The Devil's Triangle of Bank Failure (part 2)

In the last post, I discussed the FDIC’s three roles, as bank regulator, insurer of certain deposits and receiver for failed banks, and how hard it is to figure out from official sources if a bank is in trouble.   One final related point: although it can be difficult to figure out if a bank is in trouble, there are some sources that can help one make that determination.  There are certain private “watch lists” that, for a fee, will disclose to you their opinions about a bank’s health based on their proprietary research.   In addition, the Calculated Risk blog,  which periodically (usually on Fridays) posts an unofficial list of troubled banks among the many other treasures of economic data in that blog.In this post, I’ll discuss the five basic options that the FDIC has to handle a failed bank and its process for doing so.The five options are:1. open bank assistance; 2. management change; 3. purchase and assumption transactions; 4. receivership; and 5. depositor payoff.These options are described, along with some commentary about the FDIC’s choices of methods, in the FDIC’s Resolutions Handbook.  Though a bit dated because it was last updated in 2003, the Resolutions Handbook provides an extensive description about the FDIC’s official resolution process. FDIC  process.  The FDIC “resolution” process usually takes about 90 to 120 days, but much of this process occurs in secret before the official closure of a failing bank, and typically without notice to most of the bank’s employees.  Once the FDIC gets the needed data about the bank, a team of FDIC resolution specialists analyzes the condition of the failing bank.  This team estimates the value of the bank’s assets, generally using a statistical sampling procedure to populate valuation models (because it does not have enough time to assess every asset).   For each category of loans, the FDIC identifies a sample, reviewing selected loans to establish an estimated liquidation value based on discounted future cash flows and collection expenses.   A loss factor for that category of loans is derived and is applied to all of the failed bank’s loans in that category.  Least costly resolution is required.  Since 1991, the FDIC has been subject to federal laws that require it to use the type of resolution process that is the least costly of all possible options. The FDIC’s determination of which resolution will cost the government least, over time on a net present value basis, governs its choice. The cost to the FDIC can vary depending on a wide range of factors, including the premium paid by the acquirer that is agreeing to purchase the deposits and perhaps the assets (loans of the failed bank), the likely losses on contingent claims, the estimated value of the failed bank’s assets and liabilities, the levels of insured and uninsured liabilities, any cross-guarantees available against the failed bank’s affiliates, and the cost of collecting on assets not transferred in purchase and assumption deals.Any losses are to be borne first by equity investors (shareholders) and unsecured creditors, who are supposed to absorb all losses before the depositors.  The remaining loss is shared by the FDIC and customers with uninsured deposits, as the FDIC shares all amounts it collects proportionately with uninsured customers. Open Bank Assistance (“OBA”) and Similar Devices.  The FDIC can leave a troubled bank open and pump assistance into it.  This option has not been used frequently by the FDIC since the savings and loan crisis in 1989, when the FDIC started comparing the cost of such OBA proposals against selling failed bank assets via competitive bidding, and found that selling assets usually cost less. In addition, in a 1992 policy statement, the FDIC announced that its concerns about bank soundness would require that it make certain positive findings concerning the competency of management of an institution after an OBA transaction.   In 1987, the FDIC was first authorized to establish free-standing “bridge banks,” meaning temporary banks created to service a failed bank’s assets prior to their sale.  A bridge bank provides the FDIC more time to find a permanent solution for resolving a significant collection of assets.  These and other policies changed the FDIC’s preference from leaving a troubled bank’s assets in the hands of its original management.  As a result of such less expensive policy options, OBAs are no longer commonly used, unless required by threatened systemic risks to the financial system, as seen in late 2008 and early 2009 when the Troubled Asset Relief Program provided billions of dollars to banks deemed by the government as “too big to fail.”A number of similar programs, which amount to propping up or deliberately overlooking some of a troubled bank’s failings, also have been used from time to time. These include net worth certificates, essentially a temporary fiat that the bank will be deemed to have more reserves than its examination verifies; and other forms of income maintenance and regulatory forbearance in which a bank is acknowledged (at least privately between the regulators and the bank’s management and board) to have defects in its balance sheet or sound practices, but permitted to continue to operate, generally subject to certain conditions.  