Foreclosed Properties: What is a Board to Do?

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bank-owned.jpgIn the wake of the recent (and in some markets, ongoing) real estate downturn, many banks are saddled with levels of other real estate owned, frequently referred to as OREO, well in excess of historically normal levels. The strongest banks have been able to deal with OREO issues very easily—by simply selling the properties at the highest prices reasonably possible—but many banks, even banks that inherited OREO through FDIC-assisted acquisitions, need a strategy for dealing with the OREO on their books.  Certain recent actions by regulators (including the Federal Reserve’s recent guidance regarding rental of OREO properties) and other public and private parties underscore the need for a systematic and organized approach to addressing OREO disposition and exposure to liability for properties that remain on the books. The focus of this article is to provide some high level keys to developing and implementing a strategy from the board level down.

Why It’s Important to Get Rid of Bank-Owned Properties

At the outset, it is important to understand why OREO is referred to as a “toxic” asset. In all but the rarest of scenarios, OREO will be deemed a “substandard” asset, which impacts the regulatory standing of the bank. The assets are very expensive to maintain and also expose a bank to a variety of liabilities, as discussed below. Therefore, the end result of any OREO strategy should be to dispose of the asset as soon as reasonably possible. In a depressed real estate market, this strategy goes against the nature of many bankers and bank directors, which generally do not view selling an asset in a depressed market as a good decision, but we have seen time and time again that disposition is the most effective strategy.

We recognize, however, that disposing of OREO is not as easy as it sounds in many markets. For example, there are simply no buyers for certain OREO properties in some markets. Notwithstanding the willingness and ability of a bank to sell the property (or, in some cases, to give it away), there may be no counterparty to take the property. Second, for banks with capital constraints, the bank may not be in a position to absorb the losses associated with disposing of the asset in the current market. As a result, it is important to implement measures to mitigate the bank’s potential liability while the OREO is on the books.

Development of an OREO strategy, particularly one that involves holding certain properties for a period of time, has become increasingly complex as a result of recent industry developments. On one hand, a large financial institution was recently fined by a local court because a piece of property held by the bank was being used as a methamphetamine lab (clearly without the bank’s knowledge), and we are aware of other situations in which a bank has been sued as a result of wrongful acts committed by a third party on its properties. These situations would obviously lead a director to believe that a bank should be very active in ensuring that its OREO properties are in the best condition possible. On the other hand, the FDIC, acting as receiver for Omni Bank, N.A., sued certain former officers for Omni for investing too much in the rehabilitation of its OREO properties, alleging corporate waste that rose to the level of gross negligence.  Layered on top of all of this is the Federal Reserve’s recent guidance that indicates that holding and renting residential OREO can be part of a reasonable disposition strategy.

Given the complicated landscape for dealing with bank-owned properties, we recommend adopting and implementing a board-level policy. This policy will ensure that management understands the guidelines for dealing with OREO in accordance with the bank’s overall strategy.  It will also ensure that the board has business judgment protection should anyone question the bank’s handling of OREO. A strategy and policy should incorporate the following components:

Conduct a present value calculation.  Management should prepare a present value calculation that compares disposing of the property (or group of properties) as soon as possible to holding the property for a more extended period of time.  The analysis should be based upon reasonable assumptions and should incorporate all direct and indirect holding costs of the OREO. From this calculation, management can determine the disposal strategy.

Mitigate risk.  Obtain appropriate insurance for all reasonable risk associated with the property. Have your insurance policy reviewed by a competent insurance broker or attorney.  If the bank is acquiring new property, assign the loan to a special purpose subsidiary to isolate the risks of holding the property to the extent possible.

Place reasonable limits on improvements.  As made clear in the Omni case referenced above, there is a level of investment in bank-owned property for the purpose of preparing it for sale that will be criticized by regulators. While banks can take reasonable steps to improve property to increase its marketability, management should analyze the return on investment in improvements. The bank should not enter into the development business.

Let the professionals handle it.  If a decision is made to continue to hold property for income production, be aware of additional laws that may apply, particularly landlord-tenant laws. In many cases, it will make sense to engage a property management company familiar with these laws to handle the management of the property. A written policy should set forth approved property managers, and the bank should provide appropriate oversight.

Think at a high level.  It is often easy to fall into the trap of deferring a loss because it appears that a property could yield a better return after a holding period. However, decisions to continue to hold property should be made in accordance with an overall strategy, the focus of which should generally be to liquidate as soon as feasible. The old maxim continues to apply: The first loss is usually the best loss.

Management of elevated levels of OREO is never easy for a bank, particularly in light of the current depressed market conditions.  However, with a systematic approach to addressing OREO, banks can avoid taking more of a loss than they must and can get back to the business of banking.

