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If Banks Are Really Sound, Why Are Investors Scared?

Despite a seemingly never-ending stream of bad news about big losses, top banking experts say the industry as a whole is sound.

So why are so many people panicking?

For one thing, there are good reasons for fear. Banks are posting billions of dollars of losses and warning of more bad times ahead. There also is continued speculation that the government may have to intervene even more than it has to prevent some of the biggest banks from collapsing.

But what's really hurting banking stocks, the pros say, is the uncertainty over what the government may—or may not—do about the banking industry. Part of that, ironically, is whether the government will relax regulations that have forced banks to declare bigger losses than they might otherwise have incurred.

"We can fix this," said Bill Isaac, chairman of the Federal Deposit Insurance Corp from 1981-85. "We just need a coordinated policy on all fronts, including accounting and regulatory actions, that is clearly articulated to the world."

Without a clear legislative direction, investors have been abandoning banks in droves.

Titans of the industry, most notably Bank of America and Citigroup , appear at least according to stock-price movement, to be on the verge of collapse.

For investors:

But to Isaac and other analysts, much of the damage is self-inflicted by a government that has hamstrung the sector with burdensome rules that don't reflect the state of affairs in banking.

Accounting rules that are forcing institutions to severely mark down assets and reserve regulations that restrict risk are wrecking balance sheets and spreading panic throughout both the industry and investors. On top of that are worries that the government may step in to nationalize banks, which would wipe out shareholder value.

Paramount among the fixes Isaac identified are changing the mark-to-market accounting rules, and assuring that banks have access to capital without the burden of strident loan-loss capital reserves.

While some have argued that loosening the rules could encourage more irresponsible lending from banks, Isaac said the government needs to set priorities.

"Don't worry about ideology now," he said. "Don't worry about systemic risk and moral hazard--now is not the time to worry about that stuff. Now is the time to get things under control. We can worry about moral hazard going forward."

Current FDIC Chair Sheila Bair said in an interview on CNBC that the government needs to take the proper steps, including capital injections, to restore investor faith.

"The share price issue is being driven by uncertainties about what the future will bring," she said, adding the fear is coming "from a balance sheet standpoint, which is why we're working on troubled asset relief to try to put an outer bound on what some of those losses could be on those troubled assets, to give the market confidence to try to stabilize the situation." See video for full interview.

Bank of America in particular has been maligned despite its solid position in the global banking market, Isaac said. Investors have been ditching BofA shares since the company disclosed larger than expected losses realized from its takeover last year of Merrill Lynch.

"I believe that Bank of America has the most attractive banking franchise in the world," Isaac added. "I don't understand why people are getting all flustered."

One reason is likely the fear that widespread bank nationalizations would crush shareholders, including those invested in the sector through funds and pension plans.

A template for such a doomsday scenario would be the takeover of government-sponsored enterprises Fannie Mae and Freddie Mac , the mortgage giants who fell into precarious positions from their exposure to the subprime mortgage crisis. The government's position in the companies superseded those holding common stock, causing shares that traded a year ago in the $35 to $40 range to enter penny-stock status.

As the fear lingers that the government could inflict the same damage on other big banking names, convincing investors to buy stock is a tough sell.

"It's time for the government to make it clear that it's not going to do that. The shareholder has been punished enough," Isaac said. "Who are the shareholders of these banks? It's all of us who have 401(k)s and pension plans and the like."

"People don't invest in banking stocks because they're speculators," he added. "It's not like they're investing in dot-coms. The people who invest in bank stocks are looking for fairly steady growth and good dividends."

The government can get banks back to solid ground by making sure they're well-capitalized, and by implementing policies that are more than one-off events like rate cuts that provide little lasting relief, Bair said.

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"We need a programmatic response," she said, later adding, "The whole purpose of all this is to get banks lending again."

But Isaac said the Securities and Exchange Commission has not done its part to quell the fear contagion through the market.

"I am deeply disappointed that we have not done anything to address mark-to-market accounting, which has destroyed billions of dollars in bank capital," he said. "The SEC just blithely goes along and doesn't get rid of that terrible accounting requirement that is wreaking havoc on our accounting system. The SEC is irresponsible in the extreme."

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