Bank Lawyer's Blog

Loss Sharing: A Tempest In A Teapot

A front page story in today's The Wall Street Journal must have thrown a lot of people off their feed, judging by the vitriol hurled about in the online comments section to that article. A superficial reading of the beginning paragraphs of Damian Paletta's could lead a reader to think that the FDIC is up to something underhanded and unwise in offering acquirers of the assets of failed banks "loss sharing" agreements. However, nothing could be further from the truth. In fact, loss sharing makes perfect sense, as Paletta explains later in the same article.

The practice is largely a response to the number of bank failures of the past 18 months, which has stretched the FDIC's financial and logistical resources. The FDIC had just $10.4 billion in its deposit-insurance fund at the end of June, down from more than $50 billion last year. The agency said Thursday it had 416 banks on its "problem" list at the end of the second quarter, which means the list of banks at a higher risk of insolvency has been growing.

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Loss-share agreements made a brief appearance in the early 1990s during the savings-and-loan crisis, but haven't been used this extensively before. The FDIC sees the deals as a way to keep bank loans and other assets in the private sector. More importantly, it believes such deals mitigate the cost of cleaning up the industry.

The FDIC contends it would cost the agency considerably more to simply liquidate the assets of failed banks, especially with the current crop of troubled institutions and their portfolios of loans on misbegotten real estate.

The FDIC's premise is that banks that take on the troubled assets will work to improve their value over time. The agency estimates the loss-share deals cut will cost it $11 billion less than if the agency seized the assets and sold them at fair-market value.

"This is an issue the FDIC is grappling with because the loss rates they are estimating on these failed banks are pretty amazing," says Frederick Cannon, chief equity strategist at Keefe, Bruyette & Woods Inc.

By potentially mitigating losses -- or at least stretching them out over time -- the deals provide some protection for the agency's insurance fund. "It's a great opportunity for banks," says James Wigand, deputy director of the FDIC's division of resolutions and receiverships. "It's a great opportunity for us."

[...]

"The hardest part today in the acquisition game is valuing assets or determining real equity, and with a loss share you can do that," says Len Williams, chief executive of Home Federal Bank in Idaho, which picked up $197 million in assets from the failed Community First Bank in Oregon on Aug. 7, most of it covered by a loss-share agreement.

God forbid that all losses wouldn't be recognized immediately in the midst of the worst market since the Great Depression (thereby ensuring that the FDIC's losses are even more monstrous and that the assessment hit to the banking industry even more horrific than it's going to be without recognizing such losses immediately), and that troubled assets might worked out over time by bank asset managers more adept at dealing with them than federal employees. Someone might start to believe that rational minds were at work, minds intent on saving the banks and (ultimately) the taxpayers some bucks, cushioning the body blow that would be delivered by dumping billions of dollars of loans and real estate on the market in a short period of time at distressed prices (thereby accelerating the downward pricing spiral). Rather than disconcerting people, loss sharing should comfort them. The FDIC actually knows what it's doing. Really. Of course, it doesn't know as much as blog commenters, many of them anonymous, who display the experience level of folks born, if not yesterday, then no earlier than the day before yesterday.

None of this is, or should be, news to anyone. As the FDIC made clear during the savings and loan debacle, when it staffed the RTC, the only "asset" that the FDIC knows has value when asset values are in the tank is the "asset" of deposit "liabilities." The FDIC knows that other banks will pay the FDIC a premium for the deposits. As to most of the other assets of a failed bank, especially most of the garbage that failed banks are chock full of, determining the current value is guesswork. Because it's guesswork, buyers won't buy it without steep, steep discounts. And remember, the FDIC has ALL the downside risk for the lousy assets of failed banks anyway. If it wanted to sell them at current "fair market value," it would likely be getting pennies on the dollar. By agreeing to take the majority of the loss over an extended period of time, it has actually agreed to palm off some of the risk (however small) on a third party, and the third party has agreed to take over the management of the troubled assets, a task that is becoming so monumental that the FDIC could never be staffed up to handle it in the time required even if it desired to do so. If the values don't recover over time, we're all going to be in such a deep hole that "would-a, could-a, should-a" second guessing about not dumping the assets immediately at a huge loss is going to be the least of our problems.