Pooling Resources to Buy Middle Market C&I Loans

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Community banks have been pushed, squeezed and shoved out of the lending market during the past two decades for many types of commercial and industrial loans, where the pricing has become so competitive that it’s not worth the effort. But with the pitfalls of high concentrations in commercial real estate so obvious now, many banks are trying to diversify revenue streams in order to survive. John Delaney and Lewis “Lee” Sachs founded asset manager Alliance Partners in June 2011 to help community and regional banks diversify income and gain access to C&I loans too big to otherwise put on their books. The related entity, BancAlliance, is a cooperative of member banks that identifies, evaluates and refers loans to members. Bank Director magazine talked to John Delaney and Lee Sachs about the market for C&I loans and how their company works.

Why did you think there was a need for this?

Lee Sachs: From the bank’s perspective, for the last 20 years, they’ve been pushed out of so many different markets. As a consequence, community banks have gone from having around 60 percent of their loan assets in real estate to some having almost 80 percent of their assets in real estate. That is not a sustainable business model over time.

John Delaney: Banks do better when they have balance and choice, and the problem with community banks is they don’t have balance and they don’t have a lot of choice. A lot of community banks have just become local real estate lenders. Much of the growth occurring in our country is in the middle markets. The U.S. is more of a service economy and service-based businesses tend to be more regional and national, and you need a certain amount of scale to successfully compete for loans in that market. Right now, a disproportional benefit of that growth goes to large banks. If you look at where jobs are being created, it’s at fast growing, mid-sized business that go from 100 employees to 1,000 employees in a couple years. The middle market requires loans of $50 million to $250 million, which are bigger than what a lot of community banks can handle. However, these borrowers would prefer to do business with community banks. Truly, that’s what they would rather do.

Lee Sachs: Sometimes a Main Street bank will lose a client as that client grows, because the bank can’t accommodate the larger loans. One of the things we help our members do is retain that client.

Who are your members and what does it cost to join?

Lee Sachs: We have 38 members and they’re all over the country, from $200-million asset banks to $10 billion. They don’t pay anything to join. We receive asset management fees based on the volume for the loans they fund through BancAlliance. The banks set the parameters for the loans, policies and procedures, and they tell us what kind of loans they want. Each individual loan may or may not fit with every bank’s needs. We introduce a loan to the membership and each member decides if that loan works for them. We service the loans on behalf of the group. We consider ourselves an extension of their loan department.

John Delaney: We’ve looked at 450 opportunities, and a little less than 10 percent made it through our filter, so 40 loans have been approved on behalf of the network.

C&I lending is a fairly competitive business, especially in terms of pricing, so how do you think you can offer a strategy that will be attractive to community banks?

John Delaney: For small banks, there are too few opportunities in C&I lending and too many banks going after that. In terms of national credits and mid-sized businesses, we find that to be a market that has average competition. We don’t think it is nearly as competitive as the C&I loans in the local footprints. The return profile is better and the risk profile is better.

How do the regulators view your model?

Lee Sachs: We’ve gotten good feedback. We are doing this very carefully; we designed this in a way that fits with regulatory guidelines. The former Comptroller of the Currency, John Dugan, has been outside counsel for BancAlliance and has been instrumental in helping us think this through.

 

Lending in an Uncertain Economic Environment

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Joe Evans, chairman and CEO of State Bank Financial Corp out of Atlanta, shares his lending strategy in a weak economy and tumultuous real estate market in Georgia.

Over his 30 year career, Joe Evans has run some of Georgia’s beset community banks. In December 2006, Joe Evans sold Atlanta-based Flag Financial Corp. to the U.S. arm of Royal Bank of Canada for $456 million. Since starting State Bank, Evans and his team have acquired several failed banks in the Metro Atlanta area.

In 2011, State Bank was named the top performing bank in the United States by Bank Director magazine in our 2011 Bank Performance Scorecard, a ranking of the 120 largest U.S. publicly traded banks and thrifts.

Watch the below video filmed during Bank Director and NASDAQOMX’s inaugural Boardroom Forum on Lending held last December in New York City.

Bank Buildings: When Directors Are the Landlords

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landlord-keys.jpgDuring the mid-2000s, it was commonplace for a bank, particularly a de novo bank, to lease some or all of their bank facilities from an entity controlled by the bank’s directors.  At the time, these arrangements truly represented a “win-win” situation.  The bank was able to occupy built-to-suit facilities while conserving liquidity so that cash could be deployed  through making loans with attractive yields.  At the same time, the directors, many of whom were real estate professionals, were able to make a sound real estate investment with the knowledge that a very stable tenant would occupy the property.

As we know, much has changed since the mid-2000s.  Vacancies in commercial properties have caused market lease rates to plummet.  Similarly, market values of commercial properties have decreased substantially.  Many banks have excess liquidity caused by soft loan demand, making a potential investment in fixed assets more attractive.

Because many of these leases were written with five-year initial terms, a number of banks are now weighing their options with respect to renewal, extension or renegotiation of the leases.  To make matters more complex, many director-controlled entities borrowed money to construct the bank facilities.  If those notes had five-year terms, they are coming up for renewal, and the lending bank may be eager to move the commercial real estate loans off of its books.

