Bank failures to accelerate

Wachovia, the enormous nationwide bank, couldn't open its doors to customers due to a lack of funds, the board of the Federal Deposit Insurance Corporation voted for the first time since its creation, during the Great Depression, to take a "systemic risk exception" to the rules that usually limit what it can do. The exception allowed the FDIC to cover some of Wachovia's potential losses, enabling the bank's sale to Citigroup and its continued operation. Doesn't sound like much, but let the language sink in for a second. The fiscally conservative organization charged with guaranteeing American bank deposits found that, for the first time ever, the economy of the United States of America was at risk. Not just one bank — but the whole financial system. If Wachovia failed to open, or did but blocked depositors from continuing the run on cash that had begun the previous Friday, panic could have spread to other banks, big and small. Crisis could have become financial catastrophe in a matter of hours. The FDIC's concern about the fragility of the system has spread to other agencies since then. On Sept. 23, while lobbying Congress for the $700 billion to lift bad loans out of the financial system in hopes of restarting lending between banks, Treasury Secretary Henry Paulson downplayed another, more extreme approach to shoring things up. "Some said we should just stick capital in the banks, take preferred stock in the banks. That's what you do when you have failure," Paulson said. "This is about success." Well, last Friday, Paulson embraced sprinkling the banks with billions of dollars, announcing at a press conference that he intended to pursue it "to promote financial market stability." Which leads to an obvious question: are the banks failing now? The obvious answer is: yes. Banks are failing — 13 have gone under so far this year — and they're going to continue failing. As one hedge fund star explains the markets are now pricing the chance of a default in the next five years by Morgan Stanley or Citigroup at 45% and 21% respectively. The FDIC has a clear message for Americans who are beginning to awaken to the size of the problem: don't panic. Banks will fail, but it is highly unlikely depositors will lose their money. The FDIC now guarantees up to $250,000 in individual deposits at the banks it insures. And by law it gets its hands on a failed bank's assets before any other creditors do. FDIC chair Sheila Bair is eager to talk about how no insured depositor has ever lost a penny of his or her deposits.
But experts in and out of government expect bank failures to accelerate. Banks that are too big to go under, like Citibank and Bank of America, could fail but will stay alive in one form or another — through a bailout or a government-backed sale, for example. But plenty of medium and smaller banks are going to disappear or be divvied up by creditors. And the longer Paulson's new capital infusion plan takes to get up and running, the higher the likelihood of failure will be. That worries economists, as bank failures exacerbate the already bleak situation by decreasing the amount of lending in the system. That's one reason most now predict the country will sustain a protracted recession even if it manages to avoid the kind of systemic risk the FDIC feared a disorderly and public Wachovia failure might have brought.