Sales in Distress

By Robert Stowe England

In the wake of a regulatory crackdown, banks face a harder task shifting risk off their balance sheets, at least temporarily.

Ever since the economy began weakening in 2000, banks have strongly relied on the bulk sale of bad loans, either directly to investors or indirectly via securitization, in their struggle to maintain acceptable credit quality ratios. Wall Street developed ingenious methods of packaging these loans, and investors were eager to buy them.

A recent regulatory crackdown on one of the securitization instruments, however, threatens to raise the cost of selling such assets. This may not ultimately pose a long-term problem, but at least for now, banks are clearly left with fewer options for disposing of bad loans.

The crackdown involves "special purpose entities," instruments banks use to sell loans to third parties, who then issue notes to securitize those loans for investors. Not only can banks shift bad loans off their balance sheets, thereby improving credit-quality ratios and freeing up loan-loss reserves for investment elsewhere, but they also retain a chance to recoup some of the value of the loans if there is a recovery in performance. About one-third of last year's $5 billion in distressed loan sales by banks was accomplished through SPEs.

The outlook for SPEs clouded in January, when the Federal Reserve criticized the accounting of deals done by PNC Financial Group Inc. The Pittsburgh-based bank had transferred $550 million in loans to subsidiaries of the American Insurance Group in 2001. But it had to take back the loans following regulatory inquiries, which triggered a $155 million charge in the fourth quarter. J.P. Morgan Chase & Co. likewise has attracted Congressional scrutiny for its role in SPEs the bank arranged for bankrupt Enron Corp.

The regulatory uncertainty has put pending SPEs on hold, forcing banks to use less attractive mechanisms, like outright sales. Given the volume of bad loans generated by today's weak economy, this means banks may now have to sell at bigger discounts into a buyer's market if they wish to take problem loans off their books. "Banks are anxious to hold down their levels of non-performing assets, so they're willing to sell some credits at discounts that strongly induce somebody else to buy them," says Kevin Blakely, group executive vice president for risk management at Cleveland-based KeyCorp.

How long this situation persists remains to be seen. In theory, banks could structure new SPEs that satisfy regulatory concerns by ensuring that the sales are complete and don't offer any recourse back to the bank.

And the economy itself could come to the rescue. Although business conditions remain weak, the downturn has not been nearly as severe as occurred in the early 1990s, which means banks may be able to work their way through problems more quickly than was the case a decade ago, when commercial real estate losses toppled several major institutions.

"From the standpoint of the pain quotient, it's not so severe," says Maurice H. Hartigan 2d, chairman and CEO of the Risk Management Association, a Philadelphia-based trade group for bank credit officers. "Banks are also in significantly stronger shape from the standpoint of capital and loan-loss reserves than they were a decade ago."

Assuming the recovery stays on course, banks may find the SPE controversy to have been an inconvenience, at most. If the economy remains weak, however, banks could be seriously hindered in their efforts to dispose of problem loans.

Shedding Risk

Banks have long sold off loans for a variety of reasons, including a desire to remove risk from balance sheets and redeploy capital to areas deemed more productive. They are motivated to reduce "reputational risk" as well. Under renewed scrutiny by investors and ratings agencies these days, banks can't afford to let their concentrations of non-performing assets rise too much from the norm.

The '90s saw a proliferation of instruments to transfer this risk. There followed a concomitant growth in the number of investors willing to buy loans, both good and bad, helping to create a vibrant $42 billion market in loan trades last year, according to Loan Pricing Corp. in New York. Charlotte, N.C.-based Bank of America Corp., for example, sold off $2.1 billion in non-performing loans in 2001, which a spokesperson attributed to a desire to improve the bank's "credit-risk profile."

These loan sales are accomplished in a variety of ways. All of them require the bank to take some sort of discount, or "haircut," on the transferred credit. This discount can be steepest on an outright sale, where the bank transfers all ownership and servicing to a third party. SPEs emerged as a viable alternative for reducing the discount after FleetBoston Financial Corp. engineered the first bank-sponsored deal in early 2001. That was followed by SPE deals for CIBC World Markets of New York and Bank of America, which last October sold $470 million in loans to PPM America, a Chicago subsidiary of the British-based Prudential Portfolio Managers.

