We put out yesterday, Senator, which I am sure you haven't had a chance to look at yet, a broad, comprehensive policy statement addressing conversions going forward in New York-compensation, the appraisal, solicitation of proxies, fairness of disclosure-addressing a whole host of issues. And I think that policy statement really speaks to what New York's position is going forward; not so much the Green Point result, because that was a particular set of circumstances.

The CHAIRMAN. Now let me ask you, in the Green Point deal you also questioned the appraisal submitted as part of the conversion. How does your office go about insuring that an appraisal is accurate?

Mr. CEPHAS. We have a staff that reviews them, and we use the guidelines that are promulgated by the OTS. We have come to believe that those guidelines may need to be supplemented. And the recommendations in the document that we released yesterday are three items, three ways that the OTS guidelines might be supplemented in order to bring greater comfort to the appraisal process. It is a complicated process, and there is in all of these appraisals no exact, specific, or pro forma fair market value. But we came to believe that in going forward we could do a better job and the appraisers could do a better job or come closer to the number that more approximated what the stock was actually worth after the conversion. So we focused on that, and we have made a set of three recommendations.

The CHAIRMAN. We will look at that. Good. Thank you. And you have given us, I assume, a copy of it?

Mr. CEPHAS. Yes.

The CHAIRMAN. This was put out yesterday.

Mr. Carson, let me come back to you, if I may. In your testimony you state that you and the Savings and Community Bankers of America are pleased that the FDIC's interim rule will, and I quote you here, essentially track "the regulations of the Office of Thrift Supervision." I am wondering if you would advocate that the FDIC adopt measurable standards in areas such as benefits to insiders as the OTS has done in its conversion regulation.

Mr. CARSON. I think the OTS regulations are a good guideline, and I think put in a context of guidelines, they should be considered as part of the regulations that the FDIC would adopt.

The CHAIRMAN. Would you agree with that, Mr. Drumm?
Mr. DRUMM. Yes, I would, very much.

The CHAIRMAN. Mr. Lewis, I assume you would as well?
Mr. LEWIS. Yes.

The CHAIRMAN. Mr. Cephas?

Mr. CEPHAS. Yes.

The CHAIRMAN. Very good.

Gentlemen, we may have some additional questions for the record. I appreciate your coming today and your testimony and the quality of your presentations.

The committee stands in recess.

[Whereupon, at 12 noon, the committee was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

PREPARED STATEMENT OF ANDREW C. HOVE

ACTING CHAIRMAN, FEDERAL DEPOSIT INSURANCE CORPORATION

Good morning, Chairman Riegle and Members of the committee. On behalf of the Federal Deposit Insurance Corporation ("FDIC"), I appreciate this opportunity to testify regarding institutions that convert from mutual-to-stock form. I believe there are important and difficult issues that need to be addressed with respect to conversions. Chairman Riegle articulated a number of these issues in his letter inviting me to testify today. Currently, the FDIC has an internal task force reviewing the entire conversion process, whose members are conferring with staff at the Office of Thrift Supervision ("OTS"). We also have an interim regulation in place and have solicited comments from the public on both the interim regulation and a proposed policy statement on the subject. I hope the committee will, therefore, understand if I characterize today's comments as a "rough draft" and reserve the right to modify our views as we better understand this long-studied and complex subject.

Our interim regulation should permit the FDIC to halt the abusive practices that have recently plagued the conversion process and to protect more fully the interests of depositors in a converting institution. However, we have to do more than simply curb abuses in the current process; we need to reexamine the process generally to determine whether it should be redesigned and, if so, how best to achieve that result.

Our testimony will make a number of observations about mutual conversions and in the process respond to the questions in Chairman Riegle's letter. I will then summarize our preliminary thinking about how conversions ought to work and briefly comment on S. 1801.

THE QUESTION OF "OWNERSHIP"

As we read the history, mutual institutions originally had two purposes: to give ordinary citizens access to credit and a safe place for their deposits. With that in mind, it is hard to say whether depositors "own" mutuals, or the whole community does, or no one does.

Under OTS rules and most State laws, depositors are usually given preference to any value in the institution. Some have argued, in the alternative, that the value of the institution should go to the community, or to the Government, or to the deposit insurance funds which suffered losses when mutuals failed-on the basis that depositors did not contract for that value, and do not deserve it. There is some merit to these arguments.

