Investors tend to assume that only the Gordon Gekkos of the world have enough financial wherewithal to engage in 'vulture investing.'
Not so. Especially in the case of failed banks.
Keep in mind, banks and thrifts don't literally go bankrupt; it’s not allowed under the Bankruptcy Code. Typically, when a bank is insolvent, its state or federal chartering authority forces it into receivership and appoints the FDIC as the receiver. The FDIC seizes control of the bank's assets (such as outstanding loans with payments) and liabilities (such as deposits, undisbursed loan funds, and leases).
Buying Bank Assets
When a bank fails, the FDIC attempts to sell its assets at the best possible price so it can pay off its liabilities. Any leftover liabilities are covered by the FDIC (which is why it's important for your deposits to be FDIC-insured).
In most cases, the highest bidder doesn’t want all the loans, especially those that are in default. So the FDIC is always looking for buyers for these tough-to-sell loans, and in the wake of the financial collapse on Wall Street, the hard-pressed agency has experimented with several innovative ways to get bids that are as high as possible, including online auctions. An increasing number of 'average Joes' are coming to the table to play.
Buying a Bank
If you're looking for something a little more advanced, the FDIC has also made it easier for private investors to buy a struggling institution before they're forced to seize it. If you have reason to believe a bank's troubles are exaggerated, or its assets are unfairly undervalued, it may make sense to inject equity into the institution and ride out the downturn. Call it deep value investing for those with superior banking know-how.
The FDIC expects private investors (which it calls 'Covered Investors') to satisfy certain conditions if they want to be eligible to bid on a failed bank.
First and foremost, a Covered Investor must maintain at least 10% of the failed bank's assets as capital reserves, as opposed to a 5% minimum requirement for banks acquired by other banks. And the bank must stay at 'well capitalized' levels for as long as the investor owns it.
Other FDIC requirements include a three-year minimum holding period, disclosure of the chain of ownership, prohibition on 'insider lending,' and restrictions on how the investment may be structured. The rules are there to make sure it is perfectly clear who owns the bank -- private equity firms and hedge funds are notorious for their complicated legal structures.
The FDIC also urges private investors to limit their involvement in a failed bank to a so-called 'passive' investment. This is so private investors can avoid becoming a bank holding company and thereby subject to strict FDIC supervision, regulation, reporting, capital requirements and limitations on non-banking activities. They encourage investors to limit their equity investment to less than 25% of voting shares and/or 33% of total equity.
When looking for a potential investment, remember that the FDIC does not publish its 'watch list' of troubled banks. But there’s a way for you to do some homework and find stressed institutions that might be worth a bid: you can often find struggling banks by looking at their Texas ratio.
To find out exactly how to make a bid for a failed bank, contact the FDIC at 1-877-ASK-FDIC (1-877-275-3342). Their staff can answer any questions you may have about the process.