Raft of Deals for Failed Banks Puts U.S. on Hook for Billions
By DAMIAN PALETTA
WASHINGTON -- The biggest spur to deal-making among banks isn't private-equity cash or foreign investors. It is the federal government.
To encourage banks to pick through the wreckage of their collapsed competitors, the Federal Deposit Insurance Corp. has agreed to assume most of the risk on $80 billion in loans and other assets. The agency expects it will eventually have to cover $14 billion in future losses on deals cut so far. The initiative amounts to a subsidy for dozens of hand-picked banks.
Through more than 50 deals known as "loss shares," the FDIC has agreed to absorb losses on the detritus of the financial crisis -- from loans on two log cabins in the woods of northwestern Illinois to hundreds of millions of dollars in busted condominium loans in Florida. The agency's total exposure is about six times the amount remaining in its fund that guarantees consumers' deposits, exposing taxpayers to a big, new risk.
As financial markets heal and the economy appears to be pulling out of recession, the federal government is shifting from crisis to cleanup mode. But as the loss-share deals show, its potential financial burden isn't receding. So far, the FDIC has paid out $300 million to a handful of banks under the loss-share agreements.
The practice is largely a response to the number of bank failures of the past 18 months, which has stretched the FDIC's financial and logistical resources. The FDIC had just $10.4 billion in its deposit-insurance fund at the end of June, down from more than $50 billion last year. The agency said Thursday it had 416 banks on its "problem" list at the end of the second quarter, which means the list of banks at a higher risk of insolvency has been growing.
Many of the government programs aimed at attacking the financial crisis have carried high price tags, including the Treasury Department's $700 billion Troubled Asset Relief Program, which includes major government investments in American International Group Inc., Citigroup Inc., Bank of America Corp., and the U.S. auto industry. But federal money isn't just going one way. Some of the emergency programs put in place last year, including TARP, have brought in billions of dollars for the government.
On a range of rescue programs run by the Federal Reserve, such as loans to investment banks and purchases of mortgage-backed securities, the Fed earned $16.4 billion through the first six months of 2009. The FDIC said earlier this year that it earned more than $7 billion on the fees it charged through a program that guaranteed debt issued by banks.
On Aug. 14, Alabama's Colonial Bank collapsed, felled by bad commercial-real-estate lending. The FDIC, assuming its traditional role, brokered a sale of the bank's deposits to BB&T Corp., ensuring that customers wouldn't see any interruption. It also agreed to help BB&T buy a $15 billion portfolio of Colonial's loans and other assets by agreeing to absorb more than 80% of future losses. Under the deal, the most BB&T can lose is $500 million, the bank says, and that is only in the unlikely event that the entire portfolio becomes worthless. The FDIC is on the hook to cover the rest.
In June, Wilshire State Bank, a division of Wilshire Bancorp Inc. in Los Angeles, agreed to buy $362 million in deposits and $449 million of assets from failed Mirae Bank, also of Los Angeles. The FDIC agreed to assume most future losses on roughly $341 million of those assets, largely commercial real estate and construction loans in Southern California.
Loss-share agreements made a brief appearance in the early 1990s during the savings-and-loan crisis, but haven't been used this extensively before. The FDIC sees the deals as a way to keep bank loans and other assets in the private sector. More importantly, it believes such deals mitigate the cost of cleaning up the industry.
The FDIC contends it would cost the agency considerably more to simply liquidate the assets of failed banks, especially with the current crop of troubled institutions and their portfolios of loans on misbegotten real estate.
The FDIC's premise is that banks that take on the troubled assets will work to improve their value over time. The agency estimates the loss-share deals cut will cost it $11 billion less than if the agency seized the assets and sold them at fair-market value.
"This is an issue the FDIC is grappling with because the loss rates they are estimating on these failed banks are pretty amazing," says Frederick Cannon, chief equity strategist at Keefe, Bruyette & Woods Inc.
By potentially mitigating losses -- or at least stretching them out over time -- the deals provide some protection for the agency's insurance fund. "It's a great opportunity for banks," says James Wigand, deputy director of the FDIC's division of resolutions and receiverships. "It's a great opportunity for us."
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The federal government is on the hook for billions of dollars in bank losses if the economy doesn't recover. It will carry that burden for a long time. Many of the loss-share deals will be in place for up to 10 years.
Some industry officials worry that bankers might tire of the partnerships with the FDIC and put little effort into reworking the soured loans because the bulk of losses will fall to the government. FDIC officials maintain that because banks still have a "material" exposure, they will be reluctant to do this.
"There is certainly an incentive for the banks to play fair and do right, but there is never a limit on the ability of the private sector to shift cost to the government," says John Douglas, a former FDIC general counsel who now advises banks as a partner at the law firm Davis, Polk & Wardell LLP.
The FDIC's inspector general has said he is examining the controls designed to ensure that banks play by the rules.
Since Jan. 1, 2008, 109 banks in 29 states have failed, ranging from one of the smallest banks in the country, Dwelling House Savings and Loan in Pittsburgh, a one-branch bank with $13.4 million of assets, to Washington Mutual, which had $307 billion of assets and was the largest bank failure in U.S. history.