Few of these methods, though, preserve the possible value of a troubled bank’s assets — or minimize the running losses — as quickly as an asset sale (“Purchase & Assumption”) transaction, so in the current decade, these older options tend not to be favored.Management Change.  While this option is not found in the FDIC’s official resolution playbook, the FDIC appears to use it with some frequency.  As a regulated industry, banks always are subject to “safety and soundness” supervision, and to continuing vigilance over the qualifications, competency and absence of conflicts of interest of a bank’s senior management and board of directors.  The wide-ranging powers of a bank’s principal regulators to unilaterally remove a bank’s management are difficult to challenge.  This uneven power relationship is rarely far from the minds of senior management; a bank’s reduced health often gives the FDIC a control-change hair trigger to use in negotiations.  Most of the large-scale bank merger and sale transactions accomplished at the beginning of the current wave of resolutions in 2008 clearly were regulator-instigated.  News reports  suggest that even management of some buying institutions may have felt that that their jobs were threatened if they did not accept federal bank regulators’ urgently suggested rescue transactions.  In their business dealings with banks, counterparties should be sensitive to the bank’s loss of flexibility and other changes in tone;  such changes can indicate trouble is brewing.Purchase and Assumption Transactions.  Purchase and Assumption transactions currently are the FDIC’s most favored procedure for resolution. Through this procedure, the failed bank, or some of it, is sold to a healthy acquirer.  The buyer assumes certain liabilities (deposits foremost), in return for assets and, usually, some federal assistance/risk protection. If the FDIC decides that a Purchase and Assumption transaction is the most cost-effective resolution, it will choose whether to sell the failed bank as a whole or in parts, what assets should be offered for sale, how to package them, whether loss sharing will be offered, and at what price the assets should be sold. Operating under strict confidentiality prior to the bank closure, the FDIC markets the failing bank as broadly as possible to its list of approved potential acquirers.  Acquirers, who must have adequate funds, may be either financial institutions or private investors seeking a new bank charter. Typically, all bidders are invited to an information meeting, sign confidentiality agreements, and are provided with an information package prepared by the FDIC’s resolution team.  The deal terms usually focus on the treatment of the deposits and assets held by the failing bank. Once the bidders’ due diligence is complete, each bidder submits its proposal to the FDIC.  A typical process might require bid submission 1 – 2 weeks before the scheduled closing.  The FDIC evaluates the bids to determine which is the least cost bid, and compares them to the FDIC’s estimated cost of liquidation.We’ve been informed that many of the FDIC deals are structured essentially as “as – is” deals, with negotiation allowed over price, and possibly downside loss protections, but not much negotiation of other terms.  This makes some sense in light of the large current and anticipated volume of resolution transactions facing the FDIC, and its desire to assure lowest-cost outcomes by letting the market set the prices, thus reducing the risk that the resolution will be second-guessed later. The FDIC submits a written request for approval of the negotiated Purchase and Assumption transaction to the FDIC Board of Directors.  Following Board approval, the FDIC notifies the acquirer (or acquirers, if assets of the failed bank are split up), all unsuccessful bidders and the failing bank’s chartering agency; arranges for the acquirer to sign all needed legal documents; and coordinates the mechanics of the closing with the acquirer.  After the FDIC closes the bank, typically on a Friday, the acquirer reopens, usually on the next business day. If the Purchase and Assumption Transaction includes continuing help, such as loss sharing, from the FDIC, then the FDIC monitors the assistance payments until the agreement expires, which may take several years.If the resolution of a failing bank  is not completed before the bank fails, or before there’s a run on the bank or other liquidity crisis for the bank, the FDIC may not have time to conduct the careful valuation and analysis needed for a Purchase and Assumption transaction.   In that case, the FDIC must use its other options, by electing to pay off the insured deposits, to transfer the insured deposits to another bank or to form a bridge bank.  To avoid those typically more expensive and therefore less desirable results, the FDIC prefers speed and relative secrecy in its Purchase and Assumption deals.Receivership.   If a Purchase and Assumption transaction is the FDIC’s “carrot,” its power to undo a failed bank’s deals in a receivership is the “stick.”  Most bank receiverships are administered by the FDIC who, as the insurer and protector of the bank’s depositor claimants, represents what often is a troubled bank’s largest creditor group. The formal rules of a receivership proceed much like a corporate bankruptcy: based on a finding that the institution is insolvent, the “receiver” takes over for the bank’s management, many claimants are required to make their claim known rapidly in a formal process or lose their rights, the receivership can “stay” litigation against the bank and undo fraudulent conveyances, the regulator can clean up or reject many of the bank’s liabilities using other special legal powers that change or ignore the bank’s legal obligations, and the regulator can sell off, liquidate or close pieces of the bank’s business or the entire business as a whole. But there are some serious differences between receivership and conventional bankruptcy.  