Cl i e n t Al e r t

February 2009

Contacts The State of Banking 2009

Peter G. Weinstock By: Peter G. Weinstock1 A number of players entered banking 1445 Ross Avenue, Suite 3700 after the “dot.com” meltdown with the We have issued literally dozens of client Dallas, TX 75202-2799 strategy of using brokered deposits (214) 468-3395 alerts since the crisis in banking became to fund a focus on a particular type [email protected] acute toward the middle and fall of 2008. of lending. In other cases, there were Despite the torrent of information that growth strategies that were based on we have provided to our clients, there wholesale funding. The experience of are a number of issues that have flown bank regulators in such circumstances underneath the radar or which need has been that wholesale funding has further defining.2 I have attempted to been quick to flee a deteriorating bank. tackle certain of these issues below. In the event a bank becomes less than Liquidity well capitalized or worse on a prompt corrective action (“PCA”) basis, its There have been a number of develop- wholesale funding eligibility is subject ments regarding the regulatory and to regulatory limitations and potential market reaction to liquidity issues. prohibitions.3 If a bank enters into a formal Examiner Scrutiny. Wholesale administrative action, then the regulators funding has become a negative term. can drop it one level on the PCA scale. Unfortunately, the regulators are paint- Thus, a bank that is well capitalized but ing with a broad brush. In a number which signs a cease-and-desist order of the almost 40 bank failures since could be deemed to be only adequately the start of 2007, the failed financial capitalized for PCA purposes. This triggers institution had a high portion of funding the advent of the brokered deposit rules. from brokered deposits and federal In light of this combination of factors, home loan bank (“FLHB”) advances. banks, even high-performing banks, have been hesitant in pushing back against examiners who advise them 1 Peter Weinstock is practice group leader to reduce their reliance on wholesale of the financial institutions corporate and regulatory section of Hunton & Williams LLP. funding. Obviously, this has had national Mr. Weinstock writes and speaks frequently ramifications because it limits a free on topics of interest to community bankers. You may contact him at (214) 468-3395 or flow of funding to where it would do [email protected]. the most good to spark new lending. 2 In the event you have not received our client alerts, please do not hesitate to call me at my 3 Please contact me if you would like a copy number or email me, and I will be happy to of our memorandum of the rules under such provide you with copies. circumstances.

Hunton & Williams LLP FDIC-proposed Action on Interest The FDIC will now presume that the six placement agents that would be Rates. The FDIC has recently issued a rate in any market is the average willing to assist financial institutions proposal concerning interest rates that national rate unless it determines, in issuing such indebtedness. an institution that is only adequately cap- based on available information, The pricing on such funding is generally italized or worse can pay. Tucked away that the average rate in that market based off of the three-year Treasury in the FDIC’s proposal is the following: differs from the national rate. rate or the three-month LIBOR. The [S]ection 29 [of the FDI Act] In short, for institutions that are less all-in cost for such issuances tends to authorizes the FDIC to impose than well capitalized, they will be be 350–375 percent (this includes the by regulation or order, such required to pay a rate that is no more FDIC’s 1 percent special assessment). additional restrictions on the than 75 basis points higher than the We have negotiated agreements with a acceptance of brokered deposits national rate, unless an institution can variety of these placement agents. The by any institution as the [FDIC] overcome the FDIC’s presumption that funding received is obviously a com- may determine to be appropriate the national rate will also be the local modity to the issuing bank. Accordingly, … this broad grant of author- rate. This restriction is in addition to the it is important to be mindful of differ- ity does not refer to capital restrictions on brokered deposits for ences in placement agents, trustee fees categories (emphasis added). adequately capitalized banks or banks and the overall costs of issuance. Even that are in a lesser PCA category. Thus, the FDIC could adopt additional though we represent issuers, certain restrictions on the acceptance of bro- TLGP. On October 14, 2008, the FDIC of the placement agents asked us to kered deposits without regard to capital announced the temporary liquidity guar- help them to improve their program. categories. To date, the FDIC has not antee program (the “TLGP”). The TLGP adopted any such additional restrictions, enables financial institutions to issue Regulatory Issues but the FDIC is interested in obtaining senior unsecured indebtedness with a In addition to wholesale funding, the comments on whether the adoption of government guarantee. Initially, it was regulators are revisiting issues that they such restrictions would be appropriate. hoped that the FDIC would also afford have not stressed since the early ’90s. that guarantee to holding companies in Comments are due on the proposal order to enable them to add capital to Real Estate Appraisals. The on or before April 6, 2009. In effect, their subsidiary banks. Recent FDIC pro- regulators again are scrutinizing the FDIC is requesting whether it nouncements have indicated that such the appraisals supporting collateral should impose a rate cap on the a use of the TLGP guarantee will be values and other real estate owned. amounts that all financial institutions granted only on an extraordinary basis. The appraisals are being evaluated can pay for brokered deposits. for staleness and also for whether the Banks can, however, issue senior The FDIC proposes to establish comparables are appropriate. The unsecured indebtedness equal to 2 a “national rate,” which would be examiners have once again raised the percent of their liabilities on September calculated and published by the FDIC. question of whether banks have an 30, 2008, provided that they did not The FDIC has said that rate will be appropriate appraisal review process. have any senior unsecured indebted- a simple average of rates paid by ness on that date. The FDIC guarantee Loan-to-Value Ratios. The bank all insured depository institutions in extends until June 30, 2012. examiners have been refocusing on branches for which it has available data. scrutinizing bankers’ compliance with The indebtedness issued under the The FDIC will define a market area as the loan-to-value (“LTV”) requirements. TLGP is not considered wholesale any readily defined geographic area in Recent examination reports have also funding. In addition, unlike a CD, if which the rates offered by one institution criticized banks for failing to track rates increase, the noteholder under will affect the rates offered by other LTVs in excess of the supervisory the TLGP cannot pay a penalty and institutions operating in the same area. limits and reporting such exceptions reclaim its money. In response to the to the board of directors. Other TLGP, we are aware of more than

