Opinion

Felix Salmon

ShoreBank, RIP

By Felix Salmon
August 20, 2010

Remember the ShoreBank rescue, back in May? Well, it got lots of headlines at the time, but it didn’t pan out in the end, and now ShoreBank has failed. The FDIC’s deposit insurance fund is taking a $367.7 million loss, and the money which was going to be invested in ShoreBank by Goldman, JP Morgan, Citigroup and others is now going to be invested in ShoreBank’s successor institution, Urban Partnership Bank. UPB will have a whole new management team, led by former Bank One executive William Farrow — something which rather puts the lie to conspiracy theories which said that Goldman et al were only investing in ShoreBank because its CEO was a friend of Barack Obama’s.

This clean-sweep approach makes a certain amount of sense: it’s right that ShoreBank’s shareholders should be wiped out when it managed to lose so much money. But it’s interesting to me that the government, given the choice between losing $368 million of the Deposit Insurance Fund or investing an extra $75 million in bailout funds, chose the former option. The deposit insurance fund, I guess, isn’t really considered taxpayer money, and will ultimately (eventually, hopefully) be repaid with future insurance premiums.

I wish Urban Partnership Bank well, and look forward to it proving that community-based urban lending can not only perform a crucial social function but can also be reasonably profitable. It’s sad that ShoreBank failed, but the main reason for the failure seems to have less to do with its community lending and more to do with its overexposure to speculative commercial real estate ventures. Urban Partnership Bank, I trust, will stick to its core competency, and do well for all concerned by doing so.

Comments
11 comments so far | RSS Comments RSS

It wouldn’t surprise me if someone thought the $75M was likely to be lost along with something on the order of $368 at a later date.

Posted by dWj | Report as abusive
 

How would $75 million in TARP funds have filled a $368 million hole? All that would have been accomplished is shifting $75 million of the loss from the FDIC to the taxpayer. They made the right decision.

Posted by Eric_H | Report as abusive
 

There will be a second wave of bank failures over the next year

Posted by STORYBURNthere | Report as abusive
 

Felix,
According to the WSJ story, the management team is not going to be completely new.

“The new institution will be known as Urban Partnership Bank and led by William Farrow, a former First Chicago Corp. executive who was ShoreBank’s president and chief operating officer at the time of its failure.

Mr. Farrow will be president and chief executive of the new institution, said a person familiar with the situation. David Vitale, a ShoreBank board member, will become chairman. Messrs. Farrow and Vitale arrived at ShoreBank after regulators ordered the bank to raise its capital levels significantly.”
http://online.wsj.com/article/SB10001424 052748704488404575441792379592022.html

Posted by SteveVB | Report as abusive
 

Felix, you are on to a very important point here–why would the FDIC spend $368 million of paid bank insurance premiums instead of $75 million to fix a bank. Are they crazy?

The problem is that under the law, the FDIC is obligated to consider only the least cost resolution of “closed bank” assistance(putting the bank in receivership). They are not obligated to consider any “open bank” alternatives (keeping the bank operating with more capital).

Therefore the FDIC can legally ignore the lower cost of assistance to an “open bank.” Yes, the FDIC has used “open bank” assistance in a few large bank cases which means it understands this concept perfectly. “Open bank assistance, in practice, requires that current owners and management DO NOT benefit. Thus “open bank” assistance does what we like to see under the “closed bank” or receivership alternative–it wipes out shareholders and fires management.

So in Shorebank’s case, $368 million of bank industry premiums were used to “close the bank” instead of $75 million of those premiums to keep it open with new management and owners because the FDIC followed their narrowly interpreted legal mandate.

With the FDIC having already spent all of its $19 billion of this year’s prepaid insurance premiums, this blind bureaucratic waste of funds should be pointed out. And yes, the banking industry, through its premiums, is footing the bill, so they should be screaming bloody murder. But they don’t because many of them find it an elegant way to eliminate competitors. To paraphrase Churchill, each man feeds the alligator, hoping that the alligator will eat him last.

