The Federal Deposit Insurance Corp. has reinforced it promise of resolving more institutions under loss-sharing arrangements.
It happened in the recent closing of Attleboro Pawtucket Savings Bank. The $600 million-asset institution in Rhode Island was awarded to New Bedford Institution for Savings.
The Attleboro deal is much like that crafted by the FDIC in the acquisition of Southeast Bank of Miami by First Union National Bank of Florida in September 1991.
In an earlier hybrid transaction, Centerbank of Waterbury, Conn., acquired Connecticut Savings Bank. This FDIC resolution utilized a separate pool for the troubled assets and a loss-sharing arrangement for the remaining "good" assets.
Parceling Out the Shares
Under the most recent arrangement, New Bedford will assume 20% of the credit losses from the loan portfolio, except those related to consumer loans, for three years. Should total net loan losses exceed a specified amount at the end of five years, New Bedford would be responsible for only 5% of loan losses above that level.
New Bedford did not assume any real estate owned or in-substance foreclosure loans. The FDIC also agreed to provide some remuneration for the cost of carry (that is, funding costs) of nonperforming assets over the three years of the agreement and certain out-of-pocket expenses related to management of the troubled assets.
The Southeast Banking resolution was viewed as a success by the stock market, vis-a-vis First Union's stock price, and on Capitol Hill. Since then, the FDIC has been vocal in its desire to do more loss-sharing deals.
Assets kept with the institution, instead of the FDIC's division of liquidation, minimize potential losses. Risk-sharing also gives the acquirer an incentive to work the assets properly. Ventures of this type, however, can only work well in certain cases.
The FDIC uses three primary criteria in determining a candidate for such resolution: the economic downturn in the institution's primary market is believed to have reached bottom, hemorrhaging has slowed, and a valuable core retail franchise exists.
In the case of Attleboro Pawtucket, there continues to be an air of general optimism that the New England economy has improved, the banking market has somewhat stabilized with the resolution of the credit union crises, and most institutions' nonperforming assets are believed to have peaked.
Pros and Cons
Attleboro Pawtucket's nonperforming portfolio had significantly declined in the last 18 months. The savings bank also possessed a unique charter allowing it to operate branches in Massachusetts and Rhode Island, a feature no longer obtainable under Massachusetts law.
If the market has turned and asset deterioration subsided, loss sharing may offer the acquirer an opportunity to pick up a core franchise with reduced risk.
In such arrangements, the FDIC offers substantial protection against credit loss. Also, it will indemnify the acquirer from most contingent liabilities and provide some remuneration for the cost of carry of troubled assets.
By passing the institution through receivership, the FDIC provides the acquirer the right to repudiate deposit terms and rates, leases, and other contracts.
However, these ventures carry risk for the acquirer in addition to the normal business and operational risks associated with any acquisition. Much of this risk is credit-related.
Therefore, it is extremely important for the acquirer to perform thorough due diligence to quantify the risk exposure likely under various economic scenarios.
Of particular importance is the amount of estimated losses in those years after loss-sharing has terminated and for those loans (in this case, consumer-related) whose losses are not shared with the FDIC.
As part of its due diligence, the acquirer should quantify the estimated costs of working the troubled portfolio. Loss-sharing arrangements advantage the larger institutions that have workout programs in place.
Under a loss-sharing arrangement, the acquirer is typically reimbursed for 80% to 85% of the indirect costs associated with managing the troubled assets, excluding consumer loans.
The acquirer is not reimbursed for salaries, related benefits, and other expenses associated with the acquirer's workout staff; occupancy; data processing; accounting and other independent professional consultants; any allocated portions of overhead; or general and administrative expenses.
These direct costs must be borne entirely by the acquirer, which can disadvantage an institution that must build a workout staff - as is often the case with small institutions.
Environmental Liability
In estimating credit-related risks, environmental liability costs should also be considered. The FDIC's standard indemnification does not include indemnification for environmental risk.
This risk is particularly important relative to the institution's loans. The acquirer usually has a call option on the branch facilities for 90 days that would allow an environmental assessment of these bank facilities.
Once the acquirer has quantified its credit-related exposure, a discount on assets should be determined to help mitigate this quantifiable risk. This discount becomes a crucial part of the acquirer's bid strategy.
The FDIC's Mandate
An acquirer must consider not only competing institutions' or investors' strategies but also the FDIC's estimated loss in liquidation. In the past, the FDIC was only required to choose a resolution that was less costly than liquidation.
The Federal Deposit Insurance Corporation Improvement Act of 1991 requires the FDIC to choose the least-cost resolution. The FDIC determines what its estimated loss in liquidation would be.
The loss estimate is based on the division of liquidation's asset-valuation review, preferred and secured liabilities, subordinated and general creditors, and insured and uninsured depositors of the institution.
To determine the least-cost resolution, the FDIC compares its loss in liquidation to its estimated loss under each bid received.
An appropriate bid strategy should use this least-cost test as a guide in determining the maximum discount on assets and the minimum bid on deposit premiums.
At a minimum, the FDIC's estimated loss from the winning bidder's transaction must be $1 less than the FDIC's estimated loss in liquidation. In effect, an acquirer is bidding in competition with both other institutions and the division of liquidation.
When Is It Beneficial to Bid?
Every decision to acquire another institution, on either an assisted or unassisted basis, bears potential risks as well as benefits.
The net benefit to the bidder under a loss-sharing structure will depend on:
* The accuracy of due diligence. Given the relatively short time that the bidder may have to ascertain the characteristics of both assets and liabilities, it is critically important to know where to concentrate the review.
An unduly positive assessment can obviously leave the successful bidder exposed to unexpected losses. An unduly negative or conservative bid may result in a bid that fails to pass the FDIC's least-cost test.
Ability and willingness to manage troubled assets. A larger institution, particularly one accustomed to working large portfolios of troubled assets, will have a decided economic advantage.
The net discount, as bid by the potential acquirer, is intended to compensate for expected losses and unreimbursed costs of managing the troubled assets. But the successful bidder will assume all loans, including those delinquent or nonperforming. This requires the bidder to be realistic and prepared to minimize losses.
Assumptions on economic outlook. The discount, as bid by the acquirer, must reflect an accurate assessment of future economic prospects of the target's market.
Taking license with the old adage, a rising tide will float an aggressive bid. Without the tidal assist, however, the discount may be inadequate.
Is the length of time covered by the loss-sharing agreement reasonable, or does an inordinate amount of credit risk remain in the years immediately following expiration of the agreement?
* Potential for merger economies. If significant savings or revenue increases can be obtained (typical of in-market acquisitions), these benefits may help compensate for the many risks inherent in the loss-sharing purchase-and-assumption transaction.
* Strategic implications. Defensive considerations should be considered. For in-market bidding opportunities, the implications of a competitor gaining significant deposit market share may lead a bank to bid preemptively.
In some cases, the competitive cost of losing to an arch-rival may exceed the risk of winning the bid with a somewhat unrealistic (too low) net discount.
Balancing Benefits and Costs
The decision on whether and how to bid within the new FDIC loss-sharing framework should recognize both the potential benefits and costs. Reliance on any single factor can result in a costly miscalculation - for a winning bid - or disappointment - for a losing bid.
The complexity of this new structure puts increased pressure on institutions interested in bidding for failed institutions.
Good preparation will require, first and foremost, a thoughtful definition of the institution's strategic interests and tolerance for risk. As the number of such resolutions becomes more prevalent, the well-prepared and well-organized bidder will have a decided advantage.
Ms. Newcomb is a vice president at BEI Golembe Inc., Washington.
