The Devil in the Details

Thanks to the real estate crisis and loose lending in recent years, loan workouts have come back in vogue, raising the question of how boards will deal with strained portfolios in the quarters and years ahead.

The numbers get bleaker by the quarter. Rapidly deteriorating credit quality is giving many banks a laundry list of problem loans. Noncurrent loans-those 90 days or more past due or in nonaccrual status-grew to $162 billion in the first quarter, up from $68 billion for the same period a year earlier, according to the Federal Deposit Insurance Corp. The persistent downturn in the credit cycle, weakness in financial markets, and falling asset values all conspired to erode at banks’ credit quality, the agency said. FDIC-insured institutions earned $5 billion in the second quarter, versus $37 billion for the same period a year earlier. Most of the decrease in income was a result of higher loan-loss provisions.

The shifting climate means many directors will be spending a lot more time helping management devise and work through problem loans. “In good times, being on a board is a great job,” says Charles Wendel, president of Financial Institutions Consulting, a Ridgefield, Connecticut firm that specializes in advising independent and community banks. “But in rocky times, it takes a lot of time and a significant commitment on the part of the board members to really understand what is happening and not to be diverted by senior management’s self-assurance.”

When it comes to loan workouts, directors should act as advisers, but leave nitty-gritty decision making up to management. “Directors shouldn’t get involved in the day-to-day decisions on troubled assets,” says Dan Stevens, chairman of Home Federal Bancorp, a $742 million thrift in Boise, Idaho. “That is a liability that directors would not want to take on because they are not trained to do that. But they do need to be aware of the issues in case we come to a situation where we need to make a decision on taking a loss or selling something at deep discount just to get it away from us because it’s a problem.”

Regulators have also made clear the role of the board in workouts. “It is exceptionally prudent for a board to understand that above all else, they set the policy and direction of the institution,” says Grovetta Gardineer, managing director for corporate and international activities at the Office of Thrift Supervision. “Board members need to have an understanding of the mission and the agenda of the institution as far as what it expects to do with loan workouts.”

In their analysis, boards need to compare what management is doing versus other competitors. “You have to review what they are doing and what other similar managements are doing in the same situations,” says Charles Elson, a law professor and director of the Weinberg Center for Corporate Governance at the University of Delaware. “The board must also try to evaluate as best it can how effective management is in recouping the lost assets.”

This can be a tricky issue, since often boards oversee the approval of larger loans. But directors should compare statistics such as noncurrent loans to national averages to get an idea of how management fares, says Jay Brew, chief bank strategist for m.rae resources inc., a consulting firm in Bethlehem, Pennsylvania. They also shouldn’t look at performance ratios in a vacuum, but should consider how well management has done with achieving goals and benchmarks set forth in the strategic plan, such as deposit gathering initiatives. “Management shouldn’t be judged in terms of just one goal,” says Brew, who also serves as a director at Embassy Bank for the Lehigh Valley, a $361 million institution also in Bethlehem. “It has to look at other goals that may not have economically affected the bank.”

While mortgage lenders and large banks have been hit hard by subprime lending, community banks mostly have managed to avoid problems in that area. But most banks are starting to feel the pain with commercial real estate loans. Community and mid-sized banks have increased their exposure to CRE loans over the years as a way to remain competitive with larger banks, including construction and development lending. Regulators are watching carefully. “The C&D segment of the CRE lending category stands out as the most important short-term credit quality issue,” said Sheila Bair, chairman of the FDIC, in testimony before Congress in June.

C&D loans that were noncurrent increased by $8.2 billion, or 27%, during the second quarter, according to the FDIC. Noncurrent loans secured by one-to-four family residential properties increased by $11.7 billion, or 21%. Noncurrent commercial and industrial loans increased by $1.8 billion, or 15%. All told during the quarter, the percentage of noncurrent loans and leases rose during the quarter to 2.04% of all loans, the highest since the third quarter of 1993.

Meanwhile, more loans are being written off. Banks charged off $26.4 billion of net loans during the second quarter, almost triple the $8.9 billion written off over the same period a year earlier, according to the FDIC. The annualized net charge-off rate in the first quarter climbed to 1.32%, up from 0.49% a year earlier and the highest since the fourth quarter of 1991.

Of course, some banks are getting hit harder than others. In their bid to compete with the commercial lending of the larger banks, community-based institutions loosened lending standards over the years. In order to get loans approved, managements often made exceptions to underwriting policies in order to seal a deal, such as allowing for higher loan-to-value ratios, extending maturities, and dropping guarantees.

Some banks have had small increases in nonperforming assets, while others have seen increases of 100% or more between regulatory examinations. This has caused many institutions to scramble to find workout specialists, who last were employed en masse in the early 1990s when banks struggled with troubled commercial real estate loans.

Metropacific Bank, a $67 million bank in Irvine, California, saw noncurrent loans increase to 4.8% of loans at the end of the second quarter, up from 0.1% a year earlier, according to the FDIC. The bank hired workout specialist Earl McDaniel last November to help deal with problem loans. McDaniel, a senior vice president, represents a cadre of bankers resurrecting their workout careers after a long lull. The bank has been hit by souring residential construction loans, such as borrowers with tracts of two to eight houses.

All things being equal, newer banks are more at risk since they lack the institutional memory of the last bad stretch in the credit cycle. “Banks that are five to seven years old are the biggest danger for boards,” says Nicholas Ketcha, a managing director at FinPro Inc., a bank consulting firm in Liberty Corner, New Jersey. Relatively speaking, “these banks are in their teenage years and haven’t experienced this type of downturn.”


