Optimism's Big Cost to Small Banks

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Community banks are poised to revisit in 2011 many of the troubled loans they worked hard to restructure this year.

Among banks with less than $20 billion of assets, troubled debt restructurings rose 64% as of Sept. 30, compared with a year earlier.

A greater concern is that more than a third of such loans fell back into delinquency, making it difficult to determine whether more restructurings will fix the problem or simply extend the misery. A number of industry observers take the skeptical view.

"The high delinquency rate means restructurings generally have not been all that successful," said Matt Anderson, a managing director at research firm Foresight Analytics. Delinquencies include restructured loans that are 30 days or more past due or have been moved to nonaccrual status.

At the end of the third quarter, roughly 41% of the $29 billion of restructured loans among small banks were in default, according to call reports compiled by Foresight Analytics.

That figure indicates some bankers were too hopeful that giving borrowers a little more time with smaller payments would fix the ongoing problems, analysts said.

As one bank representative pointed out, loans cannot be rewritten based on expectations that the borrower's condition will heal before the grace period is up.

"Hope is not a strategy," said Jason Korstange, a spokesman for TCF Financial Corp. in Wayzata, Minn. "You simply have to underwrite these loans to the present conditions, and some are going to qualify and some are not."

Bankers also said their mind-set during the past few years has shifted because of more stringent regulatory standards and the worsening economy. Those factors have caused both the number of TDRs and corresponding delinquencies to rise since early 2009.

Regulators "are challenging almost every loan renewal as a TDR," largely because of a change in the interest rate or collateral valuation, said Dan Trigg, a partner with McGladrey & Pullen LLP and a bank auditor.

"Unfortunately, in the world of banking … there will typically be some type of increase or decrease on renewal," Trigg said.

Regardless of the contributing factors, many agree that the 64% jump in TDRs among community banks since Sept. 30, 2009, foreshadows more increases, especially with new accounting guidelines proposed for later next year.

The issue is not confined to community banks. At those banks with more than $20 billion of assets, TDRs jumped 75% at Sept. 30, compared with a year earlier, to $89.7 billion.

Problematic loans and the lackluster economy are "not improving fast enough to get a lot of loans right-side-up again, so bankers may be looking ahead and being more proactive," Anderson said. "This is not going to get fixed overnight, so they will be doing more restructurings for the next several quarters at least."

Bankers and accountants said their biggest headache lies in whether to classify renewed or modified loans as TDRs.

The biggest argument from bankers is that there is not a market rate of interest for troubled debt, said Jim Nelson, the director of credit risk at the Risk Management Association. TDRs "will be an issue as long as there is subjectivity," he said.

A reluctance to add to TDRs also puts regulators on high alert, industry observers said.

"Examiners have taken a much harder view on TDRs," said Rusty Cloutier, the chief executive of MidSouth Bank in Lafayette, La. "I'm not saying it's wrong … but hope is eternal in a lot of these cases."

A further breakdown in the types of loans handled by smaller banks shows that TDRs and delinquency rates are highest for areas such as commerical real estate and commercial and indutrial loans.

Community banks reported more than $21 billion nonresidential restructured loans as of Sept. 30, rising 63% from a year earlier and making up nearly three-fourths of all TDRs.

The delinquency rate for modified commercial loans stood at 43.5%, compared with 33.2% for the $7.2 billion of residential loans that were restructured during the third quarter.

Some analysts cautioned about using delinquency rates to make claims that debt restructurings are not working.

When a loan is restructured, it typically falls into nonaccrual status and some of the restructurings might be charged off or moved to other real estate owned, said Carter Bundy, an analyst at Stifel Nicolaus & Co. Inc.

"It's important to look at, but the standard deviation is all over the board," Bundy said.

In October, the Financial Accounting Standards Board proposed further guidance in accounting for restructurings, with the intention of clarifying some of the gray areas surrounding TDR classifications.

The provisions include classifying a loan as restructured if the borrower can not get a loan with the same collateral at a market rate with another institution. And the proposal includes more indicators for determining if the borrower is experiencing the "financial difficulties" that would trigger a TDR such as approaching bankruptcy, being delisted or projecting cash flows that can't support future loan payments.

While the changes would provide more details, bankers and accountants agree that TDRs will continue to rise as long as regulators impose more definitions and rules.

"It takes some of the ambiguity out because it makes almost anything restructured a TDR," Nelson said. The key, however, is that "it's an accounting issue, it's not a safety and soundness issue."

As banks report a larger number of TDRs, delinquencies tend to rise and banks have to set aside more reserves to cover potential losses. Such a practice essentially mirrors what the bank would do if the loan just went directly to nonperfoming status.

"The result is the same because [a] TDR is an impaired loan," Trigg said. "If I don't do something in modification, I have to take the worse loss up front. If I do a TDR, I can take less loss up front" and then more later if it still goes bad.

"It's about the timing of recognizing the worse possible scenario," Trigg added.

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