FDIC Faces '3-D Tic-Tac-Toe' In Puerto Rico Banking Crisis

The Federal Deposit Insurance Corp. faces a daunting task in finding a solution for the broken banks in Puerto Rico that doesn't damage the surviving banks or the island's economy.

The FDIC is trying to minimize its potential loss from three weak Puerto Rican banks by drumming up interest among banks and private equity investors in buying W Holding Co Inc.'s (WHI) Westernbank, R&G Financial Corp.'s (RGFC) R-G Premier Bank, and EuroBancshares Inc.'s (EUBK) EuroBank, according to several people familiar with the matter. All three banks are in dire financial condition; closing them could cost the FDIC insurance fund as much as $10 billion, based on worst-case losses from recent bank failures.

None of the banks returned phone calls requesting comment.

The FDIC hired Deutsche Bank AG (DB, DBK.XE) for advice, and the agency itself is marketing the three banks aggressively to potential buyers, according to several people familiar with the matter. The FDIC is hoping to find a solution by April 30, two people familiar with the matter said.

Not since the savings-and-loan crisis has the FDIC faced such a steep challenge in a specific banking market, and one as isolated as Puerto Rico. The three banks in danger of failing have a total of $21 billion in assets and hold 30% of the island's deposits.

The goal is to strengthen the island's remaining banks--an aim at the intersection of the FDIC's mandate to protect its funds, and political interests that would prefer that Puerto Rican banks swallow the three institutions in danger of failing.

"The end result must be that we have a smaller number of players, but solid players, that will be lending" in Puerto Rico, said Pedro Pierluisi, who is the island's nonvoting representative in Congress. "But if you are as challenged as we are, we should welcome investment" from foreign banks or mainland investors, he said.

Puerto Rico has been in a deep recession since 2006, when the government's fiscal imbalances led the economy into a tailspin.

Popular Inc. (BPOP), Oriental Financial Group Inc. (OFG), Doral Financial Corp. (DRL), First Bancorp. (FBP), all local Puerto Rican banks, have expressed interest in expanding on the island through acquisition.

The surviving Puerto Rican banks, however, "are not in the greatest shape. Each has its own issue do deal with," said John Douglas, a partner with law firm Davis Polk & Wardwell, and former FDIC general counsel.

Oriental recently raised $100 million that it said could be used to acquire a failed bank. Popular could easily raise $500 million, said Amanda Larsen, an analyst with Raymond James & Associates.

Meanwhile, "anybody of any size" among mainland private equity investors "is taking a look," one lawyer said, "with clear eyes and fully understanding the risk."

Douglas said he has had clients "kicking the tires," but "it's hard to gauge what [the interest] will amount to."

One person familiar with the matter said, "Everybody leaves [the island] shrugging their shoulders."

The biggest problem for banks in Puerto Rico is soured real estate construction loans. Bank failures could lead to further writedowns of real estate assets, which could further damage the island's real estate market and hamper lending.

One tough wrinkle: Foreclosing on delinquent owner-occupied real estate loans would lead to more unemployment. For almost 15% of Westernbank's $4 billion in owner-occupied real estate loans, collection is uncertain, according to the bank's most recent regulatory filings.

Finding a solution for the island's banks is "three-dimensional tic-tac-toe," said one lawyer who represents potential investors.

The FDIC could bundle several banks together, strip out their troubled assets into a separate "bad bank," and sell those assets separately. Sources familiar with the matter said such a structure has come up in discussions between the FDIC and potential bidders, but bundling three sick banks into one bigger bank may not make the FDIC's task of finding buyers for the banks any easier.

A big market share in Puerto Rico may not be enough to entice buyers. Puerto Rico "is not a growth area," said Gerald Ford, a private equity investor hunting for failed banks, who looked at Puerto Rican banks in the past. "I don't think we'd be interested."

Pierluisi said, "Puerto Rico has a lot of potential," but resolving the banking problems "is indispensible for the development of the economy."

-By Matthias Rieker, Dow Jones Newswires; 212-416-2471; [e-mail]