FDIC Is Clearing Away Toxic Assets

There's plenty of talk about the pent-up demand for distressed commercial assets, though few deals are trading. But the one place where there's action-and a lot more expected-is at the Federal Deposit Insurance Corp. So far this year, about 100 banks have failed and their assets have reverted to the agency's books. The FDIC has been steadily divesting those holdings through various means and deal structures. In its largest transaction to date, the agency agreed to sell a 40% stake in a group of Corus Bank's troubled loans for $4.5 billion to a venture led by Starwood Capital Group last month.

The deal marks only the second legacy loan transaction for the FDIC, following the March disposition of assets from the failed Franklin Bank S.S.B. out of Houston. So the agency is just starting to test the waters with these larger sales. Both the Corus and Franklin transactions were structured deals, with the FDIC selling a stake of the loan portfolio and providing the debt for the deal in exchange for the new equity.

"Franklin and Corus were the first instances in which the FDIC offered financing, so the thought is that those deals will serve as the template for doing open bank transactions," says Jeremy Hochberg, an associate in the financial services group at Arnold & Porter LLP, a Washington, DC-based law firm.

Up until now, all of the toxic assets that the FDIC has sold have been from folded banks. The agency has closed six transactions to date, in addition to the Corus and Franklin deals. The transactions have ranged in size from $500 million to $5 billion. For example, Plano, TX-based Beal Bank acquired more than $350 million assets from the FDIC and private real estate investment firm Colony Capital bought north of $100 million as of July. The FDIC is also trying to encourage some operating banks to sell their troubled holdings to avoid destabilization, says Jennifer Perkins, a partner in the real estate practice of Arnold & Porter.

In the case of Corus, the FDIC had to put money in to continue the construction loan and keep the buildings operating. So it is no surprise that the agency is looking for other ways to handle the growing wave of distress.

"They did a pilot program first with closed banks, setting baseline pricing. It's still uncertain whether the open bank sales will work," she says. The FDIC was unavailable for comment as of press time.

"The FDIC and US Treasury are attempting to increase the valuation of the legacy loans and toxic real property by providing leverage in exchange for equity participation," says David Michelson, an advisor with Three Arch Investors in Newport Beach, CA. "Hopefully, this will result in a higher net benefit for the taxpayers or the financial institutions." And by retaining the stake, the FDIC may also be able to share in the profits if the values of the assets recover. On the flip side, the agency is incurring a liability by keeping a stake and providing financing, but it's too soon to tell how it will all play out.

In the meantime, because of the government-subsidized leverage, the ultimate pricing in these structured deals has been inflated, says Linus Wilson, a finance professor at the University of Louisiana. "In non-commercial real estate transactions, based on the bids they received, like the failed Franklin Bank in Texas, it led to a price 22% over investors' beliefs of what the fair market value of the asset was," he says.

It is still unknown exactly how inflated the Corus pricing was because the FDIC has not provided estimates, Wilson says. However, billionaire Wilbur Ross, chairman and CEO of private equity firm WL Ross & Co. and part of the winning group that took Corus, told CNBC that the leveraged structure enabled the Starwood group to bid 10% to 15% more than with private sector money alone. And with the industry watching these deals to set pricing, it becomes more muddled. Wilson argues that the subsidized leverage that allows people to bid higher may alter the incentives of the asset managers. "If you require the FDIC to have a large stake, maybe the property asset managers have too little of an ownership stake, which may distort incentives a little bit," he says.

Another potential issue he sees is how the bank assets are marked. "A lot of the loans are not marked to market-they're going to hold these assets under the new FASB regulations," he says. "Those that are marking loans to market could inflate their value to more than they are actually worth." That would mean that the banks are holding too little capital, he says.

Incidentally, Wilson's research shows that the banks most willing to sell their distressed assets are the ones that are well capitalized. Banks that are undercapitalized are unwilling to sell even at inflated prices through the PPIP or TALF programs, he says.

If you ask most people about the volume of toxic assets that the FDIC may bring to market, it's a great unknown. That's because most of the distressed assets are still held by regional and community banks, Michelson says. "The Legacy Loan Program is currently in a test mode with the intention of opening up to include a larger group of asset managers and the possibility of allowing smaller institutions to transfer toxic or illiquid assets through this vehicle," he says. Three Arch Investment Corp.1, he notes, has qualified to submit an application as a private asset manager to the FDIC.

Arnold & Porter's Hochberg says the FDIC may be gearing up to roll out about $6 billion to $7 billion of distressed assets in the near term in roughly five separate transactions. Those assets would be from banks that failed last fall. Another wave of sales would follow shortly thereafter. If open banks start to participate in the program to sell toxic assets, the volume would obviously be much higher.

The 125 banks to fail thus far in this downturn compares to about 747 failed institutions from the Savings & Loan crisis in the late '80s. At the end of that meltdown, it cost taxpayers $162 billion, Wilson says. There's talk that this time around, we could see up to 1,000 banks fail, though Hochberg has heard that number dialed back to around 500, he says. But at press time, more than 490 banks were on credit watch on the FDIC website.

The agency is frantically trying to do anything it can to help stave off a larger crisis. One of its newest initiatives is to have banks prepay their FDIC fees for three years. That would give the agency an infusion of capital for the time being. But there's debate as to how it might impact the lending environment in the short term. Commercial real estate lending is already extremely tight these days. If lenders have to pony up more money now for fees-which reportedly could be in the multibillions for large banks and lead to at least an 8% decrease in profits for medium-sized banks-it could dampen loan generation, says John Jay, a senior analyst with Boston based Aite Group.

"That just raises the cost of doing business many times," he says. Jay explains that the prepaid asset can't be used as collateral to put against loan making. "When you add all of this up, regulatory capital is not a cash item, though an FDIC prepayment is. It really increases the cost of lending in whatever you need to do." Michelson argues the move won't further strain the lending environment, noting that the FDIC recently added to its reserves by increasing members' contributions and that Congress has intended to prevent bank takeovers where possible and to jump start lending in 2010,"he says.

One of those initiatives is loan modification for the smaller banks that are still carrying a lot of the toxic assets on their books. The idea is to rework the commercial paper as you would a residential loan, Jay explains. The FDIC seems to be treating the structured transaction auctions, run mostly by financial advisors, such as Deutsche Bank and Keefe, Bruyette & Woods, as private placement where only pre-qualified bidders can take part in the process, Hochberg says. His colleague, Perkins, adds, "In the last month or so, the FDIC has been doing some very specific vetting now with very specific forms." The initial form asked for simple information. That was followed by a second when the transaction gets closer asking about financial resources, the ability to service the loans and asset management capabilities. That is then followed by another set of forms intended to winnow down that group again, Perkins says. Bidders must also submit a $250,000 refundable deposit before gaining access to due diligence materials.

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