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Bank Losses: Are We Just Getting Started?

Those who see a light at the end of the credit-crisis tunnel could be staring at an oncoming train of further writedowns. That's the gist of a leaked study by Bridgewater Associates, according to which total bank losses could reach a staggering $1,600 billion (that’s $1.6 trillion). If Bridgewater is in the ballpark with that number, you’d better hold on to your hats: With total announced losses to date of “only” $400 billion, bank writedowns are just warming up!

Before reaching for your backup chute, you might ask: “Why pay attention to an unacknowledged report from a firm I’ve never heard of?” Here’s the background: Bridgewater is one of the world’s largest hedge fund managers. The foreign governments and central banks that are among its clients trust the company implicitly. Maybe you should, too.

Toting up the losses
To come up with their number, Bridgewater derived loss assumptions for a wide variety of risky assets and applied these to the worldwide totals across each asset type. On average, $1.6 trillion represents a 6% loss on worldwide total assets of $26.6 trillion. This new estimate trumps the most pessimistic figure out there to date: the $1.3 trillion put forward by hedge fund manager John Paulson.

Who is going to get hit hardest in the coming rounds of writedowns? The report suggests that it will be U.S. commercial banks, such as Citigroup (NYSE: C  ) , JPMorgan Chase (NYSE: JPM  ) , and Bank of America (NYSE: BAC  ) . So far, foreign banks have borne 60% of total losses -- UBS (NYSE: UBS  ) alone accounts for nearly 10% of the total. It’s time for their U.S. counterparts to pay the piper.

According to Bridgewater, U.S. commercial banks haven’t taken larger losses simply because they are not forced to apply mark-to-market accounting to their loan books -- valuing their loans on the basis of market prices, as you would for mortgage-related securities. That constraint has been the source of a lot of pain for investment banks such as Lehman Brothers (NYSE: LEH  ) , Merrill Lynch (NYSE: MER  ) , and Morgan Stanley (NYSE: MS  ) . Instead, the commercial banks take loan loss reserves based on their own loss estimates.

(In fact, U.S. banks took $38.1 billion in reserves during the first quarter -- four times the amount in the same quarter last year.)

Things may not be that bad -- really
I’m a little rosier on this subject than the folks at Bridgewater. Here’s why: They extrapolated losses on bank loans based on the market prices of mortgage securities. I can turn that argument on its head and make the case that the distressed pricing of certain securities imply losses exceeding those which will actually occur. Using such prices to gauge bank losses would produce an inflated estimate.

Last month, The Bank for International Settlements (BIS), the Swiss-based “central bank of central banks,” said the loss estimates on triple-A rated subprime mortgage-backed securities could be overstated by as much as 60%. In its quarterly report, the BIS fingered the ABX index, a subprime mortgage securities index that banks commonly use to value the mortgage-backed securities in their inventories. The Bank of England said essentially the same thing in its most recent Financial Stability Report, published in May.

I’d buy that for (a fraction of) a dollar!
Still skeptical? Here’s an example: In an article from The Wall Street Journal dated June 23, Dan Ivascyn, a mortgage-backed securities fund manager at bond giant PIMCO, pointed to highly rated securities with double-digit yields even if 80% of borrowers default on the underlying mortgages and investors recover only $0.30 on every dollar borrowed. I’ll take those odds!

Just as markets overshoot on the way up as a bubble builds, they will typically overshoot on the way down as it collapses. Crippling fear is usually the first stop once greed is exhausted -- investors don’t get off the train ride at rationality. In that scenario, securities will go from being overvalued to undervalued -- which is what we are witnessing in certain areas of the mortgage bond market.

Bad times for banks, good times for patient investors
Let me be clear: I expect a wave of bank failures and consolidation, and there’s a pretty good chance it will have us harking back to the post-1929 crash years for a precedent. However, the U.S. banking system will take its licks and move on, and it will do so promptly. There will be no “lost decade” of near-zero growth like the one that followed the Japanese property and stock market bubble of the late 1980s.

Furthermore, I think the pall that is tarring the banking sector is simultaneously sowing the seeds of huge opportunity for patient, value-oriented investors. Investing luminaries such as J.C. Flowers (J.C. Flowers & Co.) and David Rubenstein (The Carlyle Group) have said as much, and both of their firms have spoken with Federal Reserve officials to discuss ways to make it easier for private equity firms to invest in banks (the discussions were held at the Fed’s initiative).

Opportunities aren’t reserved for the big boys, either. Right now, individual investors can pick up shares of high-quality regional and local banks at very attractive prices. There could be a silver lining to these mounting credit losses after all.

Related Wall Street Foolishness:

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Alex Dumortier, CFA, has no beneficial interest in any of the stocks mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days.

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