On the other hand, depositors do have rights to participate in a conversion. The fact that being a depositor is not identical to being a stockholder does not alter that. Nor does the fact that, years ago, and many years after most of these institutions were founded, the Federal Government took the risk out of being a small depositor by creating the FDIC. Depositors' rights depend on the laws of the jurisdiction in question, so we are reluctant to generalize. However, the FDIC would be opposed to abrogating those rights, except where safety and soundness considerations come into play. We are particularly concerned where those rights have significant financial value—as is the case when healthy, well-capitalized mutuals convert-even if the financial benefit of doing so flowed to one of the insurance funds.

The existing conversion process can be characterized as a compromise: yes, depositors get an opportunity to own the institution, but they have to pay for it. And insiders, who as a practical matter control whether the institution converts or not, have been permitted to stand at the head of the line. As I will explain later, there are major flaws to the existing conversion process as it operates when the institutions in question are healthy. The economic value of the converting institution flows to those who are wealthy enough, and knowledgeable enough, to stand in line to buy it. The process may need to be redesigned, so that the economic value can be distributed directly to those who should get it. But who should receive its value is ultimately a legal and political question for legislators. I admit to a natural bias in favor of depositors. Under our preliminary thoughts on redesigning the conversion process, the Government will get a meaningful share through taxation. In addition, we encourage some voluntary transfer of value from depositors to the community that the bank serves. There is no valid argument that management owns any of the value of a mutual-although as outlined below, there is good reason to encourage some management ownership post-conversion. I would also point out that, as matters stand, management can deny that value to others unless management gets some consideration in the process.

PARTICIPATION IN CONVERSIONS

In our experience, conversion is often a very good idea for the institution in question. It allows weak institutions to recapitalize. It allows institutions to participate in the consolidation occurring in the bank and thrift industries. The FDIC would be opposed to legislation which prevented or discouraged boards of mutual organizations from pursuing conversion, whether of the stand-alone variety or through merger with another institution.

Banks and thrifts benefit when their officers and directors have a stake in the success of the enterprise. It is appropriate that they become stockholders when mutual institutions convert. However, any awards of stock-or of options or cashshould be viewed as compensation rather than an entitlement as if officers and directors were super depositors. Compensation should not be excessive. The term excessive should not be defined too precisely, as doing so tends to create a safe harbor for new, previously unimagined abuses. While giving insiders preference in subscribing for stock does not necessarily produce excessive compensation, it is an imprecise and trouble-prone way to pay senior officers, particularly as the award of options and preferential purchase rights has often represented a thinly veiled means of transferring significant immediate value to the individuals in question. We would also observe that performance-based compensation should be forward-looking; awards should vest over time, and rewards for years of loyal service at the time of a conversion should be modest.

APPRAISALS

Appraisals done in connection with conversions tend to be low. A recognized authority on the subject calculates that in 1993, share prices of converting institutions (both State and Federal) increased by an average of 29 percent in the first month following the transaction. Much of this increase typically occurred immediately. While it is true that initial public offerings are normally priced so as to trade up in the aftermarket, an immediate increase of this magnitude seems unnecessary and inappropriate. There are some obvious reasons why appraisals tend to be low: it makes the underwriters' jobs easier, and it makes those who are able to buy stock richer. Where management is granted options to buy stock at the conversion price, they have a financial incentive to make that price as low as possible. We are informed that some professional appraisal firms market themselves to managements by promising to provide the lowest appraisal regulators will approve. As I will explain shortly, however, the real culprit producing those immediate price increases is not low appraisals but the mechanics and arithmetic of the conversion process itself.

USE OF PROCEEDS

The mechanics and arithmetic of the conversion process also tend to result in institutions raising very large amounts of new capital. While this has been of enormous benefit to the insurance funds in many cases, we note that in other cases institutions have raised more capital than they needed. In some cases, this has led to failures, and losses to the insurance funds, as managements have felt pressure to leverage that capital and improve the return on equity for their new and demanding stockholders. We are concerned about this phenomenon. Reviewing and approving business plans of converting institutions helps in some cases; however, continued close supervision after the conversion is necessary to safeguard against the possibility of excessive proceeds being used imprudently. Banks which grow faster than their peers run the risk of acquiring higher-risk assets. They sometimes make loans other banks will not, either inside or out of their natural trade territory, and in industries they do not understand. They sometimes put money into real estate ventures, taking too much of the downside risk. Their eagerness can undermine credit standards in the market as a whole. Our experience in the 1980's tells us this could be a significant problem.

