Bull by the Horns

by Sheila Bair

  That was a problem, but particularly after the IndyMac failure and our protracted struggle to find buyers for the bank, I did not want to be in the business of running troubled banks. Fortunately, Jim Wigand, our resolutions whiz kid, came up with a solution.

  Usually, regulators can forecast months in advance when a bank is likely to fail. As previously discussed, bank failures are governed by something called “prompt corrective action.” That means that once a bank’s capital level falls below 2 percent, it has to be closed within ninety days unless it has some real prospect of raising capital. Based on the loss rates of a troubled bank’s portfolio, examiners will generally have a good idea of when the bank’s capital will dip below the 2 percent, triggering the ninety-day death watch.

  So as a troubled bank’s condition deteriorated, we would work closely with the other bank regulators to have the management actively hire a financial adviser and seek out investors, including other banks, to either buy the bank outright or invest additional capital in it. Because the bank management was soliciting the bidders, we avoided the signaling effect that would come from our involvement (though with some of the more difficult failures, we would have to get discreetly involved). Frequently, those efforts paid off and the bank was sold or recapitalized without failing. However, if the bank management was unsuccessful, its efforts to find new investors generally gave us a group of ready bidders who had already looked at the franchise and examined its loans. We would run our confidential auction a few days before the bank was closed and announce the acquirer on the day of the failure.

  That seamless transfer of bank deposits and assets was no more disruptive than any other type of bank acquisition. Closings would typically occur on Friday, and on Saturday morning, the failed banks’ customers could go to the same banking facilities and transact business as if nothing had happened. Indeed, from their standpoint, nothing had happened except a name change.

  The other problem we had, particularly during the depths of the recession, was steeply discounted bids based on uncertainties about how bad the economy would be and for how long. Loan default rates are heavily influenced by economic conditions. Economic uncertainty continues to this day, but it was particularly acute in 2008 and 2009. Without knowing with any degree of confidence how high losses on a failed bank’s loans could go, interested acquirers would give us very low bids. Again, through the good work of Jim Wigand and his marketing experts, we pulled a page out of the playbook Bill Seidman had used to move billions of dollars’ worth of troubled real estate loans in the last phases of the S&L debacle cleanup. To get its price up, we offered to share some of the risk of loss on the failed bank’s loans with the acquiring institution.

  Those loss-share agreements were subject to a lot of public misunderstanding, but without them, our losses would have been $40 billion, or 50 percent, higher. We simply couldn’t get decent bids on real estate loans—mortgages and commercial real estate. Because the outlook for these loans was so uncertain, buyers would assume a worst-case scenario and price the loans accordingly.

  But by agreeing to share the losses with the acquirer, we were able to attract many more bidders and substantially increase the amount they were willing to pay for the failed banks. Most important, by reducing the acquirers’ risk, we attracted other insured banks to bid on failed institutions. Healthy, well-run banks—the kind we wanted bidding—are generally a risk-averse bunch. They would not have otherwise wanted to assume future losses on loans originated by a failed bank, which, by definition, had been poorly managed. With loss share, they were willing to jump in.

  Why did we want other insured banks bidding on those failed institutions? There again, we could maximize our recoveries. By selling the loans to another bank, the failed bank’s deposits could finance the sale and provide funding to borrowers. Nonbank buyers would have to raise the cash to buy and fund the loans in the tough credit market. Selling one insured bank to another also preserved the continuity of banking services in the communities served by the failed bank. That is because other insured banks could acquire the whole bank, both deposits and loans.

  A bank’s most valuable customers are those who have multiple relationships with it, including both deposits and loans. Paying off the deposits and then separately selling off the loans to nonbank bidders would have destroyed those valuable relationships and made the franchise worth less. In addition, conveying the deposits together with the loans minimized the FDIC’s cash needs. If we separated them, we would have to write a big check when the bank failed to pay off the depositors and then wait for the subsequent loan sale to close before receiving any cash from purchasers. Selling both the deposits and the loans together minimized the amount of cash both the FDIC and the acquirer had to put into the transaction.

