Source: FDIC/The IRA Bank Monitor

As you can see, the number of "A+" banks is retreating fast from the 6,000 plus at the high tide of the credit bubble in 2006. Our colleague Dick Bove puts the prospective bank dead pool at several hundred. The FDIC now admits to some 400 banks on the troubled list. But we'd tell you that looking at the Q2 results, at least half of the banks now rated "F" in our last stress test survey are ripe for resolution. The reason we predict over 1,000 banks resolved through the cycle, as we predicted a year ago and more, is described in detail by IRA CEO Dennis Santiago in our Picking Nits blog.

Dennis provides tables for the final IRA Bank Stress ratings matrix for Q2 2009 and also a new table showing the distribution of the ratings by assets of the banks. Suffice to say that the proverbial barbell is getting more and more distorted and stretched, with virtually no banks rated "C" or "D," and over 2,200 rated "F" or about where the US banking industry was at the end of 2008. The final result of financial innovation seems to be bank resolution, and the scope of the train wreck facing US financial institutions is vast, according to our latest stress test.

"The economist Hyman Minsky noted some time ago that economic stability fosters increased risk-taking that eventually can lead to financial instability," writes our friend Martin Barnes in the Bank Credit Analyst after attending the Jackson Hole conclave. "Policymakers generally paid little attention to that view, but this has recently changed."

Perhaps there is revisionist thinking at the Fed at long last, but not nearly soon enough to do anything about the impending implosion of the US banking sector in 2010. The significant point to us is not the cost to the FDIC insurance fund implied by the rising Bank Stress Index score, a cost which the banking industry will absorb and repay. But the real point is the permanent diminution of economic activity in local communities caused when good community and regional banks die due to the end-result of bad fiscal and regulatory policies in Washington. In that regard, see our letter in the Financial Times today, "Simplify and focus the Fed's job and we will progress," about systemic risk and the debate over giving the Fed more authority to regulate same. 

In Q2 2009, the queen of the zombie dance party remains Citigroup (NYSE:C), which was rated "F" in Q2 2009 by the IRA Bank Monitor's stress test survey, down from "C" in Q1 2009 because of a large jump in the score for ROE and deterioration in the score for loan defaults. As we told subscribers to the IRA Advisory Service on Monday, credit losses at C could require additional injections of capital a la Fannie Mae and Freddie Mac, even with the flow if subsidies that has increased C revenue greatly from 2008 run rates.

It is interesting to note that the prospective marriage of Fannie and Freddie, some call it Frannie, seems to be on hold now. The lawyers were working furiously up till about two months ago, but now nothing. This is significant because during the recent influx of speculators into the moribund equity of these two insolvent GSEs, we've heard vague references to post-merger synergies. It says something of the extreme speculative tenor of the markets today that we sell ourselves the delusions of the GSEs as "investments," all the while watching as the Treasury writes a check for hundreds of billions per year in subsidies to keep the two GSEs from defaulting on their unsecured debt.

Likewise C is one of the banks rated "F" in our stress test survey and one of the zombie girls still rocking out at the House Bernanke dance party. You have to wonder why serious, smart people we know on the Buy Side see value in what remains of C -- even before the resolution process is complete. Keep in mind that unlike your mere TARP bank, C is halfway in the grave via the loss sharing agreement with the FDIC.

The mere fact of loss sharing at C makes us wonder why any manager of the average equity mutual fund would deploy capital in that name. To us, buying C common equity is like investing in a company with a going concern flag from the outside auditor. Whether or not there is value inside C is not the issue; it is just not kosher, to us, for a manager to put investment grade investors into a situation that is basically a restructuring, with the government as the largest, senior creditor - and one in which the ultimate liabilities are as yet to be quantified. As with GM and Chrysler, the private shareholders and even the creditors of C will take what they get from Uncle Sam.

We have a good friend, a former bond trader and Goldman partner now retired, who's been asking us about C for the past several months. Call buying C equity a punt on the corporate state for consenting adults. Keep in mind that C reported 412bp of default (annualized) in Q2 2009. All of the good people at C and their large bank peers know that we are perhaps a couple of quarters away from the peak in loss experience. Even with Uncle holding 34% of the equity, C remains an organization with 3.8% tangible common equity or "TCE" at the parent level and above-peer loss rates. Click the link below to see a chart of C's bank charge-off experience from Q2 2009 going back to 1989 from The IRA Bank Monitor:

http://www.institutionalriskanalytics.com/pdf/GrossDefaultsC.pdf

Notice that the rate of increase in charge-offs slowed in Q2 2009, both for C and for the large bank peers. The only decision we all need to make now is whether the rate of increase in bank defaults grows or continues to fall in 2H 2009 and beyond. Unfortunately, the data and our gut suggests that we will see more rapid increases in loss rates in the next several quarters -- even with growing forbearance by regulators regarding charge-offs and real estate owned post foreclosure or "REO."

The other question that is starting to get attention and on which we are spending a lot of time in the IRA Advisory Service is the duration of the period of peak loss, yet another toggle in the Fed's SCAP stress test assumptions that we believe ought to be subject to revision. Notice that in the early 1990s, C was above 250bp of default for over two years. If C gets up to say 5.5 to 6% charge-offs in this cycle and then lingers around those levels, all the while dealing with asset valuation issues that such a loan loss rate suggests, then the bank will probably need more capital from the Treasury.

Q: What do you suppose aggregate banking industry loss and recovery rates look like when outliers like C are in the 6% default range? And remember that the rising bank default rate is as much a function of the lack of credit availability as anything else. When no deals, even deals that make sense, are getting done in the private marketplace, then the entire economy must shrink and even good depositories must horde cash.

As one old friend noted recently, many commercial banks have largely withdrawn from the lending market, leaving the housing GSEs the only game in town in that particular asset class. Other GSEs such as Export-Import Bank have, says one insider, "moved to direct loans vs. bank guarantees because our illustrious banks refuse to take ANY risk (which begs the question as to why you need them) and of course you must be prepared for daunting fees."

But despite the efforts by the GSEs, the reduction in credit available to the US economy is having a negative impact on the overall level of activity, which creates a feedback loop of deflation and displacement that can only negatively impact depositories and their customers. Like the matrix of risk event possibilities we discussed in last week's comment, "Systemic Risk: Is it Black Swans or Market Innovations?", the number of failures of banks and private obligors is a moving target that still depends in great measure on the decisions we make in the days and weeks ahead. It's probably too late for more excuses from the Fed and the Congress, but it is not too late for the Fed and federal other agencies to make a very positive difference in how this story ends. More on that in our next comment.

IRA offers advanced analytics for risk surveillance and investment research via subscription products such as the IRA Bank Monitor for Professionals covering the US banking industry and the IRA Corporate Monitor covering public companies. For a trial subscription or an on-line demonstration, please register here.

IRA Advisory Services including our channel research and diligence support services are available to qualified clients. For more information, please contact our offices.

IRA provides consumers easy to buy online reports to independently check on their banks via our How's My Bank? system.

For updates during the week please follow IRA www.twitter.com/IRABankMonitor.