Driven by expanding problems in the commercial real estate sector (CRE), the number of distressed banks in the US rose to 702 at the end of 2009, the highest level in 16 years, according to the Quarterly Banking Profile (pdf.) report released by the Federal Deposit Insurance Corporation (FDIC). Furthermore, the report notes that US banking sector continues to consolidate at a rapid pace.

The number of insured commercial banks and savings institutions reporting financial results declined by 87 during the fourth quarter. Only three new charters were added during the quarter, while 43 institutions were absorbed by mergers and 45 institutions failed.

For the full year, the number of reporting institutions fell from 8,305 to 8,012. Only 31 new charters were added in 2009, the smallest annual total since 1942. Mergers absorbed 179 institutions during the year, and 140 insured institutions failed. This is the largest number of bank failures in a year since 1992.

The number of institutions on the FDIC’s “Problem List” rose to 702 at the end of 2009, from 552 at the end of the third quarter and 252 at the end of 2008. Total assets of “problem” institutions were $402.8 billion at yearend 2009, compared with $345.9 billion at the end of September and $159.0 billion at the end of 2008. Both the number and assets of “problem” institutions are at the highest level since June 30, 1993.

One in eleven banks in the country are now deemed in trouble by the FDIC. The regulatory body now expects a quickening pace of bank failures driven by defaults in the CRE sector.

"This year, the losses are going to be heavily driven by commercial real estate, we've known for some time and we have been projecting that," FDIC Chairwoman Sheila Bair told reporters in a press conference. "The pace is probably going to pick up this year and for the total year it will exceed where we were last year. Overall, the banking system is challenged but stable, but is performing its credit extension role."

Bair said it takes longer for losses on commercial real estate to work through the system because frequently borrowers may have cash reserves and can continue to make good on payments for a while, even as a downturn expands. "Tenants may be in longer-term leases, but those leases eventually come due and they don't renew or they renew at significantly reduced rental rates," she said.

So far in 2010, the FDIC has seized, closed or merger 20 banks. In 2009, 140 banks failed, the largest number in 17 years.

Senator John McCain, Republican of Arizona, and Senator Maria Cantwell, Democrat of Washington,  are proposing legislation that would reinstate the Glass-Steagall Act of 1933 that separated commercial banks from investment banks by banning commercial banks from underwriting securities, forcing banks to choose between being a lender or an underwriter but not both. The Glass-Steagall Act was repealed in 1999 during the Clinton Adminstration after enduring 12 attempts in 25 years to weaken its provisions.

Last week five House Democrats - Maurice Hinchey of New York, John Conyers of Michigan, Peter DeFazio of Oregon, Jay Inslee of Washington, and John Tierney of Massachusetts - introduced an amendment that would have given banks one year to choose between being commercial banks or investment banks, thus restoring the spirit of Glass-Steagall but the amendment failed. Sadly, the amendment never got a vote on the House floor.

Now the Senate is taking up the cause. From Newsweek:

More than a year after the election, the Arizona Republican is looking to repair that reputation by joining up with Democratic firebrand Maria Cantwell to propose something that will be anathema to both Wall Street and the Obama administration. According to two congressional sources, the two maverick senators want to reinstate Glass-Steagall Act, the Depression-era law that forced the separation of regular commercial banking from Wall Street investment banking. The senators' proposal echoes a failed amendment introduced in the House last week by Rep. Maurice Hinchey of New York.

The Senate prospects for the success of the McCain-Cantwell bill--which the two plan to announce together on Wednesday morning--seem bleak at best. But McCain and Cantwell join a still small but not insignificant insurgency of chronic doubters, including former Federal Reserve chairman Paul Volcker, who say not nearly enough is being done to change Wall Street and, in particular, to address the "too big to fail" problem. The issue is one of the few in Washington that can unite the left and right sides of the political spectrum. Democrats like Cantwell deplore Wall Street's outsize role in the real economy and its lobbying influence, and conservatives such as McCain are appalled at the way the market system has been undermined--some would say rigged--by the power of the big banks.

Here's why this is important:

The blinding complexity and interconnections created by modern capital markets--especially because of the way nearly half a trillion dollars in derivatives trades linked the firms to each other--demanded that there be strong firewalls and capital buffers between Wall Street institutions and their affiliates, and between banks and nonbanks and insurance companies. Otherwise there would be no islands of safety--no healthy institutions left to come and rescue the day, as commercial banks traditionally had done since the days of J. P. Morgan's famous bailout in 1907. The repeal of Glass-Steagall took things in precisely the opposite direction, eliminating most of the firewalls and inviting staid commercial banks into the buccaneering world of Wall Street trading. Representative Hinchey says it "was a recipe for disaster because these banks were empowered to make large bets with depositors' money, and money they didn't really have. When many of those bets, particularly in the housing sector, didn't pan out, the whole deck of cards came crumbling down and U.S. taxpayers had to come to the rescue."

