2008’s July 4 celebration weekend was barely over when the nation’s banks and financial markets were rocked with news of a major lender’s insolvency in California, and the need for an emergency bailout of America’s two largest mortgage lenders, FNMA and FMAC.
Fannie Mae and Freddie Mac were “sacred cows” of the American economy for decades. All this ended in mid-July when it became clear the companies were in dire financial condition and required federal funds to survive.
President Bush’s comments about the bailout were candid at an unprecedented level. His statements conceded that federal help for the two mortgage giants was essential to assure stability in both American and European banking circles.
As our country’s resources have become increasingly consolidated, and increasingly dependent on foreigners, our ability to withstand shocks like FNMA’s troubles, suffer through new, unprecedented levels of economic consequence. Small businesses, starting and succeeding, and ending with retirement, death or displacement, were the hallmarks that allowed the entrepreneurial spirit to survive. Now, the nation observes, if silently, the repercussions of financial failure in mega-companies.
But people are affected much the same. Whether the failed bank is the depository of billions owned by tens of thousands, or of millions owned by hundreds, the anxiety is the same. Will the bank reopen? How long will my money be tied up? What will I do if FDIC won’t pay me? What if it’s broke and can’t pay me?
What will happen to my loan? It’s current, but who will own it? What will they be like to deal with? Will they be interested in me, or simply find a reason to call the note so it can be collected?
These are not new questions, and bank failure is not a new phenomenon. Forty-five years intervene between the end of the Depression, and the beginning of the agricultural and oil busts of the 1980s. Hundreds of banks failed in the 1980s. Thousands in the 1930s. Now, nearly 30 years later, the potential demise of dozens of banks could impact the same number of people as suffered when more, but smaller, institutions were declared insolvent in the past.
What Is the Effect? How Does a Bank Insolvency Work?
Banks are highly regulated industries. Those with national charters are examined by federal banking authorities, who have the authority to determine the safety and soundness of an institution. When a bank’s portfolio poses too many risks, and its default rate is too great, or its cash flow is too weak, or its depositors want to withdraw their money too fast, the institution can be declared insolvent.
What is a “declaration of insolvency”? Intuitively, lawyers must know that a banking regulator cannot simply take a bank away from its owners with a declaration. There must be some due process, and some elements of proof involved.
And there are.
In Nebraska and other states, insolvency must be proven. The state banking regulators, the Nebraska Department of Banking and Finance, are authorized to declare insolvency, and petition a district court for appointment as receiver for the insolvent institution. The bank and its owners can contest this contention, and the issues can be tried. But, to protect the public the Department can be appointed receiver, take over the bank, and become its exclusive operating authority while the insolvency case is pending.
Usually, insolvency declarations are assented to. By the time this extreme step occurs, it is usually well known that the bank is unable to meet its obligations in the ordinary course of business.
The court adjudicating insolvency is empowered to appoint a receiver, take over operations, and control the assets as well as the debts. All creditors, and all persons with claims of any kind to the assets, must be paid in full before anything can pass to the failed institution’s shareholders.
Often, a corporate shell of the failed organization can be offered for sale, and sophisticated bidders can agree to bid on some, but not all, assets. While there is much potential for success in this process, it is a sensitive area in which to practice as the risks are high, and the rewards are seldom so high for the practitioner.
Domina Law Group pc llo’s Experience
Domina Law Group pc llo has much experience with bank failures. “My first involvement was the failure of First National Bank of Eldora, Iowa in 1973,” Dave Domina said. My clients held sight drafts drawn on a bank customer, but essentially backed by the bank’s general deposit assets because of dealings between the banker and the company. Domina sued directors and officers of the closed Eldora bank, along with the FDIC, and, after a five week jury trial, recovered a seven figure judgment.
“I was 24 when I tried the case. I had no idea how big a deal the work was, or how young I was or looked to the others, until late in the case when the United States District Judge offered a kind comment,” Domina recalled.
