Monday, August 2, 2010

August 2010: A Loss Sharing Recap

Loss Sharing Agreement ("LSA") Definition, History and the Bank Failure Process in Brief

FDIC “Loss Sharing" is a public/private partnership between the FDIC (closing a failing bank) and a designated, healthy bank (taking over the failed bank) where the FDIC covers an amount of the losses incurred by the healthy bank assuming the failed bank’s assets in exchange for possible upside in asset value to be shared with the FDIC in the future that results from the acquiring bank's expert asset management and from improved economic conditions.

By our tally, the volume of loss sharing assets fed into FDIC-assisted bank acquisitions or loss sharing arrangements since 2009 now exceeds $180 Billion and could eventually reach $300 Billion before the current banking crisis is over, creating a significant niche of bank resolution activity for years to come.

In the last big financial meltdown of the late 1980’s and early 1990’s “The FDIC used loss sharing a total of 16 times to resolve 24 banks that failed between September 1991 and January 1993. Those 24 failed banks had total assets of $41.4 billion, of which approximately $18.5 billion were covered by loss sharing.” This is against the backdrop of a total of $565 billion of assets associated with bank and saving and loan failures spanning the period of 1989 through 1995 resulting in RTC and agency costs totaling about $108 billion.

Current use of the loss sharing mechanism has dwarfed the use of the tool in the last big meltdown that took place in the early 90’s. The FDIC is no RTC. Outright sales into the distressed asset marketplace have been avoided this time around in favor of a more opaque approach.

We believe that the FDIC-assisted activity is seen by the surviving (thriving) banks as a once in a generation growth opportunity. The bidding for failed banks is fierce. As the US banking industry consolidates in a big way, it is preferable to be the “predator” rather than the “prey”. And once qualified as a predator, it is highly unlikely that the FDIC will allow an acquiring bank to ever become prey.

The bank failure process plays out behind the scenes. Typically 6 to 9 months after notification by the regulators that the bank is in trouble, the bidding process begins: Time passes quickly if you are under the regulatory gun and if the troubled 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 likely 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, by 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.

Colonial Bank: A Brief Case Study

The Colonial Bank of Alabama failure is a good case study. As of mid-2009, Colonial assets totaled $25.5 Billion and liabilities, including $20.1 Billion of deposits, totaling $24.3 Billion. The assets, mainly real estate loans, were severely compromised and the FDIC closed the bank on August 14, 2009.

BB&T acquired $19.6 Billion in assets via the Colonial Bank Purchase and Assumption Agreement. $19.2 Billion in liabilities were assumed by BB&T in the form of deposits.

Three items are bid on in loss sharing: consumer loans, commercial loans and the deposits.

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-consumer loan assets and a premium of 2.77% for the Deposits.

According to BB&T’s 2009 10K, the FDIC balanced the “books” by issuing a $3.1 Billion receivable or IOU (called the indemnification asset and described below).

BB&T liked the Colonial deal because the BB&T could expand their deposit base and branch network while covering downside risk by way of the LSA.  The LSA covered $15.4 Billion of the assets and in particular $13.039 Billion of Colonial’s loans.

The FDIC hoped losses would be $5 Billion or less.  Hence BB&T's loss share "threshold" number per their loss share agreement entered into with the FDIC was $5 Billion. This is the number BB&T manages to going forward. 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 potential reimbursement of $4 Billion. Once this threshold level is reached, the FDIC reimburses 95% of subsequent losses.

Since BB&T wrote the Colonial loans down from $13.039 Billion to $8.555 Billion or by $4.484 Billion, there was no near term threat to BB&T’s balance sheet or income statement for losses taken. The markdown totaled roughly 35% of the portfolio book value. BB&T stated that the maximum exposure to the bank was less than $500 million were the $5 Billion threshold reached.

In the meantime, as BB&T documents losses occurring from working out the loss shared 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.

Even though the FDIC was on the hook for the entire 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 deficit by the end of the 10 year term of the loss sharing agreement. The FDIC only funded $2.8 Billion for the Colonial Bank closure.

The FDIC is hopeful that BB&T has no immediate need to “fire sale” the marked down assets, further depressing the loan market the way outright sales of FDIC assets might. 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.

FDIC’s Market Theory

The agency claims that “Loss sharing saves the FDIC's insurance fund money.” The FDIC savings assumption is predicated on the theory that today’s cash prices are distressed and “over-discounted” versus potential future asset values. They maintain that “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 the FDIC accept today's low prices.”

Roughly 90% of FDIC failed bank asset “sales” are occurring inside the loss sharing mechanism and the only estimate of price or value is derived from FDIC estimation with the help of financial advisors and bank bids. The bank bids most often translate into an initial payment by the FDIC to the acquiring bank to cover potential portfolio losses.

