Executive Summary: While the number of failed banks in 2010 may be less than previously thought, failures will continue well into 2011. The anticipated slowdown in failures may mean that the FDIC will intensify its scrutiny of current transactions. This means that banks making loan-loss submissions need to be more buttoned up than ever in how they manage their internal shared-loss processes.

 

 

Last week, Sheila Bair, Chairperson of the FDIC, stated that while the number of forced bank closings will exceed last year’s 140, “the pace is slowing… we do think things are improving…we think it will be more than 140 but less than what we were projecting, for instance, three months ago.” She went on to say that she thought the number of failures would peak by the end of the year and that some banks that had been on the problem bank list “have actually raised capital, and they’ve come off our list.”

 

We agree that the environment has improved for banks. The banks’ costs of funds remain very low, losses appear to be stabilizing or reversing, and quality business borrowers are reemerging from their shells. To Bair’s point, investor dollars are increasingly available whether for community banks or larger players.

 

Is traditional M&A back?

That said, we are probably looking at 200 or more failures in 2010 with another 100+ in 2011. Of course no one knows how many will fail. That depends on macro and local economic factors that are impossible to predict. And, whether the total number is 150 or 300, it indicates a once in a generation opportunity to expand local share or move across state lines with very limited risk due to the FDIC shared-loss structure.

 

At the same time as the failure rate may slow, non-assisted deals will increase. Many of the banks that avoided an FDIC-assisted transaction remain weak. Even if they raise additional capital, in our view, many lack the strategy and leadership required to generate anything more than mediocre returns. Until recently, FDIC deals have dominated the M&A space. While these deals will continue, we expect ‘traditional” M&A to return with greater vigor.

 

FDIC increases its auditing focus

Not surprisingly, at least until recently the FDIC has been very stretched in addressing the expanding number of failed banks. It has opened new offices and hired hundreds, in part by bringing back retirees for a multi-year stint. While the FDIC still has a lot to do related to closing the weakest banks, we are beginning to see them increasing their focus on the 100+ deals that have already closed since 2009, reviewing them to ensure compliance with the structure and spirit of the shared-loss agreement.

 

The FDIC’s “safety and soundness” audits serve as one opportunity for them to review documentation and processes. Additionally, to our knowledge, the FDIC has hired eight independent contractors to review the acquirers of shared-loss banks, initially about six months (timing can vary) after a transaction has closed.

 

These contractors have a broad mandate. Part of their focus centers on estimating the acquiring bank’s projected losses on day one of the transaction versus what its actual experience has been. However, in addition their focus centers on evaluating the quality of the submissions made as well as the loan files that support those submissions.

 

In recent weeks we have been contacted by three banks that have experienced serious issues related to their current shared-loss process, all tied to negative feedback from the FDIC:

 

• One bank has had its Certificates rejected several times because of the bank’s failure to reconcile numbers from one period to another

 

• Another bank has experienced negative comments after an FDIC audit focusing on loan file integrity and consistency. This bank is concerned that the FDIC may hesitate to allow it to acquire other banks until it addresses these issues

 

• A third bank has been audited by one of the FDIC’s contractors. In this case they have challenged the methodology and logic supporting some of its claim submissions to the FDIC

 

All of these events, plus other examples of which we are aware, point to increased analysis and review on the part of the FDIC and its representatives. If anything, this type of appropriate oversight will increase in the future as the FDIC “catches up” with its backlog of failing banks and shifts more attention to managing its existing acquirer relationships.

 

Acquirer’s checklist

Given the heightened focus on audits, what steps should acquirers take to reduce audit issues? We think they include:

 

• Conduct audit of the loan portfolio to ensure completeness and consistency. On day one post-acquisition, many loan files are in disarray, “touched” by many potential acquirers and incomplete due to prior management’s distraction or incompetence. Acquirers need to address this situation immediately and bring their loan files up to an acceptable standard. As has been our focus when we lead these initiatives, the watchwords for these types of projects should be standardization, consistency, and no exceptions.

 

• Strengthen the Special Assets Group (SAG). This area plays a critical role in the day-to-day management of failed bank clients. However, in many cases the SAG is unprepared for the increased workload or the “special handling” that shared-loss customers require. Many SAG’s are already stretched by their “core” bank workload; other groups need to be assessed in order to streamline processes and increase effectiveness as it relates to managing shared-loss workouts.

 

• Apply technology to the Certificate generation process. Relying on manual processes to manage the Certificate submission process is a mistake, resulting in reduced staff productivity and data inaccuracies. Whether it be FIC’s Portal or another software solution, senior bank management should insist on using technology (beyond an Excel spreadsheet) as a tool to improve the quality of the submissions made to the FDIC. The old phrase “penny wise, pound foolish” comes to mind.

Concluding thought

The shared-loss world continues to change with the seemingly improving economy as well as the increased number of interested investors. So too may be the FDIC’s emphasis. By end of year the failed bank wave should have crested, providing more time and staffing for management of prior transactions. Acquirers should be anticipating increased scrutiny and preparing for it.