It's likely that if the FDIC had a huge recapitalization appropriation as the RTC had, it might not be doing the kinds of loss-sharing deals that are being done now. It doesn't, and it's not likely to get one, either. The $500 billion line of credit, when it's tapped, will be repaid by the surviving banks, the ones that didn't cause the problems. Thus it has been, thus it always shall be.

While the WSJ headline screams that loss-sharing "puts the U.S. on the hook for billions," the U.S. (actually, the FDIC, but the U.S. is the ultimate backer of the FDIC) is already on the hook for those billions. In the face of this reality, the FDIC's decision to pump up the volume of loss-sharing and mitigate the losses over time is justified. Loss-sharing is a time-tested attempt to make lemonade out of lemons. So, quit the fear-mongering and bitching, and get with the program. We need more, not less, loss sharing.

FDIC Making It Even Harder For De Novo Banks

Regulators, like most of the rest of us, are adept at fighting the last war. Friday's release of Financial Institutions Letter 50-2009 is a classic case of slamming the barn door after the horses are loose.

The policy outlined in the Letter applies only to FDIC-inured institutions that are newly chartered or are less than 3 years old, and are non-member, state-chartered institutions. Currently, newly chartered banks and thrifts are subject to a three-year de novo period of higher capital requirements and heightened supervision and examination. FIL-5-2009 will extend this period to seven years. It will also increase the frequency of examinations, subjecting each such institution to a limited risk management examination during its first six months and full scope risk management and compliance exams and a CRA evaluation during the first 12 months. Thereafter risk management exams will be annual (not on an 18-month cycle) and compliance examinations and CRA evaluations will alternate on an annual basis.Of course, more frequent examinations mean greater expense to the institutions.

The FDIC is also going to tighten up deviations from business plans. Currently, the FDIC requires prior written notice of any material deviations from the approved business plan during the first three years of a de novo bank's existence. In the future, prior approval of the FDIC will be required for any material deviation from or change to the business plan during the first seven years. Currently, a de novo bank has to provide pro forma financial statements for its first three years of operation at the time its application is submitted. Going forward, such institutions will have to provide revised business plans and financial statements for years four through seven prior to the end of the third year of existence. Existing institutions that are less than three years old will have to submit such pro forma financial statements and business plans for years four through seven, and all existing institutions that are less than seven years old will be subject to the 12-month examination cycle through the seventh year.

The stated reason for this revised policy is the FDIC's contention that "troubled or failed de novo institutions have demonstrated" the following "common elements during the first seven years of operation:"

• rapid growth

• over-reliance on volatile funding, including brokered deposits

• concentrations without compensatory management controls

• significant deviations from approved business plans

• noncompliance with conditions in the deposit insurance orders

• weak risk management practices

• unseasoned loan portfolios, which masked potential deterioration during an economic downturn

• weak compliance management systems leading to significant consumer protection problems

• involvement in certain third-party relationships with little or no oversight

The fact that the FDIC is not granting many, if any, new FDIC insurance applications to any applicants for a de novo institution, (notwithstanding the FDIC's denial of the existence of an informal new charter "moratorium") makes the new policy of more immediate interest to people other than those cock-eyed optimists who still hope to start a brand new community bank from scratch in these most difficult of times. For example, those private equity players who may decide that they can live with the most recent policy statement of the FDIC issued last Wednesday regarding the purchase of deposits and assets of failed institutions from the FDIC by private equity investors ought to take note. If those private equity players aren't already owners of an FDIC-insured bank or thrift, they should expect these these new policies to apply to any de novo charter they use to "get in the game," even a shelf charter. In addition, I would not be surprised if the policies embodied in FIL-50-2009 are extended to types of charters other than the state, non-member bank charter that is technicaally covered by the policy statement. If the FDIC's rationale for the adoption of the latest policy is correct, there is no reason that the policy should not extend to de novo FRB-member, state-chartered banks, as well as to national banks and federal savings banks. Also, I would not drop in my tracks with shock if some or all of the restrictions embodied in this policy are eventually applied in situations where acquirers from outside of the banking system apply to acquire control of an FDIC-insured institution and the FDIC (and/or other federal regulator) has "concerns" about how well the acquirer will "oversee" the institution after the acquisition is completed.