Boards also offer a mixed bag of talent in terms of financial acumen. Often, boards-made up of members of the community-bring their own sophisticated knowledge of their own businesses, yet they may know nothing about banking, Wendel warns. On a typical board, he says, there is a tremendous spectrum of capability and knowledge of financial businesses. “Some people are totally clueless; others are very engaged,” he says. The latter “are the ones who have to take leadership positions. They have got to push management to make sure they are making the right decisions. They have to encourage management to be forthcoming, not take things for granted, and to look behind the numbers.”

In the process, directors can’t be passive, adds Frank De Lisi, a founding principal of the Bank Experts Group in Brewster, Massachusetts. “They have to be very active and understand the role of the workout process,” he says.

Boards of community banks-unlike those of large financial institutions-can bring local community knowledge that can help them stay ahead of trouble. Their eyes and ears can help tip off management of a souring business, Wendel says. “They should be hearing things about borrowers, the companies and industries. That kind of knowledge is very valuable to the bankers, and they should be bringing it to the bankers.”

Yet it all comes down to management’s effectiveness, Brew adds. “The real task for a director is to gauge whether the CEO and management are capable of working through this period and limiting the amount of loss that could be taken,” Brew says. “Do they feel comfortable with the type of person they have? You have got be a bulldog out there, because the other side is trying to get out with the least amount of pain possible.”


Experts stress no two workout situations are alike, and no single strategy is a panacea. A number of factors will be in play, such as whether a borrower had a sustainable core business, the strength of management, cash flows, industry health, the value of collateral, and how any bankruptcies will affect the financial institution, says Doug Lipke, a partner at law firm Vedder Price’s Chicago office.

“The devil is in the details,” Lipke says. “The board should, in times like this, insist on very detailed reports on credits over a certain amount.” The minimum-sized loan depends on the size of the bank, so there is no golden rule on what a board should see. At Illinois-based Hinsdale Bank & Trust, a $1.2 billion financial institution where Lipke serves as a special adviser to the board, troubled loans in the general range of $50,000 and above go to the board for review. The bank had noncurrent loans rise to 2.86% of all loans at the end of the second quarter, up from 0.85% a year earlier, according to FDIC data. “We get very detailed reports on these troubled loans,” Lipke says.

To be sure, directors should pepper management with questions to help determine how to proceed (see sidebar). Another critical element includes making sure management knows the borrower, Lipke adds. “You might have good collateral and a good business plan,” he says. “But if you don’t know the borrowers well enough to know how they are going to react in good times and in bad, then you’re making a mistake. It’s the same and even more important when you are doing a workout. You have to know whether you should crash and burn or do a forbearance agreement and work it out.”

Directors have a responsibility to review those loans on a periodic basis, either monthly or quarterly, De Lisi says. Directors also must probe, cajole, and maintain independence in their review. “I’ve seen too often where the directors have just relied too much on the senior management on the deals they originated,” he says.

Boards need to keep tabs on how the bank is managing loans coming off versus loans coming into the workout area, De Lisi says. Paydowns, chargeoffs, and return-to-accruals are subtracted from the number, while new loans coming in are added. “You develop from quarter to quarter what is actually happening in the workout area,” De Lisi says. “It is a very important tool.”


Boards must also be involved in determining whether to use independent firms to help with workouts. Workout firms allow a bank to hand off nonperforming loans quickly, while collections are still feasible, Wendel says. Bankers are often conflicted when having to collect on a loan, perhaps lacking the judgment that someone with an independent eye would have. “Bankers are often not very good at collecting their own loans,” Wendel says. “They will make collection calls at the end of the quarter or month when they have to report it. They are not doing it proactively. And they are not doing it with a whole lot of sophistication.”

It’s often advisable to get an independent adviser, such as a lawyer or consultant, to review loans to determine whether management is making the right decisions, experts say. For large loans, often executives were involved in the initial deal. “They have too much of an emotional investment in it,” De Lisi says. “You really want a separation there.”

Having someone else do the collecting, whether in-house or outside, will also help bankers focus on their jobs. Stevens says Home Federal has capitalized on the troubles of others who have slowed down lending to a trickle as they cope with mounting losses. That has allowed Home Federal to lure away good customers from its competitors who are preoccupied with working out or charging off bad loans. “The banker still needs to be doing some selling in order to keep the bank growing and able to make money,” Stevens says. “If they do collections, they are not going to be able to do that.”


Boards should also be in tune with how management decides whether it will stick it out or sell the assets. “That’s a judgment call that can be difficult,” says Dorsey Baskin, a professional standards audit partner in Grant Thornton LLP’s Dallas office. “It can depend upon the resources and the experience of the bank and the borrower. Certainly if the bank has doubts about the [borrower’s] integrity, or the ability or the attention it is paying to the management of the assets, maybe the bank is better off taking over that management. But quite often, banks don’t have in-house expertise to maximize the value of the assets, making it better to work it out.”

In other situations, a bank may face having to invest more money in order to complete the building of a property. That might make it worthwhile to exit the asset quickly. “Sometimes it’s in a bank’s interest to go ahead and take the loss and not devote staff to managing bad assets,” Baskin adds.

Ultimately, “the owners and the management have to believe in the plan,” says Patrick Cavanaugh, a partner at High Ridge Partners, a Chicago workout firm that helps both middle-market businesses and banks. “If I believe in the business and I really think that the owners have their hearts in it, I’ll go to bat with the bank and point out intangibles.”

Regardless, troubled banks face a tough choice: take a big loss, or work out a loan that often takes three to five years to fix. That means crimped profits for some time to come. Yet for those managements that get through this difficult period, a lesson will be learned by officers and boards. “If management has not had the experience and they go through it, it develops them into an excellent team,” Brew says. “The tendency is they will never go back there again.”

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