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Banking Sector: Worst Is Yet to Come

This analysis is dead on. One of the reasons bank failures persist is that the banks have been permitted to "play games with their loans". Troubled construction loans in 2008 and early 2009 were extended or the builders were allowed to complete the project with the construction financing still flowing. Look at Corus Bank. It was obvious that the projects financed by their loans were doomed in early 2008 yet they kept sending money out the door. From the bank perspective, their is no hope of recovering money on an incomplete project, better to continue funding the loan and have a completed project to sell in a potentially better economic enivornment when the project is finished. The loan stays current as there is an interest reserve built in so all the statistics the FDIC looks at to determine capitalization levels are not affected. Then once the loan comes due it immediately defaults with a very high loss severity since the economic recovery didn't materialize. Construction loans are very similar to negative amortization mortgages in that respect. Look how fast all those loans went bad and how severe the losses were.

One reason Paulson's current strategy is successful is that the government has removed the risk that many banks will be forced to shut or be seized. First in the too big to fail tier, there is zero chance of failure so the banks are now given time to rebuild the capital base and will eventually earn extraordinary profits by virtue of artificially low cost of capital and by reduced competition. In a normal banking environment when by virtue of idiosincratic risk a bank that falls below the required level of capital it is shut, it is game over with no chance of a future therefore zero equity value. Correspondingly, the only losers should be the equity holders as the assets should be sufficient to pay depositors and creditors. While for smaller regional and local banks, the shut down condition has not been completely removed, it is certainly less likely. The FDIC seems taking out the worst banks first so a relatively better bank, which in normal times would be seized immediately, now has a long time during which it can potentially earn enough to recapitalize.

When Warren Buffet was privately financing the banking system, the cost of capital was over 10% yet the Federal Reserve now provides it at 0.25%. That subsidy is a great stealth transfer of wealth from savers to the banks. The stockholders of the banks that survive are going to be richly rewarded.

Disclosure: No positions. Formerly short FED, CORS, WFC, BOFL.