There's absolutely no doubt that starting a new bank has gone from very difficult to extremely difficult. Of course, if you've got scads of money and plenty of time, there will be no shortage of "experts" who will tell a potential organizing group or acquirer, "Well, it will be difficult, expensive and time-consuming, but we think we can get it done."

Filled With Inertia

This past January we related the sad tale of a de novo bank charter applicant who spent $2 million in organizational costs before the FDIC finally got around to telling it what the FDIC should have told it to begin with: "No way, Jose." Today, The American Banker (paid subscription required) featured a story today about the similar trials and tribulations of non-bank commercial lenders who've been left at the alter by the FDIC in their pursuit to acquire or start a commercial bank.

Though the lenders are eager for cheap deposit funding, a few have called off plans to enter the retail banking business, after encountering extensive regulatory delays.

One frustrated commercial lender had been approved by the OCC but after spending well over a year on the applications and over $1.8 million in expenses, the FDIC refused to approve the applicant for FDIC insurance, and likewise refused to provide a concrete reason for doing so.

"We had a conference call with an FDIC official out of Atlanta who basically said to us that we had been successful already with our current nonbank business model," [the applicant] said. "He made the comment, 'Why should we help you become a bank so you can take advantage of FDIC insurance on deposits? You're doing just fine now.' "

And you couldn't have told them that at the initial pre-application meeting? Of course, doing so would have required more than ounce of integrity and more than a thimbleful of testosterone. Silly me!

On the other hand, to determine whether or not a nonbank, monoline commercial lender has a snowball's chance of ever entering the banking business, all you have to do is make some telephone calls to a few regulators you know will be honest with you, and with former regulators and other sources who have contacts you may not possess. All that palaver can be "off the record." Getting the lay of the land should not take $1.8 million. Nevertheless, the regulators need to be honest at the outset on such transactions. It's bad enough that so much money was wasted, but think of the futile efforts and diversion of time and effort that could have been better spent in more productive endeavors. 

Tales like this do nothing to encourage anyone to try to enter the banking business. Perhaps that's the FDIC's plan. If so, it's doing a bang-up job.

The Best Umbrella

The head of a Big 3 financial institutions consulting practice group was relaxing over cocktails with a friend of mine and me almost ten years ago and made one of the classically cynical remarks that drives clients berserk. We were talking about the then-hot topic of "personal information privacy." Lots of lawyers, accountants, large technology consulting firms, and various other forms of snakes and snake-oil salesmen were trying to find a way to capitalize on the subject. He told my friend and me that the secret to securing any consulting engagement was to convince the prospective client that "there's a s**t storm coming and you have the best umbrella." I assume he and his firm made a bundle from selling umbrellas.

Unlike the privacy hype, which, while it had a basis in fact, always seemed to me to be like Mark Twain's observation about the weather: everyone talks about it but no one does anything about it, there's another "dust storm" on the horizon and it does not appear to be hyped. Rather, it appears to be making certain people hyperventilate, mostly directors and senior officers of banks that have failed or are at risk of failing in the next year or two. As we've been talking about the past couple of months (most recently here), the FDIC plans to come looking for every pocket it can stick its hands into to recover money for the rapidly-depleting insurance fund. Prudent management and directors of banks need to get their ducks in a row before the first shots are fired.

Joe Lynyak and John Zink of Venable LLP recently put out a Financial Services Alert on the potential liability of officers and directors of failed FDIC-insured financial institutions. As the authors suggest, the alert may be a "useful starting point" for management and directors to understand their exposure and what to do to minimize it (other than simply find a safer line of work, such as being a bomb disposal expert in Afghanistan). It can be read as a prelude to another alert co-authored by Mr. Lynyak on responding to enforcement actions (which I previously mentioned here).

When the risk of "regulatory rain" is high, it's never too early to arm yourself with the best umbrella you can find: knowledge. Get it anywhere it's offered, especially when it's offered for free.