I'll add one more point. As long as banks can mint money on their trading side, then they are not compelled to seek or even entertain risk on their commercial lending and credit side. Separating commercial banks from investment banks will allow each to focus on their very separate societal functions.

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The Glass-Steagall Act of 1933 established the Federal Deposit Insurance Corporation (FDIC) in the United States and provided a strong regulatory environment that largely served the nation and its banking sector well. The law separated commercial banks from investment banks by banning commercial banks from underwriting securities, forcing banks to choose between being a lender or an underwriter but not both. The law was finally repealed in 1999 during the Clinton Adminstration after 12 attempts in 25 years had weaken the provisions.

The law was effectively rendered obsolete when in December 1996, with the support of Fed Chairman Alan Greenspan, the Federal Reserve Board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting. I had joined Alex. Brown & Sons, then the nation's oldest investment bank in August 1996. Less than a year later in April 1997, Bankers Trust, which in turn was acquired by Deutsche Bank, bought Alex. Brown becoming the first US bank to acquire a securities firm. The implications of the change were quite obvious. Suddenly what we did on the finance side could determine the placement of a commercial paper loan on the commercial side. The impact on the nation's banking sector has been an increased dependence on short-term gains over long-term planning.

I have had the good fortune and privilege to work at three investment banks including Goldman Sachs. Goldman is an exceptional firm and resource rich but at my core I remain a Alex. Brown guy and bleeding Alex. Brown red. One of the Four Horsemen of the US Investment Bank industry, Alex. Brown traced its roots to the Baltimore of 1800 when the firm started as trading and shipping firm. It grew into a banking concern financing canals and railroads. Alex. Brown underwrote the first initial public offering in the US, that of the Baltimore Water Company in 1808. We were the first East Coast bank to open an office in San Francisco and along the way we underwrote initial public offerings for companies from the B&O Railroad to Genentech to Krispy Kreme. A firm of some 7,000 employees world-wide, we were a niche player, highly profitable and committed to our clients. Engaging in high-risk speculation was not part of our business. Along with the venture capital industry, investment banking industry is effectively the nation's industrial policy setters. These are the industries that pick the winners, the companies to nurture and to grow into titans of industry. It is important to allow the sector to assume risk without subsuming commercial banks. Nor should the lending practices of commercial banks threaten the viability of investment banks. These two are indeed separate businesses and should be again separated in practice and by law.

The repeal of Glass-Steagall, however, has changed the culture in the nation's banking sector which underwent a period of consolidation under the mantra that bigger was better. In a 13 month period without changing desks, I had three separate employers. Combine that big is beautiful mentality along with the lack of derivative regulation plus the fear that a bank failure has long-standing fateful repercussions for the overall economy and you have the present day mess that we face. We could let a brokerage like Smith Barney or an investment bank Salomon Brothers fail but letting a financial behemoth Citibank fail is another matter.  We have seen the end of moral hazard with bailout after bailout for the super-rich who keep on making speculative bets because they can and because ultimately they know that the public sector will bail them out when on the verge of collapse.

This week five House Democrats - Maurice Hinchey of New York, John Conyers of Michigan, Peter DeFazio of Oregon, Jay Inslee of Washington, and John Tierney of Massachusetts - will introduce an amendment would give banks one year to choose between being commercial banks or investment banks.  I support this amendment and believe it critical to the future success of the country because it will restore a balance within the finance industry letting commercial banks do what they do and investment banks do what they do.

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Rarely has a Senate Banking committee hearing been so entertaining. I have listened to this clip now three times and in it I have a new found respect for Senator Jim Bunning of Kentucky. To call Chairman Bernanke the living definition of a moral hazard is long overdue. Some highlights:

Chairman Greenspan’s attitude toward regulating banks was much like his attitude toward consumer protection. Instead of close supervision of the biggest and most dangerous banks, he ignored the growing balance sheets and increasing risk. You did no better. In fact, under your watch every one of the major banks failed or would have failed if you did not bail them out.

Rather than making management, shareholders, and debt holders feel the consequences of their risk-taking, you bailed them out. In short, you are the definition of moral hazard.

Senator Bunning now joins Vermont Senator Bernie Sanders in trying to block Bernanke's reappointment by putting a "hold" on it when it reaches the Senate floor. Essentially that means the Senate would need 60 votes to approve the nomination, rather than a simple majority.

Let's just cut to the chase, as a regulator Chairman Bernanke has been a dismal failure.

The full comments of Senator Bunning are below the fold.

Update [2009-12-3 21:41:43 by Charles Lemos]: Senator Jim DeMint, Republican of South Carolina, has also placed a "hold" on the nomination of Federal Reserve Chairman Ben Bernanke. Unlike Senator Bunning and Sanders, however, Senator DeMint's hold is conditional upon an audit of the Fed. More at the The Hill.

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I have a new found respect for Senator Jim Bunning of Kentucky. To call Chairman Bernanke the living definition of a moral hazard is long overdue. Let's just cut to the chase, as a regulator Chairman Bernanke has been a dismal failure.

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