The developing community bank crisis of loan participations
Bring up the subject of loan participations these days and the universal response includes a groan and a roll of the eyes.
Fourth quarter 2010 Call reports are being filed this week. The quarter was worse than expected for many community banks in Georgia. Some credit officers and executive teams no doubt struggled to craft loan loss allowances and establish reserves based on tortured collateral valuations. As year-end auditors and regulators review those files for adequacy, expect much wailing and gnashing of teeth…and then amended call reports with material negative adjustments.
10 years ago, loan participations were an assertive but acceptable strategy for both portfolio diversification and balance sheet growth. Rural banks looking for growth opportunities and others with ready access to funding pursued loan participations methodicallyand with reasonable success. Participations arose for two reasons: some credits were simply too large and exceeded the regulatory limit of the lead institution, or the originating bank had a self-imposed house limit and sought to share the exposure (and resulting revenue) with several willing partners. Most bankers understood that taking participation exposure was the equivalent of acquiring brokered assets, since the relationship---with its associated deposits and transaction fees—would remain with the lead institution. “Relationship banking” this was not, but loan brokering was a supportable secondary strategy..
The early 2000’s brought a new age of participation-fed growth. Some banks began to pursue a primary strategy of growth via brokered assets. These banks funded much of that growth with “wholesale” or brokered deposits and institutional borrowings rather than local money markets and retail CD’s. Problems developed as relationships evolved: bankers came to trust and depend upon the underwriting process of their peers. Exposure was taken on with little more than a phone call between lenders rather than the time-honored approach of diligent in-house underwriting and the maintenance of detailed and independent credit files. The brokered loan growth strategy worked really, really well for Georgia’s community banks…until it didn’t. Around the middle of 2007, the market froze…and history happened.
Say a $10 million loan is participated between three banks at 40%/30%/30%. If the bank holding 40% of the troubled credit fails, and the failed institution is subsequently acquired by a bank utilizing an FDIC loss- share agreement (LSA), that loss share does NOT extend to the participating banks. If the loan goes bad and the 'covered' institution eventually represents to the FDIC that recovery on the troubled credit will only amount to 30% of par value, that covered institution will submit a documented request to the FDIC for reimbursement (that’s how “loss sharing” works). If/when the FDIC accepts that valuation, the other two banks face a grim choice: they can either buy out the former lead bank’s exposure at the value at which the remaining participants hold that loan on their books....or write down the asset to 30% as determined by the LSA of the “covered” institution. Now bear in mind that the former lead bank, probably under stress for a couple of years prior to failure, likely did a lousy job of keeping the participants informed of the borrower’s status. Little, if any monitoring information was likely distributed to the participating banks and now, with a skimpy or non-existent credit file…well, you get the picture.
Think about that for a moment: the forced write downs on these deals are going to be very painful to banks desperately trying to preserve capital. It's another headlight in a dark tunnel that’s hurling toward community bank directors...and it IS an oncoming train.
I spoke recently with a friend who sits on the ALCO of community bank in north Georgia. He was bemoaning the 2010 failure of Bank of Ellijay and talked about the numerous participations his bank had done with that institution. Atlanta-based institutions like CS and State Bank were established and have grown by acquiring failed institutions "by the pound". The success of these new banks is being measured by the speed at which they can liquidate covered assets under FDIC-sponsored LSA’s. To a significant degree, the price of real estate in metro Atlanta and north Georgia will be set in 2011 and beyond by these two institutions that have grown from $0 to $2 billion+ in under two years. CS and State are not functioning as banks; they are liquidation machines. As the remaining participating banks are forced to write down soured assets, a reckoning day approaches.