Later, Domina became a Special Assistant Attorney General responsible for investigation of the failed Commonwealth Savings Association in Lincoln, and the investigator for matters associated with the organization’s failure. Nebraska’s incumbent Attorney General was impeached as a result. The case resulted in the second of three impeachment trials in Nebraska history. One occurred in the 1870s. Domina was involved in the other two.
“Banks dropped like flies in the eighties,” Domina said. In Nebraska he was involved in bank failures at Niobrara, Crofton, Jensen, Oakdale, Gehring, Center, Lincoln, Omaha and Grand Island.
Iowa cases included Eldora, Creston, and consultation with others. Wyoming bank failures in Casper and Cheyenne required Domina’s efforts too.
Good people on boards of directors who were committed to civic minded public service found themselves confronted with FDIC or RTC claims against them, Domina recalled. The bank failures arose largely from “asset based lending, like the mortgage markets, where no attention was paid to repayment because everybody thought the collateral was increasing in value so rapidly there was no end in sight, and no one paid attention to cash flow.”
The Regulatory Process
People know, broadly, that banks are examined by government regulators. “But they don’t know that examinations include analysis of the loan portfolio.” Domina explained, “loans or ‘credits’ inside a bank are subject to adverse classification if they pose credit risks of loss to the bank. Three general classification groups are used: substandard, doubtful, and loss.”
“A bank may have to write off some of a substandard loan’s value, and significant more of a doubtful loan. Usually, a loan categorized as “loss” must be charged off entirely, except to the extent of the conservative value of its not-yet liquidated collateral.”
“Bank owners are entitled to due process of law, and they get it. If there is serious question about their bank’s insolvency, they can probably stay in place while waging a fight.”
This due process right assures that owners will not have their bank stock stripped from them without a fair hearing. It means they can present their case, and find a salvage value from their assets.”
Impact on Depositors
Bank failures are starkly frightening for depositors. Life savings can be tied up, jeopardized and if they exceed $100,000 in total deposits, regardless of the number of accounts, they can be lost. Domina noted, “there is an incorrect perception that FDIC insurance runs to $100,000 per account, so customers can save more by opening more accounts. This is not the case.
FDIC insurance, activated by a claim form, and depending on the bank’s documentation of account balances, insures deposits up to $100,000. The insurance, funded by assessments against member banks throughout the year, spreads the risk of bank failure to the population of banks, and their depositors, nationwide.
Above $100,000, a depositor’s sole source of recovery is from a banking institution’s residual assets after failure. If loans can be collected eventually, and wind up expenses do not consume any equity, a bank failure caused by a cash liquidity problem can, eventually, mean depositors will not suffer a loss.
More commonly, bank failures occur because the bank’s loan portfolio deteriorates rapidly, and loans, assets to a bank, become less value than the amount the bank owes its customers for the money they placed in the bank’s care.
“Where a bank is insolvent because its loan portfolio has suffered huge losses, bank depositors seldom are made whole. There is simply no source from which to do so.”
“Depositors aren’t the only ones who lose.” Domina explained, “Bank shareholders lose everything. And, often, bank officers and directors face civil claims for imprudent decisions about how to operate the bank, and unwise decisions about oversight of daily activities. Each bad loan is scrutinized for officer and director involvement, and each poses a threat to those charged with the bank’s operations and oversight.”
Domina successfully defended bank officers and directors in litigation many times in the 1980s, and made recoveries against others, in different institutions. “An officer’s or director’s liability is largely dependent on his or her vigilance. Good minutes, reflecting thoughtful oversight, careful inquiry, and prudent judgment after seeking information and facts, are the keys to safe, sound banking operations. The officer who can’t face a loss, or the director who won’t do the work, is a threat to the bank, and a threat to banking.” Domina added, “The shocking news about Fannie Mae and Freddie Mac means repercussions for other banks, and for financial markets. There is no choice but to be thoughtful about this fact.” Domina hopes another round of banking difficulty does not vie ahead, and urges bankers to be cautious about management, and begin portfolio cleanup immediately.
Domina Law Group pc llo is a firm of trial lawyers. We specialize in complex litigation on a national basis. Our lawyers are ethical, aggressive, and committed to providing spirit and vitality to the judicial system and our client’s legal rights.