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FEDERAL DEPOSIT INSURANCE CORPORATION, Washington, o.c. 20429 1 o SAVINGS BANKS’ PROBLEMS: WHERE WE HAVE BEEN AND WHERE WE ARE HEADED An address by jr( U William M. Isaac,' Chairman Federal Deposit Insurance Corporation Washington, D.C. presented to the National Association of Mutual Savings Banks Midvear Meeting 'New York<* -N-e-w—Y-o-rk» December 7, 1982, J When I appeared before your convention in Atlanta last spring, the majority of your banks were operating in the red, losses were rising, and the outlook was decidedly unfavorable. I stressed the importance of enactment of then-pending legislation to broaden the FDIC’s powers to deal with failing institutions. I also emphasized the need for expanded thrift powers and for action by the DIDC to hasten deposit deregulation. Things have changed considerably since last spring. Instead of a gloomy outlook, the prospects for the savings bank industry are much improved. The Garn-St Germain Depository Institutions Act of 1982 has brought about many of the regulatory changes we had been seeking. An even more important development from the standpoint of the savings bank outlook has been the dramatic decline in interest rates during the past several months. If interest rates stay at present levels during the next several months, we expect the industiy u a. whole to break even by about March of next year. Today I will focus on the earnings picture for savings banks, on the new deposit instrument recently approved by the DIDC, on possible further changes in deposit interest ceilings, on the approach the FDIC has taken in handling troubled savings banks and, most importantly, on the policie we will follow as a result of the new authorities contained in the Garn-St Germain legislation. I will then say a few words about some accounting issues of interest to many of you and the federal-charter option. Savings Bank Earnings During the first three quarters of 1982, FDIC-insured savings banks lost more than $1 billion, an annualized- rate of about one percent of assets. If we were to eliminate the sale of buildings and other transactions to boost surplus, the losses would be even greater. The monthly figures collected from large savings banks indicate that earnings improved considerably in September and October, a trend we expect to continue. During the third quarter, the cost of funds at large savings banks averaged about 10.2 percent. That figure has been coming down as borrowing costs have declined and as six-month and jumbo certificates have been rolled over at lower rates. In October the cost of funds at large savings banks was about 9.5 percent. If rates stay at present levels, the cost of funds will likely drop below 9 percent in early 1983. This would enable most savings banks to go into the black. 2 Recent rate declines have reduced average asset yields, particularly for savings banks with heavy liquidity. That should be offset several fold over the next few months by declines in the cost of funds. What has been unfortunate has been the inability of the industry to raise yields significantly during the past two years despite an extraordinarily high rate environment. Cash flow has been limited by operating losses, low turnover in mortgage portfolios, and deposit outflows. The deposit outflows may have been due in part to depositor concern about the weakness of specific savings banks or the thrift industry in general. The competition from money market funds and other unregulated competitors has been an even more important factor. This artificial constraint on deposit growth will be eliminated with the introduction of the new money market deposit account a week from today. Deposit Ceiling Deregulation The members of the DIDC have faced a dilemma from the beginning. If banks and thrifts had been given greater freedom to compete with money market funds, deposit growth would have been higher, but more passbook funds would likely have shifted and the cost of funds probably would have risen faster. It is no secret that I have generally been on the side of faster decontrol; it seems clear that most savings banks would be better off today if they had enjoyed the cash flow to put more loans on their books during the past couple of years. We believe the new money market account will improve deposit flows. It should stop outflows to money market funds and, over time, should bring a good deal of money back to thrifts and commercial banks. There may be some significant transfers to this new account from other deposits within the same institution. Transfers from passbooks will likely be large, as will transfers from maturing six-month certificates. Much will depend on how the new account is priced and structured. We may see some very aggressive pricing initially, but based on our experience with other accounts, we believe most in stitutions will quickly settle down and price sensibly. With the introduction of this new account, the DIDC must take a good look at the restrictions on other deposit instruments. There is no point in having a higher minimum denomination on the six-month or other certificates than on the new, deregulated instrument. 