking their wounds. -- Corporate buyouts will not reinvigorate the stock market anytime soon. Loans for takeovers are as hard to find as unindicted S&L executives. Bank regulators have forced commercial banks to pare their support of highly leveraged transactions. With the junk bond market moribund, new multi-billion- dollar deals are almost impossible to complete. And some banks are so skittish they are backing out of commitments to finance smaller deals. -- Second-tier corporate borrowers will find credit scarcer. Some big-time borrowers, including Chrysler and Marriott, have left the commercial paper market, and banks are stepping up to lend money to these companies. As they do, they are cutting their loans to marginal borrowers. -- Credit for rapidly growing small and medium-size companies could get tight. Total business lending at the nation's largest banks was down $700 million in the first ten months of this year, after increasing by $24.6 billion in 1988 and $17.2 billion in 1989. It could get worse. Regulators are pushing banks to raise capital if they want to increase their lending. But investors show no appetite for new issues of bank stocks, and the only way for most big banks to strengthen their balance sheets will be to sell loans and to make fewer new ones. Borrowers in businesses that tend to do poorly in a recession will be the losers, and that category includes small builders and entrepreneurs. -- The poor health of the banks will increase the cost of bailing out the nation's thrift institutions. The RTC's forecasts of the cost of the bailout assumed that commercial banks would buy thrifts and would also finance the purchase of properties from the RTC. But most of the potential buyers of thrifts are so troubled or so short of capital that they are not bidding. And the RTC has found few banks willing to write mortgages for potential buyers of its real estate, forcing the agency to consider financing the deals itself. The RTC's problems will swell if the economy stays soft. Says Harry Keefe, the dean of Wall Street's bank analysts: ''In addition to Bank of New England ((a troubled $23 billion bank that could be taken over by regulators)), I see thrifts with up to $12 billion of assets coming onto the market in New England in the next few years. Some will be brain dead, others barely alive. Who is going to buy them? There isn't anybody.'' The longer the RTC holds on to a troubled thrift, the higher the ultimate cost to the government. How bad could the economy get if money center banks are so overextended and undercapitalized that they cannot lend to business? Says John Medlin, chief executive of First Wachovia Corp., a North Carolina regional banking company with a rock-solid balance sheet: ''We've been on a credit drunk for the past decade. Now we're going through an adjustment period. It won't be short or easy, but I don't think it has to be of the dimensions of the Thirties.'' The Thirties! Soup kitchens? Bread lines? Bank holidays? No, it won't get nearly that bad. But those who have suffered through regional recessions in Texas, Arizona, Colorado, or New England know that it can be very painful indeed. The failure of so many local banks and S&Ls helped prolong these downturns. Texas lost some $8 billion of bank capital, while New England banks are expected to lose more than $3 billion. Since every dollar of capital on a bank or thrift balance sheet can support as much as $15 in loans, those losses mean the curtailment of as much as a substantial $165 billion in lending. With the Comptroller of the Currency finally getting tough -- Robert Clarke, the incumbent, is proud to be known as the regulator from hell -- and demanding that banks raise more capital and add reserves to cover losses on those risky real estate and highly leveraged transaction (HLT) loans, regional credit shortages are turning into a national problem. America's biggest banks are so capital short that they are trying to sell loans and shrink, rather than take on new business. For example, Chase is trying to shrink a portion of its HLT portfolio, Maryland National Corp. wants to shed its credit card subsidiary, and Citicorp is marketing its huge municipal bond insurance subsidiary. Contrarians will argue that all this gloom represents an opportunity to buy stock in the industry. Bank shares have declined an average 50% in the past year, with some stocks, including Chase, off more than 75%. In fact, the total market capitalization of the country's ten largest commercial banks is $28 billion, $3 billion less than that of the nation's third-largest retailer, Wal-Mart. J. Richard Fredericks, an analyst at Montgomery Securities, says that money center bank prices haven't fallen this sharply since 1932. Have the stocks hit bottom? Financial daredevils like the Tisch family (see box) and Warren Buffett