RTC Rigidity Clobbers Taxpayers

From August 1989, when the thrift bailout law was enacted, through Sept. 30 of this year, the Resolution Trust Corp. disposed of $177 billion in deposits of failed thrifts, in 472 transactions.

Deposits sales by the RTC are generally structured like branch sales in which the acquirer assumes the deposit liabilities and buys balancing assets of cash and readily marketable assets

The average premium paid in these deposit sales was 1.41% of total deposits.

During the same period, the private sector conducted 63 sales of thrift branches for which premium data are available. The average premium was 4.9%.

The difference between average premiums in the public and the private sectors was 3.49 percentage points.

Taxpayers' Burden

Multiplying this figure by $177 billion - the dollar value of deposit sales by the RTC - gives a staggering product: $6 billion.

This $6 billion can be viewed as a rough estimate of the degree of inefficiency in the RTC sales as compared with that of the private sector.

Is it really possible the RTC deposit sales process has cost the taxpayer $6 billion so far?

If so, there are four reasons for the RTC's dismal performance:

* The "damaged goods" syndrome.

* The pure auction process.

* Finding the private investor bid groups.

* The "seller must sell" syndrome.

Damaged Goods?

One claim is that the RTC branches and their associated deposit bases are "damaged goods" - so, of course, the premiums will be low.

Nothing could be further from the truth.

Significant runoff in thrift deposits occurs as an institution fails. But a typical conservatorship lasts several months. By the time resolution occurs, the remaining deposits represent truly core deposits, the most stable of deposit relationships.

True, the RTC could gain higher absolute dollar premiums if it could sell the deposit franchise before the deposits run off.

But once that runoff occurs, deposits remaining at the time of sale should bring higher premiums, other things equal.

A related argument is that conservatorship institutions pay higher rates on deposits than sound thrifts and, therefore, those deposits are worth less.

However, conservatorship thrifts bid no more for deposits than privately managed thrifts that are selling branches to help meet capital standards.

Moreover, the buyers of RTC branches - as well as of Federal Deposit Insurance Corp. branches - have the right to reduce deposit rates after a 14-day waiting period. This right is without regard to contractual terms of deposit, provided that adequate notification is given.

After several months of a conservatorship, most remaining depositors are there because of geographical convenience, not rates.

Therefore, buyers that reset rates after the 14-day period do not experience significant runoffs of deposits. In most cases, deposit growth remains positive, albeit less positive than before the rate reduction.

Factors in Runoff Rates

The specific runoff experience, if any, will depend on such matters as whether any additional troubled institutions remain in town and the composition of deposits - for example, money market deposit accounts versus certificates of deposit.

At a minimum, the RTC should be studying post-acquisition runoff rates to provide potential buyers with more than guesses as to the rate sensitivity of the deposit base.

Deposit value can also be affected by branch deposit size. Indeed, the average size of RTC branches sold is slightly higher than in the typical private thrift branch transaction: $38.9 million in deposits versus $36.7 million.

This is the case because the RTC tends to liquidate - pay off - small failed thrifts. And, in some cases, it liquidates some small branches of failed thrifts while selling the larger branches.

Larger branch deposit size generally means a lower ratio of noninterest expense.

Thus, not only are RTC deposit bases likely to be more stable than in a typical branch sale, but noninterest expenses are also likely to be less burdensome.

Why then the low premiums?

The real reason the RTC does so poorly in deposit sales - and the FDIC can be faulted on these grounds, as well - is obsession with fairness in the bid process.

Legitimately worried that Congress will second-guess its every move, the RTC structures sales in the auction fashion popular with sellers of used autos and other damaged goods - even though what the agency is selling is very valuable indeed.

In the typical bid session, the RTC gives each interested party an information package sufficient to let the buyer calculate a bid. Also distributed is a set of predefined bid structures that represent conforming bids.

The FDIC is much more innovative in varying bid structures from deal to deal. But neither agency departs from the auction process, as opposed to a negotiated bid process. And neither one does something that every auto dealer, real estate agent, stereo salesman, or investment banker does: set a "sticker price."

In properly conducted private branch transactions, the seller often employs a financial adviser. Before any marketing is done, the adviser analyzes the product to be sold and comes up with a range of likely clearing prices.

A sticker price is set at the upper end of this range. The adviser then meets individually with each potential buyer to review the logic of the sticker price, actively promote the transaction, and suggest alternative structures that may particularly suit a given buyer. This is analogous to the way the real estate agent provides free consulting on financing to help seal a deal.

Neither the RTC nor the FDIC does this. Generally, they say: "This is how we will structure the deal." They never say: "This is the price we want." Again, the FDIC is to be faulted less than the RTC in this regard, especially as deal size rises.

Harmful Rigidity

In theory, the agencies should be able to accept widely differing deal structures, price the components separately, and arrive at a least-cost deal. And they ought to be able to pressure-sell a buyer into a good price - again, much like good real estate salesmen - by saying: "If you pay the higher price I think it's worth, we'll tell the other bidders to stop; it will be yours."

But the agencies generally don't negotiate. In fact, they go out of their way to let the market know that nonconforming bids will be frowned upon.

This was the clear signal, for example, sent by the FDIC when it rejected BankAmerica Corp.'s bid on Bank of New England.

The agencies will say they use auctions and limited deal structures because negotiating differing deals for differing buyers is expensive and leads to "apples and oranges" comparisons. Determining a sticker price is also expensive and may preclude bids above the sticker price.

