Smart Money Goes on Fishing Trip for Floundering S
If the nation’s savings and loan industry is in such terrible shape, why are all these smart-money guys named Bass, Simon and Perelman buying failed thrifts?
Even the leveraged buyout wizards at Kohlberg Kravis Roberts & Co. are about to plunge into an industry swamped in billions of dollars in red ink. And Merrill Lynch Capital Markets, an arm of the nation’s biggest brokerage, is amassing $100 million from investors to acquire savings and loans.
In a phrase, these savvy investors are “bottom fishing”--trolling among dead and near-dead institutions for cheap deals with the potential to turn a relatively small amount of up-front money into a megaprofit with a minimum risk.
Along the way, they are constructing transactions that insulate them from big losses and secure lucrative tax benefits that will enable some investors to recoup their money within a year even if an institution is not restored to strong health. If the thrift is revived eventually, their return will be all the greater.
To cut their risk, investors have been able to persuade the regulators to promise to pay any future losses on loans on the books of the failed institutions. These guarantees are in addition to cash assistance from the regulators and the benefits from tax losses.
Together, these strategies protect the investors and impose potentially huge hidden costs on the regulators and the taxpayers.
The hidden costs are in two basic forms: The guarantees to cover loan losses string out the expense of the rescues over many years, and the tax-loss benefits constitute a direct drain on the Treasury and an indirect means of having the taxpayer finance the bankrupt Federal Savings and Loan Insurance Corp.
“Clearly, there are some bargains out there of extraordinary dimension, and most people who have taken advantage of them to date have done it with minimal risk,” said Rep. Jim Leach (R-Iowa), a member of the House Banking Committee. “What has developed is a giveaway system where potential profit has been privatized while potential losses are socialized.”
Whether this bottom fishing will turn out to be good for the savings and loan industry is a subject of some controversy, particularly with the regulators working around the clock to close as many as 50 deals for distressed thrifts before the end of the year, when a change in the law reduces the value of the tax benefits.
Going to Come ‘Unglued’
In some cases, there appear to be benefits, both for individual thrifts and the industry. Investors have committed enough capital and resources to turn around institutions that have a healthy potential but have been dragged down by mismanagement and bad real estate loans.
But in other cases, doubts have been raised about whether institutions are destined to return to the rolls of the insolvent in the next few years.
“It appears that we’re looking at deals that, as a country, we will regret in the not-too-distant future,” said Bert Ely, a prominent industry consultant in Alexandria, Va. “Someday all this is going to come unglued.”
Judging the transactions is difficult because most details are kept secret by the regulators, who maintain that disclosure would damage their bargaining position in future deals.
But the danger appears to be greatest in deals where a number of deeply troubled thrifts are packaged for sale to an investment group by FSLIC and its parent, the Federal Home Loan Bank Board. This is occurring most often in Texas, where a third of the thrifts are insolvent.
Robert E. Litan, a thrift expert at the Brookings Institution, a Washington think tank, warns that propping up sick thrifts with minimal capital from investors is likely to backfire.
“Many of these institutions are too far gone and should be shut down,” Litan said. “But the regulators don’t have the cash to just shut them down, so they have to arrange these mergers. A few of them may work out, and the FSLIC will have saved money. But a lot of them won’t. The whole thing is like Las Vegas.”
If the atmosphere smacks of Las Vegas, FSLIC is a broke gambler who must deal with the money men on their terms in hopes of staying afloat until Congress and the new Administration come up with a solution that is long overdue.
For their part, the regulators defend the flurry of year-end deals and the other controversial transactions in 1988 as a means of drawing desperately needed capital to the beleaguered industry.
“I am not naive enough to say there won’t be any of these deals that won’t work or will not have a problem,” M. Danny Wall, chairman of the bank board, said in a telephone interview. “But on the other hand, we are doing the very best that we can with the resources that we have available to us.”
Separating Wheat, Chaff
Wall said that, despite the rush to finish a total of 200 deals this year, the regulators are not flinching at rejecting transactions with which they are not comfortable. He also said that the pool of bidders has been far larger than he had anticipated, which improves the chances for making good deals.
One of the toughest tasks for the harried regulators, Wall acknowledged, is weeding out the fast-buck artists from the serious investors who are willing to stick around long enough to do more than reap the tax benefits.
In fact, many of the current problems are blamed on lax regulation in the early 1980s that allowed real estate developers and others with a penchant for risk-taking to enter the industry. Many of the thrifts now being sold to investors are the fruits of wild growth, greed and mismanagement that started in the early ‘80s.
The regulators have been getting better marks in selecting new owners this time, although questions have been raised about selling again to some big real estate development firms and breaking down the old wall between banking and commercial businesses.
“The regulators have to distinguish between the good and the bad (in acquirers),” said Thomas P. Vartanian, a Washington lawyer and a former bank board general counsel, who represents thrifts and investors. “I’d say they (the regulators) have been doing an A-plus job.”
Even with that praise, Vartanian offered this caution: “The people who are bidding for these failed thrifts are not patriots.”
The first person to make a splash acquiring sick thrifts was William E. Simon, the former U.S. Treasury secretary who made a fortune as a leveraged-buyout pioneer.
First, he bought Honolulu Federal in 1986 and Southern California Savings in Beverly Hills in 1987, both failing institutions. Last fall, he acquired another sick thrift, Bell Savings in San Mateo, and merged it with a healthy one, Western Federal in Marina del Rey.
While the SoCal and HonFed deals raised questions about whether the regulators had been too generous to Simon, FSLIC officials welcomed his arrival because his reputation for financial shrewdness seemed sure to attract other big-time investors.