obviously think so and have already started acquiring them. But they also have the wherewithal to wait out a rebound that could take a long time. Indeed, what may well be under way is a fundamental change in the way investors look at the banking industry, thanks to all those problem LDC, HLT, and real estate loans. Bank profits have been swinging like the Flying Wallendas. In the past 12 months, 33 of the top 50 banks have announced special charges for loan losses or restructurings. Two dozen have reported losses for at least one quarter and 14 have ended their fiscal years in the red. Earnings are no longer predictable and shareholders are less sure that banks will keep paying steady dividends. Chase and Chemical Bank have already cut their dividends, and many investors suspect Citicorp and Manufacturers Hanover will follow suit. Citi, however, is adamant about maintaining its quarterly 44.5 cent payout. LOOKING AHEAD, investors have to wonder where any improvement in bank earnings will come from. Says James McCormick, president of First Manhattan Consulting Group: ''A lot of bank real estate portfolios have grown at 20% to 25% a year during the last half of the decade, enabling those banks to earn 20% or more on equity. Even if they don't suffer huge loan losses, they can't sustain those growth rates. A forecast of slower growth, by itself, would cut some bank stock prices by 25% to 30%.'' If that weren't enough, there's the unnerving effect of all those doubtful credits heaped on the balance sheets. It's almost impossible to tell which bank will take the next big bath. Aside from a few stalwarts like J.P. Morgan and First Wachovia, almost every major bank has a hobgoblin lurking somewhere, be it loans to Latin America or to developer John Portman's Peachtree Center. The challenge to investors is to figure out how to value those loans in judging a bank's stock price. The banks themselves don't help much. Says Christopher Snyder, president of Loan Pricing Corp., which tries to do this kind of valuation: ''Disclosure is so inadequate today that no investor knows what a bank portfolio is really worth.'' One group that has made money through careful calculations is Feshbach Brothers, an investment company based in Palo Alto, California, that has made 70% returns this year largely by shorting bank stocks. The firm has developed a rule of thumb it thinks indicates distress: an accumulation of high-risk loans three times greater than a bank's equity. When you see that, says Tom Barton, the Dallas general partner who works with the three Feshbach brothers, ''I don't care what any bank president tells you, that institution is in serious trouble.'' If the Feshbach indicator starts flashing, Barton analyzes the loan portfolio -- banks are required to break out their loans by type, although not by borrower -- to see how much money is in risky categories. Then he applies historical loss ratios to the various groups and compares his projected losses with the bank's combined equity and reserve against loan losses. When the projected losses exceed the bank's equity and reserves, he has a candidate for a short sale. Among his recent targets: Citicorp, Wells Fargo, and Security Pacific. Figuring out what a bank is worth requires some huge assumptions about the future. That explains why Warren Buffett, one of America's premier investors, was paying upwards of $40 a share to acquire a 9.8% stake in Wells Fargo & Co. even as Feshbach Brothers shorted the stock, expecting it to drop to the teens. The two investors disagreed about the outlook for California real estate, to which Wells is a big lender. Will California become another New England? Buffett appears to be betting it won't, while the Feshbachs are looking for a downturn. TO ANALYZE what stock prices say about investors' take on the nation's largest banks, FORTUNE performed some calculations of its own. First we spoke with traders in the small but growing market for buying and selling bank loans. As you might expect, prices varied widely from loan to loan. For example, the prices for creditworthy HLT loans, such as those made to RJR Nabisco, Georgia Pacific, or Kroger, ran between 95 cents on the dollar and par, while low-quality credits ranged all the way down to 20 cents on the dollar. A stringent lender could have a portfolio of HLT loans that is worth close to 100 cents on the dollar, while a less discriminating bank could be looking at 50 cents to 70 cents. A portfolio of real estate loans might range in value from less than 50 cents on the dollar in New England to perhaps 100 cents on the dollar in parts of California. Based on what we learned, we developed a somewhat Procrustean formula to be applied across the board to the balance sheets of every bank we looked at, + whatever the actual quality of its portfolio: We valued HLT loans