Many Banks Still Plagued by Bad Loans, May Need More Capital

The greatest threat to the financial system is the billions of dollars in toxic assets that continue to clog bank balance sheets, says the Congressional Oversight Panel, a government group formed to monitor financial reform, in a report issued today.

The good news is that the nation’s biggest bank holding companies, while still suffering from their years of reckless lending, are financially stable. The bad is that many of the nation’s regional, community and other smaller banks remain plagued by bad loans, notably for commercial real estate. Worsening the problem is that the main government program to help banks dump distressed loans, the Public-Private Investment Program, is for disposing bad securities, while distressed smaller banks need to unload whole loans.

The large “money center” banking companies were somewhat protected during the financial crisis by securitizing their residential and commercial mortgage loans, which passed on the lion’s share of the risk to other suckers. By contrast, banks outside this category, which the COP defines broadly as institutions with $600 million to $100 billion in assets, largely held onto their loans. If a significant chunk of these assets goes kaput, such institutions could face a capital crunch.

As the chart below illustrates, the projected capital shortfall is concentrated in banks with assets ranging from $1 billion to $100 billion. Assuming a negative forecast for the U.S. economy (indicated in the graph as “Additional Need under Starting Point”), the COP says banks in this group may need to raise $12 to 14 billion to offset their losses. A steeper downturn could require them to take in as much as $21 billion to remain sufficiently capitalized (indicated below as “Additional Need under Starting Point +20%”; click on the chart to expand).

So the $64 trillion question for all but the biggest U.S. banks is how many gnarly loans are still out there. Unfortunately, that’s hard to tell. Says the COP, “The risks troubled assets continue to pose for the banking system depend on how many troubled assets there are. But no one appears to know for certain.”

The reason no one knows is because there’s no consensus on how to define a “troubled” asset. As a result, it’s often hard to distinguish loans or securities that continue to fester from assets that a bank has already marked down. And since history isn’t written in advance, it’s difficult to project how future economic developments will affect the value of this stuff.

Still, the panel offers a best guess on the total losses non-money center banks could incur on CRE and construction loans, where, again, these companies are very exposed. If the economy nosedives, the roughly 700 institutions the group looked at in this segment are on the hook for $81.1 billion in such loans through 2010. The Treasury Department “must be prepared to turn its attention to small banks in crafting solutions to the growing problem of troubled whole loans,” the COP concludes.