Banks Make Progress Freeing Selves from FDIC Loss-Sharing Pacts

Regulators and failed-bank buyers are finally managing to negotiate an end to loss-share agreements inked during the financial crisis.

Banks and the Federal Deposit Insurance Corp. have infrequently agreed on early ends to their loss-sharing deals, but that may be changing. Bank of the Ozarks, one of the most prolific failed-bank buyers, reached an agreement last month with the FDIC to terminate all seven of its outstanding loss-share agreements.

That agreement is the most significant early-termination accord so far, and it could be an ice-breaker for other banks eager to exit similar loss-share deals.

"I think everybody, large and small, will be looking at the Bank of the Ozarks deal, and there will be a lot of focus on the precedent it sets," said Walt Moeling, a lawyer at Bryan Cave.

When the FDIC seizes and sells a failed bank, it agrees to reimburse the buyer for a portion of the failed bank's loan losses, usually for five years. Such loss-sharing agreements make acquiring failed banks a viable strategy for buyers, by reducing exposure to problematic assets.

These arrangements also have drawbacks. They involve complex accounting and, over time, amortization of the indemnification asset tied to the pacts can reduce a bank's noninterest income. The administrative requirements, including collection efforts, can be particularly burdensome. As a result, banks are often keen on closing out the loss-share agreements as early as possible.

For some banks, loan losses - and hence payments from the FDIC -- have been lower than expected, while loss-share bookkeeping and reporting costs have been higher. From the FDIC's perspective, too, administrative costs can make early termination appealing.

Even when both sides are willing to consider an early end to such deals, negotiations have proven difficult, due largely to accounting challenges like the uncertainty of estimating future losses.

So far, most early termination agreements have been with smaller banks with relatively small pools of loss-share loans. The FDIC’s policy has been to approach those banks about closing out loss-share agreements to reduce the banks’ administrative burden, an FDIC spokesman said. To be eligible for early termination, a loan balance covered by the agreement must be $50 million or less, and the FDIC’s total payment cannot be more than $10 million, the agency said.

The FDIC has closed 51 loss-share agreements with 20 separate banks, the spokesman said.

Most industry observers consider loss-sharing a policy success, as well as a huge boon for failed-bank buyers, because it helped reduce the economic damage from failures. The deals also gave failed-bank buyers incentive to work through the foreclosed property left by shuttered banks.

Loss-sharing's utility as a public policy may explain why the FDIC has not been eager to end the agreements early, said Pat Jackson, chief executive of Sabal Financial Group, a California distressed-debt specialist.

"There's been a real reluctance to have a discussion about early termination, and part of the reason is that the FDIC is expecting banks to help with the recoveries," Jackson said. "The advantages that loss-sharing brought to banks were pretty compelling, and part of the bargain was they were going to do their part."

Some bigger banks, like the $20.5 billion-asset EverBank Financial in Jacksonville, Fla., have managed to strike deals with the FDIC, but most negotiations get stuck before completion, industry observers say.

That was the case with Home BancShares' efforts to reach an early end to its loss-share for a 2010 failed-bank deal. The Conway, Ark., company had trouble coming to terms with the FDIC, and Chief Executive Randy Sims told analysts in October that the deal was in limbo, though not yet dead. Home did not respond to a request for further comment.

"It was really important to us to get [the agreement] done in the third quarter, and things have dragged on and dragged on," Sims said during the quarterly earnings call. "If we don't hear something pretty soon … it's not going to be as attractive as it once was."

As the time period covered by loss-shares reaches an end, the FDIC's incentive for winding them up increases, which may make it more eager to negotiate, Jackson said. The FDIC serves as the receiver for the failed bank as long as the loss-share is open, which generates administrative costs for the agency and delays repayment for the parties owed money by the failed bank.

When nearly all the loans have been worked out, the FDIC may by more inclined to wind down the process, Jackson said.

"There's a benefit to both parties to terminate early when there's not a lot of dollars left in the loss-share," he added. "As long as that receivership is open, it's costing the FDIC money, and there is a whole line of people waiting to get paid."

Other factors could encourage banks and the FDIC to come to the table. As the economy improves and bad loans turn good, some loss-sharing agreements may become irrelevant. Also, banks now have more experience working through the loans, so they can better estimate the dollar value of a portfolio of covered loans.

These factors may have helped Bank of the Ozarks close out its loss-share agreements, said Brian Zabora, an analyst at Keefe, Bruyette & Woods. Zabora said he expects the agreements to improve the Little Rock, Ark., company's earnings, even without taking possible cost savings into account.

"Now that we're getting close to the end of these agreements, I think Ozarks had a better handle on the credits and on what its losses will be," Zabora said. "They've had the loans for so long now that there's less uncertainty."

Bank of the Ozarks said that, following the early termination agreements, it would reclassify $27.9 million of FDIC-covered loans as non-covered foreclosed loans. The company also said it would wipe a $36.6 million receivable from the FDIC and $26.7 million payable to the agency off its books.

Bank of the Ozarks did not disclose what payments, if any, it exchanged with the FDIC to terminate its agreements, though the company said it expects to record a gain on the exchange. A company spokeswoman declined to provide further details, though she said management may do so as part of its fourth-quarter earnings release.

Like other banks that have ended their loss-share deals early, the $6.6 billion-asset Ozarks could see a reduction in its administrative burden. Ozarks could also gain flexibility to dispose of assets in ways that would be more difficult under a loss-share agreement, like auctions and bulk sales, Zabora said.

Aside from considerations of profit and loss, ending the loss-shares could reduce a headache for management. Dealing with the complexity of loss sharing eats up a lot of a banker's energy, Moeling said.

"The cost of maintaining the relationship with the FDIC is so great that, even if you have to come out a little bit behind on the financial terms of the exchange, you can win just by freeing up management's time," he said.