WASHINGTON — The Federal Deposit Insurance Corp. is facing a new challenge in Puerto Rico.

Three banks on the island holding more than $20 billion of assets are in trouble, and the agency has to resolve them without causing problems for the seven other institutions in the market.

"The best solution would be to do this in a way that the healthy" institutions on the island "all have a part in it, because that way you would end up with a consolidated industry but also an industry that's not overly weighted in any one" institution, said Bain Slack, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc. who covers banks in Puerto Rico.

The banks — $12 billion-asset Westernbank Puerto Rico, $6 billion-asset R-G Premier Bank of Puerto Rico and $2.6 billion-asset Eurobank — account for nearly a quarter of the assets on the island and were severely damaged by real estate problems and a local recession. All three have been subject to federal enforcement actions and two have given some indication they may not survive.

Observers said regulators are likely to act soon before the situation worsens.

"My sense is they're trying to do something during the month of April to try to find answers to all three," said John Douglas, a partner at Davis Polk & Wardwell, and a former FDIC general counsel.

Among the FDIC's options are packaging multiple banks together, forming a conservatorship to run at least a piece of the banks' assets or even using a rare exception in federal law to resolve the institutions without closing them if their failure could have a systemic effect.

"What the FDIC tries to do when it has a region that had multiple bank challenges is take a regional approach and offer solutions which could provide a positive result for the entire region," said a former FDIC official who spoke on the condition of anonymity. "Especially in an island region like that there are clearly going to be effects on other banks, either through shared credits or similar loans by type or geography. You can't help but have some effect."

Problems in Puerto Rico's banking sector date back to at least 2004 when several companies were caught up in an accounting scandal tied to the overvaluation of certain mortgage assets.

Slack said the aggressive moves by banks on the island "falsely fueled the housing market," and the scandal was "the beginning of a realization that the banking system had been overbanked."

Those problems were accompanied by financial struggles in the commonwealth's government, which employs about a third of its workers, throwing the island into a recession. The "third shoe to drop" was the slowdown of the broader U.S. economy, Slack said. "It's fair to say this situation is certainly rare."

Filings with the Securities and Exchange Commission from the parent companies of two of the three banks have cited the possibility of failure.

The February filing of R&G Financial Corp., R-G Premier's owner, included an assessment from its auditor, Crowe Horwath LLP, that its problems "raise substantial doubt about the company's ability to continue as a going concern."

On April 1, Westernbank parent W Holding Co. said regulators "may take other actions, including further enforcement actions, capital directives or even assumption of control of the bank."

None of the three banks responded to requests for comment, and the FDIC declined to comment.

Many observers said the FDIC cannot afford to deal with each failure individually.

"You have to be concerned that closing any one of them may result in a run on the other two," Slack said.

But if the FDIC needs to resolve all three institutions at the same time, it may face a shortage of buyers. For starters, two big players in the region — $9 billion-asset Doral Bank and $20 billion-asset First Bancorp — are still dealing with their own asset problems. While $34 billion-asset Popular Inc. could take one or two of the banks, it is not large enough to handle all three.

"I could see" Popular "buying one of them," but the three banks together "would be a lot for someone to take on and have the capacity to handle," said Bert Ely, an independent consultant based in Virginia.

Moreover, the large mainland banking companies, including Citigroup Inc., have all but abandoned Puerto Rico. More likely players are foreign firms, including Spanish-owned Banco Bilbao Vizcaya Argentaria SA and Banco Santander SA and Canadian-owned Bank of Nova Scotia, which already operate sizeable banks in the region.

"There hasn't been a lot of interest from banks who aren't already in Puerto Rico," said Joe Gladue, an analyst with B. Riley & Co. Inc.

Ely agreed. "Puerto Rico is a special situation because of its political status and its geographical isolation," he said. "What we're seeing in the United States is banking companies moving into new markets and other states through the acquisition of failed banks. I'm skeptical that at this point in time there are any mainland-headquartered banks that want to move into Puerto Rico."

Another potential bidder is Oriental Bank and Trust, a $6 billion-asset institution based in San Juan. Slack said Oriental's recent announcement that it had raised $100 million in new capital is a sign prospects on the island are improving.

"Up until recently, I think there was probably an argument — a valid one — to say: Can the rest of the industry" in Puerto Rico "handle three closures of this magnitude at once? Probably through '09, and even into the early part of this year, the answer was 'no,' " he said. But with Oriental's capital raise, "all of a sudden there is a little bit of a sign of life that there is interest in the capital markets in Puerto Rico."

The FDIC could try a more radical approach by invoking the systemic-risk exception, Douglas said.

The agency could provide one or all of the banks with open-bank assistance in the hopes of facilitating a merger.

"With respect to Puerto Rico, they could get a systemic-risk determination if they wanted," Douglas said.

But that approach would require the support of the Treasury secretary and Federal Reserve Board, and could be greeted with hostility in Congress where many lawmakers are still fuming about bank bailouts.

Still, regulators may also fear that closing the banks could force writedowns of related assets held by other banks in the region.

"It's probably likely that some of these loans are syndicated, among both some of the healthy banks and the troubled banks. Therefore if you close the troubled ones and you have price recognition, that means you may be taking more capital losses at the healthy ones and therefore creating damage at the banks that you actually need to help the consolidation," Slack said. "I'm sure the regulators are thinking that's probably not a least-cost method. So keeping them open until solutions can be found is probably better."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.