This fact presents a particularly difficult challenge for the affected directors.  Banking regulations require that transactions with affiliates be made on terms at least as favorable to the bank as those terms prevailing at the time for transactions with unaffiliated parties.  Most bank directors understand their duty to act in the best interests of the bank, but they are also facing personal financial exposure if the lease is not renewed on terms that allow the entity to continue to service its debt obligations.  In addition, given public scrutiny of directors and officers who are perceived to have profited at the expense of the bank they serve, creating a proper process to manage these situations has never been more important.

While state law should be consulted regarding the appropriate process for analyzing and approving a transaction with an affiliate, the following best practices are helpful in reaching a fair and appropriate resolution to transactions between a bank and its affiliates.

  • Wear your “bank hat.”  It is imperative that any director with a financial interest in the transaction focus on making the appropriate decision for the bank.  Directors should understand that these transactions are likely to be heavily scrutinized by regulators and could potentially be scrutinized by shareholders.
  • Allow independent directors to take the lead.  To the extent that two or more directors do not have financial interests in the transaction, appoint them to a committee with full authority to analyze and negotiate the renewal of the lease.
  • Rely on third party experts.  Engage trusted third parties, such as appraisers and other real estate experts, to provide information to the board (or independent committee) regarding the bank’s alternatives.  In addition, ask management to prepare a lease/buy analysis based on the bank’s existing and projected liquidity and its ability to leverage that liquidity.
  • Document carefully.  Remember, if it is not documented, it did not happen.  Be sure that all relevant considerations, discussions and reports are fully documented.
  • Consider all relevant factors.  While an appraisal or other analysis of market lease rates is helpful, also consider the “soft” costs of failing to renew the lease, which might include

    • employee downtime related to moving;
    • additional marketing expense created by advertising the move and updating existing marketing materials;
    • reputation risk created by leaving the existing location vacant; or
    • loss of branding associated with the existing location.

While a situation involving a lease of property from a director-controlled entity can be addressed using these best practices, they also can be used in analyzing a lease between the bank and its holding company.  In addition, they can be helpful in renegotiating a lease with a third party or deciding to purchase facilities that the bank currently leases.  Regardless of the circumstances surrounding a decision regarding the bank’s facilities, bank directors should familiarize themselves with all available alternatives in order to make the best decision for the bank.

The Crisis in Community Banking

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growth.jpgLost in all the Sturm und Drang surrounding the financial crisis of 2008 – when several large U.S. financial institutions either failed (Washington Mutual Inc.), sold themselves off to avoid failure (Wachovia Corp.), or were simply propped by the federal government (Citigroup) – is the very real crisis facing community banks throughout the country.

The nation’s largest banks – all of which received direct capital infusions from the U.S. government under the controversial Troubled Asset Relief Program (TARP) – are once again profitable, and many of them have long since paid back the money. On the other hand, a great many community banks are still struggling to regain their footing – and for them the long nightmare is not yet over. 

Haves vs. Have-Nots
 
The disparity in fortunes between the industry’s largest institutions and smaller regional banks is framed perfectly by two bank stock indexes published by Keefe Bruyette & Woods Inc. The KBW Bank Index (BKX), which is comprised of 24 U.S. money centers or super-regional banks, was up 17% on the year through late October, while the KBW Regional Banking Index (KRX) – which is comprised of 50 smaller regional banks – was up just 3% on the year. Clearly institutional investors like what they see in the BKX universe, and that has allowed large banks to raise capital at a reasonable cost and put their troubled past behind them. 
 
Smaller regionals have had a more torturous recovery – and many of them were actually quite grateful to receive their TARP funds because when that money was being doled out two years ago it was the only available source of capital for most banks. 
 

Overdosing on Real Estate

But most challenged by far are the thousands of small community institutions that are either privately owned or have thinly traded and highly illiquid stocks and haven’t been able to raise fresh capital to fuel their recovery. For the most part, their downfall has been the result of bad commercial real estate and real estate development loans, including loans tied to the grossly overbuilt housing market in such places as Florida, Nevada and Arizona. 
 
Although the U.S. housing bubble attracted lenders, investors and buyers like moths to a flame, there is a reason why so many community banks ended up being so overexposed to real estate. After 30-some years of disintermediation and conglomerization, there are only a limited number of ways that community banks can make money. Several large asset classes, including car loans, credit cards, mortgages and home equity loans, are now dominated by giant financial companies that have enormous marketing and efficiency advantages. 

Expanding Their Business Model

Many community banks focus on small and medium-sized businesses because it’s one market where their superior service gives them a competitive advantage over the big banks, but generally they lack the revenue diversification of their larger peers. So when the residential real estate market took off in the early 2000’s and local developers were looking for loans to finance their construction activities, many smaller banks saw that opportunity as manna sent down from heaven. 
 
As the U.S. economy improves and the real estate market gradually recovers, community banks will rebound as well. Unfortunately, their underlying weakness – the lack of revenue diversification – will remain. And the challenge for community bank CEOs and their directors will be to expand their business models to include a variety of fee-based activities that will make them less reliant on cyclical lending markets like real estate.
 
Otherwise, the community-banking sector will just be an accident waiting for the next recession to happen.