Only time (5-10 years) and post closing transparency will bear out the accuracy of initial value estimates and the DIF (Deposit Insurance Fund) costs. Downside adjustments to book values will be made by way of asset restructurings, resulting accounting charge offs and losses resulting from arms-length asset sales.

In what may turn out to be a brilliant and intended effect and though commercial real estate fundamentals have not yet improved, a scarcity of distressed assets openly available in the market in the face of strong demand by opportunity investors combined with favorable FDIC financing for such structured sales (loss sharing among them), has pushed CRE asset prices up as evidenced by strong structured sales and spot market prices.

Bank Asset Managers and Bank Examiners Begin to Scrub LSA Assets

A picture of the administration of LSA's after the bank failure has begun to emerge. The FDIC continues to expand dramatically in the past two years, hiring staff to work on new bank failures and loss sharing agreements.

The FDIC has lined up third party compliance firms to monitor the execution of loss sharing agreements and insure "effective accounting, asset management, financial reporting, and risk-grading processes for LSA-related assets".

The best run banks that have acquired loss sharing portfolios are deploying “Special Asset Officers” to assess the newly acquired FDIC-assisted loan portfolios. Typically part of a Special Assets Division (“SAD”) and often under the supervision of a Senior Credit Officer, SAD reviews the loans, assesses the financial condition of the borrower, analyzes the value of the collateral property and arrives at conclusions regarding the condition of each loan. SAD works with the borrower to develop possible methods of resolution based on each loan and the ability of the borrower to make payments on a timely basis moving forward. SAD manages the reporting process, completing "Problem Loan Resolution" reports, and feeding information to the management team on the status of the LSA portfolio. Through this process loss sharing assets become integrated into the bank’s existing credit culture.

Asset management data feeds back into the loss sharing system resulting in adjustments to acquisition asset values. Revised loan collectability estimates and asset restructurings ultimately result in accounting charge offs and real losses from arms-length asset sales. Accounting and economic LSA portfolio losses are reimbursed by the FDIC via loss sharing certificates submitted periodically to the agency.

Unlike the approach often taken by opportunistic investors, the SAD approach should emphasize and attempt to value and preserve the existing borrower relationships in addition to assessing the underlying collateral value and asset condition.

Loss Sharing Accounting

FDIC-assisted transactions bring with them a new and evolving set of accounting and financial guidelines. Accounting and consulting firms will be hired to help institutions navigate through a byzantine maze of sometimes obscure and often unfamiliar accounting rules that might otherwise slow down the asset resolution process.

Many banking institutions and investors may be unaccustomed to loss sharing accounting which differs from the accounting for originated loans. Loss Sharing Agreements have their own set of books.

The assets in an FDIC-assisted transaction are transferred to the acquiring institution at Colonial Bank's book value.

At the time of the failed bank bid, a fair value is established by the acquiring bank as part of the bid. Fair value is the marked down value of the failed bank assets and is based on the initial estimates collectability of the loans determined through the acquiring bank’s due diligence. This is the acquiring bank's book.

Fair values for loans are most often based on a discounted cash flow methodology (or a modeled approach) that is called a “level 3 valuation in the fair value hierarchy”. Put very simply, level 1 and 2 methods in determining fair value use actual asset sales in very active and somewhat less active markets, respectively.

Level 3 valuation is used in inactive markets or non-functioning loan markets like we have had since 2008; valuations are not based on asset sales or trades. Fair value requires the bank to make estimates about discount rates, market conditions, expected cash flows and other future events that are highly subjective in nature and subject to change.

Level 3 valuations of acquired loans includes the use of projected cash flows, type of loan and related collateral, classification status, contractual interest rate, term of loan, amortization status, current market conditions, market illiquidity and discount rates.

Loss sharing loans are grouped together according to similar characteristics and are evaluated in the aggregate when applying various valuation techniques. The present values of projected cash flows are measured using discount rates that are based on current market rates for new originations of comparable loans.

The Indemnification Asset

In addition the FDIC provides coverage or a guaranty to the acquiring bank for possible additional losses on the acquired assets. These expected future losses are quantified in the “threshold” amount.

FDIC-assisted banks carry on their balance sheet the FDIC “indemnification asset”, a receivable or an "IOU" from the FDIC for the loss sharing agreement obligation due from the agency over time. The indemnification asset value will adjust over time as the condition or "collectability" of the individual assets is determined and changes due to borrower and market conditions. The individual values are “rolled up” into what become the cumulative losses of the LSA portfolio.

An FDIC indemnification asset represents the present value of the estimated losses on covered loans to be reimbursed by the FDIC based on the applicable terms of the loss sharing agreement. Individual assets can be sold; the indemnification is a non-transferable asset of the bank specifically tied to the loss sharing agreement.