NUMERICAL EXAMPLES

I would like to provide the committee with a few numerical examples to illustrate the points made in the previous paragraphs, and to demonstrate how the use of stock purchase rights might solve certain problems.

The following examples, for ease of comparison, make reference to market values as a percentage of the book value of the institution. In fact, appraisals performed in connection with conversion transactions typically determine the estimated market value of the institution by considering a number of factors, including book value, earnings, and assets.

The mechanics and arithmetic of the existing conversion process work fairly well when the institutions in question are thinly capitalized and/or the market is skittish

about the industry in general-exactly the conditions which prevailed a few years ago, although no longer the case now.

Consider a hypothetical example of a mutual savings bank with $30 million of equity and a leverage ratio of 3 percent. The market thinks the institution may fail. If this institution had stock, the stock would trade far below book value. In order to stave off disaster, the institution's board of directors decides to convert. The board of directors wants a leverage ratio of at least 6 percent, so they set out to raise $30 million: 1.5 million shares at $20 per share. Book value per share will be $60 million divided by 1.5 million shares or $40, but because of the institution's weak earnings, and the taint the thrift industry is under, the appraisal estimates the stock will trade at only 50 percent of book-or $30 million. Since that is exactly what the new stockholders will pay for the stock, the transaction is "fair." The appraisal firm, of course, may be a little cautious. Suppose, as it turns out in this example, the stock trades at 55 percent of book value-or $22 per share. Those who bought stock-and the underwriters had to sell most of it because depositors subscribed for very little enjoyed an immediate 10 percent increase in value of their stock. In this situation, the existing conversion process has worked reasonably well.

Now consider a second hypothetical example: an excellent mutual savings bank with $100 million of capital that wishes to convert. The institution already has an 8 percent leverage ratio and a much higher risk-based capital ratio, and earns $15 million a year. If this institution had stock, the stock would trade at book value. If the institution simply printed up 5 million stock certificates and distributed them to its depositors in the mail, a market would emerge—at $20 per share.

The existing conversion process does not permit our hypothetical mutual to do this, however, and it would not be an effective way to introduce the institution to the capital markets. An offering of new stock is required. Since the mutual is already well-capitalized, and is cautious about expanding too rapidly, it decides to sell only $20 million of new stock. The institution instructs its lawyers to prepare for an offering of one million shares, and as required by the conversion process, it hires an appraisal firm to certify that $20 per share is a fair price.

The problem is that the one million shares to be sold will give the buyers ownership not only of the $20 million of cash they will pay for the shares, but also of the $100 million of economic value the thrift had before it converted. The one million shares would therefore trade in the aftermarket at roughly $120 each, so then perhaps the shares should be priced higher, say at $100 apiece.

The problem with pricing the shares at this value is that since the thrift only wants to raise $20 million, a price of $100 per share means it will sell 200,000 shares. Since those shares will have a claim on the same $20 million of cash plus $100 million of value, they will trade in the aftermarket at $600 apiece!

The only way, in this situation, to bring the offering price into line with the probable aftermarket price, is to increase the amount of capital to be raised. For example, if the hypothetical thrift stayed with the plan to sell one million shares, but increased the offering price to $100 per share-raising five times as much new capital as it wanted to those new shareholders would be given a claim on $100 million of cash and $100 million of pre-existing economic value. The institution would have a leverage ratio of 16 percent. Since it would be difficult for the thrift to prudently employ that capital within the next few years, the aftermarket price of the stock would probably fall below book value. If, for argument's sake, the stock price fell to 80 percent of book value, or $160 per share, there would still be a large gap between the offering price of $160 per share and the "fair market value."

