Leaky Banks Swamped by Hurricane of Bad Debt

(MoneyWatch)  Since 2008, 191 U.S. banks have collapsed -- only 800 more to go. Experts predict that 1,000 could fail before the financial crisis finally abates.

Indeed, even as a handful of big banks report profits, the wave crashing down on the industry as a whole is gathering force. Financial regulators shut 15 banks in January, more than double the number in the year-ago period. Through February, closures were up roughly 25 percent over 2009. After mostly knocking over larger financial institutions such as IndyMac and Washington Mutual in 2008, the problems today are concentrated among banks with less than $1 billion in assets.

There's no mystery why so many banks are toppling: They remain saddled with bad loans and don't have the money to cover them. All that crummy debt hurts earnings and asset values, which also affects liquidity and makes it harder to raise capital.

That capital shortfall, along with the number of toxic loans, is the killer here. Industry players will need to raise at least $600 billion over the next five years to offset falling loan and lease balances. Sure, institutions are working to boost their capital ratios. But as the FDIC noted in its latest quarterly banking report, much of that improvement stems from the declining value of their assets; in effect, the dud loans don't look as bad, in relative terms. But that doesn't disguise the reality that many banks badly need to replenish their reserves.

Such woes naturally ricochet into the broader economy. When bad loans fester, let alone when institutions crumple, institutions have less money to lend out. No surprise, then, that bank lending has seen its steepest fall in nearly 70 years.

Where does that leave the banking sector? In a new report, Huron Consulting Group puts it this way: "As banks seek to stabilize loan portfolios, they will face a fundamental question ?€"- retrench or advance."

That's the same question facing the entire U.S. economy. It's also worth recalling, as Washington ponders financial reform, that behind all the bad loans is a lot of bad regulation. Many of the banks blowing over today might still be standing if Washington had ensured their foundations were strong.

Chart courtesy of Huron Consulting Group