Odds Are Poor for Sick Thrifts

Once a thrift reaches the brink of insolvency, can it earn its way back to a healthy capital position?

More specifically, can profitability be enhanced through improvement of basic operations -- without a stock offering, government assistance, or a decline in interest rates?

The question holds more than academic interest.

If thrift turnarounds exist, Congress and regulators should know how they are accomplished and what policies will minimize the cost of the bailout.

Alternatively, if S&Ls rarely recover, the apparent game plan of the Resolution Trust Corp. -- selling sick S&Ls to investors -- seems fundamentally flawed.

Options Scarce

S&L turnarounds are harder to achieve than turnarounds in other industries.

That is because thrifts have fewer options.

Thrifts can shrink their asset base, curtail high-cost funding sources, attempt to cut costs, refocus on retail activities, and take steps to reduce interest rate risk.

Little else is available.

Four proven strategies, used in other industries, won't work:

* Focusing on a niche.

* Restructuring financially.

* Selling units.

* Modernizing.

Regarding niches, the S&L business involves one product: mortgages.

Capital's Cold Shoulder

A financial restructuring is also impossible.

Capital markets disdain thrifts. Only the industry's top thrifts can issue investment-grade debt.

Divesting subsidiaries enabled Bank of America to turn around. But most S&Ls own no gems like BankAmerica Corp.'s former discount brokerage unit, Charles Schwab & Co., which can be sold at big premiums.

Modernizing entails a large initial outlay for a computer system, which would penalize capital in the short term and provide questionable future savings compared with a service bureau.

Inadequate capital itself is a direct cause of poor S&L profitability, because the institution typically lacks interest-free funds (the surplus of interest-earning assets compared with interest-costing liabilities) that aid earnings.

It is also difficult to overcome negative publicity, which imposes higher funding costs and deposit outflows.

Lastly, troubled thrifts often became troubled because they were run by unskilled, incompetent, or dishonest managers. This suggests that asset writedowns may be required.

Tough Tests

Realizing the magnitude of the task, we still hoped to find one example of a turnaround. Candidates (all publicly owned) were drawn from among:

* Substandard earnings performers.

* Those that had submitted approved capital plans to the Office of Thrift Supervision.

* Thrifts that had announced major restructurings.

* S&Ls that recently achieved capital compliance.

Each candidate was evaluated for ability to enhance or resume core profitability; likelihood that no ugly surprises would surface -- for example, a big addition to reserves; management capability; and a competitive endownment such as a base of low-cost deposits.

Unfortunately, our search located only one possible winner. Most candidates were deeply insolvent, had serious asset-quality problems, or were not remotely profitable on a core-earnings basis.

Sometimes, we did lacked information to evaluate a candidate.

Search Had Its Lighter Moments

Regulators seized County Bank of Santa Barbara, Calif., while the study was being conducted -- relieving us of the need to assess the company's longterm prospects.

It was challenging to find companies with odds of success as good as 1 in 10.

Perhaps the leading turnaround contender is Northeast Federal, a $4.6 billion thrift based in Hartford, Conn.

Formed in 1982 through the assisted supervisory mergers of thrifts in New York, Connecticut, and Massachusetts, Northeast was a wholesale shop in the 1980s.

It invested in purchased mortgages, mortgage-backed securities and junk bonds funded from Federal Home Loan Bank borrowings, brokered deposits, repurchase agreements, and other capital-market financings.

With the arrival of George Rutland as chief executive in July 1988, the company abandoned its wholesale focus to become a traditional retail thrift.

Has the strategy worked? Yes.

After 2 1/2 years of steady losses, Northeast returned to profitability (before credits for net operating losses and after unpaid preferred dividends) for two consecutive quarters. Northeast also met all three capital tests mandated by the bailout law.

Capital compliance was attained by downsizing the balance sheet, combined with reclassification of the company's two preferred stock issues to obligations of a newly formed holding company, rather than the thrift unit.

[Northeast said Thursday that in the quarter to Sept. 30 it earned $904,000, about one-third the year-earlier figure. Tangible, core, and risk-based capital ratios remained in compliance. -- Editor]

Profitability was restored through the cessation of non-thrift activities, reduced reliance on wholesale funding sources, an emphasis on the origination of adjustable-rate mortgages, branch consolidation, centralization of loan-processing operations, and simplification of the deposit product line.

A drop in short-term interest rates since September 1990 also contributed greatly.

Tangible capital under generally accepted accounting principles stood at 2.14% on March 31, 1991, more than twice the 0.97% level of June 30, 1988.

Northeast's interest rate spread was 2.19% at March 31, 1991, also more than double the extremely compressed spread of 0.93% on June 30, 1989.

Total assets were $4.6 billion on March 31 of this year, down 44% from a peak of $8.2 billion on Dec. 31, 1988.

General and administrative costs were cut 8.3% in fiscal 1990-1991, after a 9.9% reduction the previous fiscal year. And fee income rose 9.4% last year, helped by many of the cost-saving measures cited earlier.

Significant Challenges Remain

The company's interest rate spread of 2.19% is well below the spreads of the largest public thrifts, which averaged about 2.5% to 2.6% at the end of March, with a range of 2.1% to 3.2%.

The main reason for this compressed spread derives from the fact that about 44% of Northeast's $4.4 billion portfolio of earnings assets comprises purchased loans and mortgage-backed securities yielding a below-market 9.26%.

Nonperforming assets are also snowballing, reflecting the slump in Northeast real estate; large reserve additions are possible over the next several quarters.

Dividends are in arrears on the company's two preferred stock issues.

Northeast has a distant shot at reaching 3% tangible capital, but it certainly won't be easy.

Moral: The fact that S&L turnarounds are so rare implies that the cost of the industry bailout will increase further.

Mr. Huber is a senior industry analyst with Standard & Poor's Corp., New York.

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