What's next for the banking sector?

What's made the stock market so jittery lately? Was it oil prices or commodity run-ups? I don't think so. I think what's bugging investors is: will something bad happen in the banking sector?

So far, the banking sector has suffered from defaults on higher risk mortgage investments. Some of these were subprime, some were Alt A (a step up from subprime, but not prime), and some have been home equity loans. All were bad loans and bad investments to begin with.

Because many market participants were buying mortgage investments with other people's money (read: borrowed money), this part of the market really suffered when it became clear that almost no one knew what the mortgage investments they bought were worth.

But, so far, the banking sector hasn't really suffered from major defaults on business loans, credit card loans, auto loans, prime mortgages, etc. In other words, the banking problems that started in March of 2007 have almost entirely been an investment phenomenon, not a broader bank lending problem, per se.

The question now is: could that change? Could the problems seen so far be the tip of a broader loan default problem? Could the economy be rolling over into recession and signaling that loan defaults will increase across the board?

If the answers to these questions are yes, the the problems in the banking sector, and the rest of the economy for that matter, may only be getting started.

Can the Federal Reserve fix these problems? Many people believe they can, but some strong dissenting opinions, even from within the Fed, are starting to question the validity of this premise.

The Fed may control interest rates and be able to bail out banks, but not without cost. The cost, in most cases, is higher inflation. With soaring energy and food prices, this will not be welcome news.

The other problem is that Fed actions are creating moral hazard. When you bail out stupid risk takers, they learn a bad lesson: they either make a ton of money making risky bets or they get bailed out. "Heads I win, tails you lose." This may be leading to even more bad lending and highly levered investing.

What's next for the banking sector?

It all depends on fundamentals at this point. Either banks have made good loans and have enough reserves to weather tougher times, or they don't.

If they don't, then expect the banking sector to hit new lows as more and more news comes out that broader loans--like credit card, auto, business, commercial real estate, prime mortgages--are hitting higher default levels.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.