These arguments aren't very persuasive. The typical financial advisory fee in a branch transaction is far below the 349 basis points, on average, that the RTC is losing.

Private Investor Groups

Another tragedy in the resolution process is the almost complete lack of private investor groups as viable bidders for both RTC and FDIC transactions.

In some cases the bidders have been other thrifts, but mainly commercial banks. Private investor group bids have not been numerous for several reasons, including the perceived or actual difficulty in becoming an approved bidder.

A major reason, however, is that private investor groups generally do not wish to pay the expense of hiring advisers to structure transactions, conduct due diligence, develop a post-closing business plan, and develop regulatory strategies such as how to avoid entry-exit fees.

Why should they? The typical money manager faces a near-constant deal flow. Each of these competing transactions is being marketed to the money manager by a financial advisor on behalf of a specific seller.

All the money manager has to do is decide among competing transactions. No board of a failing bank or thrift is likely to hire its own advisers to structure an assisted transaction, if it believes the result will wipe out original shareholders' interests. So it is unlikely that potential new investors will ever have the opportunity to accept or reject the investment opportunity.

The FDIC, at least, has begun to recognize this chicken-and-egg problem. In some cases it will permit the failing bank to hire advisers to structure an open-bank assistance bid that may result in preserving residual value for original shareholders.

Often, these attempts degenerate into ordinary closed-bank bids with the original shareholders being wiped out.

At least, however, the FDIC is on the right track. Consider the recent New Hampshire transactions, in which the FDIC simultaneously closed five institutions with combined assets of approximately $5 billion. Various advisers assisted the failing banks to structure closed-bank bids, even though the cost of this work ultimately was borne by the FDIC.

The effort to raise private investor capital for an assisted deal was successful in one case, the Craig-Keller group acquisition of Dartmouth Bank, Numerica Savings Bank, and New Hampshire Savings Bank. To accomplish this acquisition, totaling $2.4 billion in assets, approximately $40 million in new investor capital was raised.

According to various press stories, the FDIC was able to raise the number of bidders by 25% by allowing the failing Dartmount Bank to support the bid process.

The winning bid by the Craig group saved the FDIC money - since any winning bid must pass the least-cost test.

Open and Closed Alternatives

So far, the Office of Thrift Supervision has been less inclined than the FDIC to permit failing thrifts covered by the Savings Association Insurance Fund to attempt open-bank assisted deals. Generally, the OTS does not permit the thrift to use potential Resolution Trust Corp. funds to support the process of making bids for closed-bank deals.

Moreover, the OTS and RTC have sent mixed signals to the troubled thrift sector. OTS director Timothy Ryan has said that open-bank assistance transactions should be fostered, if possible.

Yet, no open-bank assistance transactions for thrifts insured by the Savings Association Insurance Fund have been done. In some cases, the Office of Thrift Supervision has instructed troubled institutions not to hire advisers to attempt such transactions.

The problem, of course, is not the OTS, the RTC, or the FDIC. The problem is the U.S. Congress.

Congress is intent on punishing everyone associated with a failed thrift or bank, especially the shareholders who are supposed to be a major policing force.

But if the shareholders have seen the erosion of 95% of their equity value, isn't that punishment enough? Why insist on the elimination of the remaining 5% of shareholder value?

Federal Incentives

Conversely, a clear signal could be sent to failing thrifts and banks that the agencies will look favorably upon open-bank assistance transactions that preserve the remaining 5% of shareholder value.

The troubled institutions would then have incentive to go out and grab potential new investors by the collar and show them the attractiveness of investing in a federally assisted transaction.

Even if the end result is simply that more bidders are brought into the closed-bank bid process, the RTC and FDIC will receive higher effective deposit premiums. As an added bonus, some assisted transactions will occur prior to the runoff of deposits that typically occurs when an institution is placed in conservatorship.

The |Must Sell' Syndrome

The marketplace correctly perceives that the RTC and FDIC must sell their wares, the deposit bases of the seized institutions.

So long as a purchase-and-assumption bid results in lower cost to the agency than a deposit payoff, the deposits will be sold.

Time after time, the adviser to the bidder for RTC and FDIC branches says: "It's worth 300 basis points, but I know you can get it for 50 to 100 basis points!" This advice often becomes a self-fulfilling prophecy.

In the private sector, however, the seller may not actually sell the branch if the buyer does not meet a reservation price that reflects the present value of the earnings potential of the branch for the seller.

Perhaps it is time for the RTC and FDIC to begin seriously using their bridge bank powers to run a deposit franchise themselves, if the selling price is not high enough.

Delays Can Cut Costs

Our simulations show that the RTC and FDIC often could save considerable expense by delaying the resolution process, rather than adhering to the blind instruction: "Close 'em up and bid 'em out."

At a minimum, the government would gain the economic profit otherwise accruing to the private-sector workout firm.

The government would also gain the economic profit otherwise accruing to the winner of the "good bank" for what have become absurdly low bids.

Would extended bridge banks, in effect, mean a nationalization of the banking industry?

No. But they would create situations in which the agencies would operate banks for several years in competition with the other banks they regulate.

Appropriate standards could be developed that would cause government-owned banks to adhere to the same profit-maximization goals as their competition.

The concept of extended bridge banks needs much additional analysis. However, the potential saving could well be worth the effort.

Mr. Mingo is managing director of Potomac Financial Group Inc., Washington. A version of this article appeared earlier this month in SNL Securities' Bank Mergers and Acquisitions.

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