In this example, the gap could be completely eliminated by increasing the amount of money raised to $220 million. The arithmetic works as follows. The market values the thrift as it is at $100 million. It values "usable" new capital of $20 million at $20 million. It values capital that will be difficult to deploy quickly at 50 percent of book value-since it will be invested in Government bonds for a considerable period and earn less than half of the required rate of return on thrift equity. In the previous paragraph, that produced an aggregate market value of $160 million: $100 million, plus $20 million plus 50 percent of the hard-to-deploy $80 million. If the amount of capital raised is increased to $220 million, and the amount of hard-todeploy capital is therefore increased to $200 million, the thrift will have an aftermarket value of $100 million, plus $20 million, plus 50 percent of $200 million, or a total of $220 million—exactly the amount the shareholders had paid for the stock.

Needless to say, this is an inefficient use of capital, and it might be that depositors and other prospective investors would not be willing to provide $220 million of new money. In that case it would be impossible to bring offering price and aftermarket price into line.

It is certainly true that appraisals deserve scrutiny, that some insiders have abused their positions, and that some institutions have raised more capital than they could prudently employ. However, the fundamental problem is the "windfall" the existing process itself creates when the institution and the industry are not in extremis.

USE OF STOCK PURCHASE RIGHTS

Distribution of stock purchase rights would give those rights the value of that windfall, and allow the amount and pricing of new stock sold to be both sensible and fair. In our hypothetical example of the healthy thrift that wanted to sell $20 million of new stock, the intrinsic value of the right to purchase at $20 per share each of the one million shares to be sold is $100-assuming the share will trade in the aftermarket at $120 apiece.

As a practical matter, the rights themselves might trade at more or less than $100, because there would be uncertainty about where the market would value the stock. If most depositors wanted to sell their rights immediately, the rights could change hands well below $100. This problem could be alleviated if management arranged to have an underwriting group, or a dealer/manager, exercise rights and sell stock on behalf of depositors who did not wish to invest. Depositors might get two different forms in the mail. Send in the pink one, plus $20, and they get back a stock certificate. Send in the blue one and they get back whatever the shares sell for in the public offering, less the $20 going into the institution. How much depositors, in fact, received for their rights would depend on how good a job management did in presenting the institution to prospective investors and in negotiating with the underwriters.

To reiterate a point made earlier, if legislators or the directors of the converting institution believe someone other than depositors should get some of the windfall, they can transfer that value to those other parties by issuing them some of the rights. This revised conversion process works the same, no matter who is considered to own the institution.

MERGER CONVERSIONS

Merger conversions are situations where a mutual thrift in essence is directly acquired by a stock organization. These are the lineal descendants of "supervisory conversions"-which were essentially unassisted resolutions, and made a lot of sense. A healthy bank or thrift absorbed a failing institution, by regulatory fiat, and sold stock to support the increase in its balance sheet and risk profile. Since there was no economic value to the acquired mutual, depositor approval was not required. Merger conversions were conceived as appropriate where the mutual was in danger but had not yet failed. While an appraisal was performed, its purpose was to demonstrate how little value there was.

In a merger conversion of a healthy mutual, on the other hand, an acquiror sells stock at market value and gets the converting institution for free. Depositors of the acquired thrift get preference in subscribing for the stock, but unless they are offered a discount, that preference has no economic value; if the acquisition is positive for the acquiror the immediate increase in price occurs on announcement, not after the stock offering is priced. Where depositors do get a discount, there is still the problem that few benefit, because they lack the cash or risk appetite to buy. History shows that merger conversions have often involved substantial benefits for insiders at the converting institution—often in the form of rich compensation packages.

This analysis does not lead us to the conclusion, however, that other financial institutions should be taken out of the equation by prohibiting merger conversions completely. It only means that the structure of merger conversions has to be changed along with that of standard conversions.

REFORMING THE PROCESS: PRELIMINARY THOUGHTS

As I mentioned at the beginning of my testimony, the FDIC has several efforts underway with respect to mutual-to-stock conversions. First, we are reviewing conversion applications under our new interim regulation to determine whether to object to a transaction for safety and soundness reasons, violations of law or breaches of fiduciary duty. This process involves a case-by-case determination based upon the facts of each proposed conversion transaction. The current standards used in the FDIC's review of proposed conversions under our new interim rule will not necessarily be affected by the potential long-term reforms mentioned in this testimony. Second, we have formed a task force to review the entire conversion process and will work with the OTS on an approach for regulating the conversion process in the long term. While the task force has just begun its work, our testimony will outline our preliminary thinking on the issues, assuming that the mechanics can be satisfactorily worked out.