Executive Summary: FDIC Shared-Loss Arrangements with banks and investors should increase significantly in 2010. To ensure strong productivity and to optimize returns, buyers of these failed banks need to implement a tailored and discrete process for identifying priority loan submissions and managing the multi-year submission and recovery process.
Our experience with Shared-Loss transactions suggests that every aspect of these deals, from due diligence to client management to tracking and reporting needs to be seen through eyes that are trained in and sensitive to the specifics of the Shared-Loss process.
The Pre-Failed Bank
Example: Lenders often remain emotionally tied to their borrowers even after a loan has begun to go sour, particularly in those instances in which the relationship manager (RM) generated the loan. We all know instances in which RMs appear to be wearing rose-tinted glasses as they assess their customer’s future prospects. At the failed banks that are subject to FDIC Shared-Loss Agreements, this situation is even more pronounced.
In many cases, prior to failing, bankers appear to have worked hard to avoid having to take reserves on commercial loans. (Write-offs related to residential loans tend to be more objective and direct, less subject to interpretation or delay.) One major reason for this occurrence goes beyond the typical denial that a situation is worsening. Many of the “pre-failed” banks simply did not have the capital required to take reserves and write-down loans. More likely implicitly rather than explicitly, the bankers avoided any actions that would force that move. For example, we find that commercial loan files are often incomplete and even inaccurate. (There is, after all, a reason why these banks went belly up.)
Further, an oral culture seems to have replaced the memo-orientation of most banks. Information that best practice banks would expect to see in their files simply is not there. Procedures that are standard at many banks may have existed but were not uniformly followed. Therefore, one of the first steps required as part of managing the Shared-Loss process involves conducting a detailed audit of each file; every commercial real estate and C&I Loan needs to be “touched.” While the originating bankers may need to be involved in the process (for example, following up with clients to obtain updated financials or other information), this process needs to be centralized and standardized. This should result in the files achieving greater quality and consistency and allow for the proper risk assessment of each loan.
Moving to Focus and Urgency
If delay in recognizing loan losses has been one of the key tactics of a bank trying to avoid failure, the opposite should be true after acquirers reach a deal with the FDIC. The acquiring bank’s management should act with a sense of urgency to identify problems in the portfolio and create clear priorities for near-term action.
Urgency in evaluating and acting on the implications of the portfolio review is critical. Under the agreement with the FDIC, acquirers are covered for, initially, 80 percent of losses occurring in the purchased portfolio. Our experience indicates that these portfolios contain substantial “low hanging fruit” that can be readily submitted to the FDIC for payment, enhancing the transaction’s immediate cash flow.
Non-accrual loans are the first place to look. However, as mentioned above, rose-tinted glasses distort a failing bank’s perspective when dealing with the more subjective commercial loan space. Acquirers may find that risk ratings applied to these loans are overstated; in some cases loans viewed as performing are in fact either at or about to become non-accrual. As appropriate, managing this portfolio with urgency will allow a bank to identify troubled assets that require immediate short-term action, resulting in near term submissions. As important, it will also identify loans that are currently performing but that have an elevated level of risk, which need to be monitored closely. In addition, some of the loan relationships offered previously overlooked growth opportunities to the acquirer, all the more reason to assess the portfolio quickly and rigorously.
As with file review, bank management needs to centralize and standardize the loan review and submission process. The bankers who originated a loan and have lived with it day-in and day-out will be hard-pressed to transform themselves to suddenly look at their borrowers as a glass half (or more) empty rather than half full. Therefore, in most cases, banks cannot rely on the heritage bank’s personnel to drive this extensive loan review process nor to effectively identify and manage high risk credits. In some cases, they seem almost incapable of believing management when they are told to provide an un-biased assessment of credits in their portfolio; this is so different from their previous reality and apparently why disconnects exist.
Segregation is a Good Thing
Many, although certainly not all, of the customers acquired in a shared-loss transaction will fail to meet the segmentation criteria and marketing focus pursued by the acquiring bank. We think management should clearly distinguish this customer community from its traditional focus, particularly until it decides whether the customer (residential or commercial) is of a transactional or relationship nature. By the way, there is nothing wrong with serving and making profits from transaction oriented/low-priority customers. They need to be served with a strong base line of quality; however, the bank will also want to minimize its investment in that group.
This is yet another instance in which Shared-Loss transactions call out for a discrete and focused approach, one that may differ substantially from traditional ways of doing business.
Concluding Thoughts
Failure to effectively manage the Shared-Loss portfolio can result in missed opportunities that may delay FDIC reimbursement or even render a loan ineligible for continued Shared-Loss treatment. Therefore, a consistent, standardized Shared-Loss approach implemented with urgency and discipline is critical to the success of these transactions.