It's looking like the 1980s again for some banks modifying commercial real estate loans to troubled retailers, home developers and other businesses.
Lenders with big CRE books are resurrecting a workout method that was common in the sharp downturn two decades ago: splitting loans to cash-strapped clients into two pieces and charging off the bad slice. The healthier piece stays on their books at new terms that are easier for the borrower to meet.
Bankers say cutting a note in two can keep a borrower afloat while stopping a lender from having to collect on a money-losing asset through foreclosure.
"A bunch of us have been around and done this before" in the recession of the late 1980s, said Michael Quick, executive vice president and chief credit officer with Susquehanna Banchshares Inc. in Lititz, Pa. "You just call it a good loan/bad loan."
Gauging how many banks are using the practice — also known as an "A/B" modification — is tough given how little banks have to disclose about their restructured loans.
Industry watchers say this tool will become more popular in coming months because modifications are rising and regulators essentially gave their blessing to the procedure in a policy statement in October.
"I think we're already starting to see some use of it, but now with the [policy statement] out, I think most banks are exploring the use of it," said Jefferson Harralson, an analyst with KBW Inc.'s Keefe, Bruyette & Woods Inc. "In general, it leaves you with a loan that should be sustainable."
Loans secured by income-generating properties like office buildings or apartments have become a major source of pain for the banking industry as the downturn has hurt property values and consumer spending.
They are particularly an issue for regional lenders because they are sensitive to local trends.
In the last year, most regional banks have been extending maturities, forgiving principal and granting other concessions to commercial borrowers to help them stay solvent.
Worried that mounting CRE losses may sink more banks, the Federal Deposit Insurance Corp., the Federal Reserve Board and other regulators outlined how lenders should modify CRE loans in a prudent fashion in a 33-page policy statement last month. A section on splitting loans stated that "a restructuring may involve a multiple note structure" and that "lenders may separate a portion of the current outstanding debt into a new legally enforceable note that is reasonably assured of repayment."
The other piece that is "not reasonably assured of repayment" should be "adversely classified" and "charged off as appropriate."
The paper includes an example of an A/B modification involving a $10 million loan to a shopping mall builder having a tough time finding tenants. The lender divided the loan into a $7.2 million note with market rate, and a $2.8 million, interest-only piece accruing at 2% that the bank charged off.
Harold P. Reichwald, a corporate finance lawyer with Manatt, Phelps & Phillips LLP, said the paper essentially urges banks to consider the strategy when it makes sense.
"What regulators were doing was encouraging banks to think creatively," he said. "I don't know that I'd say [it was] a 'stamp of approval,' but I would certainly say they were being encouraging — that you should look more favorably than not on such a process."
Paul Miller, head of financial institutions research with Friedman, Billings, Ramsey & Co. Inc., said such modifications could lower banks' nonperforming assets, because the healthier loan can be classified as performing in some cases. It could also keep more repossessed assets off bank's books.
"What it's doing is allowing the owners of the companies to keep control of the asset, and to work through the problems and not give the properties back to the banks," Miller said.
The regulators appear to be "trying to limit how many properties are coming out to the market."
Quick said good loan/bad loan also positions a bank to recover the bad loans it charged off when the borrower's fortunes improve. Susquehanna has been actively doing A/B modifications for nine or 10 months, he said, and about half of its $36 million in net chargeoffs last quarter involved these workouts, he said.
Brad Copeland, chief credit officer and senior executive vice president with Umpqua Holdings Corp. in Portland, Ore., isn't quite as optimistic.
"If we get some lift in the housing markets, many of these notes will result in recoveries. This thing drags on, they'll probably just remain chargeoffs — it's very economy-driven at this point," Copeland said.
Copeland said he has done relatively few A/B workouts, as most of Umpqua's borrowers have the cash or collateral to modify a loan without splitting it.
He declined to say exactly how many A/B modifications Umpqua has done, though most have involved home developers in the Northwest.
The company, he said, only gives multiple-note workouts to "a customer who is a good operator but has been hurt by the economic conditions — it enables you to keep him in business."
Umpqua does want to recoup some of the bad loans it has charged off, he said, and like Susquehanna, it keeps track of those off-balance sheet credits.
"We've already taken the pain. They're charged off," Copeland said.
"Anything we were to receive from them would all be upside at this point."