The Devil’s Triangle of Bank Failure (part 1)

What happens if a bank is on the other side of your deal, and then the bank fails? Most people have not spent much time thinking about this – but now more and more of us who are involved in the CRE world must do so. 

37 banks have failed to date in 2010, after 140 such failures in 2009.  All of these banks have been closed by the FDIC.  More bank failures are expected as commercial real estate loan defaults increase, and high unemployment keeps the economy limping along at best.  What legal impacts will those failures have on you and your business?  To assess that, you need to understand the FDIC and its role in “resolving” failed banks. 

This set of posts will first provide an overview of how the FDIC handles bank failures, then will discuss how a bank’s failure and resolution by the FDIC might affect an entity that is doing business with a bank in various capacities (as borrower, landlord, etc.).   (The topic’s a bit dense, so I can’t fit it into one post.  I’ll try to describe it as clearly as possible.)

What is the FDIC and what does it do?  

The FDIC is a bank regulator.  The Federal Deposit Insurance Corporation oversees U.S. insurance funds for depositary financial institutions.  It has several functions.  The FDIC is one of several regulators responsible for banks and thrifts.  Others include the Office of the Comptroller of the Currency, which is responsible for supervising national banks, the Federal Reserve, which is responsible for supervising both state member banks and holding companies, the Office for Thrift Supervision, for S&Ls, and various state agencies. (For purposes of this set of posts, I’ll simply refer to all such institutions as “banks.”) 

The FDIC is an insurer.  As the insurer of certain deposit bank accounts, the FDIC manages and controls risks to two separate deposit insurance funds, the Bank Insurance Fund and the Savings Association Insurance Fund, and protects the depositors in FDIC-insured institutions. When a federally insured depository institution fails, ultimately the FDIC pays out insured bank deposit accounts (if no other resolution is less costly). 

The FDIC is a receiver for failed banks.  In addition, the FDIC acts as receiver, conservator or liquidating agent for failed federally insured depository institutions, as well as for most state-chartered financial institutions, in order to promote the efficient and expeditious liquidation of failed banks and thrifts.  In this capacity, the FDIC has broad power and authority:  

  • it can  “resolve” the problems of the failing institution, through asset sales or a number of techniques discussed later; or 
  • it can put such an institution into receivership, and close it; or
  • it can combine a partial resolution with a receivership.

The FDIC has two main goals: to maintain stability and public confidence in the U.S. banking system, and to minimize the government payout of monies from the FDIC insurance fund.  The FDIC’s actions become more understandable when one understands these priorities. 

Overview of bank failure.  Like other businesses, which are subject to bankruptcy when they fail, failed banks are subject to a legal regime for sorting out their balance sheet, their commitments and their inability to honor them.  U.S. insolvency law for financial institutions is similar to, but quite different from (and excluded from), conventional corporate bankruptcies under Title 11 of the U.S. Code. To some extent, workout lawyers will recognize the process: it looks like a horse, and runs rather like a horse, but it’s a zebra, and some parts are very different.  Federal bank regulators handle troubled banks with two principal public policy goals in mind: special protections for the benefit of depositors (who are a protected class), and the need to protect systemic soundness of the financial markets.  As a result of the latter, regulators enjoy far more discretion in working out a troubled bank’s obligations than in a typical corporate bankruptcy. 

Few early stage warnings.  It can be difficult for a counterparty to anticipate a bank’s  failure.  A bank’s creditors and contractual counterparties should be aware that, long before any official “resolution” process, troubled banks may be subjected to special rules or limits on their transactions.  Additionally, the “supervisory” correspondence, examination reports and warnings from a bank’s regulators often are explicitly confidential. 

Banks are obliged to maintain both “capital adequacy” and balance sheet solvency.   However, those calculations are rarely simple, and sometimes they are not wholly transparent to outsiders.  Complex banking regulations relating to capital adequacy complicate evaluation of a bank’s assets and liabilities.   So, for example, a bank with inadequate capital — which inadequacy might occur passively by negative revaluations of investment assets in the bank’s portfolio — may not have the ability to make new loans or extend more credit to existing borrowers.   Or interest rate or similar restrictions on permitted loan terms may be imposed by regulators on a troubled bank, if the regulator feels that the bank’s interest rate practices or exposures are questionable. 

Bank regulators usually work very hard to keep a troubled bank’s predicament quiet to prevent a run on the bank, to preserve systemic economic confidence, and to obtain the best price for the bank’s assets in any arranged deal.   In some cases, regulators issue an order requiring the institution to take certain actions (usually to increase its capital within a certain period of time),  but it is still difficult to determine the status of the bank’s compliance.  Often, the only public advance signal of a bank failure is a securities filing from the bank itself that it cannot continue as a going concern, which usually comes only days before serious regulatory action occurs. 

Since the government is given broad discretion in making decisions about banks, there is also some risk that the contracts of a healthy bank may be altered for public policy reasons, particularly in a difficult economy.  See, e.g., the consumer home mortgage forbearance and reformation provisions in FDIC Financial Institutions Letter 36-2009 (the Obama Administration’s home mortgages protection initiative). 

The beginning of an official “resolution”, comes with the issuance of a “Failed Bank Letter” to the FDIC by the agency which charters the bank, stating that the bank is failing or is in imminent danger of failing, and will be closed.  (This typically happens when a bank becomes critically undercapitalized, insolvent, or unable to meet requests for deposit withdrawals.)  As a practical matter, these notices are not likely to be a timely source of guidance or warning for the bank’s creditors and counterparties.  Once the official resolution phase has started, using one or more of the specific methods described later, the cow already is out of the barn. 

In the next post, I’ll discuss what the FDIC’s options are for “resolving” a failed bank, and which of these options it uses most often. 

 Note:  Many thanks to my co-author and partner Ed Karlin of Seyfarth Shaw LLP and to my co-author James Bryce Clark, General Counsel of Oasis-Open.com, who both coauthored with me a shorter version of this material in an article entitled “Take it to the Bank” which appeared last October in Los Angeles Lawyer Magazine, and to LA Lawyer Magazine for its permission to reuse some of the same material.
 
 
 
 

  

 
 

 

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10 Responses to “The Devil’s Triangle of Bank Failure (part 1)”


  1. 1 sk March 23, 2010 at 8:15 am

    interesting !

  2. 2 Allan March 29, 2010 at 7:06 pm

    I am currently attempting to refinance three client projects that were underway when the FDIC closed the bank. Now they ( FDIC ) are DEMANDING client repay the debt to the closed bank. THAT is the problem with dealing with closed banks, not knowing in advance or after the fact that the Feds will closed it, but what to do when the deed is done! Plus, the Attorneys that client has deal with have not been of ANY value, but CONSIDERABLE expense!

  3. 3 Mario C April 1, 2010 at 4:22 pm

    Great post!

    I have worked with a number of troubled banks selling distressed CRE and when the FDIC takes the bank over, in most cases, all negotiations are halted for at least 3 to 6 months…

    http://lighthouseas.wordpress.com/

  4. 4 KCH April 5, 2010 at 5:08 am

    Love your blog!


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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.

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