3 Perhaps it is also time we consider accelerating the current phaseout schedule for time deposits. The Garn-St Germain Act mandates the elimination of all differentials by no later than January 1, 1984. With the phaseout schedule and the in place, the new ceiling-free instrument in effect, differential eliminated, there may not be much point in maintaining any ceilings after January 1, 1984. FDIC Assistance During the last 14 months the FDIC has assisted 11_ savings bank mergers involving assets of about $15 billion. Several considerations dictated the way we handled these transactions. We were most concerned with maintaining public confidence in the industry. We placed failing institutions into stronger hands and provided sufficient tangible assistance so that acquiring institutions were not weakened. In requiring the departure of top management and trustees of the failing institutions, we facilitated smooth and orderly takeovers by management of the acquiring banks. We wanted to keep our costs down and be as fair as possible to potential acquirers, so we used a competitive bidding process. In order to obtain the benefit of future declines in interest rates and encourage more aggressive bidding, we entered into arrangements where a cons iderable part of the assistance was tied to the future spread betwe en the yields on acquired assets and the cost of funds. The original estimated cost of effecting these transactions wa s a fraction of the market depreciation of the assets of the failing savings banks, and recent rate declines will enabl e us to substantially lower our original estimates We avoided propping up existing institutions for several reasons. First, prior to the enactment of the GarnSt Germain Act our authority to provide such assistance was extremely limited. Second, in those few instances where we have provided this kind of assistance in the past, the transactions have not worked particularly well. Third, there exists, within and outside our agency, a negative feeling toward the fairness and appropriateness of so-called "bail outs” . Finally, we felt that assisted mergers of failing savings banks would strengthen the industry as a whole. We were aware that our policies would not be univer sally acclaimed. In view of the tragic circumstances con fronting so many savings banks with long and proud traditions of public service, and the necessity of fashioning a program that would be fair and helpful to the entire industry, no course of action could have been devised to please everyone. 4 We are satisfied with the results to date. A series of sound mergers was arranged at a reasonable cost. The acquiring banks were not weakened, nor subsidized beyond what was necessary to justify the acquisitions. We did not litter the landscape with financially crippled firms. We did not inject our agency into the business of subsidizing and operating private institutions. Finally, not one deposi tor suffered any loss or even inconvenience, and public confidence in your industry and our agency was maintained. Circumstances have now changed. The most seriously troubled institutions have already been merged out of existence. Rates have declined substantially, improving the outlook for most of the remaining banks. Fina lly, Congress has passed Title II of the Garn-St Germain Act , which prescribes a net worth certificate program. Our policies will be modifie d to reflect these new circumstances. For savings banks in need of assistance, we have structured a plan that we be lieve will meet the needs of both the industry and the FDIC Basically, we plan to utilize the provisions of Title II of the Garn-St Germain Act, supplemented by incentives to encourage voluntary mergers. Before addressing the specifics, let me take a moment to explain why we have chosen to grant as sistance under Title II. High on our list is our interp retation of Title II as representing the clear preference o f Congress. It would be difficult to justify granting ei ther more or less assistance in the face of this statement of Congressional intent. Of equal importance is our desire to minimize the effects of FDIC assistance on the normal functioning of markets. We do not want to dictate market structure or competitive positioning within any market. Finally, Title II exempts issuers of net worth certifi cates from state and local franchise taxes. For just those savings banks operating in New York City, this exemption could reduce costs by more than $100 million over the initial three-year life of the Title II program. We plan to follow both the letter and spirit of the Title II provisions.