Is It a Good Time for a "Bad Bank"? Variations on an Old Tool May Help Banks Beset with Troubled Real Estate Loans and More

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Banks of all sizes are eligible for, and are assessing the potential use that they can make of mid-March's federal Public-Private Partnership Investment Program, designed to remove the burden of both "legacy" loans and legacy securities from their balance sheets. But already, a handful of institutions have launched efforts trying a private-sector strategy, the so-called "bad bank."

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These "bad banks" are single-company efforts to offload bad loans to a better position under each holding company's umbrella.

Will the federal program eclipse private-sector efforts? Or will this tool begin to catch on, especially as the anticipated deterioration in commercial real estate loans materializes?

Many details remain to be made clear of the brand-new, much-awaited federal effort. In addition, the reception of the private investor community toward the program will only be revealed over time. One point that is clear, although the government's announcement dwelled on examples related to residential mortgage pools and residential mortgage-backed securities: the federal program is intended for both residential and commercial real estate credits. On page five of the Treasury Department's white paper, it states that the "primary areas of focus for the government's troubled legacy asset programs are the residential and commercial mortgage sectors, including both whole loans and securitizations...."

Several different "bad bank" models have been launched in the last year by banking companies on their own. And back when the industry's only problem seemed to be the "structured investment vehicles," there was talk of the nation's mega-banks forming a sort of bad bank, with federal facilitation. (That never worked out.) We'll summarize each of these recent efforts, after looking at the roots of the concept. We'll also examine a potential structure that may be used by smaller community banks.

Germ of the idea from Crocker

Turn back the clock to 1986. Banking troubleshooter Frank Cahouet became head of California's Crocker National Bank. In seeking ways to clean up the troubled West Coast lender, Cahouet thought outside the box--literally. He convinced the bank's parent, the U.K.'s Midland Bank PLC, to buy $3.5 billion of Crocker's bad loans. Having sent the loans to a Midland workout group, Cahouet now had a relatively clean bank, and this enabled him to sell Crocker.

Cahouet arrived at Mellon Bank, N.A., with this fledgling concept, recalls Michael E. Bleier, then general counsel for Mellon and its parent, Mellon Financial Corp. "Frank had the germ of this idea," said Bleier, now a partner in the Pittsburgh office of Reed Smith LLP. Mellon had a slew of bad loans, resulting both from real estate difficulties and trouble in the oil patch.

Research determined that the Comptroller's Office, Mellon Bank's regulator, appeared to have the power to charter a noninsured liquidating bank. From this began four or five months of heavy-duty work for Bleier and others. So long were the hours, the lawyer recalls, that "my 14-year-old son thought I was away on business for two weeks."

Not that this deal was a slam dunk. "I think everybody felt that the idea made sense," says Robert Clarke, Comptroller at the time, and now senior partner at Bracewell & Giuliani, Houston. But Clarke says his staff spent a great deal of time helping Mellon break this new ground. (In this period the government structured several bad bank entities to work through some large failures and acquisitions in Texas.)

Because the bad bank being invented--Grant Street National Bank (in Liquidation), chartered in late 1988--would be corporately separate, means needed to be found for it to purchase the loans from Mellon. In this way loans and related assets would come off Mellon's books. (Grant Street shares were presented to Mellon Financial holders as a dividend. …

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