Banking Law

An article in The Wall Street Journal (paid subscription required) last month prompted some inquiries about the good bank-bad bank strategy from the good old-bad old days of the 1980s.

James Dierberg, the 71-year-old chairman of First Banks Inc., is dipping into an old playbook to deal with the U.S. banking industry's worst crisis in a generation.

Mr. Dierberg and his family, which control the St. Louis bank, recently pledged $100 million to a new subsidiary that will absorb the most troubled loans now dragging down First Banks, allowing the bank to strengthen its capital levels and shed the distractions of its souring portfolio. The new unit, called FB Holdings LLC, will try to liquidate the problem loans "at a more opportune time," says Terrance McCarthy, president and chief executive of First Banks.

The push by First Banks, which posted a net loss of $39.9 million in the second quarter that was fueled by an $84.1 million loan-loss provision, marks the return of the "good bank-bad bank" technique used in the late 1980s and early 1990s to rehabilitate damaged financial institutions.

The comeback is likely to accelerate as banks scramble to escape loan woes. Regulators seem open-minded about the idea, even though it has the effect of essentially erasing problems from a bank's balance sheet without resolving the underlying loans.

In the 1980s, this type of restructuring was used by a number of banks, including some large multi-bank holding companies in Texas, to get bad loans off the balance sheets of those banks that the holding company thought had a chance to survive, so that those "good banks" wouldn't be impacted by further deterioration in the future poor performance of those loans or by additional write-downs in the value of the real estate collateral that everyone was sure were coming. Ultimately, the tactic didn't save most of the largest home-grown Texas bank holding companies. They failed (other than Frost Bank). Moreover, FIRREA, enacted in August 1989, included a provision that pledges the capital of each bank controlled by the same holding company as support for all other banks within the holding company umbrella. In other words, if one bank goes down, all the others may go down. This "cross-guaranty" provision presents some problems for the use of a "bad bank" structure (or otherwise trying to shift bad assets among the banks of a multi-bank holding company). The holding company needs to move the assets outside the holding company structure.

Even that might not work, as The Journal's authors note, because of the Federal Reserve Board's so-called "source of strength doctrine."

[T]he Federal Reserve's "source of strength" rule requires bank-holding companies to support their subsidiary banks, said Chip MacDonald, a banking attorney with Jones Day in Atlanta.

 

But John Douglas, a former FDIC counsel, said that if loans are taken out of the bank's holding company, the cross-guarantee liability doesn't apply. The source-of-strength doctrine is "more myth than fact," he adds. The courts "have never forced a bank-holding company to put money in a bank subsidiary."

John's correct. In a footnote to a 2004 FRB New York Staff Paper prepared by Adam B. Ashcraft, the author relates how the source of strength doctrine was ruled unenforceable by a federal appeals court (the Fifth Circuit, by the way), although the Supreme Court has not ruled on the issue. In addition, the FDIC apparently so doubted the doctrine's enforceability that it settled with two other failed Texas bank holding companies in bankruptcy proceedings where the companies sued to recover money they had been pressured to downstream into their failed banks shortly before the banks were seized (and the holding companies filed bankruptcy). On the other hand, Mr. Ashcraft argues that the FIRREA cross-liability provisions "strengthened" the source of strength doctrine. John Douglas doesn't agree, obviously. Let's all agree that the issue is not entirely free from dispute.

One of the biggest practical challenges to the use of the strategy to offload distressed loans is that the loans are transferred to the bad bank at their written down value, and the capital of the good bank usually takes a hit (to the extent it hasn't already recognized the loss). The Journal correctly states that this is often a major hurdle for already troubled banks. It's also an argument that if a bank is going to use this structure, "the sooner-the-better" may very well be the best policy. As John Douglas says, you can do it only if you have the "wherewithal" to do it and, therefore, only the strongest banks may be able to take advantage of it.

Notwithstanding the obstacles, I know banks who've done it and other banks who are taking a hard look at doing it. I hope it works out better for everyone than it did in Texas in the late 1980s. It certainly couldn't work out any worse.