As problem loans escalate, it may not be a bad idea for bankers to make friends with the "mopes" -- that is, the management of a faltering company.

Confused? Welcome to the rapidly changing world of workouts, or dealing with borrowers whose loans are nonperforming. Though banks have had bad loans since lending began, the workout process has changed dramatically in recent years.

As a result, workout specialists say, new strategies are necessary, such as aligning with the management of a troubled company -- never a common way for banks to resolve tanked credits.

William A. Brandt Jr., a former workout banker who is now chief executive officer of Miami-based Development Specialists Inc., said bank workout specialists face new challenges from secondary trading, speculators, arbitrage, and internal pressure to reduce costs and sell loans whenever there is even a hint of trouble.

"Friends that you are," Mr. Brandt told bankers, "I have to say you are overmatched by what's happened in the last four to five years. ...This business has always been about two things: revenge and money. But I'm here to tell you it's not that simple anymore."

Speaking at the Robert Morris Associates conference on risk management last week in New Orleans, Mr. Brandt and a contingent of loan workout specialists sounded a clarion call that as workouts become more frequent, many bankers will find themselves unprepared to cope.

The warnings were bolstered by a newly released Robert Morris study that shows bankers soon expect a tide of nonperforming loans to appear in their portfolios. The study, which polled senior workout officers, found that 69% of bankers believe bankruptcies are increasing, 85% believe business failures are on the rise, and 51% believe special assets -- problem loans -- have increased more than 10%.

The findings are bolstered by a wave of recent defaults that suggest problems are not confined to borrowers in any one industry. Big defaults include Iridium LLC, a telecommunications company; United Cos., a specialty finance company; and the health-care giant Vencor Inc.

"Clouds on the horizon suggest that our eight-year glide through the economic jet stream is ending," said Joseph W. May, chief credit administrative officer at Whitney National Bank in New Orleans. With those statistics in hand, it is no coincidence that the association loaded this year's conference with speakers familiar with problem loans, said Kevin M. Blakely, who is the group's chairman and executive vice president for risk management at Cleveland-based KeyCorp.

For workout specialists, gone are the days when bankers sat across the table from borrowers and argued about how much of the loan would be recovered, usually "about 60 cents on the dollar," Mr. Brandt said. "And then you go home."

The main issue for lenders today "is not about replacing managers but about leadership and capitalization issues," he added. "What about backing management as a bargaining chip against those who want to change management? The bottom line is you have to approach this differently."

Today the chief threat in the workout process is the growing secondary market for loans and the emergence of "distressed traders." Such traders scan bankruptcy court filings electronically and immediately begin buying debt.

Mr. Brandt said the sellers are often banks that at the first sign of borrower trouble immediately look for a "near-term exit strategy" when dealing with bad loans. These days there is a very good chance that an "agent bank may no longer be in the deal. You just don't know who holds the debt," he said.

As the bankruptcy process moves forward, distressed debt traders use the Internet to participate in chat rooms devoted to troubled companies. There, creditors can find a mix of accurate and misleading information about workouts. However, much of the chat may be from traders looking to increase the value of the debt they hold.

"Debt trading will complicate your life immeasurably," Mr. Brandt said.

In recent months debt traders have been poaching even the smallest workouts. Some trade in loans of less than $5 million, Mr. Brandt said. And debt trading now begins within 24 to 48 hours after a bankruptcy case is filed.

Mr. Brandt said bankers who show up at a bankruptcy meeting "can face the unreal position of ... discovering that there are people in the discussion who are worried more about the yield curve than (about) the borrower."

Workout specialists say bankers have to weigh the chances of recovery, the threat of debt traders, and the return that can be had by selling a nonperforming loan immediately.

Jeffrey C. Gardner, a bankruptcy attorney with Miller Nash Wiener & Carlsen LLP in Portland, Ore., said that the new pressures mean bankers now avoid the adversarial approach once used against borrowers.

"Early identification" has become of chief importance, Mr. Gardner said. "Banks are saying, 'We might be able to salvage this relationship.' "

As a result, prepackaged bankruptcies, in which creditors and borrowers bring an already-established agreement to a filing for protection under Chapter 11 of the U.S. Bankruptcy Code, have become more common. By filing for bankruptcy protection, a borrower can force structure on the workout process, and that can be good for banks looking to rein in third parties, such as vendors, landlords, and debt traders, Mr. Gardner said.

For banks not interested in dumping debt, a new "maintain and hold" strategy is emerging, Mr. Gardner said.

"Banks are saying, 'We're not going to do anything to precipitate a crisis as long as the loan doesn't get worse,' " he said, "as long as they can stabilize, usually through performance-based pricing."

Ultimately, bankers will have to face the new challenges of loans gone awry. Though it is unanimously agreed that sound risk management is the best prevention against bad loans, even the toughest credit culture can produce them.

As William P. Middlemas, a risk management executive for Bank of America Corp., put it: "At the end of the day, we have to make choices and be courageous -- knowing we'll be wrong."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.