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The New Banking Crisis: Veteran Banking Attorneys Say This Time Around Things Are Very Different

The last several months may have seemed a bit like a reunion for veteran banking litigators, Hughes Hubbard & Reed’s Dennis Klein told participants at the opening of a two-day conference on the FDIC and the New Banking Crisis held in mid-January. When he and partner Scott Christensen sat down to put the conference together, he said, “the thing that kept coming to mind was the famous Yogi Berra phrase that ‘this is déjà vu all over again.’” He found himself reconnecting with old friends and colleagues who last worked together from 1987 to 1995 during the last banking crisis. “I guess all of us, to some extent, have been hibernating and doing other types of litigation,” Klein explained, “Then all of a sudden, just sort of out of nowhere, this banking and thrift crisis hit us again.”
At its peak, the last banking crisis had the FDIC employing “more lawyers than anywhere in the history of mankind” and during one two year period nearly 700 banks went under, said Klein.
However, Klein asserts “this crisis is different.”   He explains, “right now we are in a very interesting time because I don’t think anybody really knows what kind of legislation is going to be passed and what is going to happen.”  First was the passage of emergency legislation designed to provide funds to buy out bad mortgages from problem banks, “then all of a sudden it seemed that that plan was scrapped and the TARP plan was initiated where Congress started investing in banks and taking stock.” While there are approximately three to four thousand banks scheduled to get TARP funds, Klein says, it is unclear “how this TARP money is actually going to get to the banks in time and what they are going to do with it and how it is going to change things.” 
This uncertainty is one of the main differences between the current crisis and the last one. “To some extent, looking back, it makes you realize how thoughtful Congress was in dealing with the last crisis,” says Klein. The emergency FIRREA legislation passed in the late 1980s has been amended but is still the basis of the FDIC’s powers, he noted.
Dealing With People’s Homes
“One of the main differences between this crisis and the last is the subprime market and the fact that this is all, at least now, consumer-driven,” says Klein. This time regulators are dealing with people’s homes. That fact alone raises a host of political issues that were not a factor in the last crisis, which centered primarily on the overdevelopment of commercial property and involved a fair amount of fraud.
The FDIC’s more traditional goals under the FIRREA statute of minimizing costs while maximizing the assets of the banks that they are going to take over “doesn’t sell politically in a situation where you have subprime mortgages and consumers and individuals homes. The way to maximize the assets here is to just foreclose on all the homes, take what you can, sell them, and use the FDIC powers in order to do that. But so far the FDIC has not been willing to do that. They are trying to find other strategies to try to deal with this crisis,” Klein explained.
However, he notes, “we are starting to see the consumer problems evolve into the commercial problems. When that happens it might change the dynamics of what the government and what the FDIC is doing.”
Looking at the S&L crisis of the late 1980s and early 1990s Christensen noted that 71 percent of the failures were in Texas, Louisiana and Oklahoma and the problems spread to other parts of the country in the late 1980s. Factors that contributed to the failures included: volatile oil prices; explosive growth in commercial real estate especially in the Southern part of the country; changes in the loan portfolios of commercial banks that included higher risk loans, particularly land development loans and commercial and industrial loans; and finally lighter regulation of the banks based on the Regan administration’s deregulation of the banking industry which resulted in less frequent bank examinations and created an environment conducive to fraud.
Similarly, in the current crisis, Christensen said volatile oil prices have hit consumers hard and there has been an explosive growth in real estate, with the five biggest banks doubling and in one instance tripling the number of consumer real estate loans they were making between 1995 and 2005. In addition, he noted, the lending has been increasingly on higher risk loans. “By the middle of last year, 34 percent of all mortgage originations were either subprime or Alt-A loans,” he said, noting that the Alt-A loans are “somewhere between prime loans and the subprime loans which are the folks with the lowest credit scores, the lowest incomes, and the highest debt risk.” The result was that by the middle of last year, 13 percent of U.S. households had either a subprime or Alt-A mortgage.   
In addition, he said, banks are carrying higher risk loan portfolios and “there has been once again lax regulation over the last several years.”
What is Different This Time Around?
The differences this time, in addition to the predominance of consumer loans, is the prevalence of securitizations and derivatives. “The securitizations are essentially just a new, more complicated version of loan participations,” Klein explains, used when banks didn’t want to hold loans on their books. “In the old days during the last crisis they would make a loan for $5 million and they would sell four or five different banks a piece of that loan so that they didn’t hold everything on their books. Now what they did was they securitized the loans and they sold them through the financial market. It is just a little bit more sophisticated way of doing the same thing.”  
Will there be more bank closings? “I think the bottom line is unless there are runs, you will not see big banks being closed down. I don’t think IndyMac or WaMu would have been closed down if there hadn’t been runs. Once that occurs, then the FDIC has no choice and they have to step in and close the banks,” according to Klein. However he added the so-called “zombie banks,” the banks that do not get TARP money or other help, are likely to close. “If a bank doesn’t get TARP money it is pretty much going to be gone in the next year or two,” says Klein.
Right now, Klein added, the FDIC’s biggest problem is staffing. “The FDIC has just been overwhelmed by WaMu and IndyMac,” he said, referring to press reports that FDIC has been calling people out of retirement to help with closings. Christensen quoted statistics that at the peak of the S&L crisis, the FDIC had approximately 24,000 employees. When IndyMac failed, that number was between 6,000 and 8,000 employees.  So, he explains the FDIC is facing “by far the largest bank failures in U.S. history with a quarter of the staff and energy.”
However, Klein predicts, “I think what you will see when all of this calms down after Obama and his administration come out with a plan is that the really, really weak banks at the bottom of the barrel are the ones that are going to be closed down. For lawyers I think that is going to create a lot of work. Every time a bank closes there is a lot of litigation.”
Scott Christensen and Dennis Klein are partners with the Washington, D.C. firm Hughes Hubbard & Reed, LLP and co-chaired HB Litigation Conferences’ conference on “The FDIC and the New Banking Crisis” held Jan. 15 and 16 in Washington, D.C.   Christensen has represented the FDIC in receiverships and is with the firm’s financial litigation task force. Klein has represented federal banking agencies since 1987 and has worked on nearly every major bank failure in the last 20 years. Copies of their presentations are available in video, audio and text for a fee. Send inquiries to