It’s Time to Take Control of NPAs and Return to Capital Strength
Below is a summary transcript of the discussion that took place Sept. 8 at the Union League Club. More than 40 community bankers and other financial services experts attended the event.
Special Guest:
David G. Schroeder, VP of Federal Governmental Relations at the Community Bankers Association of Illinois, discussed how the new financial reform legislation would affect community banks. 
The panel discussion included comments from:
- Michael Iannaccone, Community Bank Strategist
- Justin Barr, Distressed Asset Authority
- Chris Feurer, REO Brokerage Expert
- Rick Levin, Real Estate Auction Leader
- William Mitchell, Loan Sale Advisor
Introduction:
Michael Iannaccone, of MDI Investments, spoke of his appreciation for everyone’s attendance. Time is money and solutions need to be found before time runs out. These are tumultuous times and to survive, fortitude, research and proven strategies must be employed to get us through. There is no need to explain finance 101 or economics 101. We all are finance people and understand how the economy affects banking. No significant change will happen until our country puts more people to work and the unemployment rate drops below 6.0% and the GDP starts growing more than 2.5%. If you need to sell assets and reduce losses, you need to sell into the euphoria of the market when it happens. Because with no real change on unemployment and GDP the market rise is unsustainable.
The panelists’ goal today is for the participants of this seminar to leave with:
- Understanding of the current landscape
- Understand some proven solutions to deal with NPA
- Successful ways to preserve capital
- Strategies to attract capital
- Access to professionals who can help
Let us start with David Schroeder of the CBAI who will update us on the regulatory landscape during your lunch.
Dave Schroeder outlined the significant effects the CBAI had on the Dodd-Frank financial reform legislation. The Dodd-Frank Act contains many provisions advocated by CBAI and ICBA. It differentiates community banks from the mega-banks with precedent-setting exemptions for community banks that only the community-banking lobby supported. It also addresses too-big-to-fail; regulates non-bank competitors such as payday lenders, mortgage brokers, and finance companies; permanently sets the deposit insurance coverage limit at $250,000; and establishes a fairer deposit-insurance-assessment method for community banks that was opposed by the mega-banks.
Although the new Act creates about 300 new regulations, more than 80 percent of them deal with systemic risk and investment banking practices that do not affect community banks. Furthermore, community banks received 16 separate carve outs or favorable new statutes.
There are some negative provisions contained in the Act such as debit interchange restrictions and consumer protection regulations that CBAI and ICBA will address during the rule-writing phase and through subsequent legislation during the next session of Congress.
As expected, the mega-banks and their trade groups opposed the reform measure because Wall Street firms were sternly taken to task. Now they are playing the blame game by chastising community banks for not uniting with them in opposition to the measure. In truth, community banks have little in common with the financial giants and will not do their bidding for them. Instead, community banks were united behind CBAI and ICBA, and it certainly paid off.
CBAI has also invested considerable effort to allow community banks to amortize commercial real estate loan losses over a period of up to 10 years. The provision passed the House in a small business lending fund measure, but its fate remains uncertain. Neither the big banks nor their associations supported this important proposal despite the fact that it would spare hundreds of community banks from having to raise capital or close their doors.
The combination of Fannie and Freddie low-doc mortgages and Wall Street's use of collateralized debt obligations and credit-default swaps resulted in an overheated residential and commercial real-estate loan environment. Although community banks did not cause the financial and economic crisis, the fallout has been substantial. Since last October alone nearly 150 banks have been closed nationwide, including 17 in Illinois. A disturbing double standard has become readily apparent: the mega-banks that caused the meltdown and would have failed without government support continue in operation while community banks are being summarily closed. CBAI is dedicated to ending that egregious double standard.
Michael Iannaccone: Before we start the panel discussion, we will introduce the panelists and walk through the five (5) questions we will be discussing. I will ask the question and then have two to three of the panelists weigh in on the issue. If other panelist would like to comment, we will engage them as time permits. If any attendees would like to ask a question, they can raise their hand during the discussion or write their question on one of the index cards on your table and hand it to my associate Bryan Yankton.
Our experienced professionals on our panel:
Michael Iannaccone: Over the course of my 25-year career, I have worked in bank operations, capital markets, equity research and corporate finance. I have led numerous engagements at well-established Chicago and Wall Street investment banks. I have managed capital offerings totaling over $2 billion and completed 27 M&A transactions.
The imbalance between the need for capital and supply has never been greater than during this financial crisis. To attract capital, financial institutions must accurately assess the legacy risks of their balance sheet.
Justin Barr: I began my commercial lending career with LaSalle Bank and Bank of America. My commercial and real estate secured loan workout experience includes senior positions with money center banks Harris, N.A. and Credit Agricole, S.A. I am widely recognized by the financial media as a knowledgeable source on community banking. In addition to nearly a decade of experience in middle-market commercial and real estate lending, I have spent the last 10 years exclusively focused on loan workout and community bank turnaround projects.
