Will The Subprime Flu Infect De Novo Bank Prospects?

By: Peter G. Weinstock

The current economic difficulties, often labeled the subprime flu, may have a happy ending for those who are able to navigate the charter process. The process, however will be more arduous for those who desire to charter a new bank. Thus, these economic difficulties present a mixed bag for new charters.

In recent years, the large money center banks have developed a new way of approaching the lending business. Historically, banks underwrote credits and then used their own liquidity to fund the loans. Because the bank was going to keep the credit for its entire term, the bank needed to ensure that it was comfortable with not just the risk at loan origination, but the credit quality of the borrower over the longer term. Bankers insisted on solid debt coverage, strong collateral and tough loan covenants (to allow for an early response to borrower difficulties), while eschewing speculative deals.

In recent years, however, large banks have developed a "CDO," or collateralized debt obligation, structure. In a CDO structure, banks originate the credit. Thereafter, the bank holds the credits while it aggregates sufficient other loans to package together. The credits are securitized in a CDO structure. Investors buy different securities depending upon their risk tolerance. What made these structures truly work was that the credit rating agencies (principally Moody’s and Fitch) advised investors what the risk was associated with the various tranches and assigned a rating. For instance, a AAA rating might have resulted in pricing of 20 bases points over the 3 month-LIBOR.

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