Banks and the FDIC: The noose tightens

Today's financial reading: the refreshingly straightforward Karl Denniger questions whether the FDIC is broke and covering it up.

An excerpt:

Finally, we have Colonial. I made a nice chunk of coin shorting and PUTting that turkey last year, when their CEO (and a lot of other people) said they were "very conservative." Uh huh. My read of their balance sheet said they were (like many other regional banks) massively over-exposed to condo construction loans in..... you guessed it.... Florida (which incidentally is what killed Corus.) Oops. But here's the money quote on Colonial:

If the FDIC were to seize Colonial, it would be the sixth-largest seizure, by assets, in American history. Such a large failure could strain the bank safety net. Colonial has $20 billion in deposits, while the FDIC insurance fund has dropped below $15 billion. The FDIC wouldn't have to cover every dime, but when Florida's BankUnited, with $12.8 billion in assets, failed earlier this year, it cost regulators nearly $5 billion.

Add all three of these up and tell me what you think is going on?

These three are not small banks. They are significant regional institutions, unlike the tiny little banks that we hear about every Friday after the close of business.

Here's the nut to the story above: When BankUnited was seized note that the total loss on assets was some 40%. They were not in the hole by anywhere near that much according to their so-called "accounting." Neither was IndyMac, but they also created an enormous loss.

So what's going on here?

Simple: An enormous number of banks are holding loans at or close to "par" that really aren't. They're holding mortgages at massively-inflated values, even on defaulted properties, and this is why you are not seeing more foreclosure sales - that is, why inventory is being held back. If they sell it the accountants will force recognition of the loss, which will render them instantly insolvent, but so long as they "extend and pretend" they are marking these loans way, way above recovery value. The upshot of this is that these firms' balance sheet claims on asset values are massively inflated, regulators know it, and they're intentionally ignoring it. ...

Read the rest here, then read his follow up article here. The government and the banks are betting on a quick magical recovery to reflate the housing and commercial real estate bubble, so that all those losses (in the trillions?) that they have failed to recognize on their books suddenly disappear. Of course the problem is that those losses cannot be hidden forever. You can hang on a precipice by your fingers only so long, and when failure of the weakest fingers starts it tends to spread rapidly to the rest, with gravitationally predictable results.

Should the hoped for recovery not occur (and the signs don't point to a quick recovery at all), we could see a rapid cascade effect as the continuing bank failures (when the losses become too large to hide anymore) and loss of confidence in all banks' accounting spreads and wreaks havoc with the market. The exact scope of the damage may be uncertain, but will likely prove severe (and potentially catastrophic), especially if the FDIC is broke and has to tap their $500 billion credit line with Treasury (the "FDIC Bailout" plan). In that case, a massive run on the banks doesn't seem all that implausible. Can you say "Indefinite Bank Holiday"?

(Depression era bank run)

You don't have anything you can't do without in your safe deposit box, right?