Is Your Bank in Immediate Danger of Failure?

As the Dow dips below 10,000, it’s not just your investments that might be at risk.

Your bank could be, too.

Let’s face it: The global economy is still rough. The European debt debacle continues to spread from one country to the next, with no one sure where it will end. Here at home, the recovery is soft at best.

The best way to evaluate the economy is to ignore the mishmash of indicators that are released each day and focus on the one metric that really matters. It’s not reported like chain-store sales or the unemployment rate, but it’s nevertheless the best gauge of how the economy is doing.

This indicator is called the “net charge-off rate.” It is the amount of bank loans that borrowers can’t repay, and I think it’s the most telling way to measure the nation’s actual financial health. Say unemployment drops from 10% to 5%. If people still can’t afford to pay back their loans, then the country really hasn’t grown stronger, has it?

The charge-off rate is 1.94%, and it has, astonishingly, grown fivefold since the beginning of 2007. In a typical year, a bank should expect to lose about 32 cents for every $100 it lends. Right now, however, banks are losing $1.94 on $100 in loans.

This problem is made worse by bank’s deteriorating financial condition. At the beginning at 2007, banks had $1.80 in cash reserves for every dollar of loans that were past due. So even if all those loans went belly up — and not all past-due loans will — the banks were more than covered. Today, banks have only about 80 cents for every dollar of problem loans.

Don’t kid yourself into thinking that the worst of the financial crisis has passed. For some banks, it’s just beginning. Eating all those bad loans is hurting all banks, and many more are going to fail. The Federal Deposit Insurance Corp. (FDIC) says 77% of banks are profitable. But that leaves 23% that are bleeding cash.

The FDIC currently has 775 banks on its “Problem Bank” list. So far this year, 83 banks have failed, about half of which did so in the second quarter. That’s a truly frightening number by historical standards: About a third of the banks that have failed since 2000 have done so in the first 5 months of 2010.

The FDIC does not release its problem loans list, it only says how many banks are on it. But using a special ratio that measures a bank’s problem loans (the precursor to the loans that are eventually charged off), investors can determine with a high degree of accuracy whether their bank is safe.

It’s called the “Texas ratio.” It was developed by a financial wizard at RBC Capital Markets named Gerard Cassidy, who used it to correctly predict bank failures in Texas during the 1980s recession, and again in New England in the recession of the early 1990s.

The Texas ratio is determined by dividing the bank’s non-performing assets by its tangible common equity and loan-loss reserves. Tangible common is equity capital less goodwill and intangibles. As the ratio approaches 1.0, the bank’s risk of failure rises.

Every bank that has failed in the second quarter has had a Texas ratio of greater than 0.90. In fact the average was about 5.0.

Bank failures are announced on Friday afternoons, after the close of the week’s business. On June 5, Bloomberg news reported that three banks had failed: TierOne Bank in Nebraska, Arcola Homestead Savings Bank in Illinois and First National of Rosedale, Mississippi. On June 11, it was reported that another bank, Washington First International Bank, was seized. And June 18, it was Nevada Security Bank.

Frankly, none of these failures should have come as a surprise. After all, Rosedale had the highest Texas ratio of any bank in the country, at 15.78. TierOne’s ratio was 4.05, and Arcola’s was 0.91.

Investors simply cannot afford not to know if their bank is one of the ten banks I’ve identified as being in grave danger of failing. It’s crucial that all investors view the list of banks to ensure that their money is safe. And if your bank has a high or even a higher-than-average Texas ratio, then for heaven’s sake go in tomorrow and close your accounts. It’s always best to get out of Dodge ahead of the posse.

Using this highly accurate barometer of bank health, I’ve not only reassured myself that my own bank — the highly excellent Amarillo National — is safe and sound, I’ve also made a list of the top ten banks most likely to fail. If you bank at one of these institutions or have friends or loved ones who do, please pass this information along to them.

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