Open-Bank Assistance Can Work for All Stakeholders
Institutions with low capital ratios and double-digit ratios of nonperforming assets are seeking ways to strengthen capital-asset ratios and get out from under troubled assets.
These institutions can't raise their capital-asset ratios through retained earnings, mostly because of the low margins associated with extensive nonperforming assets. And investor concerns about such assets make the companies hard to sell.
Therefore, many troubled institutions are considering seeking help from the Federal Deposit Insurance Corp., generally in the form of FDIC assumption of nonperforming assets or creation of a segregated asset pool.
Must Shareholders Lose Out?
The question is whether such so-called open-bank assistance can be done without the institution's failing eventually and shareholder interests being wiped out.
In general the FDIC has not been doing open-bank deals. But recently it has expressed a desire for serious effort to structure them, in the hope of saving money. Several attempts are being made in New England, where some large, troubled institutions are concentrated.
Under Section 13(c) of the Federal Deposit Insurance Act, the FDIC may help banks and savings associations to prevent their default or to reduce risk to the FDIC "when severe financial conditions exist that threaten the stability of a significant number of insured institutions."
Bailout Law Made Provision
Under the Financial Institutions Reform, Recovery, and Enforcement Act - the thrift bailout law - the FDIC also can also offer aid to eligible members of the Savings Association Insurance Fund before grounds exist to appoint a conservator or receiver. Such aid falls under Section 13(k)(5) of the deposit insurance act.
In all open-bank transactions since 1986, either another banking institution acquired the troubled bank, or significant third-party equity was injected into the troubled institution.
The current hiatus in open-bank transactions stems primarily from passage of two landmark pieces of legislation - the Competitive Equality in Banking Act of 1987 bill and the thrift bailout legislation of 1989.
The 1987 law gave the FDIC the capability to create bridge banks.
The 1989 thrift bailout law included "cross-guarantee" provisions that permit the FDIC to attach the value of a sound bank affiliate of a troubled bank in a multibank holding company.
Before the 1987 law, the FDIC was concerned that it must prop up a troubled bank, especially if a run were imminent, if no close-bank assisted transaction had been negotiated.
Getting Off Scot Free
And before the cross-guarantee provisions, a multibank holding company structure especially troubled the FDIC. If a troubled bank in the chain were simply closed, the holding company could continue to profit from the "good" banks.
Open-bank assistance gave the FDIC a negotiating lever by which it could require the holding company to merge its good banks with its troubled bank or banks, in return for FDIC aid to keep the troubled one open.
The thrift bailout law, however, put all the cards in the FDIC's hand. The agency can now close down the troubled bank and, in effect, invoice the healthy affiliate banks for the FDIC's costs.
A final reason for the dearth of open-bank deals is that the FDIC, explicitly since April 1990, has required that any open-bank aid proposal be compared with an alternative closed-bank bid session.
Do the enactment of the Competitive Equality in Banking Act and the bailout law and development of the comparison-bid policy mean the end of open-bank assistance? Not necessarily.
To understand the prospect for open-bank transactions, we must look at the objectives of such a transaction from the point of view of the major stakeholders: original shareholders, management and directors, the community served by the institution, insurers, and potential new investors.
The original shareholders' goals are simple and straightforward - to secure and maximize any residual value in their ownership of the institution. Such an objective may be met, for example, by securing an equity injection into the troubled bank, along with federal aid, which would leave the old shareholders with, say, a 5% interest.
Such an ownership position in a recapitalized bank, preferably one with its troubled assets transferred to the FDIC, is better than no position at all for the original shareholders and certainly better than the 100 percent loss that generally would flow from a receivership.
The personal goals of management and directors generally are straightforward - to avoid liability, to fulfill their fiduciary responsibility to shareholders, and to keep their jobs.
Serving All Interests
These objectives at times are compatible. A CEO could take the opportunity to lead a recapitalization and be rewarded with a job and a new contract at the recapitalized company while preserving some shareholder value.
Also, management and the board may seek to avoid control by an existing, larger banking institution, which ordinarily would win a purchase and assumption bid for the failed institution's assets and liabilities. Thus, both from shareholders' and management's viewpoint, open-bank assistance avoids the shutout of being placed in receivership and dismantled in a typical closed-bank bid situation.
