Will Toxic Loans Wipe Out Smaller Banks?

An article in Bloomberg today paints a dire picture. It says more than 150 small and mid-sized banks face failure due to having 5% or more of their assets consist of nonperforming loans. If these banks all fail, then Bloomberg is certainly right about troubled times ahead. I'm just not convinced that fate is as likely as the article asserts.

In order to determine that 150 banks were at risk, Bloomberg did some analysis. In doing so, it excluded the 19 largest banks that were subject to the government's stress test. Here's a rather scary result that its findings imply:

Excluding the stress-test list, banks with nonperformers above 5 percent had combined deposits of $193 billion, according to Bloomberg data. That's almost 15 times the size of the FDIC's deposit insurance fund at the end of the first quarter.

So if all of these banks failed, so would the FDIC, 15 times over. Lovely.

But don't start a bank panic yet. Bloomberg also explains the following:

Ratios above 5 percent don't always lead to failures because banks keep capital cushions and set aside reserves to absorb bad loans. Banks with higher ratios of equity to total assets can better withstand such losses, said Jim Barth, a former chief economist at the Office of Thrift Supervision. Marshall & Ilsley and Synovus said they've been getting bad loans off their books by selling them.

Right. Banks should have some cushion to absorb losses. That's one of the purposes of capital requirements. In fact, smaller banks generally have less leverage than bigger Wall Street banks. Thus, the 150 they tested might be better off than the big guys when it comes to covering their losses.

There's an even more important reason not to worry. I highly doubt banks who hold these bad assets will see anywhere near 100% losses on those loans. In other words, if a bank has 5% toxic loans, and they incur 50% losses, then the bank only needs a 2.5% equity cushion to be okay. Even bad loans are generally not worthless. Most of them are for real property somewhere. That property's value has likely taken a huge hit in the current market, but it's not suddenly all worthless.

The government can also still bail these banks out. And if faced with a hundred more bank failures and possible collapse of the FDIC, it probably would. As some banks pay back the government that cash goes into a recycle bin -- not a trash can. The Treasury can then reuse it to save some of these smaller banks by bringing their capital ratios back up to required levels.

But don't get me wrong: Bloomberg's findings are ugly, and some banks will fail. Bloomberg is also right that if these banks all fail, then it would be very, very bad. I'm just not ready to panic quite yet. If Bloomberg wants to scare me, then it needs to show that the equity cushion all these banks have in place is smaller than the likely losses on their portion of nonperforming loans. That's not what this article does.