Those collapses have cost the FDIC $40 billion, putting a huge dent in its reserves. The FDIC was created during the Depression to maintain consumer confidence in banks by guaranteeing deposits. If its deposit-insurance fund runs out, the FDIC would likely have to borrow money from the Treasury Department or slap higher fees on the banks whose contributions keep the fund afloat.
During the savings-and-loan crisis in the 1980s and early 1990s, more than 1,000 banks failed. The government set up the Resolution Trust Corp. to take over assets from failed banks and sell them. Such a structure doesn't exist now, which means that the FDIC has to take on those assets or somehow persuade healthy banks to do so.
Last year, the agency struck only a handful of loss-share deals with healthy banks. That left the government with lots of troubled loans from failed banks to sell.
"The hardest part today in the acquisition game is valuing assets or determining real equity, and with a loss share you can do that," says Len Williams, chief executive of Home Federal Bank in Idaho, which picked up $197 million in assets from the failed Community First Bank in Oregon on Aug. 7, most of it covered by a loss-share agreement.
Over the past 12 months, no bank has been a buyer of more failed banks than Stearns Bank of St. Cloud, Minn., which began as an agricultural bank. It bought the deposits and most of the assets of Horizon Bank in Pine City, Minn., on June 26; of Community National Bank of Sarasota County and First State Bank, both of Sarasota, Fla., on Aug. 7; and of ebank in Atlanta on Aug. 21.
It brokered loss-share arrangements on all the deals, covering $619 million in assets. The acquisitions expanded the bank's assets by 60%, with limited risk of future losses.
By comparison, when Stearns agreed to buy the deposits of failed Alpha Bank & Trust in Alpharetta, Ga., last year, loss-share deals hadn't yet become common. Stearns purchased just $39 million of Alpha's $354 million in assets, leaving the rest for the FDIC to sort out.
Stearns has entered into more loss-share deals than any other bank. "We have had to bid on [each of the banks], so everybody has had the same opportunity," says Chief Executive Norman Skalicky.
In most cases, the FDIC agrees to cover 80% of future losses on a big portion of the assets, and 95% on the rest. The FDIC says it doesn't anticipate facing the 95% loss-coverage scenario on any deal.
Typical assets include loans on commercial real-estate developments, condominiums and single-family homes. Banks are required to report at least every quarter on estimated loan losses, and to have a team in place working full time to maximize the value of the assets. Banks must get permission from the FDIC to sell any loans.
Big banks also have used the deals to grow with minimal risk. On Aug. 21, BBVA Compass, a unit of the giant Spanish company Banco Bilbao Vizcaya Argentaria, bought $12 billion in loans and other assets from the failed Guaranty Bank in Austin, Texas. As part of the deal, the FDIC said it would cover most losses on a $9.7 billion portion of that pool.
The Office of Thrift Supervision said last week that more than half of Guaranty's loans were "higher risk," including commercial, construction and land loans.
BBVA Compass said the deal would have the FDIC "bear 80% of the first $2.3 billion of losses and 95% of the losses above that threshold." Its chairman, José Maria Garcia Meyer-Dohner, described it as a "low-risk transaction." The arrangement made BBVA Compass the 15th largest bank in the U.S.
Veteran banker Joseph Evans saw the loss-share deals as a major opportunity.
He approached State Bank and Trust Co., a tiny bank in Pinehurst, Ga. with just $35 million in assets, with a proposition: He would take charge of the bank, find investors to pump $300 million of capital into it, then buy up the assets of failing banks in Georgia.
Mr. Evans, who has spent years selling distressed assets, recruited investors, and on July 24 he put his plan in motion. The FDIC shut down six affiliated Georgia banks and agreed to sell $2.4 billion of deposits and $2.4 billion of assets to Mr. Evans's team.
The FDIC agreed to absorb most losses on $1.7 billion of those assets. Overnight, the small bank became one of the largest in the state.
"From a turnaround guy's perspective, I've never had this kind of downside protection," Mr. Evans says. "I don't believe we would have either been interested or found interested investors to enter the banking industry at this moment in time, absent the FDIC assistance."
He says there's a good chance his team will make a strong profit. He estimates it will take roughly four years to work through the bad assets in the portfolio.
The FDIC wouldn't have to resort to such deals if it could easily sell the assets of failed banks. But last year, most healthy banks refused to bite.
In 20 of 2008's 25 failures, banks acquired less than 30% of the assets of the failed banks. When ANB Financial failed in Bentonville, Ark. on May 9, 2008, for example, Pulaski Bank and Trust Co. of Little Rock agreed to buy only $236 million of the $2.1 billion of the failed bank's assets.
Last month, Galena State Bank in Galena, Ill., bought most of the assets of failed Elizabeth State Bank in Elizabeth, Ill., under a loss-share agreement.
As a result, Galena's portfolio now includes delinquent loans on two log cabins in the area. Andrew Townsend, Galena's chief executive, say his people have yet to visit the properties, which were often rented out to tourists.
"There's a lot of work to getting your arms around everything and working through credit issues and conversion issues and valuation," he says. "Relatively speaking, that shouldn't take forever, and at the end of the day, we should have a nice pool of earning assets and clientele."
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