Banking Bubble About To Burst

While the nation still struggles with the economic fallout from the housing carnage, a potentially more lethal explosion is bubbling just beneath the surface in the banking industry. Yet nothing is being done by the Obama Administration to address the issue.

Many small to medium-sized banks, the bedrock of thousands of communities throughout the country, are facing increasingly tough times. Slumping housing prices, rising foreclosures, high unemployment and commercial real estate loan defaults are eating into bank reserves and drying up loan demand.

The Federal Deposit Insurance Corporation (FDIC) has closed the doors of 129 banks this year. Nearly all have been small and medium-sized banks. At this time last year, bank failures had reached 98. For all of last year, the FDIC shuttered 140 banks, the most since the Great Depression. This year's total will easily eclipse that number, based on the current rate of failures.

For these community banks, the news may get even worse soon. Here's why: When the government coughed up $700 billion of taxpayer money to bailout the financial industry, a total of 707 banks received funds, including many small and medium-sized banks. Today many of those banks are struggling to repay the government, putting more pressure on their balance sheets and reducing their financial flexibility.

To date, a total of 80 banks have repaid the government in full. The amount comes to $140 billion, about 75 percent of the total Troubled Asset Relief Program (TARP) money lent to the banks. The remaining 627 banks owe $65 billion. That doesn't sound like a lot of money, when compared to the billions repaid by the likes of Bank of America and Goldman Sachs. However, for small and medium-sized banks the debt is weighing down their long-term prospects for recovery.

Banks were expected to repay most of the funds by 2011. The chances look grim for the remaining 627 financial institutions. As a result, most analysts predict that the banks will be forced to raise capital or sell out to the highest bidder. Raising capital for a weak bank in this economy is like trying to find an Obama supporter at a Tea Party Rally. Won't happen. That leaves the second option. There are some regional banks still circling like vultures, snapping up failed banks. However, there aren't many attractive banks left for the picking, even at today's distressed prices.

Many of the TARP banks are paying dividends to the government today as part of the repayment plan. However, those dividend payments will rise from five percent to nine percent on the fifth anniversary of the TARP loan in 2013. If banks are having a hard time making dividend payments today, any increase in the amount will drive the institutions closer to the financial cliff. A Congressional Oversight Panel recently came to the same conclusion.

In its report, the panel criticized the Treasury Department and warned that many of the banks that have not yet repaid their TARP funds could face rising challenges to meet obligations in the coming years. When dividend rates increase in three years for the TARP repayments, there will be almost no chance for the banks to pony up the money, the panel predicted.

Officials at many of the weakened banks are tap dancing with regulators to try to work out a repayment plan that will allow them to keep their doors open. However, the regulators, while sympathetic, have not budged. Further delays in payments and dividends could have dire consequences for the banks on the TARP repayment list.

That is only the beginning of the banks' problems. All financial institutions are dealing with stronger capital requirements forced on them by the Dodd-Frank Act passed this year with the support of the Obama Administration. These new requirements will only hinder the banks' efforts to try to renegotiate repayment schedules.

This is not a pretty picture for the community banking industry. While the Obama Administration has shored up the financial balance sheets for the banking Goliaths, the smaller Davids are suffering. Ultimately, the inability of many small and medium-sized banks to repay TARP funds will led to record numbers of failures and send a shock wave through communities stretching across the nation.

How long will the Treasury Department and President Obama dither before the issue is addressed?