Washington prepares for big bank failure

NEW YORK (Fortune) -- The government is bracing for a big bank failure.

A bill introduced in Congress would give the FDIC, the agency that stands behind Americans' bank deposits, temporary authority to borrow as much as $500 billion from the government to shore up the deposit insurance fund.

The bill -- the Depositor Protection Act of 2009, backed by Senate Banking Committee Chairman Chris Dodd, D-Conn. and Sen. Mike Crapo, R-Idaho -- wouldn't change the status of individual bank accounts, which through the end of this year are insured up to $250,000.

But the Dodd-Crapo bill acknowledges what the financial markets have been signaling for the past month -- that the government must take the lead in a costly cleanup of the mess in the financial sector.

"I think it's a commendable start," said Simon Johnson, a former International Monetary Fund chief economist who tracks the crisis on his BaselineScenario.com blog.

Dodd said he introduced the legislation at the behest of other regulators, notably Federal Deposit Insurance Corp. chief Sheila Bair, Federal Reserve Chairman Ben Bernanke and Treasury Secretary Tim Geithner. All three recently wrote Dodd to support an emergency expansion of the FDIC's capacity to borrow from the Treasury.

"This mechanism would allow the FDIC to respond expeditiously to emergency situations that may involve substantial risk to the financial system," Bernanke wrote in a Feb. 2 letter to Dodd.

The Senate bill is being introduced at a time of rising market stress about the health of the banking industry. Sixteen relatively small banks have already failed this year and 25 went under in 2008. Last year's failures included the July demise of mortgage lender IndyMac and the September collapse of Washington Mutual, which was the sixth-biggest depository institution in the nation at the time it failed.

Shares of Citigroup (C, Fortune 500), the giant financial company that last week received a third round of government aid, have fallen 58% since the government outlined a plan to convert the bank's preferred shares to common stock. The stock even dropped below $1 Thursday.

The Citi plan aimed to ease market concerns about the bank's health. But fears have only increased, judging by the swoon in financial stocks this week and the sharp rise in the cost of protecting financial-sector debt against default.

The Credit Derivatives Research counterparty risk index -- a measure of the annual cost of insuring the bonds of 14 global financial companies against default -- surged nearly 30% this week as investors rushed to protect themselves against possible defaults at giant institutions.

It now costs an average of $289,000 per year to buy insurance on $10 million's worth of bank debt, according to the CDR index. That's just shy of the $300,000 average premium in force the day the index hit its all time high -- Sept. 17, 2008.

That was the day after the government's $85 billion first bailout of AIG (AIG, Fortune 500), two days after the failure of broker-dealer Lehman Brothers and a week before WaMu was seized by regulators.

The current degree of stress in the financial sector is "totally shocking," said Johnson, given the massive resources governments around the globe have devoted to reducing fears of a major collapse.

The financial fears point to the need for the Obama administration to produce a detailed plan of how it will deal with troubled too-big-to-fail institutions and bad assets in the banking sector, said Johnson, who teaches in the business school at MIT.

"If you don't do a systemic plan fast, you set up a target for speculators," said Johnson.

The market's reaction to Geithner's failure to produce an adequately articulated proposal as promised on Feb. 10 stands as a cautionary tale. The Dow Jones Industrial Average has dropped 20% since then.

The insurance that the FDIC provides to bank depositors is funded by annual assessments on banks. But the fund has been depleted by a sharp rise in bank failures over the past year, and efforts to raise the fees that support the deposit fund have been complicated by the poor health of the banking industry.

The deposit fund's balance fell 64% in 2008 to $19 billion, putting deposit fund assets at just 0.4% of banking industry assets. That's barely a third of the 1.15% statutory minimum.

Despite the welcome signs that policymakers are coming to grips with the extent of the U.S. banking crisis, observers say officials have yet to make clear that they fully grasp the scope of the financial industry's problems.

A $500 billion loan to the FDIC "begins to approximate the maximum loss from resolving the top four banks," said Chris Whalen, a managing director at Institutional Risk Analytics, a financial research and hedge fund advice firm.

The five biggest U.S. bank holding companies - Bank of America (BAC, Fortune 500), Citi, JPMorgan Chase (JPM, Fortune 500), Wells Fargo and Wachovia, which is now owned by Wells - had domestic deposits of between $271 billion and $701 billion at the end of the second quarter of 2008, according to the most recent data available from the FDIC.

With credit costs, which reflect expenses tied to bad mortgage and credit card loans, on the way to doubling the levels reached in the 1991 recession, Whalen expects the cost of fixing troubled banks to hit $1 trillion.

Whalen adds that he believes regulators may have to swing into action in coming weeks. With bad loans rising sharply even at the better managed banks, the next round of financial reports from the most troubled banks, due out in April, could be truly horrific.

"Does anybody really want to see Citi's first-quarter numbers?" Whalen said.