Strategic Defaults Pose Huge Risks to Banking Industry

At the halfway point of 2010, 86 US banks have gone under. That is well ahead of last year's pace, when 140 banks were closed.

There have been only 11 years since the creation of the FDIC in 1933 that 100 banks have failed in a single year. We are now on track to surpass that number for the second consecutive year, and we may do it before the summer ends.

To provide some perspective, just three US banks failed in 2007, and 25 US banks were closed in 2008, which was more than in the previous five years combined.

However, this year the FDIC is bracing for a wave of bank failures due to foreclosures and commercial real estate failures. That will cost the agency billions of dollars at a time when it is already facing financial trouble. The agency is expecting an additional $20 billion in losses over the next three years.

At the end of 2009, the federal deposit insurance fund carried a negative balance of $20.9 billion. To manage the crisis, the agency raised $5.6 billion in a special assessment and $46 billion in prepaid quarterly assessments last fall. For accounting purposes, the agency will add that gradually over 13 quarters.

What this means is that the FDIC has $30.7 billion ostensibly insuring $4.83 trillion in deposits.

In the fourth quarter of 2009, the FDIC said there were 702 lenders on its "problem" banks list, the most since 1993. Yet, by the end of the first quarter, the list had climbed to 775, the highest since 1992.

The banks on this list are most likely to fail, yet their names are never made public out of a fear of creating a run on these banks.

Bank failures over the past two years pushed the number of FDIC institutions to below 8,000 for the first time in the agency's 76-year history. Two decades ago, the FDIC insured more than 16,000 institutions nationwide.

Lenders are facing additional stress since many mortgage borrowers are deliberately choosing to default when their mortgage exceeds the value of their property. These "strategic defaults" have become a heavy burden for the banking industry.

A Federal Reserve study showed that when equity falls below 50%, half of defaults are strategic.

According to CoreLogic, more than 11 million homeowners across the country are underwater. It's estimated that number could double in the next year, which means nearly half of all American mortgage holders will owe more on their homes than those homes are currently worth.

That would spell disaster for the banking system. And the FDIC would be quite challenged to cover all the losses.