  Of course, by selling the whole bank, the acquirer would have to honor all of the insured deposit obligations. That wouldn’t be a problem if the value of the loans exceeded the acquiring bank’s obligations on the deposits; that is, in accounting parlance, if the assets exceeded the liabilities. But what if the loss rates on the loans were higher than the acquirer had anticipated? The loans would become much less valuable, but the acquirer would still be committed to honoring all of the insured deposits. That was the fear that dampened bid prices, and it was why we found it advantageous to provide loss sharing.

  Even with loss sharing, at times the value of the failed bank’s loans was so low that we would have to put cash into the deal to make sure all of the insured deposits were fully covered. In those instances, the press would make hay out of the fact that we were “giving” money to failed bank acquirers. They would consistently fail to point out that we were contributing the cash to make up for the shortfall between our obligations to insured depositors and the value of the failed banks’ loans.

  What if we hadn’t been able to convince healthy, insured banks to buy failed banks from us? Who else would buy failed bank assets? Primarily speculative investment funds—hedge funds and private equity. Some of those funds specialize in distressed assets. They are called, somewhat unkindly, “bottom feeders,” but their willingness to take risks in buying toxic assets plays an important role in economic recovery. Some of the funds saw the attractiveness in buying the whole bank from us, given the increased value in maintaining customer relationships as well as the reduced need for cash up front to buy the bank. So they started applying for bank charters and seeking approval to bid on failed banks.

  Because they generally had ample money to capitalize a new bank charter and could provide competent management, the chartering agencies (the OCC, the OTS, and the states) gave many of them charters, and we approved some of them to bid. However, we started seeing problems. For instance, some of their bids reflected plans to flip their investment right away. Some also were owned by shell holding company structures located in offshore tax havens. The true owners of the bank were not transparent to us. I didn’t want nameless sharpies buying banks from us just to make a quick buck. With an established insured bank, I knew who the owners were, I could see the management’s track record, and I could know the bank’s regulatory history. With the new banks created by hedge funds and venture capital firms, I didn’t know any of those things.

  As the number of failures escalated in 2009, we needed to find more qualified buyers to ensure a competitive auction process. Without multiple bidders, the prices we usually received on failed banks were very bad. So it wasn’t as though we were in a position to be picky about bidders. On the other hand, I cared about the reputation of FDIC-insured banks, and, most important, I didn’t want to see a failed bank coming back into our laps because the new management was more interested in turning a quick profit than responsibly providing banking services.

  So in July 2009242, I proposed to the FDIC board, and we approved for comment, a policy statement that put additional conditions on bidding by new banks backed by private equity. Perhaps the most important constraint: we proposed to require that the new banks mainta
in a 15 percent leverage ratio for the first three years—three times the 5 percent leverage requirement that applied to established banks. We also said that they had to keep their ownership interest for at least three years, to scare off flippers. Finally, we put very strict constraints on the ability of the bank to do business with any other entity owned by the same fund—so-called affiliate restrictions—and required that offshore owners make their books and records available to us as needed.

  Some of the funds really went after us, including the Carlyle Group and WL Ross & Co. However, others, including Deryck Maughan at Kohlberg Kravis Roberts, came to our defense. And much to my surprise, we received support from the usually antiregulation Wall Street Journal editorial board. Saying that “the FDIC is right243 to drive a hard bargain for taxpayers,” the newspaper’s editors went on to conclude that “the FDIC is being roughed up—even by some in the Obama Treasury—for demanding capital and other standards from nonbank investors who won’t have to meet current bank holding company rules. This is not the way to restore confidence in the banking system.”

  However, industry lobbying continued and the lobbyists made headway with some of my board members, notably John Dugan. To keep my board together, I fell back a bit on the higher capital requirement. We reduced it244 to 10 percent but required that the entire amount be filled with the highest-quality capital: tangible common equity. The private-equity funds still squawked, but they also kept bidding, and overall I think we struck the right balance.