While details vary, SPEs share certain common features. For starters, the SPE gets the loans off the bank's books by selling them to a third-party entity. Under accounting rules, the third party's equity stake must represent 3% of the structured financing of the SPE deal.

When banks sell their loans to the SPE, they typically fetch a price that reflects the economic value of the loan, thereby avoiding the deep discounts that some vulture funds and other buyers demand. The third-party common equity shares are unrated. Banks may own an additional, larger portion of the non-voting equity as preferred stock, which is posted on their balance sheets as securities held for sale.

Should recoveries exceed expectations, banks can gain some of the upside. Conversely, if the underlying loans continue to deteriorate, the value of the equity holding will fall, but the bank does not have to add to its loan-loss reserves since those assets are no longer held on the balance sheet.

The credit quality of an SPE is usually enhanced by the transfer of investment grade quality, or performing loan assets, into the pool of non-performers. This provides a secure source of cash flow to pay the note holders. There are also usually several levels of investment grade and non-investment grade notes involved known as "collateralized debt obligations," a generic term that includes both collateralized loan obligations and collateralized bond obligations.

Regulatory Backlash

While much detail regarding SPEs is not made public, some information has surfaced about the structure of the deals that were done last year. FleetBoston's SPE, given the name of "Ark," received $225 million in non-performing loans and $775 million in "troubled, but accruing loans," according to a bank press release. In return for the transfer of these assets to New York-based Patriarch Partners, FleetBoston received $725 million in cash and $203 million in an investment grade note. The transaction enabled FleetBoston to slash its non-performing assets by 10%, according to the bank, thereby permitting a $75 million reduction in loan-loss reserves.

The Bank of America SPE set up last October, known as "Endeavor," devoted a third of its $470 million portfolio to asset-backed securities with an average investment grade of A, according to Marion Silverman, a senior director at Chicago-based Fitch Ratings, which rated the deal. Distressed loans represented 63% ($296 million) of the portfolio, while cash and cash-equivalents made up 4% ($19 million). Endeavor issued $300 million class A notes rated AAA; $135 million class B notes rated BBB; and held $35 million in unrated equity, Silverman says.

Neither Bank of America nor FleetBoston would comment on their SPEs, even though they have not inspired any public controversy. Some reticence on the part of bankers may be understandable, however, in the wake of the recent Enron bankruptcy. Enron's troubles began late last year when the press and investors began to criticize various SPEs set up by the Houston-based energy company. It now appears those SPEs were designed to disguise troubled assets while enriching company insiders, provoking investigations from Congress, the Justice Department and federal regulators.

J.P. Morgan Chase recently became embroiled in the Enron debacle when questions were raised about SPEs the New York-based bank arranged for Enron (rather than for itself). Congressional investigators have asked J.P. Morgan Chase to surrender documents related to the transactions. A spokesperson said the company was "complying fully" with the request, adding that the transactions "were designed to raise new financing for Enron."

Some of this regulatory backlash appears to have hit PNC, which consolidated SPE loans back on its own balance sheet and restated 2001 earnings under pressure from the Federal Reserve. PNC declines to elaborate on its brief public announcements. But some analysts and bankers familiar with the situation say the Fed was concerned about the bank's large share of preferred equity in the deal, plus the fact that PNC did not go far enough in making the sale irrevocable. "Only about two-thirds of one percent of the total equity came from AIG; PNC had the rest," says Thomas D. McCandless, an analyst with Keefe, Bruyette & Woods Inc. in New York.

PNC has said it followed accounting guidelines by giving voting control to AIG through common stock. Regulators, however, focused on the fact that PNC retained nearly all the economic value of the underlying equity through its ownership of the preferred stock of all three AIG subsidiaries. This arrangement meant that if the loans failed, potentially significant losses could flow back into the bank's consolidated balance sheet, according to McCandless. Thus, the deals, while giving PNC some upside potential in a recovery, also carried a significant downside risk for the bank.

PNC Chairman and CEO James E. Rohr told a Salomon Smith Barney conference in January that PNC's decision to unwind the SPE came after its accounting firm, Ernst & Young, conferred with the Securities and Exchange Commission's accounting staff. "We decided that given the Fed's guidance, there was no way we wanted to get involved in a discussion between the Fed and the SEC, and we decided to comply with the Fed's request that those assets be consolidated on our balance sheet," Rohr told conference attendees.

