Buying Belly-Up Banks With FDIC Backing

In the banking industry these days, failure can be good news.

Being taken over by the Federal Deposit Insurance Corporation, or FDIC, is never good for a failed bank. It can be excellent news for the bank chosen by the FDIC to acquire its prey.

In November, East West Bancorp (EWBC) in Pasadena, Calif., won the bidding to take over failed San Francisco-based United Commercial Bank, its $9.9 billion in assets, and $6.5 billion in deposits. Over the next five days, East West's stock jumped 55.7%.

FDIC-facilitated buyouts of failed banks have become a major factor driving bank stocks. According to an analysis that SNL Financial conducted for Bloomberg BusinessWeek, there have been 24 government-assisted buyouts of banks with more than $500 million in deposits since July. Eight produced double-digit stock gains in the five days of trading that followed the announcements. In 10 further cases, the acquirers' stocks beat a broad, SNL-developed index of banks and thrifts.

To attract bidders for failed banks, the FDIC sweetens deals by taking part of the credit losses incurred by buyers. The government agency generally pays for 80% of losses up to a certain threshold, and 95% above it. By acquiring failed institutions through the FDIC, banks also win strategic and financial advantages.

For example, on Dec. 4, New York Community Bank (NYB), whose operations were previously confined to New York and New Jersey, acquired the $11 billion in assets and $8.2 billion in deposits of Cleveland-based AmTrust Bank. With branches in Ohio, Florida, and Arizona, AmTrust elevated its acquirer's assets by 28%, loans by 26%, and deposits by 55%. The deal is so beneficial to earnings that New York Community was able to issue 60 million shares, raising $780 million, without diluting its earnings per share, says Peter Winter, a banking analyst at BMO Capital Markets.

Don't overlook Strategic benefits

The deal "really strengthened the balance sheet," Winter says. In five trading days after the deal was announced, New York Community shares beat the SNL Bank & Thrift index by 8.7 percentage points.

The strategic benefits of FDIC-sponsored deals can be as compelling as the financial boost they provide. "It can enable a bank to overnight pick up a franchise or be in a geography" that could otherwise take years to build, says Raymond James (RJF) analyst Michael Rose.

IberiaBank (IBKC), based in Lafayette, La., bought Century Bank, based in Sarasota, Fla., on Nov. 13. "Overnight, they became the 20th-largest bank operating in Florida," Rose says. "Florida was the place they wanted to be." After the economy recovers, Florida should be fertile ground for banking, with less competition after so much hardship, he says.

The benefits of FDIC-enabled transactions are so clear that many analysts and investors are busy trying to predict which companies will get to gobble up the next big failures. Even a brief slowing in the pace of FDIC bank takeovers threatens to hurt bank stocks. In a Feb. 16 note, Frederick Cannon, a Keefe, Bruyette & Woods (KBW) banking analyst, said that after 15 bank failures in January, the casualty rate slowed in February to one small, $18-million swan dive.

Fewer failures could spell trouble for banks poised to benefit from acquisitions. Noting that the slowdown might be due to snowstorms in Washington, Cannon wrote: "If the FDIC retrenches and reevaluates its sale process, we would expect those share prices could fall back and begin underperforming in the near term."

2009 "just scratched the surface"

Cannon and other banking experts don't doubt that the pace of bank failures will eventually rebound. The FDIC closed 140 banks in 2009. The Independent Community Bankers of America expects an even greater number of bank failures in 2010, followed by a decline in 2011.

BMO's Winter notes that the last banking crisis, in the early 1990s, lasted four years, and says that this one could play out for at least three years. "Last year we really just scratched the surface," he says.

For investors who are trying to avoid failing banks while profiting from FDIC-led takeovers, the key question is where and when the next transactions might happen. The FDIC discloses very little information about its bank-takeover process. The bidding process is secret.

The FDIC keeps a list of problem banks—now at its highest level in 16 years—but the agency doesn't release the names of listed banks. The FDIC said there were 552 institutions on its "problem list" at the end of September, with total assets of $345.9 billion. An FDIC spokesman did not respond to requests for comment.

The lack of information from the FDIC doesn't stop analysts from trying to make predictions. On Feb. 8, for example, Keefe, Bruyette & Woods listed 387 banks whose finances it said were shaky.

pluses: management, capital, credit

The prime culprit in bank failures so far is the slump in the real estate market, especially problems faced by developers. According to KBW data, 8.4% of loans in the U.S. banking industry are "construction" loans. They represent 26.5% of the loans at the banks that have failed since 2007.

KBW also listed 33 banks "poised to benefit from failed institutions." The healthier banks have "capable management, sufficient capital, above-average credit quality, and regional opportunities," KBW's Cannon wrote on Feb. 16.

Raymond James' Rose says banks that have already acquired others through the FDIC may hold an advantage in future transactions.

Analysts also account for geography, figuring that acquisitions are more likely to come in regions hit hard by the banking crisis. Of assets at troubled banks, KBW says 35% are in the Midwest and 34% are in the Southeast. Only 2% are in the Northeast, meaning that the region's banks, such as New York Community Bank, need to look west or south for deals.

As banks recover along with the economy, competition for failed banks could increase. "You're going to start to see competition heat up as more banks want to compete for these deals," says BMO's Winter. Private equity shops are also looking at bank acquisitions, he notes.

More bidders raise the risks that acquirers could overpay the FDIC for failed institutions. Although loss-sharing agreements limit banks' credit risks, "the risk is that, depending on what you pay, you don't get an acceptable return on the investment," Winter says. Buying a troubled bank can mean a lot of work for a bank's staff, which must—under the watch of regulators—work through money-losing loans. "That takes time and resources," Rose says. "You could turn your attention away from your core franchise."

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