The Return of 'Good Bank-Bad Bank'

S&L-Era Approach Catches On Of Separating Loser Loans From Healthy Assets 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. Scott Pollack 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. "Given the current market disruption, we are cognizant of the need to be flexible, and we are willing to look at any proposals to assist our banks through this difficult period of time," says Timothy W. Long, senior deputy comptroller for bank-supervision policy at the Office of the Comptroller of the Currency. Struggling bond insurers are trying to implement their own good-bad structures, with Ambac Financial Group Inc. and MBIA Inc. looking to separate the business of guaranteeing lower-risk municipal bonds from structured securities that are performing poorly. Both firms are trying to gain regulatory approval to start new municipal-bond insurers. The best-known use of the good bank-bad bank structure in the U.S. was by Mellon Bank Corp., of Pittsburgh, which in 1988 created a new bank to house $1.4 billion in troubled loans. Back then, the Federal Deposit Insurance Corp. and Resolution Trust Corp. also dumped debt into bad-bank funds as a way of working through the savings-and-loan industry's meltdown. In 2001, FleetBoston Financial Corp. sold $1.35 billion in loans to a New York management boutique and transferred the assets to a bad-bank recovery fund. This time around, the good bank-bad bank structure could take several forms, according to analysts, including joint ventures between banks and real-estate investors interested in working out bad loans. But the basic concept is the same as it was two decades ago: putting a fence around troubled assets. In late 2007, San Francisco-based Wells Fargo & Co. put $12 billion in home-equity loans in a separate portfolio so that they can be liquidated by a separate management team. Earlier this year, BankAtlantic Bancorp, in Fort Lauderdale, Fla., parked $100 million in troubled loans in a new subsidiary. In May, National City Corp. Chief Executive Peter Raskind said that "various forms of good bank-bad bank structures" could be used to rid the troubled Cleveland bank of problem loans. In an interview last month, new Wachovia Corp. CEO Robert Steel wouldn't rule out a similar strategy at the Charlotte, N.C., bank. Many observers credit the original good bank-bad bank idea to Frank Cahouet, 76, the former CEO of Mellon, which was acquired last year and folded into what is now Bank of New York Mellon Corp. Despite its storied history, Mellon was in danger by 1988 of failing, overloaded with bad energy and real-estate loans made in Texas and Louisiana. Mr. Cahouet took an approach different from Chemical New York Corp., which in 1987 spun off problem energy and real-estate loans into a separate bank when it bought Texas Commerce Bankshares Inc. Mr. Cahouet created a new, federally chartered bank to liquidate troubled assets while leaving the "good" Mellon to recover on its own. The "bad" bank was financed with junk-bond notes, creating a capital shortage in the good bank that was filled with equity from Warburg Pincus LLC. Initially, regulators were reluctant to approve the bad bank, called Grant Street National Bank, because they worried it could set a bad precedent, Mr. Cahouet recalls. Eventually, the Federal Reserve and OCC went along. "The key was to get assets off our books and separate the companies," he said in an interview. Grant Street was the street where Mellon's headquarters were located at the time. Mr. Cahouet "wanted management to focus on the future, not just look at the past," says Michael Bleier, who set up the structure while working as Mellon's general counsel. Mr. Bleier now is a partner at law firm Reed Smith LLP in Pittsburgh. Warburg's $158 million investment in Grant Street generated $1.47 billion over 10 years, according to Warburg. The bank's bondholders were paid ahead of schedule, says Mr. Cahouet, and Grant Street was dissolved in 1995. To be sure, there is no guarantee that the good bank-bad bank strategy will work this time around. One hurdle: new legal and regulatory obstacles. Under current law, the parent bank is subject to a "cross-guarantee liability" that could hold the good bank responsible for the failure of an FDIC-insured bad bank. Also, the 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." Moving loans to a subsidiary typically requires a capital infusion to account for a markdown of the related assets. That could be the biggest challenge of all for banks with capital levels already being depleted by loan-loss provisions and write-offs. Given the scale of loan losses across the banking industry now, it may be that only the strongest players will be able to create bad banks. "It certainly is a viable option if you've got the wherewithal to do it," Mr. Douglas says.