The Coming Plague Of Busted Banks

¹²How To Profit From The Coming Plague Of Busted Banks

By Tom Dyson | 5 April 2010

Hundreds of banks are about to fail. Three banks failed in 2007. Twenty-five banks failed in 2008. One hundred and forty banks failed in 2009. Forty-one have failed already this year and hundreds more will fail soon. How do I know this?

Because these banks have already failed, but the FDIC doesn't have the manpower or the funds to officially "seize" them. "They've got them in a holding pattern," says K. K. is a senior community banker I spoke with last month (he didn't want to be quoted directly). He says the FDIC is treating these busted banks like aircraft circling a busy airport. They haven't closed them down yet, but they're in close radio contact with the managers making sure they don't do anything stupid until the FDIC's staff finds the time seize their assets.

Meanwhile, the FDIC is rushing to hire staff and open new offices in the most troubled regions of the country. Last year, it leased office space in Jacksonville, Florida, with enough room for 500 staff. Jacksonville sits squarely between Miami and Atlanta.

These two Florida cities have the highest concentrations of failed banks in the country. Last month, the FDIC announced it had leased seven floors and 100,000 square feet of an office building in Chicago for another 500 contractors. They've opened a similar office in Irvine, California.

How Many More Banks Are About To Fail?

The FDIC is the government branch charged with insuring banking deposits and seizing failed banks. The FDIC maintains a secret list of problem banks. It won't name the banks on the list to prevent bank runs. But it does publish the size of the list. Right now, it has 702 banks on the list.

The 'Texas Ratio' is another way to estimate how many banks might fail. The Texas Ratio indicates how sound a bank is. It compares a bank's problem loans with the money it has available to deal with them. When the Texas Ratio exceeds 100%, it means the bank has more bad loans than it can afford and it's probably going to fail.

Gerard Cassidy invented this ratio in the 1980s after studying busted Savings and Loans in post oil-boom Texas. Cassidy is currently working as an analyst for RBC Capital Markets, and he's still tracking the Texas Ratio. At the end of the third quarter 2009, 388 banks had Texas Ratios greater than 100%.

Thanks to immense government intervention, the banking sector enjoys more confidence than it has in years. You can therefore consider these current estimates of bank failures the best-case scenario. In the worst-case scenario, half the banks in the country could fail.

This is what happened in the Great Depression. There are approximately 8,500 banks in the nation today, including thrifts— banks that focus on taking deposits and originating home mortgages. Therefore, in a worst-case scenario, more than 4,000 banks could collapse.

There's a major investment opportunity here. When the FDIC seizes a bank, the first thing it does is line up another bank to take over the deposits, branches, and loan portfolio. It's often a local competitor. This way, the FDIC minimizes disruption to the banking system and keeps depositors from panicking. To make sure other banks are willing to take over, the FDIC offers them "sweetheart" deals, including loan guarantees and great deals on the assets.

My favorite way to take advantage of this situation is to buy stock in banks that receive the sweetheart deals. For one thing, the FDIC only awards these deals to the safest banks in the region, so you have an automatic indicator that the bank is safe and has plenty of capital. Secondly, the bank expands its deposit base, sometimes dramatically, without having to pay any advertising or other "gathering" costs. (Gathering deposits is normally very hard work for a local bank and extremely expensive.)

Deposits are like rocket fuel for banks. They can use them to dramatically increase their loan portfolios (using 10-to-one leverage) and their earnings. And finally, in many cases, one bank takes over another local bank. In other words, now there's one less competitor in what's usually already a small local market. The FDIC maintains a public record of all the bank takeovers here.

I study the new additions to this list every week and look for opportunities. This is the only way to find them.

Good investing,