IMPEACH BUSH

By April, Gary Holloway was almost three years into retirement.

He'd built a new home by a lake in Texas, bought a boat and was working on his golf game. While taking on some part-time work, Holloway also traveled for months across the U.S. with his wife, from Seattle to Washington D.C., catching up with old friends and family.

That life of leisure abruptly changed about six weeks ago when Holloway got a phone call from his former employer, the Federal Deposit Insurance Corp., or FDIC, which regulates U.S. banks and insures deposits.

Holloway, a 30-year FDIC veteran, had worked extensively with failed lenders in Houston during the savings and loan crisis in the late 1980s and early 1990s, when thousands of thrifts collapsed.

Earlier this year, the FDIC began trying to lure roughly 25 retirees like Holloway back to prepare for an increase in bank failures. It's also hiring about 75 new staff.

Holloway quickly went back to work. ANB Financial N.A., a bank in Bentonville, Ark. with $2.1 billion in assets and $1.8 billion in customer deposits, was failing and an expert like Holloway was needed to value the assets and find a stronger institution to take them on.

"I was very excited about coming back," Holloway said in an interview. "I'm now 57. There's still a lot of life left and the juices are flowing again."

On May 9, life for ANB ended when the FDIC and the Office of the Comptroller of the Currency, another bank regulator, announced that the lender was closing. See full story.

Only three banks have failed so far in 2008. But that number is set to surge as the credit crunch slows economic growth and hammers some lenders that grew too fast during the recent real-estate boom, experts say.

The roots of today's banking crisis grew out of the boom and bust in the real estate market. Lenders originated more and more mortgages, while other banks, particularly smaller and medium-sized institutions, ploughed money into construction and development loans.

While loan growth soared in 2004 and 2005, most regulators failed to scrutinize many banks or restrain this heady expansion of credit. Now that the loans have been made and delinquencies are climbing, some banks may already be doomed.

Marriages and managing

"At this point in the crisis, you can't stop bank failures," said Joseph Mason, associate professor of finance at Drexel University's LeBow College of Business, who has studied past financial crises.

"At this point you manage through failures and arrange marriages where another stronger bank takes on the assets and deposits," he said. "You move through the problem. You don't avoid the problem. It's too late to wait and hope that things get better."

Things may get worse before they get better.

At least 150 banks will fail in the U.S. during the next two to three years, according to a projection by Gerard Cassidy and his colleagues at RBC Capital Markets.

If the current economic slowdown deteriorates into a recession on the scale of those from the 1980s and early 1990's, the number of failures will be much higher this time around -- probably as high as 300 of them, by RBC's reckoning.

That's a massive surge compared to the recent boom years of the credit and real estate markets. From the second half of 2004 through end of 2006 there were 10 consecutive quarters without a bank failure in the U.S. -- a record length of time, Cassidy notes.

"This downturn will trigger a significant amount of bank failures relative to the past five years," he said. "There has been excessive loan growth and some banks won't be able to access capital markets to replace the money that will disappear as credit losses rise."

Texas Ratio

Cassidy and his colleagues have developed an early-warning system for spotting future trouble at banks called the Texas Ratio.

The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses. The number basically measures credit problems as a percentage of the capital a lender has available to deal with them.

Cassidy came up with the idea after covering Texas banks in the 1980s. Until the recession hit that decade, many banks in the state were considered some of the best in the country. But as problem assets climbed, that view was cruelly challenged, Cassidy recalls.

The analyst noticed that when problem assets grew to more than 100% of capital, most of the Texas banks in that precarious position ended up going under. A similar pattern occurred in the New England banking sector during the recession of the early 1990s, Cassidy said.

Along with his colleagues, Cassidy applied the same ratio to commercial banks at the end of this year's first quarter and found some disturbing trends.

UCBH Holdings Inc., a San Francisco-based bank, saw its Texas Ratio jump to 31% at the end of the first quarter from 4.7% in 2006, according to RBC.

The Texas Ratio of Colonial BancGroup, headquartered in Spokane, Wash., had a Texas ratio of 1.9% in 2006. It was nearly 24% at the end of the first quarter, RBC data show.

These banks are no where near RBC's 100% critical threshold, and several lenders have raised new capital since the first quarter. For instance, National City Corp. topped RBC's list with a Texas Ratio of 40% at the end of March, though the bank did raise $7 billion in new capital in April.

"But these ratios have skyrocketed in recent years," Cassidy warned. "If that trend continues, some of these banks may be in trouble."

CD signs of stress.  Other lenders are already in more dire straits.

IndyMac Bancorp a large savings and loan institution and a leading mortgage lender, is one of Cassidy's biggest concerns, with a whopping Texas Ratio around 140%.

IndyMac is finding it much tougher to package up and sell the mortgages it originates in securitizations. That used to be a major source of new money for the company to turn around and use in further lending.

