As the global economic downturn grows worse and confidence in the financial system continues to erode, the International Monetary Fund (IMF) is warning that banks and other financial institutions could face losses of $4.1 trillion at the close of 2010.

In its global financial security report, the IMF estimates that financial companies could write down an estimated $2.7 trillion in loans and securities that originated in the U.S. Between 2007 and 2010. That’s up from the fund’s $2.2 trillion estimate made in January, and $1.4 trillion in October.

According to the report, the financial crisis is “likely to be deep and long lasting,” noting that financial stability has evaporated since the October 2008 report, especially in emerging markets.

The IMF also doubled recent market bullishness, noting that “some improvements in short-term liquidity conditions and the opening of some term funding markets, other measures of instability have deteriorated to record or near-record levels.”

Here’s more from the Wall Street Journal:

IMF: Banks Need $875 Billion in Equity

“WASHINGTON — U.S. and European banks need to raise $875 billion in equity by next year to recapitalize banks to a level similar to the pre-crisis years — and twice that amount to match the level of the mid-1990s, the International Monetary Fund estimated.

The steep funding requirements reflect a financial crisis that the IMF said continues to deepen along with the global recession. The banking sector’s woes have spread from the housing sector to commercial real estate loans and emerging-market debt. Overall, the IMF estimates that the U.S., European and Japanese financial sectors face losses of about $4.1 trillion between 2007 and 2010. Of that amount, banks are confronting $2.5 trillion in losses, insurers $300 billion and other financial institutions $1.3 trillion.

The banking sector has already written down $1 trillion of those losses, said the IMF, which didn’t estimate how much other financial firms such as insurance companies and hedge funds, have written down thus far.

“Without a thorough cleansing of banks’ balance sheets of impaired assets, accompanies by restructuring and, where needed, recapitalization, risks remain that banks’ problems will continue to exert downward pressure on economic activity,” said the IMF’s Global Financial Stability Report, its twice-yearly review of the world’s financial sector.

While problems in the U.S. mortgage sector are generally blamed for the global financial crisis, the IMF report, showed there other regions played a big role too. About $2.7 trillion of the losses from 2007 to 2010 were attributable to the U.S. market, the IMF reported, while about $1.2 trillion came from bad loans and security losses in Europe.

U.S. banks have written down roughly half their anticipated $1.06 trillion in estimated losses from 2007 to 2010, the IMF said, while euro-zone banks have written down just 17% of their $950 billion in losses. British banks have written down about one-third of their $310 billion in anticipated losses.

“The Europeans haven’t appreciated just how bad their situation is,” said Adam Posen, deputy director of the Peterson Institute for International Economics, a Washington D.C, think tank.

In certain areas, the IMF has a bleaker outlook than some prominent Wall Street bears.

For example, the fund is projecting that 7.9% of U.S. loans will have gone bad by next year. In a recent research report, Calyon Securities analyst Mike Mayo predicted that losses will crest to 3.5%, a level that he said would slightly eclipse the peak rate during the Great Depression. Mr. Mayo estimated that U.S. banks are only about one-third of the way through losses on credit cards and other non-mortgage consumer loans, while losses on business loans “seem in the early stages.”

The IMF’s conclusion that the banking industry’s misery is far from over is likely to cast a further cloud over the industry, even as several big banks recently have reported quarterly profits. (The latest came Monday, with Bank of AmericaCorp. announcing that it earned $4.2 billion in the first quarter.)

Many banks’ profits, however, have stemmed from a combination of unsustainably high trading revenue and a variety of one-time gains. Bank executives, investors and analysts are bracing for losses to continue accelerating as economies around the world remain mired in recession, leading more individuals and businesses to default on their loans.

On Monday, those fears led investors to flee the banking sector. Shares of many top financial institutions, including Bank of America and Citigroup Inc., suffered double-digit losses, and the KBW Bank Stock index tumbled 15%.

The IMF urged governments to “take bolder steps” in injecting capital through common shares “even if it means taking majority, or even complete, complete control of institutions.” Government ownership may be necessary, the IMF said, to restructure institutions.

The U.S. government has tried to avoid outright nationalization. But Washington could go a long way to meeting the IMF’s estimate of the $275 billion in equity that U.S. banks will need by 2010 by converting into common shares the approximately $200 billion in preferred shares the government owns in more than 500 U.S. financial institutions.

Federal banking regulators this month are wrapping up “stress tests” of the nation’s 19 largest banks, and industry experts believe the results will uncover capital holes in the balance sheets of at least several big banks. But private investors remain reluctant to pump money into the industry until it’s clear that losses have peaked.”