A Fed spokesperson declined to comment on the controversy, as did the SEC. But a top official with the Office of the Comptroller of the Currency confirms the ongoing regulatory scrutiny of SPEs. "We want to make sure there is a true sale," says David Gibbons, deputy comptroller for credit risk. "The point is to get the loans off the balance sheet with no further impact or potential losses to the institution."

The likely effect of this scrutiny is that banks will, at least for now, shift their risk-transfer focus from SPEs to outright sales. Although at least two or three additional SPE deals have reportedly been in the works since last fall, banks are now wary about moving forward with them, according to Lynn Tilton, founding partner of Patriarch Partners.

While banks know they could structure a deal that meets current regulatory concerns, there is some concern that new restrictions may be put on these deals, and banks are waiting to see if that might happen. They further fear that new, more restrictive conditions might even be applied retroactively to previous SPE deals. "People are very nervous. They are like deer caught in the headlights right now. They don't know where regulators will turn," Tilton says.

More Discounts?

The upshot is that banks might have to hold on to assets that may weaken in the future or take a larger discount on the credits sold outright. And there are plenty of problem loans for banks to worry about right now. Despite all the loan sales banks have made since the third quarter of 2000, when the first major bulk sales were announced, a mountain of distressed loans has accumulated in the market in the wake of recent economic weakness.

Goldman Sachs Global Equity Research, for example, is tracking the loan pricing for an estimated $86.7 billion in distressed credits held by U.S. banks and other institutions. This includes $7 billion from Xerox Corp., $4 billion from Enron, and $1.5 billion from Kmart Corp., plus exposures to whole industries and business sectors ranging from telecommunications to lodging and gaming.

It's possible that loan sales this year will top last year's volume. Initial reports in the first quarter show a big 50% to 75% rebound over December levels — when deteriorating pricing prompted banks to pull back. Problem loan sales fell to $654 million in the fourth quarter, from $1.6 billion in the prior quarter. Total sales were $4.9 billion for all of last year, according to Goldman Sachs.

Since banks are eager to sustain their ratio of loan loss reserves to nonperforming loans at a level deemed appropriate by regulators, they are willing to accept the deeply discounted pricing currently offered by private purchasers of problem loans. KeyCorp's Blakely estimates that distressed loan traders can build in a margin for themselves of anywhere from 25% to 40% on some deals.

There is evidence, however, of some firming in loan pricing as the economy begins to recover. Although the prognosis for loans to the telecommunications and information technology sectors continues to be poor, "you're seeing loans in some manufacturing industries trade up in value," says Art Zimmer, senior vice president and portfolio manager at Oppenheimer Funds in Englewood, Colo., which purchases distressed loans. The funds have about $1 billion in collateralized loan obligations and collateralized bond obligations.

KeyCorp's Blakely says these signs of an improving economy are already reducing the industry's appetite — and need — for bulk sales. "I don't think there's going to be that many banks that will want to sell problem credits much longer," he adds.

If those sales are required, Blakely believes SPEs can be structured so that the sales are complete and without recourse to the bank, which will allay regulatory objections. That, and a continuing strong market among buyers, should ensure that banks do not have to endure a long period of steep discounts on their sales, he says.

It's useful to keep in mind that bank sales actually represent only a small portion of the huge $41.7 billion in total loan sale trades last year. Analyst McCandless says that's because banks no longer represent the majority of new issues in the syndicated loan market, which is now funded by a combination of non-bank players, including insurance companies, hedge funds, prime funds and vulture funds. This change demonstrates, according to McCandless, how "banks have been able to redistribute risk to the worldwide capital markets."

This transfer will likely continue regardless of what happens with SPEs. Longer term, the controversy over SPEs could even have a beneficial effect if it forces banks to heighten their focus on the basics of good credit discipline, i.e., careful underwriting, close monitoring and quick intervention in case of trouble. But for now, anything that limits the options for shedding bad loans is unwelcome news.

Mr. England is a freelance writer and author based in Arlington, Va.

Copyright © 2003 by Banking Strategies, published by BAI.

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