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Two Asset Crises, Two Resolutions

In August, the Congressional Oversight Panel (the COP) released its report, “The Continued Risk of Troubled Assets.” The report covers, among other things, a summary of methods that have been and are being used to manage toxic assets. Community bank organizers and acquisition teams can turn to this section of the report as a refresher on the dangers of getting caught up in the race to lend more and more.

The report details the strategies used in two prior crises, along with those used in the current situation. The two prior crises mentioned are the Less Developed Country (LDC) Crisis and the savings and loan (S&L) crisis; both were predicated by, among other things, rapid increases in certain types of lending.

LDC crisis

The LDC crisis was characterized by:

•    Rapid increase in debt made to Latin American countries
•    A concentration of debt among the largest money-center banks
•    Broad-based defaults (40 countries were in default by the end of 1982)

Strategies used by banks and legislators to manage through these defaults included:

•    Debt restructure
•    Increased loan loss reserves
•    Conversion of debt into tradable bonds to remove debt from bank balance sheets
•    Debt forgiveness

S&L crisis

In the same decade, U.S. thrifts faced another asset quality crisis which led to the failure of more than 1000 savings and loans institutions. Circumstances included:  

•    Rapid increase in real estate and commercial loans
•    Concentration of bad assets in a subset of thrifts (primarily those located in Texas)
•    Insufficient regulatory oversight
•    Broad-based defaults

The S&L crisis was addressed with the formation of the Resolution Trust Corporation or RTC. The RTC was tasked with selling the assets, good ones and bad, of any thrift placed in receivership. Assets were primarily sold at auctions, but equity partnerships were also used—particularly in situations where the RTC wanted to recover more than market value would allow. In those cases, a private partner would manage the assets and eventually sell them, providing the RTC with a portion of the proceeds. In still other situations, the RTC used securitization to liquidate certain commercial and multifamily loan assets.

According to the COP report, the RTC recovered approximately 85 percent of the assets it acquired.

The RTC’s success was assisted by a functioning market that allowed for the valuation of these assets. This is a circumstance that has not been consistently present in the current banking crisis—indicating that an RTC-style solution would not be as effective today. For that reason and others, the Treasury took a more sweeping approach this time around, setting up the TARP to reinforce balance sheets, requiring stress tests to prevent future problems, and establishing the PIPP to heal the market for these assets. The COP report does question whether debt restructure, as used in the LDC crisis, could have or should have played a larger role in the Treasury’s solution.

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