Dead Man Talking

A couple of weeks ago, former disgraced Wall Street analyst Henry Blodget, a man flushed from his perch by The Sheriff of Wall Street, Eliot Spitzer, sat down with the former disgraced Attorney General and Governor of New York and conducted a civil discourse about the origins and possible solutions to the current financial crisis. Blodget broke down the interview into six bits and posted them Yahoo Finance (starting here). I was sidetracked last week and am only now getting around to posting about the interview. In the blogosphere, if you're a day late, you're a dollar short. On the other hand, it's evident to regular readers that I violate many of the rules of the self-proclaimed experts of blogging. It's just the way I roll.

One of my favorite portions is the one in which Spitzer reiterates a theme he's propounded recently in his Slate column: we don't need new regulators or new powers for the existing regulators. What we need is for the existing regulators to do their jobs. With every financial crisis, there appears to be a reflex reaction of those who love big government to make big government even bigger. They seem to think that bureaucrats in a spanking new agency will act differently from the way in which bureaucrats in legacy agencies have acted previously. Through governmental action, human nature will be perfected or at least corrected. All we achieve is to concentrate more power in another federal agency where it's exercised as imperfectly as it has always been exercised by flawed human beings.

I listened last week to the giant brained David Kotok discuss the banking crisis of 1907. That collapse led to the creation of the Federal Reserve Board, an entity that was designed to ensure that no such a banking collapse would ever again occur. Worked like a charm, didn't it? About as well as the creation of the FDIC nearly 30 years later ensured that there would never be another "bank run." It certainly prevented a run on IndyMac, eh?

I also like Spitzer's acknowledgment that preemption does make sense from the regulated entities' perspective. In other words, national banks are not purely evil because they desire to have a single set of rules governing the playing field. I doubt whether he would have conceded that point when he was toe-to-toe with the OCC. On the other hand, it is also difficult to argue with his contention that competition keeps regulatory agencies (as it does other types of entities) on their toes. If it leads in some cases to a "race to the bottom," it's also true that eventually, the bottom feeders are legislated out of existence. 

If there are two good examples of men who've seen the limits of human hubris, it's Blodget and Spitzer. As one commenter said in response to the usual chorus of Spitzer bashers (of which this blogger has been a long-time member), "I like the guy since he fell off his horse." We all might benefit from listening to a few more humbled former masters of the universe whose perspective has been "purified" by their fall from grace, and who no longer grasp for power based upon anything other than the quality of the insights they offer. I don't agree with everything either man has to say, but I enjoy the fact that former claymation death match opponents can sit down and have a civil discussion of issues of such critical importance and offer some seemingly honest perspective. To me, that's certainly preferable to the "sound bites of fury" and "obscenity-laced tirades" that have been prevalent lately.

Oversharing

Although this article does not discuss problems that are confined to employees of banks, it's apropos of a talk I gave Friday on, among other related topics, the problems that can arise when employees of banks use social media. According to The Wall Street Journal, "oversharing" on social media sites like Facebook and Twitter about your employer can get you fired.

One of the most dramatic tales that surfaced this month was the unnamed woman in the UK who was fired after she insulted her boss and wrote “OMG I HATE MY JOB!!” in a Facebook status update, without realizing that he was her Facebook friend.

Her boss responded on Facebook: “You also seem to have forgotten that you have 2 weeks left on your 6 month trial period. Don’t bother coming in tomorrow….And yes, I’m serious.” Screenshots of the whole Facebook exchange has spread virally all over the Web.

That comment on the employee's "wall" by her "friend" must have brought home to the hapless Facebook user one of the all-time "oops" moments in the history of foot-in-the-mouth disease.

“You definitely want to make sure that you’re aware of your employer’s electronic communication policy if they do have one,” says CareerBuilder spokeswoman Jennifer Grasz. “People may be tweeting about their company, or maybe they’re…not realizing that there should be a separation between what they’re talking about socially and what they’re talking about professionally.”

Memo to banks: If you don't already have a policy about the use of social media by employees, think long and hard about implementing one.

Memo to bank employees: Think before you Tweet. Seriously.

Heading For The Hills

The blog will be on vacation for the rest of this week. I'm headed to Utah for the annual convention of the National Association of Industrial Banks and the Utah Association of Financial Services. They've asked me to speak on Social Media and Banks, of all topics. I assume that's because they'll need a break from all the doom and gloom coming out of Washington, D.C., specifically the assault on the industrial bank charter embodied in the "reform" proposal being pushed by the artist formerly known as "The Change We've Been Waiting For " and rapidly becoming, in some quarters, at least, "The Change We've Come To Dread."

