Cracks in The System

By Christine Gorman

Even diligent readers of the financial pages may be feeling bewildered by the goings-on in the banking industry. One day the headlines are proclaiming good times and rising profits for most financial institutions. Next day they are telling of bank failures and bailouts.

Despite five years of expansion by the U.S. economy as a whole, many banks and savings and loan associations are racked by troubles in the farm belt, depressed conditions in the oil patch and unwise real estate ventures all over the country. While the large majority are solidly in the black, the weakest institutions are in such bad shape that they threaten to exhaust the multibillion-dollar Government insurance funds that protect depositors. If that happens, taxpayers will have to come to the rescue. Federal regulators are confident they can clean up the mess before it overwhelms the financial system, but if the U.S. falls into a recession in the next year or two, the problems in banking will grow much worse.

The staggering cost of correcting the situation came into sharp focus last week, when the Federal Home Loan Bank Board, which regulates thrift institutions, announced a two-part bailout of 20 Texas S and Ls that could ultimately cost the Government $6.8 billion. First, the Bank Board conducted a fire sale of twelve failing Texas institutions, including Richardson Savings (assets: $707.8 million) and Mercury Savings ($332.9 million). The S and Ls will be merged and turned over to an investment group led by William Gibson, an executive vice president at Chicago's Continental Illinois bank, for a token $48 million. To attract the investors and revive the S and Ls, the Bank Board agreed to provide financial aid that may run as high as $1.3 billion over the next decade.

. The real shocker came a day later, when the Bank Board announced the largest rescue in its history. It plans to merge eight nearly moribund Texas S and Ls -- including Dallas' Sunbelt Savings, which lost $1.2 billion in the first three months of 1988 alone -- into one financial organization with assets of $6.9 billion. The Government will provide $2.5 billion of aid initially and possibly as much as $5.5 billion over the next ten years. Although the Bank Board had several offers to buy all eight S and Ls, it determined they were in such bad financial and legal shape that it would ultimately prove less expensive for the Government to run them.

The Bank Board's moves are part of its so-called Southwest Plan for consolidating 109 ailing Texas S and Ls by the end of next May. The thinking behind the mergers is that the firms will save money by combining and streamlining operations and thus stand a better chance of survival. But the rescue plans will put a severe strain on the already cash-starved Federal Savings and Loan Insurance Corporation (FSLIC), the industry insurance fund that provides the money for the bailouts.

Last week's big S and L deals followed by less than a month the Government's rescue of Dallas-based First RepublicBank, the second largest bank bailout in history. NCNB, a thriving Charlotte, N.C., banking company, has agreed to take over management of First RepublicBank, but to keep the failing Texas bank afloat, the Federal Deposit Insurance Corporation will have to provide $4 billion -- an amount topped only by the $4.5 billion bailout of Chicago's Continental Illinois in 1984.

From 1982 to 1987, the FDIC, which collects premiums from member banks and insures deposits up to $100,000, shut down or bailed out 600 banks at a cost of $9.99 billion. By far the worst trouble spot is Texas, where the woes of the oil and real estate industries have caused 192 banks to fail since 1982. The First RepublicBank case almost guarantees that the FDIC will operate at a loss this year for the first time in its history. Its reserves now stand at $15.8 billion, down from $18.3 billion in January, and the fund is likely to lose an additional $2 billion by the end of the year. FDIC Chairman William Seidman told Congress two weeks ago that at least one and possibly two major banks may soon need substantial federal aid. Industry experts predict that the next big institution in need of rescue may be Dallas' Mcorp, the second largest banking company in Texas.

No one knows when the FDIC's hemorrhaging will stop. Almost 1,500, or roughly 11%, of the 13,700 commercial banks in the U.S. are still on the agency's list of troubled institutions. Many of these banks are already doomed, and hundreds of others could be sunk by a continued rise in interest rates, which means they would have to pay more to depositors.

While the problems in commercial banking are serious, the situation in the savings and loan industry is an outright disaster. At least 500 of the more than 3,000 S and Ls are insolvent: their liabilities exceed their assets. In 1987 alone, the Government closed 17 insolvent S and Ls and paid stronger institutions to take over 31 more. The total cost to FSLIC: nearly $4 billion. FSLIC (pronounced fizz-lick in the industry) would have shut down many more S and Ls, but the agency virtually ran out of money to pay depositors. In the meantime, the insolvent S and Ls have continued to pile up losses, making the ultimate resolution of the problem increasingly expensive.

