What if a large US regional bank goes to the wall?

I fully anticipate this will happen, so the question becomes: what will the Fed do?

The FDIC stepped in at two banks over the weekend, 1st National Bank of Nevada and First Heritage Bank. These banks failed as a result of construction loans in real estate bust regions of the US. No, surprise there. This is to be expected in a downturn and the FDIC was prepared.

But, the regional banks have been absolutely crushed over the past few months. Judging by their stock prices, equity investors expect some of them to go bankrupt. Fifth Third, Washington Mutual, National City, Huntington Bancshares, and KeyCorp are all down over 80% to mention a few names. The group as a whole is in deep trouble.

What’s more is the full brunt of the downturn has yet to be felt. In particular, souring commercial real estate and construction loans are going to be a theme oft-heard in the coming weeks and months. One other theme barely broached is land prices. Home builders have bought massive parcels of land in anticipation of an ever-increasing demand for housing. With house prices dropping dramatically, those purchases have devalued considerably, sometimes as much as 60-70%. Who do you think loaned the home builders money for these purchases? Regional banks.

So the stage is set for a major failure in the regional banking cohort — which brings us to the question of policy response. None of the major regionals has an explicit or implicit backstop from the U.S. Federal Reserve like the golden list of 19 do. Therefore, should a major regional bank go to the wall, it cannot expect a government guarantee like Freddie and Fannie. It should not expect the kid gloves treatment of Bear Stearns because systemic risk is less of a question. The best it could expect is an FDIC asset seizure, wiping out shareholders, but protecting insured deposits.

On the other hand, uninsured bank deposits are still at risk. Recent share weakness has been precipitated by rumors that Washington Mutual’s uninsured creditors are quietly pulling money from the company, weakening its liquidity position. Were WaMu to fail as a result of these liquidity concerns, a large chunk of the FDIC capital base would need to be used to fund the bank’s seizure as this would be the largest FDIC seizure by an order of magnitude. Therefore, it is likely that the FDIC would ask for more funds from taxpayers in order to shore up its own balance sheet. I fully anticipate that the FDIC will lack adequate capital to take over the banks which will fail over the next few years.

So, a regional bank will not get an explicit or even implicit backstop from the government and taxpayers. However, the magnitude of the problem is such that eventually the taxman must come calling for more money. Those individuals still under the impression that banking writedowns will not be nationalized in some form have a long overdue date with reality coming. Despite its free-market bluster and rhetoric, America is not so different from Japan.