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Community bankers are worried about stress tests, even though there is nothing in the Dodd-Frank Act requiring them to do it. While regulators are not requiring the tests for smaller banks, they are increasingly encouraging bankers conduct such tests.
March 16 -
Many private-equity firms hoped to capitalize on the financial crisis through two waves of bank investments. The first, in 2007-8, focused on large investments in major banks. These disappointing investments were too early as industry conditions worsened dragging down these investments.
March 9 -
The community banking sector is starving for capital, and yet debate is dominated by complaints about regulatory burden. Instead, banks need to push regulators to let private equity investors assist small institutions.
December 14
Private investors are no longer willing to put capital into a bank based on a snapshot loan review and traditional due diligence.
Instead, most investors are requiring banks seeking capital to commission and pay for exhaustive third-party evaluations. The reviews involve having a team of independent consultants
"All private-equity groups we've seen do recapitalizations use one if not two third-party due diligence providers," says Joseph Thomas, a managing director at Hovde Private Equity Advisors LLC.
Hovde conducts its own analysis but it also brings in another company to make sure up to 75% of a bank's loan book is reviewed, vetting a majority of every loan category. Before the financial crisis, typically 10% to 15% of the loan portfolio was reviewed as a "sampling," says David Ruffin, a co-founder of Credit Risk Management LLC.
"What we're going to see in the future ... is the requirement of much more robust loan reviews" and more frequently, he says. "The nature of the loan review has to be much more extrapolatory and more risk management-focused going forward."
Other consultants agreed.
"We believe the best way to do it is the individual, loan-by-loan approach," says Carl Streck, a principal at MountainSeed Advisors in Atlanta. "There are folks who do a very broad picture of the portfolio. Most of the losses are contained in a small percentage of the loans. If you're not going loan by loan, you have the potential to miss that."
Investors also began demanding thorough independent loan reviews after many were severely burned by past investments, particularly in instances where credit deterioration took place after a recapitalization.
"Part of the loss estimates are used to figure out how much capital a bank should raise to ensure that under any circumstance, that bank will not be forced to raise additional capital," Thomas says. "That's the one thing you do not want to happen."
As private equity began recapitalizing banks, most had to rely on third-party providers because they did not have a "legion" of in-house credit review staff, Thomas says.
Independent reviews are in such demand that Hovde is forming its own consulting group. Bankers are also warmer to the process than they were a year ago, when third parties were thought of as poison to a capital raise. Reviews often turned up underlying problems, thus prolonging a raise and lowering the offer price — or killing it.
"It has taken much longer than any of our clients wanted it to because there was uncertainty [in real estate valuations] and private equity wanted to see where the market is trending," Streck says. "That reality check has come around" for bankers and investors "so it makes deals much easier to do."
Streck says that the process is more costly but that is also because consultants are visiting the sites associated with collateral to evaluate the borrower's financial situation. Such trips are in addition to evaluations of the bank's own financial condition and credit underwriting.
Hovde also sends in its own group to review the top 20 to 50 real estate projects financed by the bank. The sites are assessed based on occupancy, state of repair, borrowers' projected cash flow, condition of adjacent properties, and even the number of cars in the parking lot.
"Depending on when the loan originated, its appraisal may be one to five years old" and "may be no longer be valid, so it's really important, in our view, to go get a fresh pair of eyes on the current state of the property," Thomas says. "Anything more than 12 [months] to 18 months in today's world is skeptical."
The process usually takes up to three weeks, with six to 10 people on-site reviewing the loans. Most private investors also require a review of at least 80% of the land acquisition-and-development loan portfolio because it is thought to have the highest risk, Streck says. Owner-occupied commercial real estate may face a review of 60% of the outstanding loans.
Investors also want to see stress testing under various "economic shock scenarios," Thomas says. Each loan category is tested differently based on a potential for losses in low, medium and high worst-case scenarios.
To illustrate the process Ruffin showed a two-year stress test for an unnamed bank with a $1.3 billion loan portfolio. The potential baseline credit losses ranged from 1.4% in the commercial real estate portfolio to 4.1% in the construction and land portfolio. In total there were nearly $27 million in projected credit losses, or 2% of the entire portfolio based on a two-year stress test.
Banks frequently did not pull the tax records of borrowers, leaving the bank paying millions of dollars in taxes on real estate from defaulted borrowers, Streck says. Some banks were not inspecting the real estate sites that served as collateral, as Streck recalled discovering a gas station that burnt down - though the bank still had it recorded as fully occupied.
Ruffin says banks must be prepared to conduct these reviews frequently as capitalizations stall, consolidation picks up and regulatory scrutiny intensifies. "Investors are not satisfied with a six-month-old review," he says. He pointed to an unnamed bank that is undergoing its third review since 2009.
Ruffin says reviews cost $50,000 to $125,000 for smaller banks, compared with $35,000 for a loan sampling before the financial crisis. He says recapitalizations and acquisitions are successful only 37% of the time after an in-depth loan review.
Even though the reviews have been painfully thorough — and often difficult for the banks to accept — third-party consultants say enough time has elapsed that real estate and economic trends can be identified better in determining valuations. This improvement should encourage hesitant investors to recapitalize more banks this year.
"Although we saw transactions were low last year, I think this year there is going to be a lot more activity," Streck says. "There's less uncertainty, there's more clarity on where valuations are and we've zeroed in on the risk."
