Problem U.S. banks and thrifts on an official watchlist rose more than a third to 416 in the second quarter of 2009, as bad loans continued to bite, but regulators saw signs of stabilization in the industry.

The Federal Deposit Insurance Corp said on Thursday that the industry swung back to a $3.7 billion loss in the second quarter, after reporting a $7.6 billion profit in the first quarter, primarily due to costs associated with rising levels of bad loans and falling asset values.

Banking industry performance is -- as always -- a lagging indicator, FDIC Chairman Sheila Bair said.

She said the source of the banking industry's problems had migrated from residential loans and complex mortgage-related assets to more conventional types of retail and commercial loans that have been hit hard by the recession.

But Bair pointed to a smaller quarterly increase in troubled loans and decreases in the volume of some delinquent loan categories, as a possible turning point in the quality of assets that have weighed heavily on banks' balance sheets.

While challenges remain, evidence is building that the U.S. economy is starting to grow again, Bair said.

The combined assets of the 416 problem institutions rose to $299.8 billion from $220 billion at 305 banks in the prior quarter. Problem banks are troubled institutions whose regulatory rating has been downgraded due to issues related to liquidity, capital levels, or asset quality.

The agency's deposit insurance fund, that safeguards up to $250,000 per account at roughly 8,100 institutions, dipped 20 percent in the second quarter to $10.4 billion.

The drop in the fund was chiefly caused by an $11.6 billion boost in money the FDIC set aside for expected bank failures.

Regulators have closed 81 banks so far this year, compared with 25 last year, and three in 2007. We expect the numbers of problem banks and failures will remain elevated, even as the economy begins to recover, said Bair.

LINE OF CREDIT

Despite the low insurance fund balance, Bair said the FDIC does not expect to have to tap its $500 billion line of credit with the U.S. Treasury Department at this time.

She also said the FDIC had not yet decided whether to charge banks another special assessment to replenish the fund, but said the agency's board would meet toward the end of the third quarter to discuss the issue.

In May the FDIC voted to impose a $5.6 billion special fee the industry has to pay in the third quarter. It also gave itself the right to charge two more special fees in coming quarters.

Bill Fitzpatrick, an analyst at Optique Capital Management, said he expects the number of problem banks will keep rising.

These are smaller institutions but they hold a lot of commercial real estate loans and that market will continue to deteriorate, Fitzpatrick said.

Keefe, Bruyette & Woods analyst Jefferson Harralson said construction loan losses related to residential real estate and development were depressing banks.

These numbers were fairly expected, and I expect we'll continue to see losses in construction, Harralson said.

The FDIC's second quarter briefing came a day after the agency approved new rules on private equity investment in troubled banks, softening an initial proposal that critics had warned could scare away badly needed capital.

The FDIC reported on Thursday that more than one out of four U.S. banks was unprofitable during the second quarter.

The industry set aside more money to cover costs associated with deteriorating loans, with reserves for loan losses increasing 8.6 percent to $66.9 billion in the second quarter.

However, the industry did show some improvement. Net interest margins, or a bank's cost of funding, improved at a majority of institutions.

Overall capital levels also improved. The industry reported that on average, the leverage capital ratio increased during the quarter to 8.25 percent from 8.02 percent.

(Reporting by Karey Wutkowski and Steve Eder; Additional reporting by Joe Rauch and Elinor Comlay in New York; Writing by Tim Dobbyn; Editing by Simon Denyer)

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