Rigid Thrift Regulations Bar the Door to Capital

The thrift industry's sad state of undercapitalization became even more apparent after the 1989 thrift reform law, the change in accounting rules for goodwill, and the elimination of regulatory accounting principles. Efforts to recapitalize the industry have been slow, with limited success.

The primary impediment to attracting capital to the industry is the uncertainty associated with it. Frequent regulatory changes and harsh examinations, which have a devastating impact on the balance sheet, are commonplace. These, coupled with a slowing economy and a precarious real estate industry, may have been major deterrents to potential investors.

It appears that these external circumstances may not be the only reasons for recapitalization difficulties. In addition, the Office of Thrift Supervision has created perhaps the single greatest hurdle to recapitalization of the industry: Thrift Bulletin 5a. This internal policy statement requires a thrift to meet its "fully phased-in" capital requirements upon completion of a recapitalization or change of ownership.

Burden on Investors

In the absence of meeting the "fully phased in" requirement, or 8% of risk-based assets less any nonqualifying investments, the investors would be required to sign a capital maintenance agreement and have the demonstrated financial ability (for example, provide an irrevocable letter of credit) to meet any future capital calls. This policy is being rigidly applied to all recapitalization or change of control applications, and has the effect of slamming the door on new capital.

Take this case, for example: A $300 million-asset mutual thrift achieved profitable operations after a change in management. The thrift was below capital requirements for all three ratios. A consortium of institutional investors committed $100 million for investment in U.S. thrifts. Their objective was to achieve solid returns through capital gains after five to 10 years.

A Sticking Point

The group was prepared to inject $11 million of capital into the thrift through a modified stock conversion. The regulators delayed approving the transaction for 18 months and have not approved it to date. The reason was that the thrift still has a non-includable investment in real estate that was acquired before the reform law was passed. The institution has successfully unloaded $14 million of the $17 million in nonallowable real estate investments.

However, because of the economic environment, one $3 million property remains on the books. Despite the fact that the proposed investment would enable the thrift to meet the 8% risk-based requirement, the application cannot be approved until all nonincludable investments are sold. The institutional investors, as limited partners in the proposed investment, will not execute capital maintenance agreements and are not willing to grossly overcapitalize the institution to accommodate the OTS.

As a result, the investment may be lost and an otherwise healthy institution may create a further burden on the taxpayer.

Another example: A limited partnership was prepared to recapitalize a billion-dollar institution with $22 million of equity. This recapitalization would have resulted in full compliance with only two of the three capital ratios. It was projected that the risk-based capital requirement would be in compliance within nine months of the transaction.

The regulators rejected the deal because the risk-based capital requirement would not be met the day the deal was consummated and the limited partnership would not sign a capital maintenance agreement. The result was that the $22 million was kept outside the industry.

Shareholders Stymied

In yet another example, a stock thrift fell out of compliance with requirements. Some shareholders agreed to infuse additional capital to bring the institution into compliance. Through this infusion, the shareholders would have increased their ownership to a position of control. Thrift Bulletin 5a requires either additional capital to meet the "fully phased in" requirement or a capital maintenance agreement. The shareholders didn't agree to either. The result: no new capital and a greater risk of insolvency.

These three examples demonstrate how regulatory rigidity is keeping precious capital away from the thrift industry. In just two instances, $120 million slated for the thrift industry may be lost. The reason for this failure is rigid application of regulatory standards, and the potential result of this rigidity is a greater burden on the taxpayers.

My advice to the regulators: Take the money. The downside for the taxpayers is minimal. With proper examination and supervision, the only real downside is for the investors who inject funds into undercapitalized thrifts. The upside is a greater cushion against possible future losses in these thrifts as well as improved profitability (greater capital, by definition, implies greater profitability since those funds can be invested to yield interest income). This course ultimately protects the taxpayers.

No Free Lunch

No one is advocating a system in which undercapitalized operators acquire marginal institutions with little or no capital risk. Nor is it advantageous to have a system that operates on a case-by-case basis without guidelines for approving recapitalization applications. Inept or dishonest management of financial institutions cannot be tolerated, and scarce capital cannot be dissipated.

Tax-avoidance deals and expensive yield-maintenance agreements are clearly inappropriate. However, Thrift Bulletin 5a and the requirement for capital maintenance agreements prevent badly needed capital from providing protection to the deposit insurance fund and the U.S. taxpayer and appear to conflict with the purpose of the thrift-reform law: enhanced capital levels. As an alternative, regulators should drop the capital maintenance requirement and requirements that "fully phased in" capital requirements be met. They ought to replace Thrift Bulletin 5a with a policy that:

* Requires institutions to meet the current capital requirement upon recapitalization. If the rest of the industry is required to meet current requirements, why should a tougher standard be applied to a newly recapitalized institution?

* Requires restrictive and conservative capital plans, monitoring systems, and more frequent examinations at the institution's expense to ensure safety and soundness for newly recapitalized institutions.

The thrift industry and the taxpayers will be much better served if the regulators do not put obstacles in the way of solid, responsible investors willing to recapitalize institutions. The regulators should facilitate, rather than hinder, these opportunities.

The Resolution Trust Corp. seems to be able to use billions of tax dollars to sell thrift assets at deep discounts. It is time for the OTS and its companion agencies to figure out how to generate the hundreds of millions of dollars of private capital needed to avoid further losses and taxpayer expense.

Ms. Bird is national director of financial institutions consulting at BDO Seidman, New York.

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