Issue 41 • September 2, 2009

Despite the Sharp Rally, More Losses Loom for Banks

Financial stocks drove the stock market higher in August ... led by the most speculative stocks, including nearly-insolvent firms, such as insurer AIG and mortgage giant Fannie Mae.

Is this vertical leap in bank shares actually justified by improved fundamentals?

The financial sector was the top performer among the ten S&P 500 industry groups, posting a gain of nearly +13% last month alone. Never mind the fact that AIG, Fannie and many others survive only thanks to taxpayer-funded bailout dollars in the hundreds of billions.¹

Talk about a JUNK rally ... these stocks are truly the junkyard DOGS of the stock market!

Meanwhile, as financial shares soared last month, back in the real world, the FDIC reported that 416 banks, with combined assets of nearly $300 billion, had received a FAILING grade last quarter ... landing on the agency’s “problem bank” list.²

That’s an increase of more than +36% — or 111 more banks facing insolvency today compared to the first quarter.³

In fact, rising bank failures — this time among regional and community banks — may be the NEXT phase of the ongoing financial crisis ... and the FDIC could go BROKE as a result!

According to Bloomberg, “FDIC-insured banks reported a net loss of $3.7 billion in the second quarter, compared with a $5.5 billion gain in the first quarter ... driven by increased expenses for bad loans.”⁴

So much for the “green shoots” that signaled less-bad conditions in the financial sector.

Healthy Banks are Hard to Find

In fact, more than 150 banks nationwide have seen a sharp increase in non-performing loans that could entirely wipe out their equity capital, threatening their very survival.⁵

Of course, the FDIC is always there to backstop failing banks, but we are talking about potential losses here that could entirely deplete the agency’s reserve funds. Three large bank failures this summer collectively cost the FDIC about $11 billion ... but its reserve fund held just $13 billion as the end of March!⁶

In fact, the FDIC reserve fund has shriveled by -40% already this year as a result of multiple bailouts ... to the lowest levels since the Savings & Loan crisis nearly two decades ago! The agency will levy “special assessments” against surviving banks that could total $11 billion next year alone ... placing an even bigger financial burden on the sector.⁷

Commenting on the FDIC’s dilemma, one banking analyst wrote, “The difficulty at the moment is finding enough healthy banks to buy the falling banks.”⁸

Not Just a Sub-Prime Problem Anymore as Bank Losses Spread Far and Wide

Here’s the problem ... while several big banks reported earnings that were “less-bad” recently, the financial sector as a whole posted losses of nearly $4 billion last quarter.

This was driven by a continuing pick-up in loan loss charges. But at the same time, the volume of new loans going delinquent continues to grow at an even faster pace.

In other words, banks just can’t write down their bad loans fast enough to keep up with soaring defaults ... two years into this financial crisis many banks are STILL behind the curve.

And the burden of loan losses this time around is shifting from the “too-big-to-fail” Wall Street banks ... to thousands of small- and mid-sized lenders across America that are choking on rapidly souring loans and leases.

It’s not just home mortgage loans that are the major source of banking sector distress either ... not anymore. Losses from commercial real estate loans, mortgage-backed securities, commercial leases and even credit cards are now adding to bank woes.

That’s not to say the worst is over for mortgage loan losses, however. Here the pain is spreading farther and wider too. It’s not just a sub-prime problem anymore.

Prime Time for Mortgage Defaults

Sure, 40% of all sub-prime loans outstanding where delinquent at the end of the second quarter, an increase of +32% from June 2008. But, among prime mortgage loans — once considered the safest — the default rate has soared more than TWICE as much in June ... UP +68% from a year ago! In fact, prime loans accounted for nearly 60% of ALL foreclosure starts last quarter, while sub-prime only accounted for 33% .⁹

It’s clear the banking sector faces another wave of loan losses ahead ... coming this time from a much wider swath of mainstream borrowers.

Falling home values aren’t the only culprit. Loan losses are now being driven by stagnant or falling personal incomes and mounting job losses.

While home prices appear to be stabilizing, they are doing so at significantly lower levels ... DOWN more than -30% nationwide from the peak in 2006.¹⁰

As a result, more than 15 MILLION home loans in the U.S. — one-third of all mortgaged properties in America — are now “underwater.” Many homeowners owe more on their mortgage loan balances than their properties are worth in today’s market, creating a powerful incentive for them to simply walk away. ¹¹

This could easily result in another wave of foreclosures ahead ... pushing home prices lower still, and it could get even worse. According to research from Deutsch Bank, the number of underwater home loans could surge to nearly 50% by 2011!¹²

Turning to commercial real estate loans that banks have on their books, the news doesn’t get any better.

Banks have been charging off bad commercial mortgages at the fastest rate in nearly 20 years, yet delinquencies continue to soar — more than DOUBLING in the second quarter from a year earlier.¹³

Here’s where small and mid-size banks are in greater peril, because regional banks tend to have higher exposure to commercial real estate nationwide.

More Banks Get Failing Grades

Of course, this calls into question assumptions made by the Federal Reserve in its famous bank stress tests earlier this year. In another Weiss Advice article at that time, I pointed out that regulators may be using “less than realistic economic assumptions” in administering these stress tests.

Now it’s becoming more apparent that the Fed’s stress tests weren’t tough enough.

One big assumption the Fed made was that banks should have enough capital plus earnings over the next two years to survive a 9% loan loss rate. The trouble is, we’re already there now, and we haven’t even reached the peak of the loan loss cycle yet!¹⁴

Institutional Risk Analytics, an independent research firm that publishes bank ratings, confirms that “the ranks of troubled institutions are growing.” Last quarter, the firm “slapped a failing grade on 1,882 banks,” UP nearly +17% from March, making it all too clear that the financial sector’s fundamentals aren’t improving.¹⁵

So what about the dramatic rise in financial shares in recent months? Chris Whalen, managing director at Institutional Risk Analytics puts it this way, “If the economy isn’t dramatically improving, then the fourth quarter of this year and the first quarter of 2010 will be another leg down.”

In spite of the big rally in financial shares of late, the banks are not out of the woods just yet.

Good investing!

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ Bespoke Investment Group: Financials Lead in August, 8/31/09
² Bloomberg: FDIC List of Problem Banks Surges, Putting Reserve Fund at Risk, 8/27/09
³ Ibid.
⁴ Ibid.
⁵ Ibid.
⁶ CNBC.com: U.S. May See 150-200 More Bank Failures: Bove, 8/24/09
⁷ Bloomberg: FDIC List of Problem Banks Surges, Putting Reserve Fund at Risk, 8/27/09
⁸ CNBC.com: U.S. May See 150-200 More Bank Failures: Bove, 8/24/09
⁹ Wall Street Journal: Souring Prime Loans Compound Mortgage Woes, 8/21/09
¹⁰ Standard & Poor’s: S&P/Case-Shiller Home Price Indices, 6/30/09
¹¹ Calculated Risk: American CoreLogic: More than 15.2 Million Mortgage Holders Underwater, 8/13/09
¹² Reuters: About Half of U.S. Mortgages Seen Underwater by 2011, 8/5/09
¹³ Wall Street Journal: Commercial Loans Failing at Rapid Pace, 7/21/09
¹⁴ Institutional Risk Analyst: Are You Ready for the Next Bank Stress Tests?, 8/13/09
¹⁵ New York Times: What the Stress Tests Didn’t Predict, 8/23/09