From the viewpoint of the bank's community of depositors and borrowers, it is important only that the institution's continuity be maintained, perhaps under the same name as before the troubles. Uninterrupted service to depositors and borrowers is most important, no matter what the deal's technical structure.
Community's Version of Salvation
Indeed, no matter whether open-bank assistance or receivership is used, the community would view the bank as saved, so long as service continues.
The FDIC's objective is to minimize the cost to the insurance fund of effectively resolving the troubled bank's problems. Therefore, the insurer often has a very different perspective on open-bank assistance than do other stakeholders.
In particular, the FDIC's April 1990 policy statement on open-bank assistance lays out 14 criteria that must be met by a proposed Section 13(c) transaction. Of special importance to the various interest groups are the following criteria:
* "The cost to the FDIC of the proposal must be less than other available alternatives and still provide for reasonable assurance of the future viability of the institution."
* "The proposal must provide for sufficient tangible capitalization, through capital infusions from private outside capital investment sources, to meet the regulatory capital standards."
* "The financial effect on shareholders and creditors of the failing institution must approximate the effect . . . had the assisted institution closed."
* "The proposal must provide for adequate managerial resources. Renegotiation or termination of management contracts is to be completed prior to the granting of assistance. Continued granting of service of any directors or any senior ranking officers . . . will be subject to approval by the FDIC."
The first of these criteria - least cost to the FDIC - is arguably the most important. In every case, the FDIC will test an open-bank assistance transaction against a typical purchase-and-assumption deal. It generally will not "shop" the open-bank assistance bid itself.
Rather, the FDIC, when it has determined that the open-bank bid is viable, will put together a bid package and ask other banks to bid on the institution before it is put in receivership.
Generally, a purchase-and-assumption bid involves a bank or bank holding company as buyer and involves assumption of the deposit base only. The purchase of assets typically consists of marketable securities, residential loans, and other performing assets, plus significant amounts of FDIC cash.
Looking at Deposit Premium
If the effective deposit premium paid by a qualified bidder (when all factors are considered, including expected FDIC costs to work out assets not acquired by the bidder) is higher than that calculated for the open bank, the bidder will win.
The typical new investor in a troubled institution wishes to maximize the internal rate of return and to minimize risk.
For those reasons, investors are often reluctant to take part in assisted transactions, especially open-bank assisted transactions in which something must be preserved for the original shareholders.
Investors ask such questions as: Why give the original shareholders anything? Why not simply wait until the purchase-and-assumption bid session and take the bank in a closed-bank deal?
Here is why.
In the past year or so, several attempts, none yet successful, have been made at closed-open transactions. These are attempts to meet the objectives of shareholders, management, and the community as in a true open-bank transaction while nevertheless passing the troubled bank through technical receivership.
Receivership is deemed necessary in order to maximize the return and minimize the risk to the new investor while giving the FDIC the least-cost solution. Note that the term "closed-open" is not recognizable to the FDIC; a failing bank is either left open or it is closed so far as the agency is concerned.
Therefore, we are comparing a closed-bank transaction with Section 13(c).
In an open-bank transaction, all liabilities and contracts of the troubled bank remain in force and become the responsibility of the newly capitalized institution. This means that, for example:
* Outstanding lawsuits could come back to haunt the new equity owners.
* The new owners must continue to pay contractual rates on high-yielding, brokered certificates of deposit.
* Expensive leases for branch and office space will remain in effect.
Therefore, an investor in an open-bank transaction generally would ask for specific indemnification from the FDIC for contingent liabilities, and the FDIC generally would consider this as more costly to it than simply giving a bidder the standard indemnification contract used in closed-bank bidding.
Also, to the extent the investor in the open-bank transaction asks for help to cover high-yield, brokered CDs until the instruments mature, or for aid to cover above-market or unwanted leases, the FDIC will consider these requests to be more costly than subjecting the lessor to receivership.
A receivership, on the other hand, has certain characteristics that make life easier for the FDIC and the investor:
* An outstanding lawsuit may not be settled before the receivership is concluded. And if the party suing the bank wins, the plaintiff must get in line with other unsecured creditors, along with the FDIC (and in some circumstances behind the FDIC), to get his pro rata share of the receivership proceeds. Often, this means that the suing party gets little or nothing.