Indeed, Texas tycoon Robert M. Bass is putting the finishing touches on the acquisition of Stockton-based American Savings & Loan, the nation’s second-largest thrift. In exchange for an infusion of an initial $350 million from Bass, FSLIC has agreed to provide a $2-billion assistance package.
And corporate raider Ronald O. Perelman’s investment company, MacAndrews & Forbes Holdings, has been selected as the winning bidder for five Texas thrifts with assets of $10 billion. The company will reportedly provide $300 million in new capital, but the terms of the federal assistance are unknown now.
Many See Benefits
The nation’s largest real estate developer, Trammell Crow Co., was part of a joint venture that acquired three failed Texas institutions last fall. And Pulte Diversified Cos., a subsidiary of a major national home builder with considerable business in Texas, acquired five thrifts in the state.
Kohlberg Kravis Roberts, fresh from its $25-billion victory in the battle for RJR Nabisco, will provide an undisclosed amount of money to acquire thrifts and banks. The venture will be run out of Los Angeles by Don M. Griffith, who recently resigned as chief financial officer at First Interstate Bancorp in Los Angeles.
While his background is banking, Griffith said he is also looking for acquisitions among distressed thrifts, adding, “You don’t have to know anything about how to run an S&L; to benefit from some of these transactions.”
One of the most successful acquisitions of a failing thrift was made by America First Financial, a San Francisco-based investment fund that raised $120 million from 12,000 limited partners to buy Eureka Savings in San Carlos and Stanford Savings in Palo Alto and merge them earlier this year. Hoping to strike again, the fund is raising another $200 million for its next deal.
Along with committing a then-record $100 million of the money to the deal, America First’s president, Stephen T. McLin, brought in a new management team and plans to restore the combined 36-branch thrift to prosperity in the coming years before selling it.
In exchange, FSLIC agreed to pay for all future losses from bad loans on Eureka’s books and contributed $291 million in cash to make the new institution solvent. FSLIC also agreed to share the tax-loss benefits with America First on a 50-50 basis. That means that FSLIC will be able to reduce its future cash assistance to Eureka by half the amount of tax savings the thrift realizes through the tax-loss benefits.
McLin, who engineered a number of major acquisitions while at Bank of America for several years before resigning in early 1987, acknowledged that the tax benefits are a strong bargaining chip for FSLIC, which can offer them in place of additional cash assistance.
“The idea is that they can use the tax benefits to attract acquirers,” he said. “It’s kind of a backhanded way of funding FSLIC through the IRS.”
Using simple arithmetic, a buyer might be willing to pay $20 million for a thrift that will earn $2 million a year. But if the income can be sheltered through pre-existing tax-loss benefits and the net goes up to $3 million a year, the buyer might pay $30 million. Or the cash-strapped FSLIC might be able to reduce its cash contribution to the deal by $10 million.
The loser is the U.S. Treasury, which does not receive taxes on the earnings of the thrift. The tax loss becomes more significant when thrifts are acquired by healthy businesses that use the thrift’s losses to shelter taxable income from their other operations.
Exempt From Taxes
The ability to shelter income by acquiring tax losses was eliminated by the 1986 tax reform act, but thrifts were exempt from the change. As a result, an acquirer can still deduct certain thrift losses from its overall balance sheet.
That is one reason Ford Motor, one of the nation’s biggest taxpayers, has been so eager to acquire distressed thrifts before the end of the year when a change in the tax law will restrict the usefulness of the tax benefits.
In addition, assistance from FSLIC is exempt from federal income taxes, which provides a mechanism for sheltering income even after an acquisition is completed.
In many cases, FSLIC has negotiated to receive a share of the tax benefits, which reduces the assistance the agency will provide in the end. But critics have argued that the benefits constitute an unfair raid on the Treasury to finance the bankrupt FSLIC.
Others, such as lawyer Vartanian and Wall, contend that the tax losses exist and there is nothing wrong with using them. If they were not available, FSLIC would simply have to come up with more assistance to get deals done, and the agency does not have the money to do that.
The line that must be drawn is whether the transaction makes sense without the tax breaks. Many experts think those thrifts that would not have been acquired without the tax benefits are the ones most likely to return to insolvency once the benefits have been sucked out.
“Once the tax benefits are gone, I think some of these people are going to find that they are not making a buck, and they are going to walk away,” said Ely, the consultant. “Even though these are smart deal makers, they are walking into situations with some of these thrifts that are a lot worse than they imagine.”
Small Personal Stakes
Even if large numbers of investors walk away from thrifts, many will not be forfeiting much of their own money.
Some investors simply are not putting up much money. A group that includes a subsidiary of Lone Star Technologies, a Dallas manufacturing company, acquired 13 Texas thrifts with assets of $2.7 billion for $48 million--a mere 1% of the liabilities of the institutions--while FSLIC put up $499 million in cash and guaranteed future loan losses.
The limited partnerships created to invest in thrifts by Merrill Lynch and McLin’s America First collect money from thousands of investors and then take out hefty up-front fees for expenses and management.
Former Treasury Secretary Simon’s acquisition of Bell Savings and Western Federal was financed chiefly by $236 million in debt and preferred stock. Fees in connection with the transaction were about $8.4 million, according to the prospectus on the deal.
Of those fees, $2 million went to a company owned by Simon and a partner in exchange for arranging for another company controlled by Simon and his children to purchase $30 million in preferred stock. A substantial amount of the remainder went to other firms controlled by Simon and his partners.
“The people who are taking over these things are really gambling very little,” said Litan at the Brookings Institution. “But from the FSLIC’s point of view, if you don’t do anything, the losses at these institutions just continue. If you arrange a merger, there is a chance that the institution may recover. Certainly it is a better chance than if you just left it alone.”
