Beyond good bank and bad bank: many options.

I was a member of the team that conceptualized what finally became the good-bank, bad-bank restructuring of Mellon Bank Corp. in 1988. Our goal, simply, was to improve the terms on which a bank could raise equity by quantifying the risk in its porfolio of nonperforming assets and stratifying that risk among different investors.

Over the next 12 months, we worked with legal and accounting advisers to secure regulatory input and to adapt the transaction structure to specific situations.

Our efforts included substantive discussions with BankAmerica Corp. and several other large banking companies.

An Uncooperative Market

In early 1988, I signed the financial advisory engagement with Mellon that led to the establishment and capitalization of Grant Street National Bank, the first structured sale of nonperforming assets.

In 1989, we attempted to execute a similar transaction for Premier Bancorp of Baton Rouge, La., but were stymied when the high-yield market collapsed late that year.

Over the past six years, we probably have thought more than most about how to reduce asset-quality risk and thereby increase the value of a "clean bank."

Certainly we have made more unsuccessful presentations (and caused the payment of more legal and accounting fees).

Because questions about the good-bank, bad-bank concept continue to come up, I want to raise several issues critical to the consideration of such a program:

What is the bank's problem or opportunity?

Is the bank experiencing a bothersome earnings drag from nonperformers and risk assets or a real restriction of access to needed capital?

Is there an opportunity to acquire a good franchise while protecting stockholders from unknowable credit problems? Or to create a friendly merger with only a difference of opinion over the value of the acquirer's or the target's nonperformers?

Is the risk portfolio confined to a discrete set of nonperforming assets or are there substantial lines of business such as commercial real estate lending that are seen to carry considerable risk?

Does the bank need to raise capital but feel that the current price would penalize stockholders?

What is best for current stockholders?

One possibility is to keep the nonperformers and risk assets, and manage them aggressively. BankAmerica Corp. ignored our advice and succeeded brilliantly in the late 1980s. Now, in connection with its acquisition of Security Pacific Corp., it is said to be considering a bad-bank transaction.

Another answer is to sell the risk portfolio to an independent third party. This is complicated by illiquidity and the steep discounts buyers demand.

Quick Returns to Markets

A bank could organize a structured sale such as Grant Street and pay the residual interest as a dividend to its stockholders. This approach relies on the markets for both investment-grade and junk debt and has high transaction costs.

However, it allows for almost complete segmentation of the risks in a defined pool of assets. This structure allowed Mellon to swiftly return to the capital markets and buy the Meritor branch system 22 months later.

"Moved the goal posts nearer," said Frank V. Cahouet, Mellon's chief executive officer.

Some banks could try to totally or partially insulate new capital from the effects of the risk assets without a writedown or asset sale.

Issuing an "assigned-asset" equity security can protect current holders from dilution while their company raises capital to improve its ratios and/or facilitate acquisitions.

A No-Transfer Approach

Finally, a bank could revalue, segregate without transferring ownership, and separately manage the risk assets. This approach allows the market to more clearly evaluate the risks.

If necessary, committed capital can be raised from sophisticated investors to authenticate the company's new value and attract new investors at a higher stock price.

Our business is helping financial companies solve problems and take advantage of opportunities. In 8, we say the liquidating bank as the best way to solve Mellon's problem. We and Mellon's management knew capital could be raised on better terms if Mellon's asset risk were reduced.

The Best Alternative

If we could have organized a less-complicated transaction or one that provided higher value to Mellon, and been guaranteed that additional capital could be raised, we would have abandoned the liquidating-bank idea in its favor.

No bank, with its opportunities and problems, is exactly like any other bank. The best transaction structure for one may not be the best for another. The return of the high-yield market doesn't necessarily mean banks should rush to replicate Grant Street.

Complex, structured financial transactions are not built like tract houses but like suspension bridges - unique to the gap to be spanned and the purpose for which it is built.

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