The dance of the zombie US banks is just starting to rock, according to leading bank analyst Chris Whalen.

In his latest note, Whalen, the co-founder of Institutional Risk Analytics, highlights the financial damage being done to the balance sheets of the big US banks as a result of falling house prices.

The situation in US housing is so dire that some estimate that one-third of all US households have negative equity, where the size of their home loan is greater than the value of their house. The number of US households at risk of foreclosure has been estimated at one in five.

And the banks are struggling to cope with the mountain of problem residential and commercial loans. Some believe the US is less than one-quarter through the process of restructuring defaulted commercial and residential real estate loans, and the backlog of problem loans is growing. And the lags between when mortgage default and liquidation is now estimated to have stretched out beyond 18-24 months.

As a result, the banks are left with a situation where they’re not collecting interest on a huge chunk of their loan book. At the same time, the banks are also facing higher administration costs as they deal with the problem property loans. Banks nursing large portfolios of problem loans typically become wary of making them new loans — effectively turning them into “zombie” banks.

Whalen paints a dire picture of the current state of the US banking system.

“Why do we still refer to the ugly girls — Bank of America, JP Morgan and Wells Fargo in particular — as zombies? Because the avalanche of foreclosures and claims against the too-big-to-fail banks has not even crested.”

He adds “the industry is under rising operational stress, a typical trend as a credit cycle matures. Banks are spending more money on servicing, for example, as well as funding repurchase of defaulted loans from other banks, Fannie Mae and Freddie Mac, and investors.”

In addition, he points out, “banks are also increasingly choking on the sheer size of the flow of foreclosed properties”. This was seen recently when one lender, Ally Financial, decided to impose a moratorium on residential foreclosures. (Earlier this week, Ally Financial, instructed its agents to half foreclosures on homeowners in 23 states. Brokers were told to stop evictions and lock-outs immediately. The company also suspended sales of properties on which it had already foreclosed).

Whalen says the move by the previous US administration to encourage the stronger banks to absorb their troubled rivals during the financial crisis encouraged the creation of zombie banks.

The decision “to slam Countrywide and Merrill Lynch into Bank of America, Wachovia Bank into Wells Fargo & Co, and Bear Stearns into JP Morgan was a fundamental error — and one that is only creating the precursors for the next systemic crisis”.

Whalen argues that as well as saddling the stronger banks with massive numbers of problem loans, it also left them at risk of legal action.

He notes that because Lehman Brothers was allowed to ail, all legal claims against it are being resolved in the bankruptcy courts.

In contrast, Whalen argues that JP Morgan boss, Jamie Dimon “and his shareholders are on the hook for all of the claims against the legacy Bear Stearns securitisation business, but Dimon is fortunate compared to his counterparts at Wells Fargo and Bank of America”.

Whalen predicts that the financial condition of the US banks will cast a pall over US politics. “Democrats and Republicans alike are going to be fed into the meat grinder over the next several years as the banking sector deals with literally hundreds of billions of dollars in direct and indirect expenses from the deflation of the mortgage bubble.”

But the greatest casualty from the zombie banks will be the US economy, which he predicts will suffer the worst economic contraction since World War I — forget World War II. “And frankly, nothing that either the Fed or Treasury does in the near-term can change this basic economic fact of restructuring.”

He says that banks such as Ally “can impose moratoriums and issue press releases, but the losses remain.  It is only a question of when they are recognised.”

This story first appeared on Business Spectator.