Tuesday, January 12, 2010

Loss Sharing

Decoding FDIC Loss Sharing

In 2009 the US had 140 bank failures and the agency in charge, the FDIC, with little fanfare entered into 94 loss sharing agreements ("LSA"s) negotiating loss sharing deals with "healthy" banks totaling $122 Billion as a means to deal with the expanding number of failed bank problem loans. The cumulative dollar volume of LSA transactions could easily double or triple in the next few years as the rate of bank failures continues to escalate. We believe it is worthwhile to understand this expanding but opaque space of our financial system.

In this brief overview we shed light on the initial part of the process of FDIC loss sharing,  a tool being used by the agency to deal with failed banks.

It all begins with the banks identified by the FDIC as problem banks, a list unofficially approaching 600 banks and totaling over $300 Billion in total assets. The banks are quietly given notice that they have a problem or are out of compliance by way of an enforcement action from the regulatory authority, in most cases the FDIC.

Time passes (quickly if you are under the regulatory gun) and if the bank cannot correct the situation (by shoring up their capitalization by raising equity or improving loan portfolio quality via loan workouts and payoffs) the bank is headed down the path to failure. Ahead of the imminent failure, the FDIC discreetly lines up qualified banking institutions from a FDIC “healthy bank” list, soliciting competitive bids for failing banks. The above steps are the most opaque parts of the process, for obvious reasons, since advance warning of a bank failure could cause public panic and a classic run on the bank.

The bidding institutions have access to bank financial and operating data including information about the failing bank’s troubled loan portfolio. The bid forms are surprisingly short, with spaces in the form for what the acquiring bank is prepared to pay for each of the Consumer Loans, Non-Consumer Loans and Deposits.

Using the Colonial Bank of Alabama Failure as a case study, as of mid-2009, Colonial assets totaled $25.5 Billion and liabilities, including $20.1 Billion of deposits, totaled $24.3 Billion. BB&T won the bidding in August of 2009 by offering a 14% discount on the Consumer Loan Pool, a discount of $1.462 Billion on the Non-consumers loan assets and a premium of 2.77% for the Deposits. By August the value of Colonial Bank’s assets had dropped to $16.8 Billion while liabilities had not changed substantially. Had the FDIC simply taken over the bank, the insurance fund as insurer would have had to fund the $7.5 Billion deficit immediately. Instead, via the loss sharing deal, the FDIC paid only $3.5 Billion to BB&T at the closing of the Colonial acquisition and issued a receivable or "IOU" to BB&T totaling $4 Billion for the balance of the $7.5 Billion deficiency the FDIC was required to insure.

BB&T's loss share "threshold" number per their loss share agreement entered into with the FDIC is $5 Billion. This is the number BB&T manages to. As BB&T resolves the commercial and residential loans in the Colonial portfolio it bought, the FDIC will reimburse the bank for 80% any of the next $5 Billion of losses or a reimbursement of $4 Billion. Once this threshold is busted, the FDIC reimbursement rate increases to 95% of losses. Since BB&T wrote the acquired loans down on 9/30/09, there is no near term threat to BB&T’s balance sheet or income statement. As BB&T documents losses occurring from working out the loans (via loan restructures, principal reductions, foreclosures, deeds in lieu, short sales etc.) the FDIC will cut checks on either a monthly or quarterly basis to BB&T for documented residential or CRE losses (called "shared loss payments"), respectively.

Even though the FDIC is on the hook for the entire $7.5 Billion deficit, their inspired strategy preserves precious FDIC cash, short term, with the hope that the ultimate payout to BB&T will be less than the initial $7.5 Billion deficit by the end of the 8 year term of the loss sharing agreement.

2009 saw 94 loss sharing agreements adding up to $122 Billion in loss sharing volume. In our opinion the dollar volume of LSA transactions could easily double or triple in the next few years as bank failures continue to mount. If we add up the potential for FDIC cash preservation on loss sharing agreements totaling $200 to $300 Billion, the insurance fund does not have the money to fund failures currently. Loss sharing is financial innovation born of necessity.

The FDIC is happy also that BB&T has no need to “fire sale” the marked down assets, further depressing the loan market the way outright sales of FDIC assets has. We believe, however, that in the BB&T example there is an economic incentive (of $4 Billion in FDIC cash reimbursement!) for BB&T to document for the FDIC up to $5 Billion in real losses as they occur in the first five years of the agreement.

In the current Darwinian financial environment, strong financial institutions get stronger by devouring the weaker ones, governed by the FDIC or applicable agency rules and regulations and supported by agency financial backing. This does not necessarily mean that the stronger banks are in reality that much stronger than their weaker counterparts or that the weak institutions are necessarily that much weaker. Widespread loan portfolio problems, in whatever form, are pulling the values of hundreds of weak institutions down. The ability to raise private capital by the winners, whether justified by due diligence or simply investor speculation, reinforces the perception of strength. The FDIC too can be viewed as one among many potential “capital sources” and an extremely powerful one at that.

The successful "psychology" of this system, to be considered among the strong, acquiring banks is a definitely a club all banks want to be a members of. In fact, in many cases, extremely small, "healthy" banks have expanded dramatically by acquiring ailing, failed institutions. These small or even newly formed banking institutions have leveraged up their size through the backing of the FDIC via loss sharing guarantees that support not only the acquired failed banks portfolio but, because of the FDIC blessing, a government stamp of approval is conferred on the acquiring bank’s original loan portfolio whether justified or not.

Finally, the administration of LSA's is still in its infancy and of this not much is yet known. What we do know is that as the FDIC continues to expand in 2010, they are hiring staff to monitor loss sharing agreements. The agency has also lined up third party compliance firms who are creating systems to track the proper execution of the agreements. The FDIC will require detailed documentation from banks of accounting losses, a process that may be more complicated and contentious if values do not start to rebound soon but instead head further south as we expect they will.