Subscribe to BusinessWeek

A toxic brew of bad bets on ultra-risky debt, a weak economy, and plunging home prices could soon leave some U.S. banks short of the cash they need to stay afloat. Adding to their worries is a sense that it's getting harder and harder for institutions to raise funds.



As a result, concerns are rising that the U.S. could see a wave of bank failures in the next year. While big banks, starting with giants such as Citigroup (C), Bank of America (BAC), and Wells Fargo (WFC) grab headlines, their financial standing is reasonably secure. It's the smaller banks that are in most danger, experts say.



Of about 8,500 banking institutions in the U.S., the most vulnerable are local banks in areas hard hit by the real estate slowdown, especially Florida, Arizona, Nevada, and California. And the most endangered of those specialized in real estate lending, with home-equity loans and loans to developers providing the most pain.



Few banking experts foresee a return to the full-blown banking crises of the 1970s, '80s, and early '90s -- at least not yet. In 1990 and '91 alone, more than 650 U.S. banks went bust. In the past year only a handful of banks -- seven, at last count -- needed a bailout from the Federal Deposit Insurance Corp., which insures customers for losses of deposits up to $100,000.



A Growing Problem List

One smaller bank that has faced trouble recently is PFF Bancorp (PFB), a Rancho Cucamonga [Calif.] company that focused on loans to real estate developers. In the past year its stock has plunged 96%. On June 16 a privately owned bank-holding company, FBOP, agreed to buy PFF for the fire-sale price of $30.5 million, even though the bank reported almost $4.4 billion in assets on its balance sheet at the end of 2007.



Last quarter the FDIC said there were 90 banks on its problem list of troubled institutions, up 18% from the previous quarter, but still tiny compared with the almost 1,500 banks rated as troubled in 1990. Most of the banks on the latest list are small, with problem institutions holding just $26 billion in assets out of $13 trillion in assets in the entire banking system.



Still, the FDIC is adding staff to prepare for more bailouts. A few failures might not rattle the system, "but collectively they start to add up," says David Ellison, chief investment officer for FBR Mutual Funds.



Banks, most of them large, are still registering hundreds of billions of dollars in losses from mortgage-backed securities and other complex credit instruments, but that's just the first phase of the credit cycle, says Matthew Kelley, an analyst at Sterne Agee. Coming soon: the full effect of declining home prices and the weak economy, as borrowers find it harder to pay back loans. "That's phase two," he says.



Skittish Investors

The vast majority of banks should have no trouble navigating even a nasty recession if they can raise enough capital to cover losses. After all, most have "seasoned leadership who have gone through downturns before," says Robert Ellis of Celent, a financial consulting firm.



Because of toxic debt investments, many giant banks, including Citi and BofA, needed capital earlier than their smaller counterparts. Banks, which have already raised more than $200 billion [and counting] to cover losses, initially found capital-raising relatively easy, as evidenced by an Abu Dhabi sovereign wealth fund's $7.5 billion injection in Citi as early as November of last year.



"The bigger you are, the easier it is to raise capital," says Raymond James (RJF) analyst Anthony Polini. But now it's getting harder for banks of any size to raise cash. "The capital-raising window is starting to close," Ellison says.



Banks' unending credit troubles -- and their insatiable need for capital -- are spooking investors. Citi's stock is down 36% since the Abu Dhabi fund's investment in November. Fifth Third Banks' (FITB) plans to raise $1 billion, announced on June 18, sent its stock down 27% in one day.



Better Credit Quality

As bank shares drop, raising capital gets more expensive and is more likely to dilute existing shareholders' stakes. That, in turn, causes stock prices to fall further. "It's the death spiral of dilution," Ellison says.



Smaller banks do have some advantages over their bigger rivals. Tiny community banks often can raise extra capital from existing shareholders, who often live in their service area.



Also, credit quality has held up slightly better at smaller institutions. The percent of all loans and leases that were "noncurrent" -- in which borrowers have fallen behind in payments -- was 1.71% in the first quarter, according to the FDIC. That compared with 1.4% at banks with less than $100 million in assets and 1.53% at banks with $100 million to $1 billion of assets.



That suggests smaller banks were more conservative in their lending in the past decade. The 6,770 banks with assets of less than $1 billion represent 79% of the total number of banks in the U.S., though those institutions hold only 11.4% of the total assets in the banking system.



New Banks Vulnerable?

An advantage for all banks over previous crises: As banks have merged and expanded in the last few decades, the U.S. banking system has gotten much stronger, says Columbia Business School's Charles Calomiris. Spanning wide geographies and offering a variety of new products, bigger banks can prosper despite economic problems in particular geographies or credit problems in particular loan products.



Many smaller institutions, however, are paying for their lack of geographic and product diversity. None has indicated they are in danger of going out of business, but examples of institutions in hard-hit areas include Silver State Bank (SSBX), based in Henderson, Nev., which recently announced plans to raise $40 million in capital; BankUnited Financial (BKUNA) in Coral Gables, Fla., which will raise $400 million through a stock offering; and Downey Financial (DSL) in Newport Beach, Calif., which has seen its nonperforming assets soar from 1.3% to 14.3% in the past year. All of their stocks are down more than 90% in the past year. Conditions are especially bad for the vast array of new banks that sprang up in these once-hot real estate markets.



It may be inevitable that dozens of these banks ultimately fail or are sold off at deep discounts. The Federal Reserve tried to help by lowering interest rates and lending cash cheaply to troubled institutions through its so-called discount window. But the central bank, worried about inflation, is reluctant to lower rates further. And liquidity from the Fed is only a temporary salve to banks' big losses.



Ultimately, these institutions need capital to permanently repair their balance sheets. If they raise cash, broader problems for the banking industry could be avoided. But that is made difficult by the volatility of bank stocks and the uncertainty about the companies' futures.



Is the Market Overreacting?

Instead of raising capital to recover from credit troubles, banks are being forced to scrounge for cash to handle losses yet to come. And no one knows how big those losses could get, Ellison says. "We had a record number of people buy a record number of homes at record high debt levels," he says. "It's a problem that goes beyond any regulatory or governmental scheme to fix."



Columbia's Calomiris is confident the banking system is strong and that home prices are not declining as quickly as some doomsayers believe. But his optimism is shaken by what he calls the stock market's "overreaction" to the banks' troubles. If banks can't raise capital on reasonable terms, he says, they may be forced to save cash in other ways, such as sharply restricting their lending.



The "extreme price movements" of bank stocks are alarming, Polini says. "No matter how bad it is, it's going to be worse if we don't go through this process in an orderly fashion."



President Franklin Roosevelt took office in 1933 in the midst of a far worse banking crisis, yet his inaugural address still resonates today: "The only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance."



And right now, many banks, and their investors, are very afraid.