As the coronavirus continues to whipsaw the economy, when will bank asset quality begin to crack and losses start to materialize?
One bank, at least, has decided not to wait for that day to arrive.
OceanFirst Financial Corp., a $12 billion institution based in Red Bank, New Jersey, accelerated the resolution of some of its credit losses by selling an $81 million in higher-risk commercial loans with forbearance exposure in late September and October. All of the loans had an underlying, systemic weakness that the bank believed would persist after the coronavirus pandemic subsided.
The sales included $30 million in New York exposure and $51 million in New Jersey and Pennsylvania, executives said. Hotel exposure made up $15 million, $12 million was related to restaurant and food and over $4 million was in gym and fitness exposure. The bank recorded a $14 million mark on the loans, which it took as a charge to third quarter earnings.
The bank also decided to sell its loans associated with the Small Business Administration’s Paycheck Protection Program during the quarter. These sales, along with additional provisioning, contributed to a net loss in the third quarter of $6 million, or 10 cents per diluted share.
First Loss is the Best Loss
Banks of all sizes are weighing their options for dealing with trouble credits, and what a credit workout will cost them in time, staffing and expenses, Greenland says.
“The friction of handling non-performing loans at a bank is huge. It’s not what banks are meant to do,” he says. “Most of the choices a bank has right now are working it out, selling it or owning the real estate.”
OceanFirst Chairman and CEO Christopher Maher says that proactively identifying and recognizing credit risk leads to smaller losses and faster recoveries. According to Maher, OceanFirst sold loans in 2007 and recovered around 70 cents on the dollar; in a year, those assets traded closer to 40 cents.
“Many bankers will say that your first loss is your best loss,” he says. “If you’re early to do something, you will get a good recovery; if you hem and haw and wait, the numbers don’t get better.”
Maher acknowledges that the ultimate recovery rates on the sold loans may have been higher if the bank had held onto them. But that recovery could take years, consuming valuable time and attention to deal with the questionable credit quality.
“There’s a finality that comes with the disposition. We were very conscious that had we merely kept these on the books, established a risk pool and taken a reserve for the $14 million — that may have proven to earn us more money in the long run. But it may also have led to several quarters of discussions about valuations with a lot of stakeholders … explaining why you thought a fitness center or a hotel property was actually valued where you think it is,” he said during the bank’s third-quarter earnings call. “This way, we get the final disposition. We know exactly what the answer is. We can be certain that we took those risks off the balance sheet.”
Strike While the Iron is Hot
Interest in distressed assets is high right now. Kingsley Greenland, CEO of loan marketplace DebtX, says that many of interested buyers using his platform had proactively raised funds in 2019 in advance of a mild downturn and are now sitting on “dry powder.” Prospective buyers are visiting the site more frequency, and both the number of buyers that enter into a nondisclosure agreement to conduct due diligence on an asset and the number of bids are up.
Throughout 2020, DebtX has seen a number of sellers listing hotel loans and now labor-intensive small business loans; Greenland expects retail and office commercial real estate loans to appear in greater numbers in 2021.
OceanFirst managed the sale of its New York portfolio alone, capitalizing on a group of real estate investors who specialize in the city and in those types of assets. It used investment bank Piper Sandler to manage the sale of the $51 million pool of loans covering New Jersey and Pennsylvania, since the bidder base consisted of institutional credit fund buyers looking for distressed loan notes. He says working with a partner helped when it came to assembling the data rooms and legal agreements.
“We made the decision that if there are buyers, we can get good recoveries now,” he says. “There will be the same buyers next year, but there will be more loan sales and they will not be at the [price] we got.”
Back to (Growing the) Business
Maher said the sale “liberated” resources the bank could use as it refocuses on growing profits by rebuilding its net interest margin and boosting operating margins. The two blocks of loan sales lowered its loan-to-deposit ratio to under 90% and generated $388 million in cash proceeds that the bank could deploy toward capital management actions that include repurchases and acquisitions. It also makes it easier to navigate conversations with regulators and prospective sellers that they have a handle on their credit risk.
“Putting this behind us allows us to potentially have stronger and more stable earnings in 2021, which should hopefully translate into a better stock multiple,” he says. “As we transition to next year, investors in general are not going to want to hear about credit surprise and provisions.”
The Board’s Blessing is Important
Maher says credit mitigation work can be tough for bankers, who pride themselves on their close relationships with borrowers and their ability to make good loans. That can make them feel vulnerable when credit quality turns, complicating efforts to resolve credit in a timely fashion, or lead to holding onto troubled loans longer than is prudent.
“The admission that a loan may be troubled is hard. It feels like a personal failure,” Maher says, adding that he has experience with this as a commercial lender. “There’s always this hope that if I give it a little more time, it’ll be OK and I won’t have this black mark or this failure.”
The board has an important role to play in these moments, diffusing emotions and helping management look ahead. Boards should make it clear that they don’t want to cast blame on the previous decisions to extend these loans, but instead focus on decisions that will strengthen the bank moving forward.
“The board plays a role here. If management feels vulnerable or that they’re going to be criticized, then they’re going to be less likely to do it,” Maher says. “I think often, the board/management interaction can perpetuate this failure to just deal with it.”