Small Banks Bear Brunt of FDIC Crackdown

New York ( TheStreet.com ) -- Regulators have ramped up efforts to seize troubled banks, yet unlike the two large failures recently, most banks that fail in the final months of this year will be small banks, observers say.

"The government's gotten to the point now where they're comfortable with allowing failure to be an option," says Frederick Cannon, Keefe Bruyette & Wood's co-director of research and chief equity strategist.

Regulators are saying, " 'It's time to address this problem and get this behind us,' " according to Cannon, who adds that the Federal Deposit Insurance Corp. has been adding staff to address the surging problem banks.

Of the more than 8,000 banks in the U.S., Cannon estimates that roughly 150 banks will fail this year.

Cannon says that while more bank failures could fall in the $10 billion to $20 billion asset range, "the vast majority of the failures will be small banks."

With record unemployment and more people defaulting on loans, more banks are having problems with capital. Banks also are starting to feel the pinch of small- to mid-size businesses and other commercial customers in crisis.

KBW said in its latest FDIC Bank Failure Update, published on Monday, that the acceleration of bank failures will continue through the end of 2009 and into 2010. Compared to the rest of the industry, the banks that failed last weekend had a significantly higher concentration of construction loans, according to KBW.

The FDIC on Friday seized four banks with $13.9 billion in assets and an estimated cost to the FDIC of $3.2 billion, or 23% of assets, according to KBW.

Friday's additional bank failures bring the total number of failed banks this year to 81, compared to 25 in 2008 and just three in 2007. While regulators seized 45 banks in the first and second quarters of this year, 36 bank failures occurred so far in the third quarter. The number of failed banks this year is the worst the country has seen since 1993.

The largest of the four banks closed was Guaranty Bank of Austin, Texas, the main subsidiary of Guaranty Financial Group ( GFG). BBVA Compass, the main U.S. subsidiary of Banco Bilbao Vizcaya Argentaria SA, acquired the bank. Guaranty was the first failed bank to be sold to a foreign institution.

Guaranty Bank had $13 billion in total assets when it failed, and it was a particularly expensive failure, with the FDIC estimating that the cost to its insurance fund from the thrift's failure would be $3 billion.

Two weeks ago, BB&T ( BBT) acquired $25 billion-asset Colonial Bank of Birmingham, Ala., which also was seized by state regulators. Colonial was the fifth largest bank failure in U.S. history and the largest since now defunct Washington Mutual last September, which was bought by JPMorgan Chase.

Colonial Bank and Guaranty have been large failures, relatively speaking, but observers say for the most part, future seizures will be of small banks, particularly since the U.S. government is supporting a number of banks deemed systemically significant, says Guillermo Kopp, an analyst at TowerGroup.

"Why aren't we seeing more failures in the $20 billion-$50 billion asset banks? It's because the government has put in money. They are taking actions helping in a way to prevent those institutions from failing -- which doesn't mean they're in great shape," Kopp says.

One issue regulators are facing is finding potential buyers for the failed banks.

Big banks, including JPMorgan Chase ( JPM) , Wells Fargo ( WFC), Bank of America ( BAC), US Bancorp ( USB), PNC Financial Services ( PNC) and BB&T, are in the midst of swallowing acquisitions from the fallout of the crisis.

Richard Bove, an analyst at Rochdale Securities, says that while some banks, such as Minneapolis-based US Bancorp, could be ready to do more acquisitions, "when you get below them you can't expect KeyCorp ( KEY) or M&I ( MI) or SunTrust ( STI) to make a meaningful acquisition in the failed bank arena."

"The capital is there. ... This money wants to work," says Peter Sorrentino, senior portfolio manager at Huntington Funds, a subsidiary of Huntington Bancshares ( HBAN). "Now you're seeing the bigger ones where they got to turn over the portfolio that needs to be worked out ... whereas if you announced them three to six months ago, you would have just rattled the system."

Regulators instead are looking to the private equity markets and even at foreign institutions as buyers as exemplified by BBVA's acquisition of Guaranty.

One controversial topic to be discussed when the FDIC meets Wednesday is whether to ease rules pertaining to private investors to buy failed institutions, according to media reports.

" There is a great deal of interest in these banks, whether from domestic sources, private equity or from abroad and also domestic banks interested in acquiring and expanding their bases and doing it on the cheap," says Gary Townsend, president and CEO of Hill-Townsend Capital, a private equity firm that invests in bank stocks. "I don't think anyone is surprised that we have ongoing bank resolutions. They're likely to continue until we see better numbers coming out of the banks."

Still another issue is how much the failed banks will eventually cost the FDIC. During the second quarter banks were given a special assessment to replenish the FDIC's depository fund, which in the short term filled a hole for the FDIC.

Yet Bove, who sees 150 to 200 more banks failing in this crisis, writes in a recent note that the banking industry will have to pay $11 billion in normal assessments and another $11 billion in special assessments next year. "If this actually occurs the FDIC premiums could be 25% of the industry's pretax income" for 2010.

Unless the FDIC finds other ways to raise funds, "the healthy banks are going to see their earnings deeply stressed in order to take care of the unhealthy banks," Bove says.

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