Monday, February 8, 2010

From the FDIC: Loss-Share Questions and Answers

"What is loss sharing?

Loss sharing is a feature that the Federal Deposit Insurance Corporation (FDIC) first introduced into selected purchase and assumption (P&A) transactions in 1991. Under loss sharing, the FDIC agrees to absorb a portion of the loss on a specified pool of assets in order to maximize asset recoveries and minimize FDIC losses. Loss sharing reduces the immediate cash needs of the FDIC, is operationally simpler and more seamless to failed bank customers and moves assets quickly into the private sector.

Does loss sharing put the taxpayer on the hook for additional losses down the road?

When the FDIC calculates the estimated cost of a failure, it takes into account all expected losses on the assets covered in loss share agreements. These current market assumptions are built into the cost of failure at resolution. Thus the cost of all expected future payments are recognized at the time of bank failure and no losses are deferred. Any loss sharing payments are made from receivership funds from the specific failed bank or thrift or, if those are insufficient, from the FDIC's Deposit Insurance Fund. The Deposit Insurance Fund is funded by assessments paid by insured banks and thrifts. It is not taxpayer funded.

How does loss sharing work?

The FDIC uses two forms of loss sharing. The first is for commercial assets and the other is for residential mortgages.

For commercial assets, the agreements typically cover an eight-year period with the first five years for losses and recoveries and the final 3 years for recoveries only. FDIC will reimburse 80 percent of losses incurred by acquirer on covered assets up to a stated threshold amount (generally FDIC's dollar estimate of the total projected losses on loss share assets), with the assuming bank picking up 20 percent. Any losses above the stated threshold amount will be reimbursed at 95 percent of the losses booked by the acquirer.

For single family mortgages, the length of the agreements tend to run for 10 years and have the same 80/20 and 95/5 split as the commercial assets. The FDIC provides coverage for four basic loss events: modification, short sale, foreclosure, and charge-off for some second liens. Loss coverage is also provided for loan sales but such sales require prior approval by the FDIC. Recoveries on loans which experience loss events are shared in the same proportion as the original loss.

Does the FDIC receive any benefits if the acquiring bank makes money on the covered assets?

Yes. If asset losses are lower than anticipated, then the FDIC receives the majority of the benefit. The acquirer will reimburse the FDIC for the difference either at 80% or 95% depending on what was booked.

What types of losses on the assets are covered, and when does the FDIC reimburse the buyer for those losses?

The FDIC covers credit losses as well as certain types of expenses associated with troubled assets (such as advances for taxes and insurance, sales expenses, and foreclosure costs). The FDIC does not cover losses associated with changes in interest rates.

For single family loans, the acquirer is paid when the loan is modified or the real estate or loan is sold. For commercial loans, the acquirer is paid when the assets are written down according to established regulatory guidelines or when the assets are sold.

How do you know that the FDIC is getting the best deal with loss sharing?

When the FDIC is preparing the sale of a failing bank or thrift, the FDIC reaches out to numerous potential bidders for the deposit franchise and the institution's assets. The sale relies on a competitive bidding process. In addition, the FDIC uses financial advisors to estimate asset values.

After bids are received, the FDIC selects the least costly option. To facilitate that analysis, the FDIC dictates the terms and conditions of a loss sharing, and the assets to be covered when bidding a failing bank. This allows the FDIC to more quickly analyze and compare each of the bids to determine which is the least costly to the insurance fund. The terms and conditions also enable the FDIC to monitor the agreements effectively.

Isn't loss sharing more costly? If not, then how does it save money? Aren't you still selling the assets?

Loss share saves the FDIC's insurance fund money. In today's markets, asset prices are low, and the prices frequently include steep liquidity and risk discounts. These agreements enable the FDIC to sell the assets today, but without requiring that we accept today's low prices. Instead, the FDIC sells to acquirers in a way that aligns their incentives with the FDIC and reduces the liquidity and risk discounts. The acquirers have the capacity and incentive to service the assets effectively and minimize losses.

How big is the loss share program? How much money has the FDIC saved?

Through year-end 2009, the FDIC has entered into 94 loss sharing agreements, with $122 billion in assets under loss share. The estimated savings exceed $29 billion, compared to an outright cash sale of those assets.

Why don't you use loss sharing for all failures?

Loss share agreements are just one way the FDIC has for selling assets of a failed bank, and may not be the best alternative for every troubled bank. For each resolution, the FDIC analyzes all available alternatives and accepts the least costly bid. Sometimes the results indicate that the loss share bids are more costly, and sometimes the FDIC does not receive a loss share bid.

What type of oversight does the FDIC have over these agreements?

FDIC periodically conducts on-site reviews of records of covered losses and overall compliance with the agreement. It also requires assuming banks to provide quarterly reports to ensure compliance with the program and to monitor the performance of the assets. Lastly, the FDIC must approve the bulk sale of any covered assets, and the loss share coverage is not transferable to the new owner.

For agreements that cover single family loans, must the assuming bank honor the FDIC's loan modification program?

The FDIC requires that buyers modify loans under two approved programs: the national Home Affordable Modification Program or the FDIC's standard modification program, which is based on the modification program applied by the FDIC at IndyMac Federal. Both programs adjust the current loan terms to achieve an affordable payment by first reducing the loan interest rate, then extending the loan term, and, where necessary, offering forbearance or forgiveness of principal. The goal is to provide an affordable monthly payment based on a debt to income ratio for housing equivalent to 31 percent of the borrower's gross monthly income (including taxes and insurance payments). Under both programs a modification is offered only if it is cost effective.

The acquirer can propose an alternative loan modification program that will achieve the goals of providing affordable payments consistent with cost effectiveness. If the FDIC concurs, then it can adopt the alternative program.

Where can I get additional information about the history and use of loss share?

In 1998, the FDIC published the book "Managing the Crisis" detailing the FDIC and RTC experience from 1980 through 1994. Chapter 7 is devoted to loss share and can be accessed at:"

Last Updated 1/11/2010