* In a receivership, the contractual terms on deposits, even insured deposits, are repudiated, and the acquirer, after 14 days, may reduce the interest rate paid or pay off the depositor without penalty.
* In a receivership, the FDIC has the ability to disaffirm leases. The acquirer may renegotiate the lease downward or vacate the premises without cost.
Taking Care of Shareholders
Therefore, if a closed-bank transaction can be structured so as to leave some residual value for the original shareholders, such a transaction may be more attractive to the FDIC and the new investor than a true open-bank deal.
One exception to a preference for closed-bank deals is the tax arena. In certain well-defined circumstances, a true open-bank deal may have tax benefits that do not accrue in a closed-bank deal. This is a very complicated area, on which the experts often disagree, and much will depend on IRS rulings in transactions currently under way.
It should be noted, however, that the FDIC generally will claim any tax benefit arising from the structure of an assisted transaction, no matter the wishes of the acquirer.
Another possible advantage to a true open-bank deal exists when the troubled institution has significant subordinated debt on its books.
If a closed-bank deal is structured so as to try to leave some residual value for original shareholders, and the acquirer assumes all liabilities from the receiver except for subordinated debt, the debt-holder will have a legitimate claim that he was incorrectly placed in a position subordinate to the shareholder. In such a case, an open-bank deal may be more appropriate - one in which the new investor and the FDIC negotiate a "haircut" to the subordinated debt or debt-equity swap.
Suppose, however, that in a particular case the investor finds the benefits of a closed-bank deal outweigh the benefits of an open-bank deal. How can management of the troubled institution agree to engage in a closed-bank transaction, given its fiduciary obligation to preserve some residual value for shareholders?
Crafting the Closed-Open Bid
The answer is that closed-open transactions can be crafted in several ways to fulfill the shareholder fiduciary responsibility of the troubled institution's management. For example, the holding company of the troubled bank can receive shares in, or warrants for the stock of, the newly capitalized bank that acquires the assets and liabilities of the failed institution. Also, the holding company or the original shareholders directly can get subscription rights to the equity offering for the new institution.
But why should the investor (who bears the risk of putting the bulk of the new equity into an open-bank or closed-open deal) give the original shareholders anything? Why not simply wait until the general bid session?
The answer is that it is very expensive to craft a bid for an assisted transaction. Important elements involved in a bid include:
* Whether the FDIC buys the nonperforming assets for cash or notes (and what is the composition of cash versus FDIC notes) and whether the FDIC creates a segregated asset pool on the books of the resultant institution.
* The terms of the pool, including put provisions with respect to which assets can be put back to the pool, at what dates, and with what penalties.
* What exceptions to previous assistance agreements will the buyer craft? For example, Bank of America reportedly asked for too many exceptions to standard purchase-and-assumption bid terms when it lost in the bidding for Bank of New England.
* What is the effective "deposit premium" paid to the FDIC by the acquirer. In the more complex bids, is the premium even measurable?
* Does the investor need the FDIC to contribute some of the equity to meet minimum capital standards? How much equity will the FDIC be asked to put in, on what terms, and what are the leverage standards for "new" banks without significant credit risk?
The FDIC would like investor groups to bid on troubled institutions because the agency has been receiving very few, and very low, bids from sound banks or bank holding companies.
The agency's intent has been signaled by its letting several troubled institutions actively seek open-bank assisted transactions. Indeed, these institutions are using outside consultants and legal advisers whose professional fees are being paid indirectly by the FDIC.
In effect, the FDIC has signaled that it believes open-bank transactions can be crafted in ways that minimize the cost of FDIC assistance and that a reasonable expenditure of effort (and ultimately FDIC funds) should be made to craft such bids.
Nevertheless, very few bids have actually been made, and almost none have been accepted by the FDIC.
A properly executed open-bank transaction takes several months to craft and involves more extensive due diligence and creativity than would be the case in a typical purchase-and-assumption bid.
Some troubled institutions seeking to craft assisted deals are considering only true "open-bank" transactions, in the belief that only with such deals will the fiduciary responsibility to shareholders be properly executed.
While the FDIC and its sister agencies are wrestling with broader issues of public policy, the managements of troubled institutions must focus on the recapitalization options available to them. Open-bank assistance is clearly one such option, and for some institutions, it may be the only one remaining.
Mr. Mingo is managing director at Potomac Financial Group Inc., Washington.