But there are some tremendous differences between receivership and conventional bankruptcy, so the analogy only goes so far.  For one thing. the finding of insolvency, which generally comes from the institution’s lead regulator, e.g., the OCC for national banks, OTS for thrifts, etc., is discretionary to the regulator, and based on special regulatory accounting principles (not GAAP).  Receivers simply do not have anywhere near the same degree of responsibility, liability or obligation to listen to creditors, as typically are enjoyed by creditors in a corporate bankruptcy.Another significant unique feature of bank insolvencies is the special priority of deposit accounts, in an insolvent bank’s estate, under the National Depositor Preference Act and FDIC insurance rules. Whatever funds are available in the bank’s resolution or liquidation will, after receivership costs, generally be applied first to pay off insured deposits.  This means that there’s a whole (and usually large) class of creditors ahead of general unsecured, contract and trade creditors of the bank, who may get nothing, unless the assets are sufficient to pay off all of the depositors in full first.The avoiding powers that an FDIC receiver has, under 12 U.S.C. Section 1821, also are far broader and more powerful than those in an ordinary bankruptcy.  Ongoing contracts with a bank may be “repudiated” (e.g., broken) if the regulator simply decides that they are disadvantageous to the bank, within a “reasonable” time; or if the regulator is dissatisfied with the bank’s original level of paperwork and approval of the contract. These expanded powers may overturn ongoing leases; the unperformed parts of partially completed contracts, including loan funding commitments; and apparently the bank’s issued letters of credit.  A party can sue the receivership for its damages for a repudiated contract … but only “actual” (not consequential or punitive) damages are allowed, and the claims will be paid off as a general unsecured claim with the same dubious after-the-depositors chance of payment as the trade creditors.  Finally, the FDIC as receiver can prevent a counterparty from enforcing most contract clauses that are specifically triggered by a bank insolvency or receivership.Depositor Payoff.  The backstop option for the FDIC – which it tries to avoid — is a straight payoff of federally insured depositors from the FDIC’s insurance funds.  As this option comes at relatively high cost to the insurance funds, and occurs when total assets fall short and there is no lower-cost option, other counterparties of the bank frequently lose their rights.Practical and Tactical Considerations in a P&A.  Three things should be noted in connection with this currently most common form of resolution.First, it creates some interesting asset purchase opportunities for institutions and investors.  Like any regulated government bidding process, careful attention to the rules, and speed, and the advice of experienced counsel with regulated assets expertise, is essential.  Qualifying as a bidder, at the right time and place, and navigating through the precise offer being made, require agility.Second, from the viewpoint of a bank’s borrower, creditor or contractual counterparty, use of P&A transactions will quickly sort out that entity’s deal into either a pool of assets and obligations to be sold, and thus very possibly ride through the bank’s resolution as just another special case of a change of lender, or into a bucket of the bank’s operating obligations.  In the latter case, the survival, repudiation or other future fortunes of that entity’s deal depend on the receiver’s choice whether to sell the whole bank or the parts of its business relevant to the deal.  If a bank asset or obligation is not transferred to an acquiror, that asset or obligation will likely be handled by the FDIC through the resolution process, and this is likely to be very slow from the point of view of the original bank’s counterparty.Finally, it cannot be emphasized enough that the current FDIC prefers speed, and usually, relative secrecy, in its P&A deals.  Recently, Calculated Risk ran a helpful pointer to an interview in the Orange County Register in which one healthy bank CEO describes his actual experience with shopping for an bank asset sale. The buyer indicated interest, assembled a quick bid, quickly conducted the diligence with the FDIC on-site under the nose of the (unknowing) troubled bank’s employees, and wrapped it all up in a few days:”We finished up on a Thursday and had to provide a bid the following Tuesday. The next day (Wednesday June 24) they asked for some clarification … Thursday … they notified us that our bid was accepted. … Then it happened that Friday at 4 p.m. They went in and took over the bank and we followed them.”In a later post, I’ll discuss some of the impacts the FDIC resolution of a bank  can have on various counterparties who were doing business with the failed bank before it was closed.