Spike in Bank Failures; D’Oench Duhme Returns

While the banking industry has pulled back from the abyss of October, 2008, the third quarterof 2009 was one of the worst quarters in U.S. banking history; 50 banks failed.

That number of failures for a single quarter was higher than the number of failures for a full year, in most of the years in which the FDIC has been in existence.

On October 23rd, the number of bank failures in 2009 exceeded 100.

In all of 2008, only 25 FDIC insured institutions failed. Prior to 2008, there had been a five year stretch during which only 10 banks had failed. Since the creation of the FDIC,total bank failures for an entire year have exceeded 50 only during the Depression Years of 1936-1939 and during the S&L Crisis Years of 1985-1992.

In 1933, in the months prior to the creation of the FDIC, a staggering total of 4,000 banks failed. In the Great Depression, before the creation of the FDIC, a total of 9,000 banks failed; one-third of all U.S. banks.

The greatest number of failures in one year since 1933 was 533 in 1989.

Prior to the deregulation of thrifts and the S&L Crisis in the 1980s, for almost 40 years, from 1943 through 1981, the yearly total for bank failures averaged in the single digits and in many years there were no bank failures.

Despite the FDIC’s efforts to mitigate losses in resolutions through loss sharing arrangements, the loss rate is higher than the 19% loss rate figure during the S&L Crisis.

On Oct. 14, FDIC Chairman Sheila Bair testified before a Senate subcommittee and reported on the state of U.S. banks and the economy. The following is a summary of information from her testimony:

100 FDIC insured institutions were added to the FDIC’s confidential list of problem banks, “problem list” in the second quarter. Presently on that list are 416 banks.

The 416 banks on the FDIC problem list, while disturbing, is one third of the total of 1,400 banks on the problem bank list in 1991.

The FDIC points out that most of these banks did not fail.

“The FDIC projects that bank and thrift failures will peak in 2009 and 2010…”

Loan loss provisions for banks and thrifts are at the highest level since 1984. The figure for C&I loan losses,while high at 2.7%, is roughly one half of the record high of 5.14% in 1987. Losses in this area are expected to peak in the fourth quarter of 2009 or early 2010.

CRE loans made up “over 43% of community bank portfolios and the average percentage of the total of CRE loans measured against total capital was 280%.”

[Regulations were promulgated in 2006 by the FDIC, OCC and Fed setting a “safe level of commercial real estate loans for individual banks at 300% of capital.]

“The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters is in CRE lending…”

“FDIC-insured institutions still hold the largest share of commercial mortgage debt…and their exposure…stands at an historic high…”

“Outside of construction portfolios, losses on loans backed by CRE properties have been modest to this point.”

“Net charge-offs…have been just $6.2 billion over the past two years.”

“Over this period, however, the noncurrent loan ratio in this category has quadrupled, and we expect it to rise further as more CRE loans come due over the next few years.”

“The ultimate scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during that time.”

“The FDIC has made several changes to its resolution strategies in response to this crisis…The most important change is an increased emphasis on partnership arrangements.”

“In the early 1990s, the FDIC introduced and used loss sharing….”

“The loss share agreements enable banks to acquire an entire failed bank franchise without taking on too much risk…”

“[T]he private sector partner manages the assets and the FDIC monitors the partner…”

“If we tried to sell the assets of failed banks into today’s markets, the prices would likely be well below their intrinsic value…”

“During 2009, the FDIC has used loss share for 58 out of 98 resolutions. We estimate that the cost savings have been substantial: the estimated loss rate for loss share failures average 25%; for all other transactions, it was38%.”

In the U.S. economy, U.S. households have lost $12 trillion in net worth over the past 7 quarters, 19% of their net worth.

“[T]he average price of a U.S. home has declined by more than 30 percent.”

“16 million mortgage borrowers [are] ‘underwater’.”

There have been 1.5 million foreclosures in the first half of this year.

In the second quarter of 2009, 8% of all mortgages were “seriously delinquent”.

Funding of the FDIC’s Deposit Insurance Fund.