As I leave the Texas heat behind me for the cooler nirvana of the Rocky Mountains, I'll also leave behind an excerpt from an e-mail I received today from a high-level executive with a Real Estate Investment Trust, who's been following the stumbling and bumbling of the federal government's "handling" of the banking crisis with a mixture of increasing irritation and fascination. With respect to recent press reports that the FDIC is now planning to adopt a form of "good bank-bad bank" plan to attract private investors to "troubled assets" of "troubled banks," my correspondent is as cynical as they come.

Sounds good until the Feds announce the actual plan.  Bair already has tipped her hand with her prior regulatory proposals that she doesn't want private capital in the process.  My guess is that the government either will want to retain an equity position in the "bad bank" buyer and/or provide financing.  Any government equity or debt interest in the bad bank will subject the private capital to government re-trading if it concludes the profit being made is too high - as determined by such greats as Barney Frank, Chris Dodd, Charles Schumer, Nancy Pelosi, and the compensation czar, Kenneth Feinberg.

There are actually people out there who make me seem positively Panglossian.

Y'all (or Ya'll, if you prefer) have a great week.

With Friends Like These

FinCri Advisor recently ran a story about private equity investors and how they’re making it expressly clear that they’ll bow out of transactions to buy failed banks from the FDIC unless major changes are made to the policy recently proposed by the FDIC. That proposed policy’s requirements of 15% Tier 1 capital, a three-year “lock in” for the investors, and expanded cross-guaranty liability are all non-starters.

In what I believe is a short-sighted position, the Independent Community Bankers of America sent the FDIC a comment letter that basically supported most of the strict requirements proposed by the FDIC, although the ICBA generously conceded that the 15% capital requirement might be lowered to 12%. !2% isn’t going to fly with private equity in light of the fact that the current requirement for de novo banks is 8% for the first three years. “Why is the ICBA in support of driving away private equity from FDIC-assisted deals?” you might ask. I know I did.

As a result of some subsequent “back and forth” that I and other concerned banking attorneys conducted with the ICBA at the state and federal level, it appears that the ICBA believes that making it unattractive for private investors to buy failed banks will somehow increase the likelihood that such investors will invest in troubled banks before they fail. The ICBA thinks that if investors know they can’t get an attractive deal to buy failed bank assets and deposits from the FDIC, they’ll decide to jump into open banks that need capital because that will be the only deal in town.

I disagree. It’s not as if there’s a large pack of salivating private investors howling at the gates of the community banking business, demanding entry. Private capital flows to investments where the reward justifies the risk, and sinking capital into “troubled banks” these days without government protection on the down side has all the appeal of making love to a porcupine. Odds are that the agony will far outweigh the ecstasy. If there’s one thing that Washington Mutual and Guaranty Federal have taught private equity investors, it’s that in the midst of the worst recession of the post-World War II era, dumping a ton of private capital into a troubled bank or thrift and expecting to “work it out” over time without government assistance is like commandeering a cigarette boat to overtake the Titanic and jumping on board right before the ice berg looms out of the fog.

Here’s what signal I think the position of the ICBA sends to private investors: “Stay away; we don’t need your dough!”

Private equity investors have investment opportunities outside the commercial banking business to pursue, ones that don’t involve getting into bed with regulators and legislators who can turn on a dime and change the rules in effect at the time capital is invested. The commercial banking business is at a serious enough disadvantage with respect to attracting private capital without the added onus of having a major trade association tell potential investors that they’ll support another “game changer” that sprays the entire business with a most unattractive odor.

Of course, I could be wrong. We'll see if the FDIC follows the ICBA's advice and, if so, how much private capital that would have gone to FDIC deals flows to the land of "dead banks walking."

It's Seriously Like Bizarro World

The news late last week that Senators Dodd and Conrad skated on charges that they violated US Senate ethics rules arising out of their being "Friends of Angelo's" hardly took the country by surprise. A  typical comment in The Wall Street Journal article on the matter summed up the rampant cynicism that permeates much of the public.

It's seriously like bizarro world. Honestly, let me get this straight, and with a straight face.