2 Client Alert criticisms of banks concerning the capital, rather than just the mathematical continues even after three years. For loan-to-value requirements are: application of the ratios. Examiners more information, see the upcoming are instructed to consider the source issue of ICBA’s “Subchapter S: The ÆÆ basing analysis off of only the of the capital and whether there Next Generation” newsletter, which funded balance rather than the total will be lender or investor pressures we co-edit with RSM McGladrey. loan commitment, on the holding company that might TARP. For Subchapter S banks that ÆÆ reporting LTVs in excess of bank render the capital that had been elect to issue the debentures to the policies without also noting excep- injected less than permanent. U.S. Treasury (“UST”) under TARP, tions to supervisory limits, The rating agencies are also considering they will be required to also provide ÆÆ failing to limit the value used to that issue. For instance, Moody’s had the government with a warrant. The calculate LTVs for real estate to the said that capital coming into a new orga- warrant represents 5 percent of level of cost or appraised value, and nization from TARP is not as reliable as the securities received by the UST. other sources of capital. Moody’s treats The warrant is deemed immediately ÆÆ failing to track the aggregate vol- TARP funds as 25 percent equity and exercised and bears interest at 13.8 ume of loans in excess of the LTVs 75 percent debt for the purpose of its percent from the date of issuance. as a percentage of capital in order calculation of tangible common equity. The UST is paying only for the to ensure that the aggregate level Although A.M. Best takes a similar debentures. The warrants will all have of exceptions is consistent with the approach, it has said it will consider a nominal exercise price. Accordingly, requisite minimum. the capital of the companies taking the price paid for the debentures will be TARP funds on a case-by-case basis. Texas Ratio. The examiners are allocated between those debentures calculating the Texas ratio for banks Subchapter S and the warrants. This creates the as an indication of whether the bank’s possibility of original issue discount deterioration warrants an administrative TEFRA Disallowance. On January 15, (“OID”). As a result, the bank holding action or further scrutiny. The Texas 2009, the United States Tax Court ruled company may be able to receive ratio equals the sum of (nonperforming in favor of the IRS in a case involving an additional interest deduction assets and 90+ delinquent loans) the 20 percent TEFRA disallowance. taken over the life of the loans. divided by the sum of (Tier I capital The question presented was whether in the allowance for loan losses). the TEFRA disallowance phases out There are many other issues that have after a financial institution has been arisen in the current environment. If Capital taxed under Subchapter S for three you would like to see our client alerts, years. The Tax Court determined that please do not hesitate to contact me. The bank regulators have begun to the 20 percent TEFRA disallowance focus upon the quality of a bank’s

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