Rick Levin: I have a 20-year track record of successfully auctioning REO for banks with nearly $500 million in real estate sold. My firm’s value added approach is demonstrated by designing unique auction models. Rick Levin & Associates (RLA) is one of the most active REO auction services providers in the country, having completed over 1,000 bank REO auctions within the last twelve months.
Chris Feurer: I am CEO of Jameson Real Estate. Jameson is one of the most active and innovative REO brokers in the greater Chicago market. With over $1 billion in real estate sold over the last decade, I am an established expert in the field and bring extensive knowledge to bear on bank client REO problems.
William G. Mitchell: With over 20 years of experience in commercial and investment banking, I manage HFF’s national distressed loan sale advisory platform. My prior experience in the secondary distressed loan market is extensive and includes over $2 billion of loan sale advisory transactions over the last 12 years as both principal and agent.
Moderator Michael Iannaccone asked the following questions:
Where has pricing on different loan types & REO gone since this past spring and where do you see it going?
Chris Feurer: Double the amount of residential unit contracts (with brokers) have been expiring in the past six months meaning that units are not selling. We are seeing an influx of residential units coming on the market through increased foreclosure activity in the recent past. With increased supply and low demand, prices have been dropping. Price drops from brokers used to be 5% but now in order to get shoppers attention the drops are 10% to 15%.
Bill Mitchell: The commercial real estate space is seeing some mild appreciation, but we do not expect that to last as the number of properties coming out of the FDIC is expected to increase. Credit for buyers in the commercial space is expensive and difficult to find. HFF does not see this credit situation turning around soon so this will continue to keep prices depressed. As credit loosens, buyers can use more leverage and thereby pay higher prices.
Rick Levin: The outlook is weak for REO prices. As we approach the winter months, banks should try to unload REO now because the cost to weatherize and maintain (so they can sell next year) can have a significant effect upon a bank’s cost basis in the property. The risks associated with a property, whether it is finished or unfinished, being empty and open to the elements as well vandals creates a potential escalating cost uncertainty.
What can I do to improve pricing of my NPL loans? How does the sale process work? What costs are involved?
Justin Barr: Defend regulatory capital levels to bank regulatory authorities. It is important to challenge the examiners by utilizing proven strategies that have been used to successfully defend regulatory capital in the current market cycle. One such recent win relates to appraisal methodology on broken condominium projects and involved an LWA community bank client that had been mandated by FDIC examiners to use only rental cash flows in determining the appraised value of a new construction condominium REO project that had been temporarily rented due to the difficult ‘for sale’ environment. LWA successfully argued that such a mandate amounted to the introduction of a ‘non-market limiting condition’ in violation of FIRREA, as some condominium sales, however anemic, were expected during the appraisal period and these expected cash flows could not be ignored in calculating appraised value. The result was millions of dollars in regulatory capital saved on this one deal and millions more after applying the same methodology to this client’s construction and development heavy loan portfolio.
Chris Feurer: Banks should finish the partially built developments. Developers cannot get financing for such developments and therefore the prices offered to banks is as if the property was land. Investing additional money into a project will still result in a loss, but the loss will be smaller than if the bank sold it and took the deeply discounted price as if the partially completed project was land.
Michael Iannaccone: Certain bank clients have acted as general contractors to complete the projects. But others have made arrangements with proven and still viable developers. The bank (1) sells the property to the new developer at a slightly discounted price on a non-recourse basis, (2) the developer borrows the money for the purchase from the bank as well as puts up some equity (3) the bank provides additional financing to the developer through a working capital line, (4) the project is completed and sold. This process reduces the NPAs because the bank has a new borrower who is making payments on the new note while the building is being worked on and the bank gets the remainder of its money in less than two years once the building is finished, rented and sold.
Bill Mitchell: Banks that have appointed a receiver for the commercial project have done better in pricing and disposal than those who have not. Also, the regulators seem to appreciate that an experienced operator is running the NPA solution with a focused mandate for the project.
What is the biggest challenge in selling REO?
Rick Levin: The biggest challenge is understanding what price you, the bank, are willing to sell the property for and then staying committed to that price. Additionally, banks need to understand that marketing is the name of the game. Just look at any realtor’s website when it comes to REO homes versus non-REO homes. Non-REO homes or properties have numerous flattering pictures, information on taxes, and information links about the community. REO properties typically have none of that. Banks also need to market the REO to different buyers; not all traditional buyers buy at auctions so you need to know how to market and reach those potential buyers.
Which successful structures and strategies are helping banks on the capital front?
Michael Iannaccone: There are several creative recapitalization models that are being used currently in the marketplace successfully or are in front of the regulators for approval. Solutions to a bank’s issue of not being able to take the hit to equity that is required to meet the price from the distressed debt buyer have been formulating for close to 24 months. MDI Investments and its affiliated broker/dealer Tangent Capital have developed two such solutions during the current market cycle, including:
- The Non-Performing Assets for Bank Equity Model®, and;
- The A/B Note NPA Sale Model®.