* Savings banks will be eligible to issue net worth certificates to cover a percentage of their *See Appendix A for the full text of the FDIC’s Title II Assistance Plan. 5 losses if their surplus-to-asset ratios are 3 percent or less. The net worth certificates will be subordinated and will be considered part of an institution’s surplus account. The FDIC will continue to purchase additional net worth certificates every six months, using the same formula, from those institutions which are initially eligible and from those which subsequently become eligible. While the FDIC will not purchase additional certificates after three years, those previously issued will generally remain outstanding for seven years from the date of issuance. Savings banks with positive earnings will be required to devote a portion of their earnings to retiring the outstanding certificates. We will reserve the right not to buy certificates where we believe mismanagement or unsafe activity exists. We will also reserve the right to exclude from coverage operating expenses deemed excessive. For many of you who receive assistance, the exemption from state and local franchise taxes will be an important savings. However, the plan will offer no additional boost to income. By covering a portion of losses, the plan will prevent or forestall book insolvency; it will buy time. Whether this will be enough to turn around savings banks that might otherwise fail depends on a number of factors, primarily on what happens to interest rates during the next few years. If interest rates average a point or^ two below present levels, the additional time would facili tate almost everyone’s survival. If rates average present levels or slightly higher, we believe that most of the assisted savings banks -- approximately 35 would be eligible by the end of this year -- would become profitable by or before the end of the three-year period. A few others could do so if they were particularly successful in paring costs,. improving noninterest income, or profitably expanding deposit volume. We continue to believe that in many cases important benefits can be attained by merging institutions: duplica te branches can be eliminated, senior management can be cut or improved, marketing programs can be enhanced, and data processing operations can be made more efficient. This brings me to the second portion of our plan. When it makes good economic sense, we want to facilitate continued mergers of savings banks. A few firms may have to be merged out almost irrespective of what happens to rates. Others will have been so debilitated by losses that mergers may be the only practical longer-range solution to their problems. 6 As an inducement to seek out appropriate partners, we will entertain voluntary, assisted merger applications in volving savings banks where at least one of the partners is eligible for or receiving Title II assistance. Our assis tance would be in the form of interest-bearing notes from the FDIC, income maintenance payments, cash, or any other imaginative form of assistance proposed that we think makes sense.* We continue to have a strong preference for proposals in which weak institutions are merged into stronger ones. We will not rule out altogether providing tangible assis tance for mergers between two savings banks eligible for Title II assistance, but these proposals will receive very close scrutiny so we can satisfy ourselves that the resuiting entity will have a reasonable prospect of remaining a viable competitor at a reasonable cost. If, however, two or more banks eligible for Title II assistance submit an acceptable merger plan involving no assistance other than that available under Title II it will likely receive favorable consideration. We intend to "shop” voluntary merger proposals involving tangible FDIC assistance to determine whether someone else can offe r a more attractive proposition. If we receive a better o ffer, which is economically sound, the savings bank to be me rged out may accept the better offer or it may continue receiving Title II assistance as long as it remains eligible to do so. In providing assistance, we will favor proposals which include a recapture of future earnings to keep the ultimate cost to the FDIC at a minimum'and to prevent assisted in stitutions from gaining a long-run competitive edge over unassisted savings banks. We will not automatically require the resignation of the trustees and top two management officials of the weaker savings bank under our voluntary merger plan. However, as a matter of efficiency, we will expect reductions in seniorlevel management and will insist that the resulting board of trustees be comparatively small. Both the Title II Assistance Plan and the Voluntary Merger Plan are effective immediately. Copies of the plans are available for your review and informal comment. As always, we welcome your thoughts and will consider any suggestion as to how the plans might be improved. *See Appendix B for the full text of the FDIC’s Voluntary Merger Plan. 7 Accounting Issues I would be remiss if I did not say at least a few words today about some accounting issues. We received a great deal of pressure over the past year to allow loss-deferral accounting. We resisted this pressure for several reasons. First, as deficient as the current historical costbased accounting conventions are, they do reflect generally accepted accounting principles, and an individual agency should tread very cautiously in overriding them. We must endeavor to maintain order and consistency in the presen tation of financial statements so they may be more readily understood by all readers. Second, we have attempted to be open and straight forward in handling troubled savings banks and have tried to avoid creating the perception that problems were being masked. We believe our agency’s credibility has been maintained, if not enhanced, during these critical times. Finally, we felt that adoption of loss-deferral accounting in a high-rate climate