Make no mistake: “Open bank” assistance is typically cheaper. Anyone that has dealt with the FDIC realizes that the cost of closing a bank involves middle men and is also hugely inefficient. “Closed bank” assitance is not often the least cost option, unless there is criminality, gross negligence or other extreme loss factors. “Closed bank” assistance is inefficent specifically because:

(i) in closed bank sales, asset prices have to be marked down enough to attract buyers. (In “open bank” alternatives you just have to collect the loans.) Typical buyers, especially private equity, investment banks or real estate funds, demand a 30%+ return on their investment which takes loan marks at or below 40% of face value in the average case of CRE or SFR loans, even performing loans;

(ii) Because of the number of failures are overwhelming FDIC manpower, the FDIC hires independent contractors (typically retired regulators and unemployed community bankers). They are paid by the hour. Hence, they have a perverse incentive NOT to resolve problem assets but to drag out the recovery process as long as possible. In a market in which prices of CRE and SFR assets are dropping, that just adds inefficient personnel expense to additional market losses.

Over the past two years we have seen some really atrocious financial industry resolution policy. For example, Bear Stearns, if you think about, was an “open bank” resolution. (Yes, I know, it wasn’t technically a bank, but that is for another discussion.) The Treasury provided “open bank” assistance ($30 billion of it) for JP Morgan Chase to buy Bear at $10/share. Wait! I thought under “open bank” assistance current owners weren’t supposed to benefit? Huh?

And now we see the FDIC blindly ignoring “open bank” resolution alternatives and blowing through their premium fund because the law doesn’t obligate them to do the right thing. What ever happened to doing the right thing because it is the right thing?

Posted by AABender1 | Report as abusive
 

You’re confused. The $75 million is what ShoreBank wanted from TARP, not from the FDIC. They didn’t get it because it would not have prevented their insolvency. TARP isn’t supposed to put money into nonviable institutions and ShoreBank was nonviable (even with the additional $150 million from their other potential benefactors). Had TARP given them the $75 million, the FDIC would still have been saddled with their failure, although it would have cost $75 million less. That would have been less costly, but it’s not TARP’s job to reduce the FDIC’s resolution costs.

Posted by Eric_H | Report as abusive
 

This story is not over. Take a very hard and long look at the subs. They, meaning the senior managers and Board memebers, dodged a serious bullet, especially given that the FDIC is going to take a loss on closing ShoreBank.

Posted by yancyd | Report as abusive
 

Eric_H:
Agreed Shorebank wanted a TARP infusion, but it is not clear at all that with an additional $225 million of new capital Shorebank was nonviable.

But it is clear that with $150 million of additional private capital, the FDIC’s loss would have been at least that much lower. And it would have been much less as an “open bank” transaction because, from personal experience, I know the FDIC problem asset management process to be terribly inefficient.

Lastly, the Treasury has used TARP to reduce FDIC resolution costs. They have agreed, at least in two instances that I know of, to take a haircut of at least 60% on a bank’s TARP repayment, if a private entity is recapitalizing that problem bank. that is just a back door bailout.

Posted by AABender1 | Report as abusive
 

I absolutely agree with you about the FDIC’s asset liquidation process, but that just means that $368 million may well be a low-ball estimate of their eventual cost. As for your other point, we have to distinguish between TARP candidates that appear viable at the time of their application and those that do not. Some TARP applicants will seem viable and get help, but ultimately fail. Those are understandable “mistakes” by TARP. ShoreBank does not seem to fall into that category. By the FDIC’s estimate, they needed $368 million to get back to zero net worth, but had only $225 million ($75 million TARP plus $150 million other) lined up.

Posted by Eric_H | Report as abusive
 

aabender1 is wrong. The FDIC is not allowed to benefit shareholders (which is basically equivalent to an open bank deal) under any circumstances according to FDICIA. The only exception is for systemic risk, which is how the FDIC could help in the Citi bailout. But it generally has no discretion in these matters.

Posted by abc123fgh | Report as abusive
 

@ AABender1: incorrectish. The FDIC was supportive of using TARP funds, Treasury was unwilling to, because of political pressure. Glenn Beck et al picked up on it and turned it into a cause celebre. It required both the Treasury and FDIC acting in tandem, Treasury couldn’t.

@ Eric_H : Mostly incorrect. Shorebank would not have been closed by the FDIC had it received TARP funds, at least not in the short-run. Determining long term viability is of course challenging, but it is probable that Shorebank could have survived with additional TARP money. Not giving Shorebank money was for political reasons, not practical. Had the bank been anywhere other than Chicago, there would never have been issues in terms of government assistance.

Posted by David_Michaels | Report as abusive
 

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