The Non-Performing Assets for Bank Equity Model® is intended to address community bank non-performing asset issues (90+ day past due loans and REO) and capital needs in two simultaneous transactions with the same investor, as follows:
- sale of all or part of the NPA portfolio at or near net book carrying value (UPB less FAS 114 specific reserves and/or charge-offs), and;
- issuance of either warrants or discounted bank stock.
Under both scenarios, the benefits to the bank seller are compelling and include:
- Immediate reduction in the bank’s Texas ratio [(NPAs) / (Equity + Reserves)];
- Immediate improvement to all regulatory capital ratios due to the elimination of 100% risk weighted NPAs, and;
- Immediate improvement to liquidity and earnings due to newly injected cash.
The A/B Note NPA Sale Model® involves the sale of a majority stake in a bank’s NPA portfolio to a third party investor at a discount, who then holds the senior A piece in each NPA asset, with the bank retaining the B piece. The benefits to the bank seller are similar to those articulated above for the NPA’s for Equity Model, and also include the bank sharing any potential upside in final resolution of the portfolio over time. The only potential sticking point with this model is how bank regulatory authorities would have the bank treat its junior B position. I am in process of getting clarification on this important point from the highest levels of the FDIC.
Rick Levin: RLA and Loan Workout Advisers developed the Lender-directed auction model where cooperative borrowers are encouraged to voluntarily contribute properties to auction in exchange for tailored settlement agreements. The result: avoidance of the discount inherent to note sales and a dramatic shortening of the time to cash recovery.
RLA has also developed the multi-bank auction model, which has the benefit of minimizing marketing expenses for each bank while maximizing market exposure. The result: higher selling prices and lower expenses.
Justin Barr: None of us have a crystal ball. No one knows for sure what prices will do in the future. The idea is not to bet all the same way. You don’t want to sell everything now any more than you want to hold everything for the next twelve months. There are ominous pressures on pricing in the current market, including more and more inventory from failed banks and just a lot of inventory in the system. That pent up inventory, delayed foreclosures for example, is growing like a cancer. But who knows for sure which way it’s going. I’d rather smooth recoveries on NPAs and dollar cost average, if you will, the next few years. I don’t think the Spring 2011 real estate market is going to save us.
Who are the investors and what are they looking for?
Michael Iannaccone: MDI Investments took on several clients about twelve months ago, who were looking for capital. Our firm keeps an active database tracking investors in community banks (both public and private) over the trailing five years. As of October 1, 2009, that database had 4,900 entities that had investments in community banks totaling $14 billion. We called all 4,900 investors and found 245 are still interested in the industry and willing to make additional investments. That is 5% of the entire database. But the interesting fact is that although the number of investors dwindled, the dollars looking to invest was not as drastic a reduction. Those 245 investors had aggregate community bank investments of $9.8 billion and had appetite for an additional $2 billion.
All of these investors are looking for third party review of the balance sheet; recent exams and realistic assessments of the bank. The game most of them are looking to play is to buy an institution that does not have many problems, fix it, get it to a CAMELS 2 rating and grow it through FDIC assisted transactions and organic growth. Much has been learned in the past 24 months from this investor base and others. They have realized certain institutions cannot be fixed (i.e. construction and development loans / total assets greater than 20%); they have realized you can’t buy a CAMELS 4, infuse capital and management and get a CAMELS 2. And they have realized there are institutions that can be saved. If they augment management teams, build viable business strategies, recapitalize the financial institutions above “well capitalized’ levels and have more capital standing by at the ready, then they can get a deal completed.
The negative side of this educational development is that most investors are looking to put a minimum of $10 million to work initially with the intention of growing that position. These investors are looking to start out as 5% or 10% investors and grow that position to possibly a 24.9% position over the next 3 years. The ultimate goal is to buy a platform bank and grow it (organic and M&A) to $3 billion to $15 billion in assets over the next 5 years in order to sell out.
But although the numbers are small for those looking at $1 million to $10 million investments, that group is growing. There is more focus on combined solutions whereby the bank is cleaned and recapitalized at the outset versus working through the assets over time.
It is a buyers’ market for real estate and banks. So you have to know who you are and market to the right audiences to attract the capital you need.
Michael Iannaccone: Thank you for attending
| Michael Iannaccone President and Managing Partner MDI Investments, Inc. (630) 347-5939 michael@mdiinvestments.com |
Justin A. Barr Managing Principal Loan Workout Advisers, LLC (312) 343-8131 jbarr@loanworkoutadvisers.com |
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| Rick Levin President Rick Levin & Assoc. (312) 656-2025 rick@ricklevin.com |
Chris Feurer Chief Executive Officer Jameson Real Estate (312) 751 0300 cfeurer@jameson.com |
William G. Mitchell Managing Director HFF (Holliday, Fenoglio, Fowler, L.P.) (312) 980-3607 wmitchell@hfflp.com |
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