Japan's "lost decade" of the 1990s was characterized by "zombie banks" unwilling or unable to make new loans because they were holding large portfolios of problem loans backed by real estate.

Today, some of our regional banks are burdened with questionable real estate-related loans that demand management focus and attract regulatory attention. Selling at deep discounts to vulture funds threatens capital ratios, but holding them will continue to restrict new lending.

"Good bank/bad bank" recapitalizations like the transaction we and our associates at the former Drexel Burnham Lambert devised to rid Mellon Bank of problem loans in 1988 could mean the difference between vigorous Main Street economic growth led by regional bank lending and a decade or more of economic stagnation.

Large problem asset portfolios affect managers, investors, regulators and customers, all of whom have a hard time accurately understanding the bank's future earning power. Bankers are publicly confident they are appropriately reserved, but they are still nervous about regulatory concerns. Shareholders are wary of dilution from new equity offerings because senior regulators publicly stress that more capital is always better.

Prospective new investors are reluctant to buy more shares in banks with significant problems. Bank morale is poor, managers consider leaving for stronger competitors and loan customers consider moving their business to other banks.

Even though they may disappoint current shareholders and loan customers, troubled banks have tended to muddle through by issuing new shares and increasing their reserves rather than proactively addressing asset issues and growing their loan portfolios.

Although the transaction model may be unfamiliar to some underwriters (and less profitable than public equity offerings), it isn't experimental or radical. It is actually composed of several completely familiar and straightforward private subtransactions that close simultaneously. Structuring and pricing each of these contingent subtransactions to appeal to all of the parties involved is critical to a successful good bank/bad bank recapitalization. In the Mellon Bank deal:

  • The "good bank" capitalized a newly formed "bad bank" with equity and debt from investors.
  • The good bank sold the problem assets to the bad bank (and contracted to collect them).
  • The good bank was recapitalized to "well capitalized" status.
  • The bad bank was dividended to the good bank's shareholders.

The deal showed that good bank/bad bank recapitalizations can produce optimal outcomes for bank customers, employees, current shareholders, new investors and for Main Street businesses and the financial system as a whole.
By 1988, Mellon had accumulated a large portfolio of nonperforming loans and other problem assets and it was losing business to its competitors. An exceptional management team chose to clear the deck of problem loans, recapitalize and come out fighting so that a well-capitalized Mellon was able to grow its loan portfolio, return to profitability, issue investment-grade preferred and use its higher-priced stock to make acquisitions.

The assets were collected for the bad bank, Grant Street, by Mellon. Grant Street's debt was paid off and its common stock retired at a profit three years ahead of schedule.

Main Street businesses in the area benefited because the assets were collected by people who knew the borrowers and the loans (rather than by vulture funds that did not). Because the assets yielded higher values from knowledgeable collection, the prices of similar assets in the neighborhood were less adversely affected.

Our updated transaction can be used in nonassisted recapitalizations like Mellon and in assisted unassisted acquisition deals. It works for community banks and the largest financial companies.

Most important for Main Street businesses and the banking system, sufficient private-sector capital is available to drive good bank/bad bank recapitalizations for a significant number of financial companies.

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