  Some of our sales to banks backed by private equity went through before the policy statement was finalized. The two most controversial of those was our sale of IndyMac to a consortium of investors, which included funds run by J.C. Flowers & Co. and John Paulson. The other was the sale of a Florida bank, BankUnited, to a new charter that was backed primarily by WL Ross & Co. and the Carlyle Group. Both of those deals made significant money for the acquirers, and both drew a lot of adverse press attention. However, both of the failed thrifts had a large volume of highly toxic mortgages in two of the most distressed housing markets in the nation. We beat the bushes for buyers and ran a competitive auction process, and those consortiums made the winning bids. The reality is that those who are brave enough to buy distressed companies in a down market—whether banks or any other type of company—expect to make a return commensurate with the risks they are taking. The FDIC, as seller, had no good options. Those sales gave us the best recoveries possible. Our total losses during my tenure were around $80 billion—all paid for by the industry. Though that number sounds high245, it pales in comparison to the eye-popping numbers some industry analysts had been projecting. Even OMB had predicted significantly higher losses for the DIF than those we actually realized.

  Notwithstanding the adverse media coverage of a few of the transactions, our strategy of selling whole banks with loss share proved to be enormously successful in minimizing our losses while providing seamless protection for insured depositors and continued services for all bank customers. It was also a highly efficient way to deal with the large number of bank failures that we experienced through 2010. We had only 3 failures in 2007, representing total assets of about $2.6 billion. The next year, we had 25, but they represented a whopping $373 billion in assets, with the failure of WaMu and other large thrifts. In 2009, the number ballooned to 140, representing $171 billion in assets, and it peaked at 157 in 2010, though those were smaller failures, with assets totaling $97 billion. The bank failure rate was tapering off as I left office. The number of failures in 2011 was “only” 92 banks, representing total assets of $36 billion.

  That is not to say that all of the smaller bank failures were as smooth as silk. Some presented unique challenges. For instance, there was an $11 billion West Coast bank—United Commercial Bank (UCB)—that specialized in serving the Asian community. It had a subsidiary in China that was regulated by the Chinese Banking Regulatory Commission (CBRC) and branches in Hong Kong, which were regulated by the Hong Kong Monetary Authority (HKMA). In addition, one of its owners was a major Chinese bank, Minsheng. In November 2008, UCB’s holding company had been approved for a TARP capital investment of about $300 million, amid the frenzy of stabilization measures and the rush to get TARP capital out to smaller institutions to support their lending. (Subsequent investigation found that UCB’s managers had committed extensive fraud to conceal their troubled loans from bank examiners as well as their auditors and investors.)

  Because of the complexities of cross-border resolutions, we notified both the CBRC and the HKMA months in advance of the bank’s projected failure date to make sure they would provide the necessary regulatory approvals when it came time for us to sell the bank and its Asian operations. In discussions with CBRC, it came to light that Minsheng was interested in buying UCB. That would have been a great result from the standpoint of protecting the U.S. government against losses; it would have averted a failure and prevented losses to both the FDIC and the Treasury Department.

  There was just one catch246: the Fed would not let foreign banks acquire U.S. institutions unless it found that they had high-quality regulation in their home country. The Fed had not yet made that determination for China, which frustrated me no end. I had always found the CBRC—then led by Chairman Liu Mingkang—to be a serious, conservative, and prudent regulator. Whatever other issues and disagreements the United States has with China, I really didn’t see how allowing Minsheng to buy the bank would violate U.S. public policy goals. But I suspect that the Fed—already reeling from public criticism, particularly from the right—didn’t want to take on the issue of whether a Chinese bank should be able to buy a U.S. bank. It seemed to me that the acquisition of that relatively small bank by a Chinese bank could have provided a good test case for the Fed, but the Fed did not feel that it had time to fully consider the Minsheng acquisition. (In May 2012, the Fed finally gave approval to Chinese banks to invest in U.S. depository institutions.) So UCB failed, and we sold it to another Asian-oriented U.S. institution, East West Bank, and the FDIC took a $2.5 billion loss on it. The Treasury lost its $300 million investment, and Minsheng, as a large shareholder, lost its $120 million investment. On the positive side, the sale went smoothly. The Asian operations were also sold to East West, with all required approvals from the Chinese regulators.

