This month begins a new column on banking and capital markets from a chief financial officer’s perspective. The author is Ron Box, a CPA who is CFO and chief information officer of Joe Money Machinery, a Birmingham, Alabama-based dealer of heavy-construction equipment.
As the CFO of a regional company that depends on consistent access to capital, I carefully assess the strength of any bank before entrusting it with any part of our portfolio. Recently, however, one of our banks experienced significant reversals in its real estate holdings. The Federal Deposit Insurance Corp. closed the failed bank after brokering a deal with a new, out-of-state bank. This purchasing bank was given a large incentive called a “loss-share” by the FDIC. In a loss-share, the purchasing bank does not have to take the loss when it forecloses on a loan; the U.S. government absorbs the failed loan. This can incentivize the takeover bank to purge the old portfolio of borderline problem assets. While we avoided having our loan placed in the loss-share category, many other businesses did not fare as well.
Whether by closure and takeover or merger, a change in a bank’s management can spell great trouble for a company’s ability to manage the flow of capital. The old credit rules that you have become accustomed to may fly out the window with the arrival of new ownership. New bank management will have its own ideas about how to manage credits, especially those deemed to be troubled or marginal.
With a loss-share, there is usually a dollar cap on the total amount of losses that the successor bank can apply to this loss-share category, so all marginal loans may not make it into the loss-share. The best a borrower can hope for is to essentially be left alone to continue through the new bank’s credit policy.
But credits selected for loss-share face a more-draconian scenario. Bank regulators will allow the new bank to take action on these credits by foreclosing or forcing the credit out of the bank without requiring the successor bank to dilute its capital position through increased loan loss reserves or additional direct loan write-offs. Once a loan, possibly your loan, is placed in loss-share, the bank will give you a short amount of time to move the credit out of the bank. If this does not occur—and very often it is not possible to move the credit since the loan is distressed—then the bank will often foreclose on the business with all of the negative ramifications attending foreclosure.
Be a Better Credit
A borrower cannot guarantee that its loans will avoid loss-share, but it can strengthen its position vis-à-vis its new bank. One, take every prudent step to move from income-statement loss to at least breakeven, if not there already. If a borrower doesn’t find this equilibrium between revenue and expenses, everything else it does means very little. Two, create positive cash flow. While asset-based loans have been popular for many years (placing a great deal of weight on the quality of collateral securing the loan), you may find your banker asking more questions about positive cash flow. Although commercial loans still require adequate collateral to secure the transaction, positive cash flow will be expected to sustain the loan-payment stream. Third, a realistic, viable, and well-documented business plan is a critical piece of the puzzle. Remember that your banker must go to bat for you in front of the credit committee, so information he or she can use as leverage could keep your business out of loss-share.
Many other factors influence how loss-share agreements work, and you should talk with your commercial banker to gather as much tactical information as possible if you think your credit could be moved to this special loan category. In any event, changes in bank ownership, even if they don’t involve a loss-share arrangement, require a great deal of planning. Be sure to develop your own sources for information to track the health of your bank, and then develop an action plan to ensure a consistent flow of credit.
(For a tutorial from the FDIC explaining how loss-share agreements work, see http://www.fdic.gov/bank/individual/failed/lossshare/.)