could have caused more harm than good in the savings bank industry. Our reasoning was simple. Interest rates were likely to decline at some point. If they did not, new accounting techniques would not be much of an answer to the industry's severe difficulties. If they did decline, savings banks would be better served by holding their long-term assets until the decline occurred rather than locking in large losses by selling in a highrate climate. A loss-deferral rule would have had some positive effects, such as permitting most savings banks to improve their liquidity and a few to switch out of significant portfolios of tax-exempts, but we perceived those benefits to be of limited value to the industry as a whole. We have under consideration a loss-deferral rule which is coupled with a current value accounting system with respect to future additions to savings bank investment portfolios. I wish I could tell you whether and how we intend to proceed on these issues. I cannot because we have not yet decided. The loss-deferral rule bothers us less today than a year or so ago due to the interest rate declines. Moreover, our proposal has been carefully written to avoid "paper" profits which would distort reported earnings. On the other hand, the case for the rule has been weakened by adoption of the net worth certificate program. The current value- accounting requirement for future investments has appeal. We are very dissatisfied with the historical cost-based system, particularly in a deregulated, volatile-rate environment. However, implementation of such an accounting change would be complex, and we question the wisdom of our agency acting unilaterally. If we were con vinced the accounting profession would move forward in this area with deliberate speed, we would not even consider acting on our own. Federal Charters The last subject I want to touch on before closing is the matter of conversion by state-chartered savings banks to federal charters. I have been asked our agency’s stance on the subject many times in the past month or so. The FDIC’s official and unofficial position on the issue of charter selection is one of complete neutrality. We have been proponents of the dual banking system for many years and were pleased to see it extended to savings banks. The Garn-St Germain Act, for the first time, makes the federal-charter option a reality for virtually all savings banks by incorporating our suggestion that they be permitted to maintain their FDIC insurance when converting to federal charters. Some state legislatures have in the past placed un realistic restrictions on state-chartered savings banks. The banks had no alternative but to accept those restraints. Now they do. We believe each savings bank should pursue' whatever charter option is -in its best interests from a business standpoint. We would only add a couple of caveats. First, it is an important decision which should receive thorough evaluation. Second, you might give your state legislature a reasonable opportunity to react before converting, as it is possible the state will adopt a law that is even more favorable than the new federal legislation. Finally, do not convert to federal charter under FDIC insurance on the premise that the basic regulatory standards under which you operate will be relaxed perceptibly. Conclusion I have covered a broad range of policy issues today including deposit deregulation, procedures for handling troubled savings banks, accounting issues, and our attitude toward charter conversions. In dealing with these and other difficult questions affecting your industry, we have been guided by several precepts: 9 * We have endeavored to take the longer view - - t o avoid the temptation to amDly a "quick fix" which might prove detrimental ov%r time. * We have tried to be innovative and practical in our approach to problems. * We have made every effort to be fair and forth right in all of our dealings. We have endeavored to do what we sincerely believed was in the best interests of the savings bank industry, the financial system, and the depositing public. * We have tried to minimize our intervention in the functioning of the marketplace. * We have strived to maintain public confidence in the financial system and the FDIC. We must hindsight to am convinced I assure you problems and leave it to historians with the benefit of judge whether our decisions have been wise. I our guiding principles have been correct, and we will not deviate from them as we address the issues ahead. Thank you for allowing me this opportunity to once again appear before you. Working together, we have made great strides in resolving the difficulties of your industry over the past year or two, and I have no doubt about our ability to continue our progress in the months and years ahead. •k k * * k Appendix A FDIC CAPITAL ASSISTANCE PLAÎT This Capital Assistance Plan incorporates only those powers provided to the FDIC under Section 13(i) of the Federal Deposit Insurance Act (Title II of the Garn-St Germain Depository Institutions Act of 1982). QUALIFIED INSTITUTIONS All "qualified institutions" as that term is used in Section 13(i) of the Federal Deposit Insurance Act may request assistance under this plan. "Institutions the deposits of which