Which Bank Will Fail Next? Oddsmakers Ponder the Question

A mortgage meltdown is turning into a bank meltdown.  The failure of IndyMac Bank last week and subsequent takeovers by the US Government of both Freddie Mac and Fannie Mae have left many - including online oddsmakers - pondering the question: Which bank will fail next?

Unfortunately there are plenty of candidates.

Louise Story of the New York Times writes:

The nation’s banks are in far less danger than they were in the late 1980s and early 1990s, when more than 1,000 federally insured institutions went under during the savings-and-loan crisis. The debacle, the greatest collapse of American financial institutions since the Depression, prompted a government bailout that cost taxpayers about $125 billion.

But the troubles are growing so rapidly at some small and midsize banks that as many as 150 out of the 7,500 banks nationwide could fail over the next 12 to 18 months, analysts say. Other lenders are likely to shut branches or seek mergers.

“Everybody is drawing up lists, trying to figure out who the next bank is, No. 1, and No. 2, how many of them are there,” said Richard X. Bove, the banking analyst with Ladenburg Thalmann, who released a list of troubled banks over the weekend. “And No. 3, from the standpoint of Washington, how badly is it going to affect the economy?” 

The most panic was felt on Wall Street Monday following the bad news surrounding IndyMac's $32 billion in assets sudden liability along with that of Freddie Mac and Fannie Mae.

Washington Mutual Inc. posted the steepest retreat ever and National City Corp. tumbled to a 24-year low.  Wachovia did not fare much better.  The fourth-largest U.S. bank, fell 15 percent to $9.84, a 17-year low, after being cut to ``neutral'' from ``buy'' at UBS AG, which predicted a dividend reduction to 1 cent and the sale of $5 billion of common shares.

The declines pushed the Standard & Poor's 500 Financials Index of 89 companies down 6.1 percent, its steepest plunge since April 2000, according to a Bloomberg report. The S&P 500 slid 11.19 points, or 0.9 percent, to 1,228.3. The Dow Jones Industrial Average lost 45.35, or 0.4 percent, to 11,055.19. The Nasdaq Composite Index slipped 26.21, or 1.2 percent, to 2,212.87. More than two stocks dropped for each that rose on the New York Stock Exchange.

``The factors that affected IndyMac are not isolated; while they're probably more severe, the pressures are evident in other financials,'' said Alan Gayle, the Richmond, Virginia-based senior investment strategist at Ridgeworth Capital Management, which oversees about $74 billion. The Treasury's plan for Fannie Mae and Freddie Mac is ``encouraging, but it does suggest that credit availability is going to remain somewhat impaired and borrowing costs will likely be higher.''

The large institutions set to report results this week, including Citigroup and Merrill Lynch, are in no danger of failing, but some are expected to report more multibillion-dollar write-offs, Story points out in her report.

The IndyMac situation is just the beginning of what most experts believe will be a major banking crisis.

The F.D.I.C. has $53 billion set aside to reimburse consumers for deposits lost at failed banks. IndyMac will eat up $4 billion to $8 billion of that fund, the agency estimates, and that could force it to raise more money from the banks that it insures.

Jane Wells of CNBC points out that depositors with accounts insured by the FDIC don’t have to worry…unless the FDIC starts to run low on funds. That looks unlikely at the moment. It has $53 billion, and says IndyMac—by far the largest bank takeover this year—will cost it between $4 billion and $8 billion.

So which bank will be the next to fail? 

Bodog Life initially posted odds on this market a few months back with Lehmann Brother's the favorite.  Lehmann Brothers Holdings Inc., which confirmed a $2.8 billion net loss for the first quarter, gained 5.23 percent Monday, however.

While considered a "major bank" there were little indications that IndyMac was in more dire straits than other major banks.  IndyMac would have fallen within the "field" category of odds as would the handful of banks appearing on a Ladenburg Thalmann analyses - barring one - Washington Mutual. 

Richard Bove at Ladenburg Thalmann looks at all the FDIC-backed institutions, comparing each bank’s bad loans to its overall assets through two ratios, which he provided to CNBC over the weekend.

First, he divides the “non-performing assets” of an institution--bad loans, late loans, foreclosed assets--by all of its outstanding loans. “A radio above 5 percent suggests danger.” The overall industry ratio is below 2 percent. That’s good news. But it’s not so good for individual names like Downey Financial, with a 13.86 percent ratio (on Sunday, Downey Financial reported its non-performing assets were over 14 percent, up from 1 percent a year ago). Other names in the “danger zone” are Corus Bankshares, Doral Financial, FirstFed Financial, Oriental Financial Bell Financial Group Ltd, and BankUnited Financial.

Bove ran a second set of numbers dividing a bank’s non-performing assets by its reserves plus common equity.  That's where Washington Mutual fell into the fray.  “A ratio about 40 percent is the danger zone.”  Washington Mutual comes in with a ratio at 40.6 percent. Bove calls this being “on the edge” of danger but not quite there yet.

Fannie Mae and Freddie Mac will essentially be rescued by the tax payer.  This is the scenario that unraveled in Sweden at the beginning of the last decade.

Sweden’s financial meltdown of 1991 involved the government guaranteeing the obligations of the entire Swedish banking system, and recapitalizing the major banks, with the sole major exception of Svenska Handelsbanken, points out Martin Hutchinson of the Bear's Lair

The total cost of the rescue to Swedish taxpayers was around $10 billion, equivalent to about $1 trillion in the context of today’s US economy. The causes of the crisis would be familiar to most Americans today: misuse of off-balance sheet securitization vehicles to invest excessively in real estate and mortgage lending.

Hutchinson offers a more dire prediction related to the entire banking sector:

It is thus not impossible for the entire US banking system to implode. It didn’t happen in 1933 (though about a quarter of US banks failed) because US banks in the 1920s had been relatively conservative in their lending, with many banks requiring a 50% down payment for home mortgage loans, for example. Stock margin lending got way out of control in 1928-29, but relatively few banks were involved significantly in that. The main problem in 1932-33 was quite simply liquidity; the Fed failed to supply adequate reserves to the banking system, so crises of confidence in individual banks led to panic withdrawals of deposits that caused the banks themselves to fail.

This time around, the problem is the opposite. Whereas the Fed had been appropriately cautious in the late 1920s, so only in the area of stock margin lending did the banking system get out of control, this time around the Fed has been hopelessly profligate in monetary creation for over a decade. The initial result of this profligacy, the tech bubble of 1999-2000, caused only modest problems in the banking system through telecom losses. The more recent profligacy and the housing bubble it caused have had much more serious consequences, mirroring those in Sweden leading up to 1991. The additional loosening since September has distorted the financial system further, producing a commodity price bubble that itself seems likely to have substantial further adverse consequences.

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Christopher Costigan, Gambling911.com Publisher CCostigan@CostiganMedia.com

Originally published July 14, 2008 8:13 pm EST