With the increase in bank failures there has been a drain in the FDIC’s insurance fund. “The FDIC…[published] a Notice of Proposed Rulemaking (NPR) to require insured depository institutions to prepay about three years of their estimated risk-base assessments. The FDIC estimates that prepayment would bring in approximately $45 billionin cash.”

[End of summary of information from Chairman Bair’s presentation]

With the increase in bank failures and the involvement of the FDIC in resolution of failures, two words have reentered our vocabularies:

D’Oench Duhme.

D’Oench Duhme is a doctrine that gets its name from the U.S. Supreme Court case of D’Oench Duhme & Co. v. FDIC. Very generally, the doctrine provides that after the FDIC becomes a receiver for a failed bank, certain prior agreements between the bank and obligated loan parties may be ignored by the FDIC.

“In an effort to protect the federal deposit insurance fund and the innocent depositors and creditors of insured financial institutions, the Supreme Court in the case ofD’Oench Duhme & Co. v. FDIC, 315 U.S. 447 (1942) adopted what is commonly known as the D’Oench doctrine. This legal doctrine provides that a party who lends himself or herself to a scheme or arrangement that would tend to mislead the banking authorities cannot assert defenses and/or claims based on that scheme or arrangement.”www.fdic.gov/regulations/laws/rules

“If the secret agreement were allowed as a defense in this case the maker of the note would be enabled to defeat the purpose of the statute [the National Banking Act] by taking advantage of an undisclosed and fraudulent arrangement which the statute condemns and which the maker of the note made possible.” 315U.S. 447, at 461.

[The majority opinion was written by Justice William O. Douglas, who had previously served as Chairman of the Securities and Exchange Commission. Concurring opinions were written by Justice Felix Frankfurter and Justice Robert Jackson. Jackson later served as the chief U.S. prosecutor at the Nuremberg Trials.]

Congress codified the doctrine in 12 U.S. 1823(e) further protecting the FDIC and the insurance fund.

“(e) AGREEMENTS AGAINST INTERESTS OF CORPORATION.–

(1) IN GENERAL.–No agreement which tends to diminish or defeat the interest of the Corporation in any asset acquired by it under this section or section 11, either as security for a loan or by purchase or as receiver of any insured depository institution, shall be validagainst the Corporationunless such agreement–

(A) is in writing,

(B) was executed by the depository institution and any person claiming an adverse interest thereunder, including the obligor, contemporaneously with the acquisition of the asset by the depository institution,

(C) was approved by the board of directors of the depository institution or its loan committee, which approval shall be reflected in the minutes of said board or committee, and

(D) has been, continuously, from the time of its execution, an official record of the depository institution.

[Source: Section 2[13(e)] of the Act of September 21, 1950 (Pub. L. No. 797; 64 Stat. 889), effective September 21, 1950, as amended by section 113(m) of title I of the Act of October 15, 1982 (Pub. L. No. 97–320; 96 Stat. 1474), effective October 15, 1982; section 217(4) of title II of the Act of August 9, 1989 (Pub. L. No. 101–73; 103 Stat. 256), effective August 9, 1989; section 317 of title III of the Act of September 23, 1994 (Pub. L. No. 103–325; 108 Stat. 2223), effective September 23, 1994; section 909 of title IX of the Act of April 20, 2005 (Pub. L. No. 109–8; 119 Stat. 183), effective April 20, 2005]” Id.

Under the Financial Institutions Reform Recovery and Enforcement Act (FIRREA), Congress added 12 U.S.C. 1821(d)(9)(A) which protects the FDIC against affirmative claims.

In essence, D’Oench Duhme and the related statutes constitute a federal holder in due course doctrine.

As was the case in the 1990s, the D’Oench Duhme case and the statutes are referred to collectively by the shorthand of “D’Oench” or “D’Oench Duhme”, even though the specific protections utilized may be statutory.

Federal courts have held that the protections of D’Oench Duhme apply not only to the FDIC, but also to assignees of the FDIC. As a result, those assignees who have purchased the assets of failed institutions from the FDIC are entitled to the holder in due course protections of D’Oench Duhme. This means that such assignees are protected from “side agreements”, oral agreements, and course of dealing arguments raised by obligors with respect to loans acquired by the FDIC under its receivership powers and subsequently assigned.