  Another one of our more challenging tasks: fully 25 percent of the Puerto Rican banking system failed in April 2010. We had been planning for the failures for months. The Puerto Rican economy had been hurt badly in 2005, when Congress had revoked special tax benefits that had drawn a large number of manufacturers and pharmaceutical companies to the island. Its energetic, charismatic governor, Luis Fortuño, was working diligently to rebuild the economy, but his efforts were not enough to save the Puerto Rican banking industry. The island had suffered a double whammy with the 2005 tax change and then the 2008 recession. Three of its banks, R-G Premier Bank, Westernbank, and Eurobank, were slowly but surely heading for insolvency.

  Because of the island’s economic woes, we were not optimistic that we could attract the support of bidders apart from the banks that were already doing business in Puerto Rico. That created a unique problem, because none of the Puerto Rican banks was in very good shape. But if we didn’t qualify any of the stronger local banks to bid, we would likely have to liquidate the failed banks, with enormous losses for us and enormous consequences for the Puerto Rican economy. For a while, we toyed with the idea of letting bidding banks contribute some of their own troubled loans into a loss-share pool. That would strengthen their balance sheets and put them into a better position to absorb the failing institutions. On the other hand, that came dangerously close to a bailout of the acquiring banks, which was prohibited by our statute and anathema to our culture. After batting the idea around for several weeks, we finally dropped it.

  We ended up qualifying all but one of the local banks to bid. We concluded that they would be in a much stronger competitive position with consolidation. That conclusion was r
einforced by the fact that the healthier local banks were able to raise almost $2 billion in new capital as investors anticipated that many of their competitors would fail. The island’s banking industry was far too large for the needs of its struggling economy, but with consolidation, investors saw the potential for significant profits as the Puerto Rican economy continued to improve.

  As it turned out, the bids were surprisingly strong, and our losses ended up being much lower than expected. Five bidders came forward; all but one already owned banking interests on the island. The one that did not, Santander, bid primarily because I had called its CEO, Emilio Botín, and asked him to. I don’t think Santander’s heart was in it, but just by being a part of the process, it kept the other bidders honest and helped us achieve better pricing. The island’s largest bank, Banco Popular, acquired Westernbank. The tiny but very healthy Oriental Bank and Trust bought Eurobank; and Scotiabank, backed by the deep pockets of Canada’s Bank of Nova Scotia, bought R-G Premier Bank. I hailed the strong bidding interest as an “inflection point” in our failed-bank resolution process. With an economy gaining some strength, even in Puerto Rico, more investors were starting to come in and commit substantial capital to failed-bank acquisitions. Indeed, after the Puerto Rico failures, our pricing improved, and we even started doing some sales without loss share.

  Puerto Rico also presented a challenge because the Puerto Rican citizenry was not as familiar with the FDIC as were citizens on the mainland. Given the close-knit nature of the Puerto Rican banking industry and the scope of its problems, we were very concerned that Puerto Ricans would lose confidence and run all of the banks, not just the weak ones. So we worked closely with the Puerto Rican government on a public education campaign months in advance of the bank failures. In addition, I personally visited the island on April 30, 2010, the day of the three bank failures, to provide media interviews and participate in a press conference with local government officials. Accompanied by Bob Schoppe, a senior staff member of our resolutions division, I attended staff meetings in preparation for the Friday evening closings and observed first hand our closing of R-G Premier.