are . . • insured or guaranteed under state law" will be interpreted to cover only those depository institutions that normally would be eligible for FDIC insurance. To qualify for assistance each institution must: — have net worth equal to or less than 3 percent of its assets; — have incurred losses during each of the two previous quarters; — have not incurred such losses as a result of transactions involving mismanagement (including speculation in futures or forward contracts, management actions designed solely for the purpose of qualifying for assistance, or excessive operating expenses); — have net worth of not less than after the granting of assistance; — have investments in residential mortgages or securities backed by such mortgages aggregating at least 20 percent of its loans (including securities backed by residential mortgages); and — agree to the conditions set forth below. one-half of one percent of assets AVAILABLE ASSISTANCE At the request of any qualified institution, the Corporation will, after consultation with any State or Federal Supervisors, purchase the institution’s capital instruments to be known as Net Worth Certificates. The initial request for assistance under this plan, if approved, will last for one year. Requests to continue receiving assistance past the first twelve months must be made annually and be approved by the Corporation. Outstanding Net Worth Certificates issued by any institution that fails to requalify for assistance past the initial twelve-month period will remain outstanding until such time as they are retired. In no case will the FDIC purchase Net Worth Certificates after October 15, 3985. Purchases of Net Worth Certificates will be made semi-annually for a period of one year, as follows: — with respect to a qualified institution having net worth as of the end of the prior calendar quarter greater than two (2) percent and less than or equal to three (3) percent of assets, the Corporation will purchase Net Worth Certificates equal to the lesser of 50 percent of its net operating losses during the prior two calendar quarters or the amount by which the sum of surplus and Net Worth Certificates falls below three (3) percent of assets before the granting of assistance; _ with respect to a qualified institution having net worth as of the end of the prior calendar quarter greater than one (1) percent and less than or equal to two (2) percent of the assets, the Corporation will purchase Net Worth Certificates equal to the lesser of 60 percent of its net operating losses during the prior two calendar quarters or the amount by which the sum of surplus and Net Worth Certificates falls below three (3) percent of assets before the granting of assistance; _ with respect to a qualified institution having net worth as of the end of the prior calendar quarter greater than zero and less than or equal to one (1) percent of assets, the Corporation will purchase Net Worth Certificates equal the lesser of 70 percent of its net operating losses during the prior two calendar quarters or the amount which the sum of surplus and Net Worth Certificates falls below three (3) percent of assets before the granting of assirt Net operating losses shall include all revenue and expenses accrued during the period by a participating institution with the exception of securities gains and losses and other below the line (extraordinary) items» Additionally, the FDIC will not consider gains or losses from the sale of assets not sold in the ordinary course of business as a component of net operating losses. In all other instances, net operating losses shall have the same meaning as income (losses) before net realized gains or losses as used in FDIC's Instructions for the Preparation of the Report of Income (Form 8040/51) by Insured Mutual Savings Banks (or Form 8040/02 by Insured Commercial Banks)» Any disagreements as to what constitutes a sale in the ordinary course of business or any other components of the income statement or balance sheet will be resolved by the FDIC in its sole discretion. As consideration for the purchase of a qualified institution s Net Worth Certificates, the Corporation will issue its non—negotiable, floating— rate promissory notes of equal principal value. Both the FDIC’s promissory notes and the qualified institution’s Net Worth Certificates will pay interest quarterly at a rate tied to the average equivalent coupon—issue yield on the U.S. Treasury’s 52-Week Bill auction held immediately prior to the beginning of a calendar quarter plus one—half of one percent (0.5%). Net Worth Certificates will remain outstanding until such time as the qualified institution has attained profitable operations. Repayment of principal will be required in an amount equal to one— third of net operating income. If any Net Worth Certificate remains outstanding seven years after issuance, the Corporation will have the right to require any qualified institution to repay all, or any portion, of its Net Worth Certificates then outstanding upon three months’ notification. CONDITIONS The initial and all subsequent annual requests for FDIC capital must be accompanied by a comprehensive business plan covering: assistance -3- — strategic plans and objectives; — lending and investment policies, including