Academic journal article New England Economic Review

The Advantages of 'Transferable Puts' for Loans at Failed Banks

Academic journal article New England Economic Review

The Advantages of 'Transferable Puts' for Loans at Failed Banks

Article excerpt

In testimony on February 3, 1992 before the Committee on Banking, Housing, and Urban Affairs of the United States Senate, Richard F. Syron, President of the Federal Reserve Bank of Boston, proposed a mechanism to help relieve current credit availability problems by making existing FDIC guarantees of loans transferable throughout the private financial system. This article examines Mr. Syron's rationale for the proposal and how it might work.

Problems with reduced credit availability have always received widespread attention. Previous episodes resulted from the flow of deposits out of banks in response to rising market interest rates, in the face of regulatory ceilings on bank interest rate payments. The current "credit crunch" has occurred even though interest rates have been falling, rather than rising, and even though deregulation has eliminated the regulatory impediments to banks' offering market rates to depositors. Because this credit crunch is taking place in a very different economic environment, alternative explanations are needed for the conditions motivating problems in credit availability. Recent research by Bernanke and Lown (1991) and Peek and Rosengren (1992a, 1992b) has focused on the role of capital regulation. Banks with depleted capital have been forced to shrink their balance sheets, frequently by reducing loans, in order to satisfy capital-to-asset ratios enforced by regulators. This article focuses on a second mechanism reducing credit availability, namely the procedure for resolving the assets of failed banks.

The number of failed banks is much larger than in previous recessions. In 1991, 124 commercial banks were closed in the United States, compared to 42 in 1982. In some regions, and particularly in New England, the recent problems have been especially acute, with 46 failures in 1991 compared to one in 1982. Not only did the institution with the most deposits in New England fail (Bank of New England), but in New Hampshire, five of the seven largest depository institutions failed. In regions with many failed institutions, the handling of loans by the Federal Deposit Insurance Corporation (FDIC) is a critical determinant of credit availability.

A second distinctive feature of the current problems has been the rapid growth in "performing nonperforming loans," loans current on payments of principal and interest whose collateral value has dropped below the value of the loan. In a healthy institution, the lender would have an incentive to work with the borrower so long as the lender had a reasonable expectation of receiving full payment eventually. Now, however, many of these loans are in the portfolios of failed banks whose assets are controlled by the FDIC. In just one failed bank acquisition, that of Bank of New England, $1.4 billion in performing nonperforming loans was transferred to the FDIC.

When a bank fails, the FDIC normally tries to find a bank to buy the deposits and good assets of the failed bank. Because the extent of problem assets may not be immediately clear, the FDIC normally allows the acquiring banks to return substandard loans, including performing nonperforming loans, to the FDIC for full face value during the first year after the acquisition. This "put" to the FDIC is at a discount to the full face value after the first year and normally does not exceed three years.

Once assets have been put back to the FDIC, they are normally transferred into a "bad asset" pool. The FDIC usually contracts to have these assets managed by collecting agencies, which are instructed to maximize the cash flow to the FDIC, after appropriately discounting for the time value of money for cash received in the future.(1) These management contracts provide neither the incentive nor the ability to work out loans in the way that might have been done, had the borrower had a relationship with a well-capitalized bank. As a result, too many loans are foreclosed.

This article discusses an alternative way to treat performing nonperforming loans. …

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