One of my old bank coworkers had recently taken over as Chief Credit Officer for a struggling bank. It was common knowledge in the banking community that the financial position of that institution was dire and my friend was doing her best to right the ship. After signing the appropriate non-disclosure agreements, I found myself in one of their conference rooms with a pile of loan files in front of me in hopes of finding a non-performing loan that I could buy for our portfolios.
There is a saying in lending “Every loan is a good loan when you make it.” During that visit, I learned that this saying is false. Included in the loan files were notes from the bankers that originally approved those loans. Those notes showed that the decision makers knew full well that the loans didn’t qualify, but they were under so much pressure from their senior managers, stockholders, and the board to produce more loans that they were knowingly making bad loans. Of course, most loans that go bad are a result of unforeseen circumstances and the saying, in most cases, applies. We chose not to purchase any of that portfolio’s loans that day, but it is a great example of why a bank would want to sell assets to an outside entity.
When a bank finds its earning down, it usually is directly attributable to issues within its loan portfolio. Many investors reach out to banks with the delusion that the bankers are stupid and can’t solve their own problems. This is not true. Most investors have no understanding of how a bank operates, therefore, they call bankers to make ridiculous, low-ball offers that only alienate them from being able to purchase assets down the road. Good bankers usually know the best path to take to get out of a deal, but they have to operate within regulations. They may not have the resources to rehab a property nor the time to go through the foreclosure process. It simply might make sense for them to dump the asset for a reasonable price.
Failure to follow regulator guidelines would cause the bank’s financial status to be downgraded, therefore, the bank would find it more difficult and expensive to borrow money and raise capital for future operations. Moving troubled assets off the books as quickly as possible while recouping as much as the bank can on that particular asset, whether it be a loan or a piece of property, is critical to a bank’s future ratings.
A collateral property that has been acquired by a bank as a result of a defaulted loan is known as “Real Estate Owned”, or “REO” property for short. In some instances, you might hear it referred to as “OREO” as if it were a sandwich cookie. Contrary to what one might think, banks are not in the real estate business. Assets such as nonaccrual (nonperforming) loans and REO provide no income to the bank and harm their balance sheet. When a loan starts to go bad, banks are required by regulators to place the loan on “Nonaccrual Status.” Simply put, this means that the bank, among other things, can no longer show “accrued” from the loan on their books. If the likelihood exists for a loan not to pay as agreed, why should the bank get to count interest in their income figures that they have not received? Once a loan has been in default for 90 days or more, the bank is required to put it into nonaccrual status on their books.
Banks are required to file a “Call Report” periodically to announce to the world the financial condition of the institution. REO and Nonaccruals will negatively impact the financial condition and rating of the bank, therefore, it is in the bank’s best interest to move those assets off the books as quickly as possible. That doesn’t mean that they will give the assets away, but they will normally be willing to sell these assets for a reasonable price if it makes sense for them to do so.
Concentration is also an issue for many banks that might give them an incentive to sell assets. Concentration occurs when an institution has a lot of eggs in one basket. For instance, an institution might have a considerable amount of their loan portfolio where the collateral are hotels, they might be concentrated heavily in a geographic area, or they might have a great deal outstanding to one individual. This often happens after two banks merge and their combined portfolios cause such a concentration. Heavy concentrations of loans will give regulators and analysts pause and could indicate that the institution is unduly susceptible to risk should the aforementioned industry, area, or entity experience trouble. In such a situation, an institution might be incented to part with assets.
Since the financial crisis of 2007 and 2008, banks and regulators have increasingly used “stress testing” to preemptively discover weaknesses within an institution’s portfolio. During a stress test, testers hypothetically change different variables such as market interest rate changes and credit risk criteria to see what would happen to the bank’s financial position if those changes were to occur. If these tests show weakness in a portfolio, banks may wish to divest itself of some of its loans in order to reduce risk to the bank. This creates yet another scenario where banks might wish to sell loans or REO property.
It is important to understand how a bank determines the overall risk to their portfolio. Banks measure the overall risk to a portfolio by rating each individual loan in the portfolio. This is appropriately called “Risk Rating”. When a commercial loan is made in a bank, it is assigned a risk rating. A risk rating of “1” means that the loan is relatively free of risk. For instance, if a business borrowed $50,000 using a $100,000 CD in that bank as collateral, you can pretty much count on recouping the money that was loaned. That would receive a risk rating of “1”. Most commercial real estate loans receive risk ratings of “4” meaning that they are “bankable.” A risk rating of “5” means that the loan needs further review and needs to be watched. A “6” is “criticized” and needs further attention where a “9” would be classified as a “loss”. Loans that are graded lower than a four but have real estate collateral values that exceed the loan balance would be prime targets to purchase. By ridding themselves of the lower-graded assets, a bank can improve the overall risk rating of the portfolio.
As a loan moves down into the lower ratings, the amount at which those loan balances are carried on the bank’s books are downgraded. A risk rating “8” loan, or “doubtful” loan, would be carried at a very low value where a risk rating “4” would be carried at on the books at the loan balance. A loan that is considered a loss would be “charged off” where its value is carried on the banks books at zero value. A bank will typically not tell you what they carry a loan on the books for, but if you can offer an amount that matches or is just below where they have it, they are likely to consider selling it to you. If the loan’s collateral value exceeds the amount you have to pay for the loan, then you might have tremendous upside in that purchase. Finding a win-win for both you and the bank means that you will continue to be a trusted outlet for that banker to divest assets to.
Understanding how banks value their assets and becoming a valued and trusted outlet for banks to divest their assets to will put you ahead of the vast majority of people that attempt to buy assets from a bank. Bankers are sick of receiving calls from jokers want think they can fleece the bank. Don’t be that person. Invest time in understanding what makes the bank tick before dialing that phone. You’ll be glad you did.