Bank Failures and Losses Ahead in 2010

After a hopeful holiday we are coming back to reality. Jobless numbers were up again, firms continue to economize on inventory, and while holiday retail sales at discounters rose, high-end stores either slowed or rose slightly from extremely low sales last year. Moreover, on Friday, January 8, bank failures resumed. Consider that if we had not experienced the financial crises of Summer 2007 and Fall 2008, we would be aghast at the continued trend of weekly bank failures. In the context of where we are, however, the situation doesn’t seem so bad. That’s the problem. The situation is very bad. Consider the history of failed FDIC-insured institutions. At the beginning of the Thrift Crisis, failed institutions were very small. The several hundred FDIC-insured institutions that failed between 1981 and 1986 in total barely amounted to $166b of current dollars, or about $360b in today’s dollars. The Thrift Crisis accelerated significantly between 1986 and 1992. The Thrift Crisis peaked in 1989 with 534 failed FDIC-insured institutions. Over the period 1986-1992, 2,304 failures involved some $745b in assets, roughly $1.26t in today’s dollars. The Thrift Crisis experience is already dwarfed, however, by today’s experience, to date. While we only experienced about 180 failures in 2008-9, those failures have been significantly larger than the Thrift Crisis failures, even adjusted for 2009 dollars. Thrift Crisis failures averaged about $500 million in 2009 dollars, while today’s failures are averaging about $22 billion apiece. The difference shows up in looking at the assets in failed banks, which today dwarf the entirety of the Thrift Crisis experience, at some $3.9 trillion, compared to $1.26 trillion (in 2009 dollars) for 1986-1992. The bottom line comes in estimating losses from the current crisis. Thrift Crisis losses averaged about $140b in losses on $745b in assets, or almost 19%. Supposing that the FDIC increases its efficiency of liquidation in the current crisis and assuming a loss rate of 15% delivers losses this time around of just under $600 billion from FDIC-insured institutions, alone. Resolution efficiency however is determined by economic conditions in tandem with FDIC efficiency. As a result, loss rates could well be greater than those obtained in the Thrift Crisis. Supposing resolution efficiency is only slightly worse than the Thrift Crisis, at 20%, losses balloon to almost $800 billion. Of course, that only includes losses on assets placed in resolution, to date. While the subprime crisis is largely behind us, by many estimates, there remain several hundred billion dollars of option-arm mortgages due to resent between now and the end of 2011. Additionally, some $500 billion of the $2.4 trillion Alt-A adjustable-rate mortgage market is due to reset between now and 2015. Many of those loans are underwater and barely affordable at current historically low interest rates. Were interest rates to rise as a result of Federal Reserve tightening, those mortgages would be rendered even less affordable to borrowers. Of course, banks are also expected to experience more problems with commercial real estate in coming quarters, as well. Among large banks, structured and leveraged loans continue to sour, as well. Sovereign defaults will add to the losses. As a result, I expect bank failures to continue throughout 2010, putting downward pressure on collateral values and therefore economic growth. While some investors will be able to extract value from the marketplace, economic growth will drag overall as buying loans will remain cheaper than making loans. Once the Federal Reserve begins tightening, a scramble for yield will ensue that will pressure lenders to create earnings to make up for lower values resulting from higher interest rates. Not until the entire dynamic plays out – when the profile of failed banks and assets in liquidation turns back down and retreats to manageable proportions – will economic growth return. Joseph Mason is a financial strategist and US economics consultant. He is the Hermann Moyse, Jr./Louisiana Bankers Association endowed professor of banking at Louisiana State University and a senior fellow at The Wharton School.