WASHINGTON (Reuters) - The number of troubled U.S. banks rose 30 percent to 117 in the second quarter, the highest level in five years, and a top regulator warned that conditions will worsen as the housing slump and credit crisis continues to pound profitability.

Federal Deposit Insurance Corp (FDIC) Chairman Sheila Bair said on Tuesday she expects more banks to join the agency’s watchlist of problem banks, which tallies institutions with financial, operational or managerial weaknesses that threaten their financial viability.

“We don’t think the credit cycle has bottomed out yet,” Bair told a quarterly news conference, adding that U.S. banks will not return to high levels of earnings anytime soon.

“We expect that banks and thrifts will keep building up reserves for the next several quarters,” Bair said.

The news initially pulled down financial shares before markets closed higher on the back of a surge in energy shares.

Nine U.S. banks have failed so far this year, including mortgage IndyMac Bancorp Inc IDMC.PK, which has drained the FDIC's Deposit Insurance Fund used to repay insured deposits at failed banks.

In a bid to replenish the $45.2 billion fund, Bair said the FDIC will consider a plan in October to raise the premium rates banks pay into the fund, a move that will further squeeze the industry.

The agency also plans to charge banks that engage in risky lending practices significantly higher premiums than other U.S. banks, Bair said, to encourage safer business practices.

Charlie Peabody, a bank analyst at Portales Partners in New York, said such a weighted tax could hurt already troubled banks past the point of recovery. “The tax will fall most heavily on the weakest, so the conclusion is, the weak are going to get weaker and the strong will be able to take advantage of the weak,” he said.

An auction sign is displayed in front of a home in Stockton, California February 2, 2008. Stockton posted one foreclosure for every 31 households in the third quarter of 2007, the highest foreclosure rate among the 100 largest U.S. metropolitan areas in that period, according to real estate data company RealtyTrac. Picture taken February 2, 2008. REUTERS/Kimberly White (UNITED STATES)

SHRINKING EARNINGS

The FDIC said the sector’s earnings fell 86 percent from a year earlier to $5 billion in the second quarter, mainly due to a fourfold rise in provisions for bad loans to $50.2 billion. With the exception of the fourth quarter of 2007, industry profits were the lowest since the fourth quarter of 1991.

“The numbers are alarming, but we are coming off of an incredibly low base of problem institutions and failures,” said Mike Stevens, senior vice president for regulatory policy at the Conference of State Bank Supervisors.

“This is nowhere near what we had seen during prior periods of weakness. Are we done? I don’t think anyone would predict that. We have a ways to go.”

The FDIC said the combined assets of the 117 problem banks increased to $78 billion, from $26 billion in assets at 90 banks in the first quarter. Bair has said that historically 13 percent of banks on the watchlist fail.

The latest figure included $32 billion of assets from IndyMac, which became the third-largest U.S. bank failure in July. FDIC examiners closely monitor the watchlist but do not publicly release the names on it.

Bair said 98 percent of the 8,500 U.S. banks continue to be well-capitalized. She also noted that the banking sector's exposure to mortgage giants Fannie Mae FNM.N and Freddie Mac's FRE.N preferred securities is "not problematic" but said some smaller institutions' exposures could cause them greater stress.

“With $8.6 trillion in deposits, banks have plenty of resources to continue meeting the lending needs in their communities,” said James Chessen, chief economist for the American Bankers Association.

The FDIC said it continues to see stress in the commercial real estate market, especially in construction and development areas. The agency said the majority of new banks on the problem list have landed there because of major exposures in commercial real estate, whereas before the problem banks were distressed by residential products.

Delinquent loans -- those more than 90 days past due -- jumped by almost 20 percent during the quarter to $162.9 billion, the FDIC said. (See <ID:nN26308013> for details.)

SHRINKING SAFETY NET

The FDIC’s Deposit Insurance Fund fell 14 percent in the second quarter due to IndyMac and other bank failures.

IndyMac is now expected to cost the fund $8.9 billion, topping the agency’s prior estimates of $4 billion to $8 billion, the FDIC said. (See <IDn:N26378608> for more details)

Diane Ellis, the FDIC’s associate director of financial-risk management, said the agency is consulting with industry about the best approach to replenish the fund.

“Any time that you are going to go through a credit cycle, you are going to be in a situation where you are going to have to start charging for insurance,” said Peter Kovalski, bank analyst and portfolio manager at Alpine Woods Investments. “It will be another cross for banks to bear, but it won’t be the straw that breaks their banks.”

The Standard & Poor's Financial Index .GSPF ended up 0.72 percent at 270.38 after hitting a low of 265.71.