Once again the weakest institutions are heavily concentrated in Texas, where 281 S and Ls lost $6.9 billion last year. In the rest of the country, S and Ls eked out a collective $100 million profit, but the industry is sharply divided between highly profitable institutions and those losing money at a rapid clip. "The bad few are pulling down the majority," says James Barth, chief economist for the Federal Home Loan Bank Board.

Late last year Congress passed a FSLIC rescue package allowing the agency to issue securities that will raise $10.8 billion in three years. Chairman Danny Wall of the Bank Board estimates that with the $10.8 billion and premiums from member institutions, the insurance fund will bring in nearly $30 billion during the next decade -- almost enough to take care of all the insolvent S and Ls. But other experts are not so optimistic. The FDIC's Seidman has told Congress the bailout figure could reach $50 billion, and some analysts put it as high as $100 billion. Few people believe the FSLIC can avoid going to the taxpayers for billions of dollars.

Though not as sick as the S and L business, the commercial-banking industry has major difficulties all its own. Chief among them is the seemingly never ending saga of Third World debt. The ten largest banks have more than $50 billion on loan to developing countries. This sum amounts to roughly 100% of their shareholders' equity; if all the loans went into default, the banks' capital would be wiped out.

| Prospects for the largest debtors, concentrated in Latin America, are at best mixed. Brazil, which owes $120 billion, seems to be on the upswing: in December the country resumed paying all its interest -- more than ten months after it stunned the financial community by stopping payments on its loans from private banks. But in Argentina, which is some $55 billion in debt, President Raul Alfonsin has imposed a wage-price freeze to curb inflation, which was running at an annual rate of more than 300% in July. Earlier this month, the U.S. announced that it would give Argentina an emergency $500 million loan to help it meet interest payments that have come due.

Not waiting for disaster to hit, U.S. banks are making substantial progress in reducing their vulnerability to Third World debt. The banks have raised new capital, set aside billions of dollars in reserves to cover possible losses, and sold off some of their shakier loans to investors at deep discounts. Chase Manhattan, for example, has trimmed its Third World loan portfolio in the past year from $6.7 billion to $6.5 billion. Since the bank's capital has been rising, its loans to developing countries have been reduced from 185% of shareholders' equity in 1987 to 150% today.

But as banks pull money out of Latin America, they are making other loans that could be equally risky. Though real estate loans helped get the S and L industry in trouble, they are now the fastest-growing segment of commercial- bank portfolios. For the first quarter of this year, 90% of the industry's $18 billion in new assets came from real estate loans.

Another source of concern is the growing pile of consumer installment debt, which has nearly doubled, from $311 billion in 1981 to $613 billion last year. Normally highly profitable for banks, consumer loans could strain industry balance sheets if a large number of credit-card holders defaulted during a recession.

Even more worrisome is the huge amount of money that investors have borrowed in the past few years to take over companies in risky deals known as leveraged buyouts (LBOs). "It's almost like a national pastime to have as little of your own money in your business as possible," complains a bank regulator. Repaying the debt from LBOs could prove particularly difficult during an economic downturn. Already the 21 top American banks hold an estimated $17 billion in LBO loans, or just under one-fourth of their exposure to Third World loans. First Chicago's LBO portfolio amounts to 55% of shareholder equity. Says a former executive at a major bank: "If the crunch comes, it will be from LBO debt, not Third World debt."

Banks have been virtually forced to make riskier loans because they have lost some of their best customers. Blue-chip corporations, which used to borrow from commercial banks, now increasingly raise money by issuing securities through investment banks. But the Glass-Steagall Act of 1933 bars commercial banks from underwriting most types of securities. That competitive inequity has led Wisconsin Democrat William Proxmire, chairman of the Senate Banking Committee, to push for a revision of Glass-Steagall that would let commercial banks into the securities business. His proposed bill appears stalled at the moment, but the eventual passage of something similar may be inevitable.

"The major banks have no choice but to compete with the investment banks," says George Salem, senior banking analyst at Prudential-Bache Securities in New York City. "If they don't, they will become dinosaurs."

One thing is certain: the wave of consolidation in the financial industry is far from over. Competition is growing both among U.S. bankers and with foreign institutions. "There won't be 14,000 banks and 3,000 thrift institutions forever," says Robert Abboud, the former First Chicago president who last year became head of Houston's failing First City as part of a federal rescue. But not even a tough survivor like Abboud knows which banks will stay and which will go.

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CREDIT: TIME Chart by Cynthia Davis

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DESCRIPTION: Four charts: Bank failures; costs to FDIC from bank failures; costs to FSLIC from savings and loan failures; savings and loan association liquidations, mergers and acquisitions; all 1981-1987 figures; color illustration: crying piggy bank.

With reporting by Richard Hornik/Washington and Richard Woodbury/Houston