You Don't Want Zombie Banks

Lessons from the S&L Crisis of the 1980s

Suppose that you mark to market a bank’s portfolio. If they booked an asset at $100 and it’s now worth $70, you mark it at $70.

After you do that, suppose that the equity of the bank is only slightly above zero, or even less. That is a Zombie bank.

There seems to be a widespread view, including at Treasury and the Fed, that we should go easy on Zombie banks. Pretend that their assets that were booked at $100 are still worth $100. Insure all of their existing deposits, up to any amount (I don’t think this applies to new deposits, thankfully). Lend to them on generous terms, using the book value of their assets (not the market value) as collateral.

The idea is that eventually Zombie might be profitable. Deposit funding is cheap, and in the long run the assets will return to book value. But this assumes Zombie just sits there passively and takes no more risks.

Unfortunately, owners and management at Zombie have no incentive to remain passive. That would mean enjoying modest income for years, hoping that in the end there will be enough positive equity to hand out as dividends and executive bonuses. Meanwhile, you’re asking a financial sector executive to be compensated like a mid-level civil servant.

So instead of being passive, Zombie will try to grow. It will lure new depositors by paying higher interest rates. It will take advantage of government loans to grow further in size. It will reach for high returns by taking on a risky asset portfolio. If all goes well, shareholders get nice dividends and capital gains, and executives get paid nice bonuses. If it goes bust, well, they aren’t losing much compared to following a passive strategy.

This is not just theory. In the 1980s, the Zombie Savings and Loan institutions did exactly this in practice. They raised their deposit interest rates. Using Freddie Mac’s “guarantor” program and Fannie Mae’s “swap” program, they borrowed against their mortgage portfolios without having to recognize losses in their accounting statements. They “diversified” their assets by buying junk bonds, risky commercial real estate loans, and so on. If you want to see how out of hand it got, read Pizzo, Fricker, and Muolo, Inside Job: The Looting of America’s Savings and Loans.

In addition to the damage that they did to themselves, the Zombie S&Ls hurt the entire financial industry. They took money away from well-managed banks by paying above-market interest rates on deposits. The risky investments that they financed ended up hurting the otherwise sound businesses that well-managed banks were funding.

What to Do

We have learned over the last few days that many small and mid-sized banks in this country are Zombies. You don’t want to let them re-run the Savings and Loan fiasco, which ended up costing taxpayers way more than it should have.

One approach for Zombies is to put them in a regulatory straitjacket. If on a market-value basis they do not have significantly positive equity, order them to behave passively. No growth allowed. A strict ceiling on the interest rate that they can pay on deposits. No big risks allowed in new loans. Hedging required for interest rate risk. No dividends, no stock buybacks, and only minimal executive pay.

The regulatory straitjacket approach effectively turns bank executives at Zombie into civil servants, running the bank in the interest of the FDIC. It probably is not a long-term solution.

The other approach is to force Zombie to be absorbed by another bank that is solvent. The combined bank will have enough equity that it will behave like a prudent bank, not like a Zombie. Sooner or later, I think this has to happen. Otherwise, we can look forward to another expensive bank bailout before the end of the decade.