Wanted: A New Solution for Handling Bad Debt

For nearly a decade now, banks have lacked a critical tool for dealing with special assets. In 2007, when the financial crisis first began to manifest, the industry was inundated by a rush of eager—and sometimes even desperate—due diligence reviews. In this process, it became clear that most banks fell into one of two categories. There were banks with problems so large that no amount of outside help could solve them. Their best case scenario was to seek out a capital infusion from a private equity group in a highly dilutive transaction (effectively a sale of the bank), and any due diligence became an exercise in ensuring that the bank wasn’t already insolvent.

The other scenario was the more interesting one. Banks that had taken big, but not fatal, hits to their capital, and still had profitable operations, could live to lend another day if they could just get those bad loans off their balance sheets.

Divestment options were limited. The few willing purchasers often demanded a very high discount and offered little in the way of transparency. On top of that, the process was often expensive and distracting at a time when banks could afford neither. As a result, very few of these transactions ever occurred. Indeed, we saw more transactions for which the bank was able to find a local buyer for a troubled loan than we ever saw loans sold to larger bad debt aggregators.

Banks that were trying to extricate themselves from a serious credit problem needed three things. The first was more purchasers, and preferably more specialized purchasers. Community bank loan pools are teeming with the non-uniform castoffs of the big banks. Community banks make their money originating loans that are outside the box painted by the larger institutions. As a result, community banks were implicitly being asked to accept steeper discounts for their “unusual” products.

Secondly, the banks required more transparency. Too often, community banks felt they made a genuine, honest effort to discount their loans only to be told that it would be another 30 percent to 40 percent discount on top of what they’d already taken, with no indication as to how that number was derived, and without the ability to discuss any disconnect between the potential buyers and sellers. Many community bankers were left with the impression that these potential buyers were vulture investors and that the banks were effectively subsidizing the cost of turning problem assets into risk free assets by virtue of steep discounts. This perception persists today with banks continuing to look suspiciously on these bad debt purchasers.

Finally, community banks desperately needed a way to make the process easier. The often time consuming and difficult process of organizing single note sales can be daunting. If the number of loan sales being negotiated rises to 30 or 40 it can quickly escalate to a full-time job.

During the last credit downturn, we saw a number of attempts by banks to deal with the problem. Mechanisms like good bank/bad bank structures and special purpose entities were discussed, but rarely executed on. Many banks also attempted to form joint ventures where they could park their problem assets, removing them from their balance sheets while retaining some of the upside. These rarely got past the discussion stage as the predictable problem of valuation popped up as soon as the attorneys were asked to draft agreements.

The ideal solution isn’t going to come from a trading desk system. Loans aren’t stocks. They lack the commoditization necessary to make those kinds of transactions. What is ultimately needed is a system that facilitates communication between parties, a system that puts buyer and seller on equal footing, without favoring either. What is needed is a system that results in increased trust rather than decreased communication. Whole loan transactions are very much about the details. And it’s communication of, and agreement on, those details that will lead to all parties being happy in the end.

CRMA is working on a web delivered solution that does just this. The goal is to have something better than a cold marketplace. Instead, back and forth communication and discussion is encouraged on sales transactions. The system will allow sellers to manage their problem loans so that the dead loss associated with a failed deal will be mitigated. The bank will still benefit from having their loans in the system. On the purchasing side, we’re providing a suite of underwriting and pricing tools that can be used to value the loan transaction in a way that bankers will be able to read and understand.

This kind of solution won’t eliminate every argument or disagreement over price. But it will create a more efficient working environment for everyone.