When lenders need to raise new capital, they can try to boost deposits by offering attractive interest rates on certificates of deposits, or CDs.

ndyMac is currently offering the highest rates on one-year CDs, according to Bankrate.com. Others in the top 10 include Corus Bankshares and GMAC bank.

 When Countrywide Financial was struggling last year, its federal savings bank unit began offering some of the highest CD rates in the U.S. to build deposits.

Bank of America as since agreed to acquire Countrywide and it didn't make it onto Bankrate.com's list of top 10 CD rates this week.

"These banks that are challenged for liquidity are having to go out and pay up in the market for CDs," Joe Morford, a colleague of Cassidy's at RBC, said.

Imperial Capital stopped paying dividends earlier this year. GMAC, owned by leveraged buyout giant Cerberus Capital Management and General Motors, is struggling to keep its Residential Capital mortgage business afloat.

Corus, offering the fifth-highest rates on one-year CDs, had a Texas Ratio of nearly 70% at the end of the first quarter, up from 9.1% in 2006, according to Morford.

Construction loan destruction.  

Corus is also highly exposed to types of loans that some experts worry will be the next major source of losses for banks after the mortgage meltdown.

Construction and development, or C&D, loans made up 83% of the Chicago-based bank's total loans at the end of 2007, according to RiskMetrics Group.

This type of loans helps to pay for things like the building of real-estate development projects and the construction of office buildings.

Small and medium-sized banks found it difficult to compete with large lenders in the national markets for mortgages and other consumer loans. So many focused on C&D loans because this type of financing relies more on local, personal connections, said Zach Gast, financial sector analyst at RiskMetrics.

As the real estate market boomed, C&D loans did too. A decade ago, bank holding companies had $60 billion of these loans. That number is now $480 billion, according to Gast, who also notes that C&D loans are almost never securitized, so they're held on banks' balance sheets.

Such rapid loan growth usually creates trouble later. Indeed, delinquencies represented 7.1% of total C&D loans at the end of the first quarter, up from 0.9% at the end of 2005, Gast said.

"It's a huge increase. Most of the deterioration seems to be coming from residential construction projects, but certainly there's deterioration in commercial projects too," the analyst said. "The rate of deterioration is still accelerating."

Colonial BancGroup had 37% of its loans in C&D loans at the end of last year, while Sterling Financial had 33% and UCBH had 20%. East West Bancorp, a rival to UCBH, is also exposed, with 25% of total loans in C&D assets at the end of 2007, RiskMetrics data show.

Regulators

Where were regulators when these banks built up such large exposures?

That's a question RBC's Cassidy has been asking himself, noting that "they dropped the ball in a big way." Officials at the FDIC declined to comment.

Efforts by the Securities and Exchange Commission to make sure banks report accurate earnings may have made the situation worse, Cassidy says.

Bank regulators try to encourage institutions to build reserves in good times, so they're ready for downturns. But the SEC has been worried that banks might use reserves to smooth reported earnings, so it advised some lenders that they couldn't set aside reserves if they weren't experiencing commensurate credit losses, Cassidy explained. That left reserves relatively low at the end of 2007, as the credit crunch was building momentum, Gast said.

Still, regulators have responded strongly so far this year. In addition to the FDIC's efforts to bolster its staff, the Office of the Comptroller of the Currency has been telling banks to boost reserves even if accountants worry that such steps will stray from SEC guidance, Gast explained.

Crisis redux?

The FDIC had highlighted 76 banks that it considered troubled at the end of 2007. That's up from 50 at the end of 2006, which was the lowest level for at least 25 years. Once identified by regulators, troubled banks are often required to limit or halt loan growth and shrink their balance sheets by selling some assets, Cassidy said.

Resolution and receivership specialists at the FDIC, like Gary Holloway, value troubled banks' assets as quickly as possible and try to find a stronger bank to absorb the weaker entity through an acquisition.

The current crisis hasn't reached the scale of the savings and loan crisis. In 1990, more than 1,500 banks were on the FDIC's troubled watch list, out of a total of roughly 15,000. More than 1,000 banks failed in 1988 and 1989, FDIC data show.

But it's possible for such comparisons to understate the scope of the coming wave of insolvencies. During the late 1980s, banks in Texas couldn't open a new branch in another county without forming a new commercial bank. That meant there were lots more lenders in the state when the S&L crisis struck. So when a bank failed, "40 of its other banks failed on the same day," Cassidy recalls. Today, no states have such requirements, so there will be fewer bank failures this time, but those that do fail may be larger.

That means each bank failure may have a larger effect on the U.S. economy, withdrawing a bigger chunk of capital from the financial system each time.

"Bank failures don't cause recessions, they lengthen them," Mason, the Drexel professor, explained. "We could get a mild recession that could linger for a while longer because of the inability to recharge capital in the banking and financial system."

Alistair Barr is a reporter for MarketWatch in San Francisco.