Bailout Bill Has Southland S&L; Revising Its Game Plan
As part of its deal to buy ailing Western Empire Savings & Loan in late December, the New York merchant banking firm of Castle Harlan Inc. had to chart a business plan that satisfied federal regulators.
Today, Castle Harlan must rewrite Irvine-based Western Empire’s recovery plan to satisfy a new set of regulatory requirements.
Western Empire, with two branches in Orange County, is typical of hundreds of savings and loan associations across the nation that must adjust to radical changes mandated by the S&L; bailout legislation signed Wednesday by President George Bush. They are healthy or recovering thrifts that worry that some of the new provisions in the bill are onerous and, in some cases, renege on promises that regulators made late last year as they hurried to peddle dozens of insolvent S&Ls.;
“We were outside investors who came in with cold cash, and now they’re changing the rules on us,” said Rob Wages, a Castle Harlan employee and Western Empire director. “We’re disappointed with the legislation. Certainly anyone who goes forward with any bailout of an S&L; has to keep in mind that the government can change the rules at any time.”
$6 Million in Goodwill
After posting losses for more than two years, Western Empire has started recording profits in the past two months. A key element of Western Empire’s return to profitability is gains from trading in high-yield corporate securities, often called junk bonds.
And nearly $6 million in previous losses were converted to goodwill, an intangible asset that has no real value yet boosts capital, a thrift’s final protection from losses. Under the purchase agreement, regulators gave Western Empire 20 years to write off that goodwill.
The new law, however, forbids S&Ls; from using federally insured deposits to trade in junk bonds and gives institutions five years to liquidate their portfolios of such bonds. It also sets up tough new capital standards and requires that goodwill be eliminated from calculations of capital within five years.
Junk bond trading “was a major part of our business plan,” Wages said. And the requirement to bolster capital while writing off goodwill creates “a very big hit on earnings,” he said.
Although frustrated by the rule changes, Castle Harlan is “committed” to the S&L; and will revise its business plan to comply with the new law and to provide the parent company with the returns it expects, Wages said.
Unlike many investors who bought thrifts in the waning days of 1988, Castle Harlan did not receive financial assistance. It paid $15.8 million in cash for Western Empire, and only $50,000 of that went to the former owners. The remainder erased the S&L;’s negative net worth and provided a cushion of capital that allowed it to resume its growth.
Impact of Junk Bonds
But regulators did approve two important items in the deal--the inclusion of goodwill as part of the S&L;’s assets and capital base and the ability to start trading in junk bonds.
At the end of June, Western Empire had $121 million--or 25%--of its assets in junk bonds, according to the S&L;’s figures.
“A large part of our operation in terms of turning the S&L; around is based on high-yield securities,” Wages said. “We’re going to have to take a look at the impact of the law on our operations.”
He termed the five-year phase-out period a “constructive” compromise and said the S&L; would be able to comply.
One option allowed in the law, he said, is to create an affiliate that would be sufficiently funded--not with deposits--to engage in junk bond trading. It may be possible, for instance, to move the portfolio to the affiliate and provide the S&L; with a promissory note to cover the deposits used to buy the junk bonds, he said.
Creating an affiliate, though, could mean that the S&L; would cut back the amount of assets it puts into mortgages.
“If the legislation forces thrifts into mortgages only, there will be a dramatic reduction in assets in the industry because mortgages are not making money for S&Ls;,” he predicted. “A lot of thrifts will be put out of business, and home owners will pay more for mortgages and get less for deposits.”
Higher Cost Seen
Castle Harlan has not decided how it will change its operations, he said.
“The total cost to everyone will be higher because the law is limiting an S&L;’s ability to invest in an area in which it has expertise to help bootstrap itself out of trouble,” Wages said.
Wages is not as concerned with the new requirement to raise the capital level.
Writing off $5.9 million in goodwill over five years instead of 20 means that the S&L; must subtract $1.2 million a year--or $295,000 a quarter--from its pretax earnings. That’s a big bite from an institution that is only now starting to post modest profits, he acknowledged.
Although it lost $1.1 million in the first six months of this year, the S&L; recorded a modest profit in May and June totaling $55,000. At the same time last year, Wages said, the S&L; was losing $500,000 a month.
At the end of June, Western Empire had $492 million in assets and its capital exceeded the requirements spelled out in the new law. But if it needs more capital in the future, Wages said, it should have little trouble raising adequate cash from private sources.
As long as it can bring more cash into its capital base, goodwill won’t be a problem. The S&L; can still write it off over 20 years, Wages said; it just cannot include goodwill in its calculation of capital for regulators after five years. Its goodwill at the end of June was $5.7 million, or about 1% of its assets, he said.
“At this point, if we were presented with the same deal to buy Western Empire, we might not choose to do it,” he said. “But we are committed to what we’ve done and think there’s enough flexibility in the new law to make it work.”
WESTERN EMPIRE SAVINGS AT A GLANCE
Western Empire, which opened in 1981 as Placentia Linda Savings & Loan, was acquired in 1988 by Castle Harlan Inc., an investment banking group from New York. Western has headquarters in Irvine and another office in Yorba Linda.
Year ended Dec. 31 (in millions) 1988 1987 1986 Assets $133 $120 $124 Net income -$8.9 -$3.4 $1.0 Regulatory capital as % of assets 9.27 0.55 3.33
Assets (1st qtr 1989): $245.8 million
Junk bonds (1st qtr 1989): $50 million
Number of employees: 55
Chief executive: Robert Margolis
Sources: Alex Sheshunoff & Co. and Federal Home Loan Bank of San Francisco