The committee found no "wrong-doing" but thought the loan program called "VIP" SHOULD have clued him in that maybe he was being considered a VIP? Seriously. They think we are complete idiots.

Dude, I swear, don't TOUCH my health care.

A responder to said comment noted dryly: "The way we keep sending the same crooks back, they KNOW we're idiots."

Meanwhile, back at the zoo, the problems of the ethically challenged keep mounting. The same day it was announced that Dodd and Conrad wriggled off the Countrywide hook, CBS News announced that the Mazillo group hug groped more than merely Messrs. Dodd and Conrad. House Committee on Oversight and Government Reform Chairman Adolphus Towns (D-NY) also is under the microscope. I doubt that he's sweating bullets, given the lenient treatment accorded his Senate counterparts, but at least even "fair and balanced" news readers like the terminally cutesy Katie Couric are starting to rake the muck and throw it on more and more of our elected representatives of both parties. As yet another commenter in the journal so aptly put it, "This is a confirmation that Republicans don't have a monopoly on stupid..."

Now, why doesn't that realization make us all feel better?

Dodd's not out of the woods, though. The folks at Hot Air (another "fair and balanced" news source, although balanced way to the right of Ms. Couric's balance point) remind us that Dodd's got more than one ethical Gordian knot to untie. That ought to keep him busy until the next election, when the voters of Connecticut will, once again, be asked to answer the accusation that they are, indeed, idiots.

Snark Attack

A banker friend uttered the obscene phrase "open bank assistance" the other day and wondered why investors with as much "pull" as Carl Icahn and Robert Rowling have apparently not been able to "pull off" a rare open bank assisted deal with the FDIC to rescue Guaranty Bank, which as of today, appears to be headed for a FDIC receivership and an assisted sale to Blackstone, Gerald Ford (who's got a shelf charter for a national bank and has been looking for a deal) or US Bank. Of course, Blackstone and Ford could still run aground on the shoals of the FDIC's recent non-starter of a proposal on restrictions on private equity investors in failed bank deals, but whoever buys the remnants of Guaranty Federal, the open bank assistance deal it proposed appears to be DOA.

There are a number of reasons for the failure, but one of them that shouldn't be overlooked is that there's usually not enough potential upside to offset the potential downside in an open bank assisted transaction where the bank is other than "too big to fail." Even If the proposal costs out as the least costly alternative, there is a good chance that the FDIC will be criticized whether the bank later tanks or whether it prospers. In the former case, the FDIC is criticized for throwing good money after bad and increasing the ultimate loss to the fund, and in the latter case, the FDIC is subject to criticism that it used its funds to make "private speculators rich." It reminds us of the old adage about the forward pass in football: there are only three things that can happen and two of them are bad (the pass is incomplete or it's intercepted). With open bank assistance, the only "good thing" that can happen is for the bank to survive and prosper, but not for a long time or not to the extent that anyone notices. If it either succeeds and someone notices or it fails and the assistance is "wasted," the FDIC takes it on the chin. From a political perspective, it's easier to let the bank fail, then deal with the remnants. God forbid private investors should lower the cost to the insurance fund in return for actually making a profit on the capital they put at risk.

Of course, letting the bank fail carries its own risks of second-guessing. The latest Inspector General's criticism of the FDIC over the failure of a small Georgia bank (paid subscription required) is typical and might have been written with crayon on a piece of construction paper by a first grader, the formula is so pat.

The Office of Inspector General for the Federal Deposit Insurance Corp. said in a report that the agency's supervision of Haven Trust Bank was "not effective in identifying and addressing problems early enough."

"By the time supervisory actions were taken against the bank, failure was all but inevitable," the IG's office said in the report. Haven Trust failed last December.

[...]

"Bank management engaged in a number of improper practices, including renewing loans that were experiencing problems and originating loans that appeared to be for the benefit of insiders and related parties," the report said.

The FDIC, the report said, should have been more aggressive in addressing the bank's use of interest reserves, "questionable loan participation practices," and conducted a better analysis of Haven Trust's allowance for loan and lease losses.

It's Washington, D.C. and there's always someone with an axe to grind looking over your shoulder, waiting for you to slip up so they can stick it to you. That town might as well be one giant gaggle of malpractice plaintiffs' lawyers.