Blacklist Grows for Troubled Banks

Includes: BAC, C, SPY, XLF
by: Zachary Scheidt

Wednesday, ZachStocks took a look at regulations concerning private equity purchases of troubled and failed banks. Thursday, that information became all the more pertinent as a report was released showing continued stress for the financial sector.

The FDIC released a report showing an additional 111 institutions were added to the black list during the second quarter. This additional constituted a 36% increase in the number of banks being closely monitored. So despite the optimistic market rally and the euphoric trading in financial equities, it appears that danger still lurks below the surface.

As is always the case, the FDIC did not release the names of individual institutions which were placed on this problem list as the disclosure would immediately cause depositors and business partners to bolt. However, the sheer magnitude of the increase will likely cause some dislocations in the market as depositors will quickly begin wondering if their bank has made the cut.

Overall asset quality deteriorated in the quarter as evidenced by higher charge offs and increasing non performing loan levels. Losses and risk remain largely concentrated in residential real estate secured portfolios and early stage delinquencies in those categories showed improvement. I will add that we are seeing increased strain in certain economically sensitive industries within our commercial portfolios.

~James Wells, CEO, SunTrust Banks Inc.

Traditional intra-bank lending to regional banks could quickly become constrained as widespread concern over solvency becomes a major lending factor. Even healthy banks could feel the sting of this report as liquidity dries up and depositors seek larger more capitalized firms in which to keep their cash. And as the Fed eventually moves its target rate higher, that will cause even more strain for smaller regional institutions.

Looking at some of the recent banking failures, there has been an interesting shift from the high profile failures of late 2008. At the time of Lehman’s demise when large firms such as Citigroup (NYSE:C) and Bank of America (NYSE:BAC) were facing extinction, much of the problem was due to the ramifications of esoteric vehicles such as the mortgage backed securities that were sliced and diced into unrecognizable forms. Since that time it appears the market has gotten at least some clarity on these “toxic assets” but now the failures are following a more traditional route.

Many of the new failures (or potential failures on the trouble list) are seeing weakness due to traditional personal and commercial loans going bad. While the headlines may not be a blaring as we saw in late 2008, the underlying reason is much more worrisome. Essentially the slow economy, low employment, reduced consumer spending, and generally poor business environment has caused many business loans to simply be unserviceable. So on bank balance sheets as they write off these loans as uncollectible, it means that their assets (receivables from borrowers) fall well below their liabilities (balances owed to depositors) which creates insolvency. The pace of more traditional banks going under (there have been 81 so far this year) points to sustained economic weakness which could quickly choke off the current “green shoot” economy.

So as you in today’s rising tide, keep in mind that many fundamental signs continue to point to weakness. This does not mean that you avoid participating in the market advance, but please pick your spots wisely, manage risk carefully, and have a plan ready for when the music stops and bulls begin to scramble.