Loss-Sharing Deals with FDIC Decline as Economy Improves

WASHINGTON — As housing prices improve, the Federal Deposit Insurance Corp. continues to move away from covering losses borne by failed-bank buyers.

About half of the 31 failed-bank resolutions in 2012 — as of June 30 — involved an acquirer purchasing a whole bank without any loss-sharing from the FDIC. That is a sharp increase from the 34% of deals without loss-sharing last year. In 2010, the 14 deals without such loss sharing agreements amounted to just 9% of the 157 failures that year.

Officials and industry observers point to many factors. Unlike earlier in the crisis, failures now are almost uniformly small, and buyers often lack the accounting to track the shared losses. The agency, seeing more confident bidders, has limited when loss-sharing is available.

Since May, the agency has not offered coverage on single-family loan portfolios below $20 million, as well as some below $50 million that are performing. Meanwhile, as the FDIC has developed other means to sell off assets — such as securitizing them — loss-sharing has grown less vital.

"Part of it has to do with the size of the institutions, but probably a greater contributing factor is that the bidders are getting more comfortable with the economic environment and the areas where they're bidding, especially when it comes to single-family mortgages," said Pamela Farwig, a deputy director in the FDIC's division of resolutions and receiverships.

When the FDIC announced the policy of removing the loss-share option for the smaller portfolios, Farwig said, "We got zero reaction from potential bidders. … They didn't need loss share in order to bid."

Although loss-sharing — which was first used in the early nineties — obligates the FDIC to shoulder some of a buyer's risk from taking over an institution with a weak portfolio, it is designed to attract more bidders for a really damaged institution and ensure that assets stay in the private sector.

The glut of bad loans during the crisis meant loss-sharing was very common in the recent housing crisis. From 2008 through 2011, the FDIC agreed to cover a buyer's losses in 68% of the more than 400 failures. But just for 2012, that figure has dropped to 39%.

"If the FDIC loss share backstop is there, it certainly mitigates the risks involved in taking the portfolio. … Given the limited amount of diligence you're able to do in these deals, and particularly earlier in the economic cycle where there was much more price uncertainty in the real estate markets, people actively wanted that safety net," said Kenneth Achenbach, an attorney at Bryan Cave LLP. "Over time, however, bidders may be becoming more comfortable with asset pricing and may be assigning less value to the protections of loss-sharing. In addition, the FDIC is now encouraging banks that are comfortable doing so to make non-loss share bids."

Overall, Farwig said, the quality of failed-bank bids appears to be improving. She said at the height of the crisis, some bids would not beat the so-called "liquidation value" — the written-down price the FDIC fetches selling the assets more piecemeal if there is no buyer for the whole bank. (Under federal law, the FDIC must resolve banks at the "least cost" possible to the agency.)

"The number of bids we have received that beat the liquidation value has been improving. Going back a couple years, we might have had a franchise that drew five, six or seven bids, but not all of them would beat the liquidation value or the least-cost test," Farwig said. "This year, we're seeing more of the bids beat the liquidation value. The bidders are more active and more competitive in their bids."

She also pointed to the agency's use of other means for selling off assets. For certain loan pools held in receivership, the FDIC has packaged some into securities as well as created public-private ventures holding other assets in which the FDIC shares ownership with investment and asset-management firms.

Farwig said the prices for those more alternative deals are now factored into the test the agency uses to ensure a resolution meets the "least-cost" requirement, meaning bidders in the traditional whole-bank deals have more competition.

"An acquiring institution has to beat the prices we're getting in securitizations or structured sales in order to be able to pick up those assets and beat the liquidation value," she said.

Some observers said that with loss-sharing less critical to finding buyers, the FDIC may also be stepping away from the loss coverage simply because of the risks the agency faces from future losses on assets covered by the deals.

"It puts the FDIC's balance sheet on the line and creates uncertainty as to how much they're going to have to use that balance sheet," said Ralph "Chip" MacDonald 3rd, a partner at Jones Day.

But with failures consistently small, others said recent buyers have tended to lack the systems to track losses covered by an FDIC agreement, meaning the FDIC coverage may prove more trouble for them than it is worth. (This year, only one failed bank had over $1 billion of assets, compared to 63 such failures occurring in the three prior years.)

"In terms of smaller deals and deals involving first-time acquirers that don't have the loss share reporting infrastructure up yet, if you can get some level of comfort on the portfolio and … not have to gear up that infrastructure, that may be tempting as well," Achenbach said.

Lorraine Buerger, an attorney at Schiff Hardin, said smaller failures and less loss-sharing may result in more bidders proposing deals for just pieces of a bank's assets, rather than the whole portfolio.

"When bidders are willing to bid without loss share, they tend also to be more picky about what they're taking," she said. "These are smaller deals, so the smaller the deal the more likely it is that your bidders can do really robust, really in-depth diligence on the portfolio. The smaller the deal the more likely it is that a bidder can put a ring around certain assets and attempt to leave them behind."