For Major Banks, Trouble Is Just Getting Started

Troubles at some of banking's biggest names in early 2009 are merely setting the tone for what is likely to be another disastrous year for the industry.

As the future of Citigroup has come into question and analysts express concern over Bank of America and HSBC, the worst could well be yet to come for an industry still smarting over a bruising 2008.

Oliver Quillia for cnbc.com

The $700 billion Troubled Asset Relief Program, which banks can access to bolster their capital positions, will help ease some of the damage as will Federal Reserve moves to ease monetary policy. The liquidity moves of 2008 have lagging effects that should take root in the coming months.

But banks will fail, and at numbers large enough to cause alarm.

"I do think some of the actions taken by both the Fed and Treasury will limit the failure, especially at the larger banks, that we have seen in the late '80s or early '90s," said Christopher Mustascio, managing director at Stifel Nicolaus. "But to think we're not going to see more failures in 2009 is probably naive."

The US saw 25 banks fail in 2008 and the number is expected to multiply this year into the hundreds.

While banks have been allowed relatively liberal access to the TARP funds, some are still burdened by huge losses suffered in the collapse of the subprime mortgage market as well as credit issues fed by consumer weakness during the recession.

In the case of Citigroup , its behemoth supermarket banking model became undone and the company was forced to sell its Smith Barney brokerage unit to Morgan Stanley .

At the same time, HSBC stumbled after analysts called into question its capital position, and Bank of America was hit after analyst Richard Bove of Ladenberg Thalmann cut his outlook of the firm because of steep losses it faces ahead due to its exposures on a number of fronts.

Shares across the sector tumbled Wednesday just as earnings season was kicking off, with JPMorgan Chase due to report Thursday morning.

"There's certainly going to be more bank failures in 2009 as the economic backdrop continues to deteriorate and the smaller banks start to feel the pain," Mustascio said. "In the past quarters much of the pain has been on larger banks, investment banks, on a mark-to-market basis that has been driving asset valuation writedowns. Now you've got a full-fledged recession...Some of these banks are not going to be able to deal with that, and you're going to see failures."

Same Problems, Only Worse

In essence, the story of 2008 will be the story of 2009, only amplified.

That's because the mortgage contagion will spread beyond simply the subprime group and start to hit prime borrowers as well who cannot meet their obligations due to rising unemployment and the intensifying recession.

"Stabilizing the banks through direct capital injections was a good first step but before things can be really stabilized the government's going to have to find a way to take the toxic assets off the books of the banks," said Mike Carlson, a partner with Faegre & Benson's restructuring group in Minneapolis. "Until that happens, things are not going to be able to move very quickly."

As a result of the continued troubles, banks will have a hard time convincing investors that their institutions are stable, which will lead to weak share prices and diminished market capitalization.

Banks with an already weak position then will see their foundations crumble as the financial storm winds blow with more ferocity. Institutions with untenable business models, such as the one-stop-shop supermarkets, will find it difficult to survive.

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"Now we're seeing where banks have been very woeful pulling off effective integrations of these cultures," said Brian Hamburger, managing director of MarketCounsel, a regulatory compliance and business consulting firm in Englewood, N.J. "They've been performing poorly, with executing the cross-sell and cost-containment that they tout in every one of those business combinations seeming to fall well short. It's just not reality."

With fears that short-sellers again could swoop in on some of the weaker names in financials, investment pros are counseling clients either to stay away from most names in the space or at least hedge any plays by using inverse exchange-traded funds that pay when bank indexes move lower.

"If you look at the banking sector as a whole just in terms of price action in the group and what the market might be saying, I think one would have to conclude that there's more trouble that lies ahead," said Todd Salamone, analyst at Schaeffer's Investment Research in Cincinnati.

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Schaeffer's is avoiding the headline-makers like Citi and Bank of America, and when it is buying banks it's also taking puts on the Financial Select Sector SPDR , a play that anticipates a move lower in the ETF.

"On the one hand there's a lot of negativity and there is an appeal to that. But there's only an appeal when the price action is not justifying that negativity," Salamone said. "This is more a sector you avoid. If you do dip your toes into certain banks, you do it in a very cautious manner by hedging."

In the meantime, big banks and small banks alike will get hit as investors avoid risk and and the shakeout in the industry continues.

"You always have a pendulum swinging too far one way and too far the other way. Over the course of time it swung too far to the side of the financial supermarket and now it's swinging back the other way," Carlson said. "Ultimately I think you're going to see risk again, but I don't think it will be for a decade or more."

© 2009 CNBC.com