pricing strategies; — liability acquisition and funding plans; — plans and strategies for managing liquidity positions and rate sensitivity gaps; — expense reduction plans including: a. board of trustees or directors; b. senior management; c. other employees; d. other overhead expenses; and e. capital expenditures; — plans and strategies to generate fee based income; and — financial information consisting of statements of condition and income for the last full calendar year and year-to-date, including details on overhead expenses, two-year budget projections of income and expenses, and pro-forma financial statements for the same period. Before the FDIC will purchase any Net Worth Certificates, each institution must have met or agree to meet the following conditions: qualified — any supervisory action under Section 8 of the FDI Act must be resolved; — all employment contracts with senior management with terms greater than twelve months must be rescinded and no new contracts of greater duration may be entered into without consent of the FDIC; — all severance payment plans or contracts calling for the payment of more than six months’ salary must be rescinded and no new plans or contracts calling for payments in excess of this amount may be entered into without consent of the FDIC; — an independent public accountant will perform an annual full scope audit with copies of all reports provided to the FDIC on a timely basis; — the bank will agree to convert to a different charter form and/or stock form if and when requested by the FDIC (the FDIC anticipates utilizing this authority only to facilitate a transaction intended to resolve the institution's underlying problems); — the bank will not convert to stock form, change its charter, merge or otherwise change the nature of its business or ownership without the prior approval of the FDIC; the bank will in good faith consider all reasonable opportunities as a means of improving operating efficiencies; merger - 4 the bank will file within 30 days after theend of all calendar quarters Reports of Income (Form 8040/51 or, if applicable, Form 8040/02) with attached schedules explaining all significant deviations from the bank’s projections submitted with its annual business plan; and state-insured qualified institutions, inaddition to the above conditions, must: a. comply prospectively with the provisions of Regulation Q; b. provide the FDIC with copies of all State examination reports; c. permit the FDIC to perform its own independent examinations; and d. arrange for its State insurance fund to enter into an indemnity satisfactory to the FDIC secured by fully marketable securities at least equal in value, at all times, to 100 percent of the Net Worth Certificates purchased plus any accrued interest thereon. Appendix B FDIC VOLUNTARY MERGER PLAN In addition to providing assistance under Title II of the Garn-St Germain Depository Institutions Act of 1982, the Federal Deposit Insurance Corporation will consider granting financial assistance to facilitate voluntary mergers of savings banks. Assistance provided would be in the form of income maintenance payments, interest-bearing notes, cash or any other form agreed to by the FDIC. A logically conceived merger proposal, with FDIC assistance, should enhance the prospects for the long-run survival of the merging institutions (as contrasted to the Title II program where ultimate survival is by no means guaranteed). In evaluating merger proposals, the following general policies would apply: 1. at least one of the merging institutions must have a surplus ratio of 3 percent or less; 2. unless an extremely strong case can be made, assistance to merge institutions which are both (all) eligible for Title II assistance will not ordinarily be given— it remains the FDIC’s clear pref erence to merge weak institutions into stronger ones (two or more institutions eligible for Title II assistance may be permitted to enter into a well-conceived merger if the resulting entity seeks no assistance other than that available under Title II); 3. the transaction will be exposed to other potential acquirers (which may include out-of-state and non-thrift firms) to determine if the transaction can be accomplished, on an economically sound basis, at a lower cost (there will be no requirement on the part of the FDIC to accept a lower offer, and the savings bank to be merged out will not be forced to enter into a merger with the firm submitting the better offer); 4. the merger must be expected to result in real economic either in the form of economies of operation or other advantages such as diversification of deposit base; 5. the assistance agreement should normally provide a means for recapture of the present value of the FDIC's outlays from future profits ; 6. the transaction must not involve more than nominal legal, accounting, investment banking or other fees or more than nominal severance pay arrangements; and 7. although there will be no automatic requirement to dismiss top management or trustees, reduction in high-level staff and trustees will be expected (the resulting board of trustees should be as small as possible, normally not to exceed 10-15 persons). benefits business
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