It’s more than Freddie and Fannie, the US banking system is in trouble, $500 billion and counting. Yet another crisis confronts us, as we will have to deal with the aftermath of a rather large number of bank failures over the next year, which is likely to overwhelm the ability of the FDIC to insure your bank deposits.

Today we look at the banking system, the FDIC, and Freddie (FRE) and Fannie (FNM). It’s not pretty, but as realists we must know what we are facing.

But first, I just want to say I am glad that Richard Russell is doing fine. For those who do not know, he suffered a mild stroke last Friday. I talked to him yesterday, and he was a little tired but doing better. He has decided to cut back his writing schedule and relax a bit more, which is a good thing. At 84, he has written a daily (and sometimes lengthy) commentary and has been writing the monthly Dow Theory Letter since 1958. He is the dean of newsletter writers. He has forgotten more than most of us will ever know about the markets.

His doctor told him he needed to seek some balance in his life and cut down on the stress. I know how much it takes to write my one letter each week; I can’t imagine what it takes to write five. Basically, his plan is now to post his stats and only write about the markets when something important is happening, about every two weeks. I hope he sticks with that plan, as I want to be sharing dinner and drinks with him for many years to come. I am sure you join me in wishing him and his lovely wife Faye all the best and a healthy and quick recovery.

The US Banking System Is in TroubleA few weeks ago when I was in Maine, I met Chris Whalen. Chris is the managing director of a service called Institutional Risk Analytics, whose primary business is analyzing the health of banks and financial institutions. If you are one of their clients, you can go to their web site and drill quite deep into all aspects of every bank in America. And what they have done is come up with various metrics which compare how well-capitalized a bank is, how much risk it is taking, and what kind of losses (or profits) it can expect. It is a one of a kind firm, and the data gives Chris a very special perspective on the US banking system.

And what he sees is not pretty. There is a crisis brewing. He expects 100 banks to fail between now and July of 2009. Most of them will be small, but there will be a few large banks. The total assets of those banks he estimates to be $850 billion (not a typo!). Those are the assets the FDIC is going to have to cover when they take over the banks.

Take Washington Mutual as an example. There are problems there. Their debt now trades at 20%, which is worse than junk. There is no way they could issue preferred stock to recapitalize their business. And they are going to need more capital, as they have writedowns in their future due to the slowing of the economy. Any common issue would have to seriously dilute existing shareholders almost to the point of nothing. There are circumstances in which they can survive, but it would take a remarkable recovery for the US economy, which is not likely. Maybe management can pull a rabbit out of the hat, but it will need some strong magic to get the capital they need at a cost they can live with.

The FDIC has about $50 billion. These reserves have been built up over the years from deposit insurance paid by banks that are part of the program. They are going to need an estimated $20 billion just to cover the failure of Indy Mac. The FDIC will have to cover only a small percentage of the $850 billion, as some of those assets will surely be good. But if they have to cover 10%, then the FDIC would need another $50 billion. Does that sound like a lot? Chris thinks a more conservative number for planning purposes would be 20-25% potential losses, and you hope it does not get there.

Sometime in the next few quarters, Congress and the President, either the current group or early in the term of the next President, are going to have to address that potential shortfall, before we see bank runs as people fear that FDIC insurance reserves may not be enough. The very sad fact is that taxpayers are going to be on the hook for some time. What is likely to happen is that a loan facility will be made to the FDIC so they can borrow as much as they need, and pay it back from future bank insurance payments.

You can’t make up the shortfall just by raising fees. Chris points out that raising fees right now is not really a winning option, as that just makes the financial books of marginal banks even worse. You can raise rates as the banking system returns to health.

If Congress and the President wait too long, there could be a very serious problem, as depositors could start moving their funds under $100,000 (the insured amount) to what they perceive may be a safer bank than their current bank. Rumors could run rampant. This is something that needs to be addressed now. Frankly, this should be addressed right after the elections AT THE LATEST, in consultation with Congress and the new President.

If you are worried about your bank, you can go to Chris’s web site and pay $50 for a brief analysis of your bank and an update for the next four quarters. If you have less than $100,000 in your accounts, you should not worry. But for businesses with large deposits and cash flows, it might be worth checking on the health of your bank. The link is http://us1.institutionalriskanalytics.com/Cart/Request.asp?affiliate=bmg123.

You can click on the link that says “Click here for the free samples” in the lower right corner of the page to see if the format of what they offer is something you would find useful.

$500 Billion and CountingWe have seen some $505 billion in bank write-offs so far in this credit crisis. It is serious naiveté to assume that this will be the extent of it. Most of the write-offs have been mortgage-related. We have not yet seen the write-offs that will come as consumers start defaulting on credit cards, auto loans, and other consumer debt. Neither have we seen the losses that will come from commercial real estate or corporate loan as the recession progresses. You can’t write off something until it goes bad, although you can increase your loan loss provisions. This of course hits earnings and your stock price and thus your ability to raise new equity. It presents a very difficult dilemma for bank managers and investors deciding whether to invest or go away.

Sober-minded analysis from the IMF suggests that the total write-offs by all banks may be $1 trillion. Dr. Nouriel Roubini is much more alarmed and puts the potential losses at closer to $2 trillion. That means that banks over time are going to have to increase their loan loss provisions, hitting both earnings and capital. And that means they will have to raise more investment capital and equity at a time when their stock prices are low.

It is a vicious spiral. Banks have less capital, so they are able to lend less to the very businesses that need the money; and without said money the businesses will be less capable of paying their current loans, which means that banks have less capital. Rinse and repeat.

That only prolongs the recession and Muddle Through Economy, which hurts consumers and corporate profits, which in turn puts more pressure on banks. Ultimately it means that banks are going to have to raise a lot more capital than anyone who is buying financial stocks today imagines. And it is largely going to be expensive capital. Look at this note from Bennet Sedacca of Atlantic Advisors:

“Financial entities like banks, broker/dealers, regional banks, finance companies, and insurance companies need credit at reasonable rates in order to finance themselves. I have been concerned for many years that the door would finally shut on banks, brokers and others to raise new capital in the debt markets.

“For many regional banks like KeyCorp, Zions, Regions, and National City, the door has already shut on them–if they wanted to raise capital in the debt market at levels where their outstanding issues regularly trade, they would have to pay 12-15%, hardly economic levels. GM bonds trade near 27% yields. Washington Mutual trades north of 15%.

“Then there are the ‘good banks’, like J.P. Morgan and Wells Fargo. J.P. Morgan recently sold $600 million of preferred stock at 8 3/4 % and Wells Fargo sold $1.3 billion at 8 5/8%, plus underwriting fees.

“Below I offer up a few guesses of what other issuers would have to pay to issue preferred stock.

• Lehman Brothers–11-13%.
• Merrill Lynch–11-12%.
• Morgan Stanley–9-10%.
• Citigroup–9 1/2-10 1/2%.
• CIT Group–12-15%.
• Fannie Mae/Freddie Mac—15%
• Keycorp–11-13%.
• National City–13-15%.
• Wachovia–10-12%.
• Zions Bancorp–13-15%.
• GM/GMAC–not possible.
• Washington Mutual–not possible.
• Ford–not possible.”

Bennet does note a good point. Banks that conserved capital and managed their risks well will be in good shape to take over weaker brethren. They will have access to the capital markets for the money they need for expansion. My own bank was acquired recently by another small regional bank. Deals are getting done.

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