Tanking banks and M&A

Over the last 18 months, the financial services industry has been turned on its head, bearing witness to more than 125 bank failures during that period. And many more bank failures are on the way. At the same time, there has been a clear line drawn in the sand by the U.S. Treasury -- a line between those banks fortunate enough to receive Troubled Asset Relief Program funds and other forms of government assistance, and those banks that have been left to solve the riddle of their future on their own.

During this period of profound dislocation and disruption, the market has seen the expected uptick in bank consolidation, but not in a form that many of us would recognize. In this current wave of bank consolidation, the seller is nearly always the Federal Deposit Insurance Corp., and the buyer often is the party receiving the consideration. How can that be?

To understand the current environment, it is important to understand the problems that banks are facing and the reasons that banks are being closed. In short, banks are subject to minimum regulatory capital requirements, meaning that they must maintain an appropriate capital cushion to protect against future losses. The larger the anticipated future losses, the larger the necessary capital cushion. As the economy in general, and the real estate market in particular, have collapsed, banks have been forced to record greater current period losses in respect of actual current period losses and, more importantly, the anticipated future performance of their loan portfolio, thus eroding their capital cushion and compromising their ability to comply with regulatory capital requirements. When a bank's capital position becomes precariously low -- such that bank regulatory authorities believe that the bank is operating in an unsafe and unsound manner -- the appropriate bank regulatory authorities ultimately close the bank. And, to make matters worse, the private and public capital markets have been closed to most banks, such that they are unable to improve their capital positions, even at prices so dilutive that the capital-raising transaction effectively would be tantamount to a sale of the institution.

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While there are plenty of potential buyers out there -- in the form of healthy, competitor banks and other strategic buyers, as well as private equity investors -- there are two principal factors that work to dissuade many of these would-be purchasers from buying a troubled bank.

First, there is the problem of determining the "size of the hole" -- that is, the amount of capital that the target bank needs to return to a well-capitalized position under regulatory standards. This requires that a host of inherently subjective, and therefore uncertain, assumptions and conclusions be made, and it exposes an acquirer to the risk that more capital is needed than originally was anticipated.

Second, the FDIC has made it substantially more attractive for an acquirer to simply wait until the troubled bank ultimately fails, and to acquire some or all of that failed bank and its assets from the FDIC, often with the benefit of attractive downside protection features.

As a result, many astute purchasers are not rushing in to acquire troubled banks, but instead are positioning themselves to cut a deal with the FDIC in a receivership setting. This approach has worked to significantly reduce the volume of classic merger and acquisition activity that has been a hallmark of the banking sector.

In the course of unraveling failed banks, the FDIC is charged with pursuing the approach that offers the "least cost resolution" in an effort to minimize the loss to the FDIC's insurance fund. There are three basic resolution techniques to choose from: (1) a payout, where the FDIC simply returns money to depositors, up to insured limits, and then auctions off the assets; (2) a purchase and assumption, where another bank assumes the deposits of the failing bank, and then has the right to "cherry pick" those of the failed bank's assets that it wishes to acquire, leaving the FDIC to auction off the remainder of the assets; and (3) a loss-sharing arrangement, where the acquirer agrees to take on the entire failed bank, and the FDIC agrees to protect the acquirer against losses by providing financial support in respect of troubled assets.

In all three of these scenarios, the troubled bank must first be closed, and the failed bank's shareholders thus lose their entire investment. In short, these scenarios are not a recipe for anything but the transition of the failed institution.

The FDIC's Resolutions Handbook does contemplate an additional resolution technique known as open bank assistance. Under this approach, the FDIC provides financial assistance to the troubled bank while it is still open, generally with a view toward facilitating the acquisition of that troubled bank by another institution. While open bank assistance is an option for the FDIC, and while it would make a tremendous amount of sense in light of least-cost resolution and social considerations, the FDIC has not completed an open bank assistance transaction in more than 19 years. The FDIC's resistance to open bank assistance is, at least in part, borne out of the fact that the FDIC is opposed to the notion of a troubled bank's shareholders benefitting from the FDIC's financial assistance.

The current bank consolidation model lends itself to a fair amount of criticism. In particular, given the extreme degree of co-mingling that the FDIC's funds and the Treasury's funds have experienced to date, as well as the inconsistencies among various governmental policies and initiatives, there is a compelling argument that the FDIC should simply offer open bank assistance to institutions that otherwise would fail, or that the FDIC and Treasury should collaborate to recapitalize the troubled institution to prevent its failure. These actions would likely result in no greater cost to the FDIC's insurance fund, would preserve jobs, customer relationships and franchise value, and would support the community in which the troubled bank operates. Moreover, by permitting the troubled bank to retain and seek to resolve over time its troubled assets, rather than having those same assets sold by an acquirer or the FDIC in a resolution setting, this approach would work to support real estate prices at a time when that price support desperately is needed.

Absent a dramatic improvement in the real estate industry and the broader economy, many banks will continue to search for a solution to their capital needs. However, in order to attract capital, banks must demonstrate that the capital will be enough to address long-term needs, and that the bank can find a way to be profitable after removing the layer of real estate lending and brokered deposits that have been superimposed on their core franchise. In the end, bank failures will continue for some period of time, leaving the strongest banks in a position to opportunistically build out their platform with government support.

Perhaps the most important wild card in all of this is the regulatory reaction. To date, we still haven't seen the "never again" regulation that undoubtedly will be adopted in an effort to prevent this flavor of bank crisis from recurring any time soon. While this may be appropriate, the timing and nature of that regulation should be carefully considered, especially given the potential negative effects that it could have on an already weak banking market.

Mark C. Kanaly of Alston & Bird LLP concentrates his practice on the transactional and regulatory issues confronted by companies in the financial services and products arena. Chris C. Frieden is a partner in the financial services and products group of Alston & Bird focusing on public and private mergers, and acquisitions and corporate finance transactions in the financial services industry.

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