Working out a problem loan is never easy, but it becomes quite a bit tougher when a troubled bank is the only underlying collateral.

Dozens of lenders that extended loans to other banks in recent years are facing such unpleasant scenarios. As an undercapitalized borrower struggles to repay, the lender is left with few options for resolution. Instead, analysts said, often the best they can do is to demonstrate flexibility while recognizing they may never be repaid in full as their borrower banks creep toward failure.

"In the simplest terms, if they do not do this and the bank fails, they get nothing," said Terry McEvoy, an analyst at Oppenheimer & Co. "Do they want to do this? Probably not, but what else can they do?"

Midwest Banc Holdings Inc. exemplifies the situation. As it seeks to recapitalize, it is asking Marshall & Ilsley Corp. to convert its line of credit into equity.

Though this is not what M&I had envisioned, analysts said a conversion that might help Midwest Banc attract other capital is in M&I's best interest. With regulators restricting the $3 billion-asset Midwest Banc and its bank unit from making payments on the $80 million line of credit because it is undercapitalized, M&I has few good choices. (Neither M&I nor Midwest Banc would comment.)

For most lenders, a failure would weigh on the balance sheet and could create bigger problems.

"For the most part, if they made one bank stock loan, they probably made several," said Jeffrey C. Gerrish, a partner in the Gerrish McCreary Smith PC law firm in Memphis. "If enough of their borrowers are in trouble or fail, you can see how this could create a snowball effect."

Bank stock loans were once common. Big banks, bankers' banks and community lenders extended lines of credit to bank holding companies with the stock of their bank units serving as collateral. During the boom years of the past decade, such loans often were a quick source of capital for fast-growing community banks.

As the economy soured in the past few years, this practice came to a halt. Though the Federal Deposit Insurance Corp. does not break out data on bank-stock loans, its data showed that as of Dec. 31, commercial banks had loans of $111.9 billion to other depository institutions. That was flat from a year earlier, but down 18% from the fourth quarter of 2007.

Experts said that with nearly a quarter of the country's banks operating under enforcement actions, more banks are undoubtedly being barred from paying on such lines of credit.

"We aren't sure how big a problem this is going to be," James McKillop, the president and chief executive of Independent Bankers' Bank of Florida in Lake Mary, said in an interview. "But depending on how many banks they fail, there could be a lot of blood."

The exposure to bank stock loans does not pose a threat to larger banks. Yet analysts said it could create problems for companies such as the Florida bankers' bank, whose core business is lending to other institutions.

Indeed, McKillop said two banks that had lines of credit with Independent Bankers' Bank of Florida have failed in recent months. Meanwhile, the Federal Reserve Board in October instructed the bank to develop a plan for reducing its concentration of loans to other banks or their holding companies. The Fed has instructed other bankers' banks to do the same in separate agreements.

McKillop noted that working out deals with its borrowers has been tough.

"There is not a simple solution. There is no straightforward, easy answer," he said. "Those [regulatory] agreements bar the company from repaying debt. They restrict them from upstreaming capital. So the company's hands are tied."

With the loan secured by the bank's stock, a lender could foreclose on the bank. Such foreclosures have occurred, mainly in healthier economic times when a lender could turn the bank around and then sell it at a profit.

Yet Jeff K. Davis, a longtime industry analyst, said that outcome is unlikely in this climate. "When it gets to the point that the bank is in so much trouble that it is restricted from paying dividends, it is a dog," Davis said. "I'd say just take the loss."

Other options available to lenders, McKillop said, are to grant forbearance, restructure the debt, seek directors' guaranties or try to obtain additional collateral. They also can begin building reserves against the loan. McKillop said his bank had fully reserved for the losses several quarters before its two borrowers failed, for example.

And though it is bitter medicine, he added that he would grudgingly consider converting such loans to common equity, as Midwest Banc is asking M&I to do.

"We would find it very distasteful. I would end up a shareholder of an organization. I would have to give up my collateral," McKillop said. "I would not like having to go through all of that process. But if it is going to save them, possibly."

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