As Fourth Quarter Gets Underway, Real-Life Stress Tests Begin

Friday marked a gloomy day for the U.S. financial services industry: as the nation’s largest small business lender got closer to filing for bankruptcy protection, nine banks were shuttered, bringing the total headcount this year to 115.

While the Dow Jones Index plummeted more than 2 percent, many on Wall Street are now asking if the recovery in financial companies has come to a temporary standstill. Despite solid quarterly GDP numbers, there is some evidence that a sustained revival in the health of the U.S. banking system might be some way off.

At the top of the pile of evidence for this theory is the dismal third-quarter earnings of Citigroup (NYSE: C) and Bank of America (NYSE: BAC). While Citigroup managed to eek out a $100 million profit, most of that was in one-time gains from its trading operations, rather than from the day-to-day process of making loans and arranging corporate finance transactions. Bank of America didn’t even manage to get into the green: instead it made a giant $2.2 billion loss. Earnings among other banks have been mixed, but so far it appears as if Morgan Stanley (NYSE: MS) and Goldman Sachs (NYSE: GS) are pretty much the only firms who can present a genuinely encouraging picture of growth across all their divisions.

The shuttering of nine banks Friday brings the tally of annual U.S. bank closures to more than 100 for the first time since 1992. While the banks were quickly snapped up by U.S. Bancorp (NYSE: USB), the failures cost the increasingly cash-strapped Federal Deposit Insurance Corporation (FDIC) another $2.5 billion. Analysts such as Meredith Whitney and Nouriel Roubini estimate that we may be as only half-way through the total number of bank closures the economy will face as a result of the credit crisis.

CIT Group (NYSE: CIT), which provides crucial financing requirements to small and medium-sized businesses (including many well-known brands such Dunkin’ Donuts), is now arranging a Chapter 11 filing, according to sources close to the proceedings.

I wrote previously that I don’t think a bankruptcy filing is as much of a sure thing as others do. Still, if one does go ahead, it will mark the fifth-largest bankruptcy ever in the U.S., and may even set off another Lehman Brothers-style panic among investors. That in turn would lead to another round of deleveraging.

For all the momentum this year, deleveraging is a scenario few — if any — banks can afford to weather a second time round. While most banks’ sales and trading units have done well in 2009, divisions such as Prime Finance — which is in part responsible for making loans — have been much slower to return to growth. Investor confidence would return to an all-time low too, hurting small brokers such as E*Trade Financial (Nasdaq: ETFC), which have only just managed to start recovering.

In the first quarter of the year, all government-supported banks underwent stress tests to determine their financial strength. What remains of the final quarter may represent this year’s greatest test to a sustained recovery for many financial firms.

Disclosure: I own shares in CIT Group.