In the classic Hans Christian Andersen fairy tale, “The Emperor’s New Clothes,” a crowd fooled into believing in a fantasy version of reality is brought down to earth by the words of a small boy.

Substitute “bank-sector and other investors” for “a crowd” and “actions of the FDIC” for “words of a small boy” and that goes some small way towards describing the potentially ugly fallout from developments detailed in the following Bloomberg BusinessWeek report, “‘On the Edge’ Banks Face Writedowns on FDIC Auctions”:

A Federal Deposit Insurance Corp. plan to auction more than $1 billion in assets seized from failed banks next month, including a loan to build a W Hotel in Atlanta, may trigger writedowns that weaken lenders nationwide.

Almost half of the loans were originated by Silverton Bank N.A., whose collapse last May was the biggest in Georgia history. Community banks that joined Silverton in providing $80 million for the 237-room hotel and condominium complex, as well as backing for 39 other projects, could be forced to write down their stakes to reflect sale prices.

The auctions may have wider repercussions. Of the $41 billion in assets seized from failed banks held by the FDIC as of the end of January, $15.6 billion are real estate loans and about 4 percent of those involve participations by other lenders, according to agency spokesman Andrew Gray.

“These banks can’t believe that the regulator they pay to protect them is going to sell these loans to someone who can flip them and cause them serious losses,” said Robert Reynolds, a lawyer at Reynolds Reynolds & Duncan LLC in Tuscaloosa, Alabama, who represents 25 lenders that took part in financing the W Hotel. “Our banks just cannot believe they’re being treated in a way that ultimately hurts the FDIC’s insurance fund, because some of them are right on the edge.”

Bank Failures

A total of 140 banks failed last year, and FDIC Chairman Sheila Bair said the number may be higher this year. It stands at 26 as of March 6. The agency said on Feb. 23 that 702 banks were on its “problem” list as of Dec. 31, up from 552 at the end of the third quarter. The FDIC’s insurance fund had a deficit of $20.9 billion at the end of the year.

“This whole thing is a mess waiting to happen across the country,” said Geoffrey Miller, a professor of securities law at New York University and director of the Center for the Study of Central Banks and Financial Institutions.

“Unlike the subprime mortgage problems, which hit mostly bigger financial institutions, the commercial real estate crisis is going to hit mostly smaller and regional banks,” Miller said. “It was common for them to make these loans and buy participations. It’s a systemic problem that the FDIC has to deal with.”

That view was echoed by John J. Collins, president of Community Bankers of Washington in Lakewood, Washington. Some banks in his state have expressed concern that they may have to take writedowns as a result of the FDIC sale of seized loans in which they participated, he said.

“We have a number of banks teetering on the edge, and we don’t need this problem,” Collins said in an interview.

‘Maximize’ Recovery

The FDIC is “required by statute to maximize its recovery on receivership assets,” Greg Hernandez, an agency spokesman, said in an e-mail. “This is achieved through a broad, competitive bid process.”