at 90 cents on the dollar, commercial real estate loans at 80 cents, and LDC loans at 35 cents. The LDC price is based on the Lehman Brothers index, a weighted average of the value of loans to countries with restructured debt. We then figured out how much each bank's portfolio would be knocked down by the application of our formula and subtracted this figure from the cushion of reserves and equity that each bank keeps on hand to protect shareholders in case of a catastrophe. The results were revealing. After the application of our one-size-fits-all haircut, four of the five largest New York institutions -- Chase Manhattan, Chemical Bank, Citicorp, and Manufacturers Hanover -- had equity equal to no more than 2.5% of total assets, vs. the 4% regulators like to see. On the other hand, First Wachovia Corp. ended up with equity equal to about 6.2% of assets -- seemingly enough to protect shareholders if a third world war breaks out. Dreary as most of the figures are, it would be wrong to conclude that any of the major banks is in imminent danger of failing. A similar calculation FORTUNE made in 1982 on just the LDC loans signaled even bigger trouble for most of the banks. In those dark days, when the international debt crisis was just beginning, banks had less capital, lower loan-loss reserves, and just about as many loan problems as they have today. Our analysis also suggests something about where the stock market is coming from: The market is focusing on the losses banks face on their riskiest loans. By FORTUNE's reckoning, Citicorp, for example, is left with a cushion of only $5.7 billion in equity -- not the $10.3 billion the bank calculates that it has. The stock market values Citi's equity at $4.7 billion, a lot less than our figure. But the market capitalization, like our calculation, appears to ignore some significant Citi assets: the bank's $54 billion of consumer deposits in the U.S. and its $25 billion of credit card loans. Bank deposits have fetched a 4% to 6% premium over their face amount in recent sales by the FDIC and the RTC, which means Citicorp's would bring an extra $2 billion to $3 billion. Credit card loans sell in the open market for a 15% to 20% premium, making Citi's worth an extra $4 billion to $5 billion. These two items alone would add $6 billion to $8 billion to the value of Citicorp's equity. Investors may be overlooking them because their value isn't likely to be ( realized soon. Citicorp isn't going to sell either in the foreseeable future. Or it could be -- disquieting possibility -- that investors expect even bigger declines in the value of bank assets than FORTUNE assumed in its calculations. While even the most devoted bears aren't predicting an apocalypse for the banking industry, they are nervously pawing bank balance sheets and wondering whether lenders with little real net worth can survive the 1990s in their current form. The answer is that to remain competitive, banks like Chase, Chemical, Manufacturers Hanover, and perhaps Citicorp may need to tie up with a significant other. BIG BANK MERGERS -- or even a menage a trois of Chase, Chemical, and Manufacturers Hanover -- might satisfy the cravings of Wall Street dealmakers, but ultimately they could prove unhealthy for the country. The rationale for such a deal would be that a combination of two or more banks could eliminate up to $1 billion in overhead expenses. But there is a flaw. Says Tom Labrecque: ''We've been looking at this for three years. You put any two money center banks together and you've got their combined LDC portfolio, their combined HLT portfolio, their combined regional concentration in consumer and business lending. You've got to ask if that is the best way to build a sound financial system.'' Labrecque and other bankers would like Washington to give them more options, the chance to merge with an investment bank, for example, or a car company. He argues, ''The banking industry needs capital. Industrial companies like Ford and General Motors and General Electric have capital. Why shouldn't we be allowed to combine? From a public policy perspective we need strong enough financial service companies to be able to support our economy's growth. It's wrong to think that Bank of Tokyo and Deutsche Bank are going to finance IBM at competitive terms when IBM is bidding against Hitachi and Siemens. That's not reality.'' What is reality is that America's financial system is in deep need of repair. A decade or more of piecemeal reform has weakened the nation's financial fabric, in the process creating a $150 billion savings and loan crisis. What's required now is some bold, imaginative thinking about how to fix the system. The bankers themselves should supply much of this. But maybe it's also time for someone in Washington to consider picking up a desk and throwing it across the room.