Rich Bank, Poor Bank: Mellon's Surprise Success

Skeptics abounded in 1988 when Frank V. Cahouet, chief executive of Mellon Bank Corp., came up with a novel way to deal with the $1.4 billion in bad loans that were battering the proud Pittsburgh institution. Cahouet planned to dump Mellon's lousy assets into a new bank created to dispose of them. In a stroke, the move would enable Mellon to begin a new life as a healthy bank. Fellow bankers scoffed. Even regulators balked. Cahouet never wavered. "You never get anything done that's particularly progressive without some people challenging you," he recalls.

Now, four years later, Cahouet's "bad bank" gamble has paid off handsomely. Last month, Mellon reported 1991 net earnings of a record $280 million, up 61% from the previous year. This year, profits could top $300 million (chart). And Grant Street National Bank, as the bad bank is called, has only a handful of bad loans left, the bulk of its job completed five years earlier than projected.

COPYCAT. That has silenced most critics. If it weren't for Grant Street, says one regulator, "there's some real question in my mind as to whether Mellon would have made it." Mellon's strategy is also seen as a blueprint for dealing with bad loans. BankAmerica Corp. is already copying the plan. "I think if you have the right franchise and you have the right management that is credible with the financial world, you can do other types of Grant Streets," says Cahouet.

When Cahouet, the former CEO of Crocker National Corp., took over Mellon in 1987, he knew it needed a bold strategy to recover. Anxious to rank with the big money-center banks, Mellon executives had piled on super-risky loans to the oil patch, real estate developers, and Latin America. Instead, Mellon was facing an $844 million loss for the year, the first ever for the patrician bank founded by Thomas Mellon in 1869.

Cahouet replaced top management and cut the work force. Grant Street, however, was the mainstay of his turnaround plan. By putting bad assets into a separate bank, he instantly purged Mellon's balance sheet. Mellon, which became known as the "good bank," would be rid of the financial drag and distractions created by bad loans. And Cahouet could preserve Mellon's reputation as a solid, blue-blood institution.

Launching Grant Street was something of a gamble. Its capital came from several sources. Michael R. Milken of Drexel Burnham Lambert Inc. sold more than $500 million in bonds, more than half of it junk. The investment firm of E.M. Warburg, Pincus & Co. paid $175 million for Mellon convertible preferred stock, almost $128 million of which Mellon then contributed to Grant Street in return for that bank's preferred and common stock. The common shares were subsequently spun off to Mellon stockholders.

Located just across its namesake street from Mellon headquarters, Grant Street opened in October, 1988. It paid $577 million, or 41 on the dollar, for Mellon's bad assets. The plan was that Grant Street would be able to sell the bad loans for enough money to pay interest on and eventually redeem its debt and preferred stock.

TICKING METER. Initially, shareholders and Wall Street analysts complained the plan would dilute Mellon shares. Indeed, after converting its preferred shares, Warburg Pincus now owns about 16% of Mellon. Cahouet, however, argued that a clean balance sheet ultimately would boost Mellon's stock.

That depended on Grant Street moving quickly. With bonds bearing 10.25% and 14.25% interest and preferred stock yielding 17%, "the meter was ticking very loudly," says William B. Eagleson Jr., an ex-Mellon chairman who came out of retirement to oversee Grant Street.

The bad bank and its 75 workout specialists proved adept at unloading sorry loans and properties. Cut-rate prices helped. On Jan. 29, Grant Street redeemed the last of Mellon's preferred stock and announced it had done away with all but about $15 million in bad assets. It has a similar amount in cash that will be paid to Mellon shareholders.

While Grant Street was grappling with bad loans, Cahouet was virtually reinventing Mellon. He has shifted its focus from corporate to consumer banking. Thanks to acquisitions such as last December's $88 million purchase of United Penn Bank in Wilkes-Barre, Mellon has 383 branches throughout Pennsylvania. Cahouet is also expanding Mellon's huge data processing business.

With that kind of record, even lingering skeptics are being forced to credit Cahouet with a remarkable turnaround. There's no question that without its bad bank, Mellon's problems would have been a lot worse.

    Before it's here, it's on the Bloomberg Terminal.