In an American Banker Comments on April 1 ["Harnessing the Good Bank-Bad Bank Strategy," page 4], Edward D. Herlihy and Craig M. Wasserman provided a useful update on an important approach to the recovery of sick financial institutions.

However, I think their tone was far too gloomy.

The article was probably not intended to be negative. But it overemphasized the potential problems and failed almost entirely to articulate the very substantial benefits that can accrue to banks employing the good bank-bad bank structure.

Many banks and thrifts desperately need new capital to survive. But they are unable to raise capital because of a high level of nonperforming assets - a defect that sends investors running for cover.

Quick Cure for Problem Assets

For such institutions, the good bank-bad bank structure may represent the last, best chance for assuring survival. It is unequaled as a means of quickly curing the debilitating problem-asset disease.

Mr. Herlihy and Mr. Wasserman raised a number of issues that require attention but hardly deserve to be labeled "impediments." For instance, any Investments Company Act concerns are easily avoided by placing the equity privately with a small number of investors.

Moreover, the concern the authors raised about the reduction in capital that often accompanies the bulk sale of problem assets is like criticizing the use of a cast on a runner's broken leg.

Though hobbled when the cast is on, the runner will race more strongly in the future.

Capital at Reasonable Cost

Similarly, the principal benefit to be derived from the good bank-bad bank strategy is to let the restructured bank raise new capital at reasonable cost and thus complete more effectively. If this means a hit to capital, then that is simply a cost of returning to financial health.

Moreover, if there is a capital hit, it is probably more a reflections of the true value of the assets than evidence of a weakness in the good bank-bad bank structure.

I would also contend that any bank that can't raise new capital immediately after the sale of the problem asset is probably not a candidate for employing a good bank-bad bank anyway. This structure is designated to help heal the seriously wounded; it is not designed to revive the terminally ill.

Immediate Benefits

The good-bad bank structure conveys three important benefits to the banks and thrifts that use it:

* It immediately improves the bank's earnings power by improving the ratio of earnings assets to costing liabilities and lowering its operating expense ratio.

* It immediately enhances the bank's ability to raise capital from external sources at reasonable cost, by improving the bank's earnings power and reducing the level of nonperforming assets.

* To use a sports analogy, it allows the bank to play offense again. A high level of nonperforming assets has enervating effects on a bank's ability to compete aggressively and plan for the future. A return to competitiveness may be the most important benefit that the good bank-bad bank structure conveys.

Not for Every Sick Bank

Even though the approach probably could have saved many failed thrifts, it has not been used enough.

One reason is that banks with good access to fairly priced capital have cheaper ways of raising capital. At the other end of the spectrum are institutions that have so little capital and earning power that they cannot operate profitably even after selling non-performing assets.

These institutions are unlikely to survive with or without the use of the good bank-bad bank structure.

That leaves only a relatively small percentage of institutions for which the structure is both feasible and attractive.

Within this subset of potential users are two types of institutions. The first group can raise capital without restructuring, but they can significantly improve the price at which they can issue equity securities by eliminating a large portion of their nonperforming assets.

For these banks, the good bank-bad bank structure is simply a mechanism for improving the cost of equity capital.

For the second group, the good bank-bad bank structure plays a much more important role. The second group is made up of banks that simply cannot operate profitably so long as nonperforming assets remain high. For this group, the quick reduction in nonperformers through implementation of the good bank-bad bank represents the key to survival

Window of Opportunity

A second reason that the bad bank has not been used more frequently is that the banks most in need of it - institutions that are in a downward earnings spiral - have a limited amount of time in which to use the structure.

These institutions tend to consume capital at an alarming rate because of the high maintenance and carrying costs of their nonearning assets.

If they wait too long, the capital hit that may accompany a bulk sale becomes intolerable and they run out of time to implement the strategy. They need to employ the structure while their capital is still at a reasonable level, say 2.5% or more of assets.

Unfortunately, the managers of troubled institutions have a tendency to deny the gravity of their problems. They fail to realize that it is virtually impossible to earn a profit on core operations so long as nonperforming assets remain high as a percentage of total assets.

Consequently, some institutions that have wanted to use the good bank-bad bank structure have not been able to do so because the window of opportunity had passed by the time they realized drastic action was needed.

Decisive Action Needed

The third reason the structure has not been used more extensively is that it requires a good deal of conviction and courage on the part of management, particularly the chief executive.

The good bank-bad bank structure is most effective and most easily implemented at the time it first becomes apparent that the institution cannot generate core-operating profits until nonperforming assets are significantly reduced.

In all likelihood, this will become apparent to senior management well before it becomes known to other employees or shareholders.

As a result, there will most likely be some shareholders and possibly some colleagues who will not fully appreciate the need to rid the bank of a large portion of its nonperforming assets to restore its financial well-being.

And anyone who does not accept the severity of the situation can easily find elements of the good bank-bad bank structure to criticize.

They might argue, for example, that the sales price of the assets is too low, or that the initial reduction in capital or potential dilution of existing shareholders is too severe.

While such concerns have some validity, they become largely irrelevant when the survival of the institution is at stake. Shareholders are best served by actions designed to assure the institution's survival either as an independent entity or as a potential acquisition candidate.

An institution with a level of nonperforming assets that remains high cannot operate profitably. Therefore, the theoretical impediments should not stand in the way: With a little creativity, none of the purported impediments are deal breakers.

However, potential users must remember that the structure is most effective and most easily implemented when the debilitating effects of the problem assets are first recognized.

Because of this, it is important to move promptly in fully evaluating the costs and benefits of the structure as a solution to an institution's problems.

We expect to see the good bank-bad bank structure used with greater frequency over the next two to three years. The economic climate is quite conducive to its use.

Interest rates are low. And the commercial real estate market seems to have stabilized sufficiently to allow lenders to feel greater confidence in their ability to underwrite loans related to real estate.

These factors will make it easier and less costly to obtain financing for the bad bank. Meanwhile, banks and thrifts burdened by nonperformers will become impatient with the restraints placed on their capital-raising ability.

This will be particularly true for institutions that have strong management and an attractive franchise. The cost of missing the growth opportunities that the recovery will present will be felt most acutely by the better institutions, and these institutions will need to rid themselves of their nonperformers as a means of gaining access, at a reasonable price, to the capital they need to grow.

Even for an institution "on the edge," like First City Bancorporation of Texas, the good bank-bad bank is worth considering. In extreme situations, it may facilitate a sale of the institution and allow shareholders to recover some of their investment through ownership of the bad bank.

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