Which Banks Will Die?

1,562 banks will be gone in the next few years.

I heard this startlingly precise number from one of the panel members at the Wall Street Journal Future of Finance Initiative conference -- a meeting which featured a keynote by Treasury Secretary Tim Geithner, as well as participation such heavy hitters as George Soros, Meredith Whitney, Robert Shiller, and Paul Volcker.

Let's put that prediction in perspective. Since the fall of Bear Stearns, only 61 banks have been taken over by the FDIC. If you believe this presenter, we've only seen 1/25 of the likely banking deaths. Yikes!

It may or may not come to pass that 1,562 banks go under. It's merely a guess, after all, albeit an educated one. But what's even more important than predicting how many banks are going down is predicting which ones are most likely to fail.

And, for the greedy folks like me, which ones are most likely to succeed.

The banks that will die
The recent stress tests were the government's golden opportunity to separate the winners from the losers -- and nationalize the losers. Instead, the government has effectively split banks into three classes:

• Big banks that passed the stress test
• Big banks that failed the stress test
• Smaller banks

Only banks that have more than $100 billion in assets were subject to the government's stress tests. These 19 largest banks (out of 8,246 FDIC-insured banks) comprise about two-thirds of all U.S. banking assets. Call them too big to fail if you'd like, but these are the banks that the government really cares about.

So you're either one of the 19 haves or you're one of the 8,227 have-nots.

And of the 19 haves, you have those that were left alone (the winners) and those that were forced to raise more capital (the losers):

You're probably a step ahead of me at this point. If the government has its way, the future banking deaths aren't going to come from the nine stress test winners or even the 10 stress test losers. It's many of the smaller banks that are most likely to die.

Should we avoid small banks?
Does that mean we should invest in the stress test banks and ignore the smaller banks? Not exactly. Just because a bank stays alive doesn't mean it's a good investment. Ask the Japanese zombie banks.

Instead, we need to be on the lookout for mispriced banks, whether they are large or small. In a market as uncertain and volatile as the current one, patience and research are rewarded more than usual.

When looking into a bank, you primarily want to assess three things besides the quality of management:

• Earnings power
• Balance sheet strength
• Price

I've already argued the big losers will predominantly be smaller banks. But I also believe the many smaller banks may provide us the biggest opportunities to use these criteria to spot winners.

Why the small banks?
Two reasons: 

1. Many smaller banks have simpler balance sheets and business models 
2. They're not followed by as many people as the big banks.

So, I ran a screen for small cap banks based on my three criteria above: earnings power (positive net income and reasonable net interest margins), balance sheet strength (high reserves versus their non-performing assets), and price (low price-to-book value ratios). Here were three high scorers:

Source: Capital IQ, a division of Standard and Poor's.

Are these banks a buy?
As I've said before, assessing banks is hard. No screen can give you anything but a high-level view of a bank's loan portfolio. To invest in an individual bank, you must be very comfortable assessing that bank's balance sheet strength, have strong faith in the bank's management, and be willing to guess where the government is headed in its banking bailout.

If you have all three prerequisites, start separating out your favorites based on earnings power and balance sheet strength and wait for a favorable price.

However, if small cap bank stocks fall in your "too difficult" bucket, don't worry because individual banking plays aren't for everyone. There are plenty of small cap companies -- banking and non-banking alike -- that are selling for bargain prices right now.

Our Motley Fool Hidden Gems team of analysts are building a real-money portfolio composed entirely of small cap companies. You can see which ones they've bought with the Fool's money by clicking here for a free 30-day trial. There's no obligation to subscribe.

Anand Chokkavelu owns long-held shares of Citigroup. American Express is a Motley Fool Inside Value selection. The Fool owns shares of American Express. The Fool has a disclosure policy.