A toxic brew of bad bets on ultra-risky debt, a weak economy, and plunging home prices could soon leave some U.S. banks short of the cash they need to stay afloat. Adding to their worries is a sense that it's getting harder and harder for institutions to raise funds.
As a result, concerns are rising that the U.S. could see a wave of bank failures in the next year. While big banks, starting with giants such as Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC) grab headlines, their financial standing is reasonably secure. It's the smaller banks that are in most danger, experts say.
Of about 8,500 banking institutions in the U.S., the most vulnerable are local banks in areas hard hit by the real estate slowdown, especially Florida, Arizona, Nevada, and California. And the most endangered of those specialized in real estate lending, with home-equity loans and loans to developers providing the most pain.
Few banking experts foresee a return to the full-blown banking crises of the 1970s, '80s, and early '90s—at least not yet. In 1990 and '91 alone, more than 650 U.S. banks went bust. In the past year only a handful of banks—seven, at last count—needed a bailout from the Federal Deposit Insurance Corp., which insures customers for losses of deposits up to $100,000.
A Growing Problem List
One smaller bank that has faced trouble recently is PFF Bancorp (PFB), a Rancho Cucamonga (Calif.) company that focused on loans to real estate developers. In the past year its stock has plunged 96%. On June 16 a privately owned bank-holding company, FBOP, agreed to buy PFF for the fire-sale price of $30.5 million, even though the bank reported almost $4.4 billion in assets on its balance sheet at the end of 2007.
Last quarter the FDIC said there were 90 banks on its problem list of troubled institutions, up 18% from the previous quarter, but still tiny compared with the almost 1,500 banks rated as troubled in 1990. Most of the banks on the latest list are small, with problem institutions holding just $26 billion in assets out of $13 trillion in assets in the entire banking system.
Still, the FDIC is adding staff to prepare for more bailouts. A few failures might not rattle the system, "but collectively they start to add up," says David Ellison, chief investment officer for FBR Mutual Funds.
Banks, most of them large, are still registering hundreds of billions of dollars in losses from mortgage-backed securities and other complex credit instruments, but that's just the first phase of the credit cycle, says Matthew Kelley, an analyst at Sterne Agee. Coming soon: the full effect of declining home prices and the weak economy, as borrowers find it harder to pay back loans. "That's phase two," he says.
Skittish Investors
The vast majority of banks should have no trouble navigating even a nasty recession if they can raise enough capital to cover losses. After all, most have "seasoned leadership who have gone through downturns before," says Robert Ellis of Celent, a financial consulting firm.
Because of toxic debt investments, many giant banks, including Citi and BofA, needed capital earlier than their smaller counterparts. Banks, which have already raised more than $200 billion (and counting) to cover losses, initially found capital-raising relatively easy, as evidenced by an Abu Dhabi sovereign wealth fund's $7.5 billion injection in Citi as early as November of last year.
"The bigger you are, the easier it is to raise capital," says Raymond James (RJF) analyst Anthony Polini. But now it's getting harder for banks of any size to raise cash. "The capital-raising window is starting to close," Ellison says.
Banks' unending credit troubles—and their insatiable need for capital—are spooking investors. Citi's stock is down 36% since the Abu Dhabi fund's investment in November. Fifth Third Banks' (FITB) plans to raise $1 billion, announced on June 18, sent its stock down 27% in one day.
Better Credit Quality
As bank shares drop, raising capital gets more expensive and is more likely to dilute existing shareholders' stakes. That, in turn, causes stock prices to fall further. "It's the death spiral of dilution," Ellison says.