Redressing loan distress

This book has something for every banker who has experienced more than an occasional non-performing loan in his bank’s portfolio over the last few years. I found it a very useful, and timely, book with something for every lender, manager, or board member.

Indeed, a striking feature of this past credit cycle has been the severity of the non-performing loan problems across the industry. Hardly any institution seems immune to at least some degree of pain, including the need to preserve capital and manage non-performing asset totals and reputation in such a way as to minimize investor and customer concerns about liquidity and solvency.

Author John Sheehan has strong credentials. He has international experience in real estate finance and as a problem asset resolution manager. He understands the world of commercial lending from the perspective of large and very large commercial and investment banking enterprises. True, he is not steeped in the unique environment of community bankers who have been dealing with extreme regulatory pressure in the wake of the current downturn. However, this is no way dilutes the value of his observations and advice to day-to-day banking practitioners.

In fact, he can see the flaws and inconsistencies of what we do perhaps better than we can ourselves.

 

Sheehan notes that many of our industry’s current problems have been concentrated in real estate lending of all types. In 1980, approximately 20% of all commercial banking assets in the U.S. were loans or securities representing real estate credit exposure. By 2008, this concentration had expanded to approximately 60%.

Behaviorally, bankers are risk averse, according to Sheehan. We are conservative principally by our capitalization, which relies substantially on debt. Bank managers prize stability of earnings, shun reputation risk, and try to minimize costs and to maximize operating profit. With relatively thin equity cushions, not all types of risks appropriately belong on bank balance sheets.

Extensions of bank credit can be thought of as a series of systems connected in a linear fashion. We market, underwrite, book, and administer credit in a defined order with specific processes designed to maximize the result and minimize the risk. We are good at relationship management, although with a distinct new business development cast to it.

The result, according to Sheehan, is that when credit-related problems occur to any significant degree, we have staffs that do not possess the skills or relevant experience needed to maximize collection of principal and interest on problem assets. In these circumstances, we tend to be organized the wrong way to respond effectively. Furthermore, Sheehan adds, our behavioral conditioning is often significantly out of alignment with what the situation demands.

 

As relationship managers in normal markets, bankers tend to make an unfortunate gearshift when things go south. In the face of growing problem asset totals, we shift from “relationship management” to “pool management” and tend to treat problem assets as pools to be administered and liquidated.

Sheehan uses a memorable Tolstoy quote to bring the problem into focus:

“All happy families resemble one another; every unhappy family is unhappy in its own way.” 

The message is that problem borrowers require individually customized treatment--workouts call for relationship management as much as does the healthy borrower.

 

This is a shrewd observation by Sheehan. But I find that he is at his best in pointing out why banks’ non-performing loan collection activities are consistently inferior to the results of non-banking entities.

He cites seven reasons:

1.  Mispricing habits. Banks tend to take a one-size-fits-all approach by viewing their problem assets as pools of similar credit. This affects collateral liquidation prices and other terms negotiated or imposed on the borrowers after default.

 

2.   Distressed debt fatigue. Bankers hunker down to minimize reputation risk. Their early bias favors protecting the book value of assets, as well as attempting to keep the borrower alive.

 

3.   Communication failure. Creditor/debtor communication breaks down and bankers shift from “judgment based” to “data based” decision-making. This is part of the pooling phenomenon and is often exactly the wrong thing to do.

 

4.   Misreading of the strategic necessity. The collection strategy is often tied incorrectly to the original deal approval rationale or logic.

 

5.   Technical and organizational competence. What is deemed appropriate is often linked to the original deal logic and may often be the wrong remedy. New credit origination is integrated and structured while problem asset recovery is a series  of opportunistically driven decisions that are unstructured in any predictable, processed way.

 

6.   Institutional philosophy. Banks are bureaucratic in nature and understandably so in the origination of new credit. The process emphasizes consistency, conformity, and conservative outcomes.

 

7.   Alignment, motivation, and compensation. For banks, elevated levels of non-performing assets are an atypical business model. Institutional tension between the administration of performing and non-performing assets is inevitable.

 

My own experience in a variety of workout assignments and situations tends to confirm the author’s observations. What is omitted, though, is the regulatory factor. Sheehan reflects no appreciation of the community and smaller regional banks’ constraints imposed on lending managements by supervisory authorities.

To wit, regulators tend to have no happy medium between “all in” or “hands off.”

So when problem asset totals reach the level of significant supervisory concern, local bank boards and managements often lose a substantial measure of discretion in their day- to-day actions. Supervisory mechanisms are often blunt instruments and will effectively foreclose many alternative strategies that would be open and available to non-banking enterprises or to very large institutions with staff depth and experience.

 

The longest section of the book and perhaps the most useful and interesting to all current-day bankers is entitled “Distressed Debt Solutions.” The author describes a variety of organizational options and choices that can be harnessed to improve collection results and hasten the institution’s return to healthy asset levels and traditional levels of performance.

Sheehan’s approaches include such now-familiar approaches as “good bank-bad bank”  and bulk sales of problem assets. He also includes a discussion of the need to separate the handling of non-performing assets from the performing for the sake of clarity and crispness of execution of strategies. Generally, the options detailed tend to be big-bank oriented and may not transfer very readily to community and small regional institutions.

However, the author’s observations about bankers’ behavioral tendencies are both very insightful and occasionally painful in their accuracy and the applicability. Like all high- level characterizations, they are not tight fits. But they are certainly recognizable to any of us who have been through a couple of complete credit cycles in our working careers.

If the stakes weren’t so high for the ultimate survivability of some banks and the unhappy ripple effects on their customers, many of the observations and comments would border on the amusing.

Bankers tend to assiduously avoid mistakes and seek to minimize losses. While these are beneficial traits in a normal business environment, they hamper and impede successful and opportunistic types of actions typical of asset resolution practices.

Furthermore, Sheehan fittingly notes that bank lenders fail to make a timely shift from a customer-service type of mentality to one of maintaining a strategic pressure on the troubled borrower. Eventually, when that shift is accomplished, as it usually is, the tendency is to both be “hard-nosed” and generally to neglect or avoid tailored solutions that will lead to more satisfactory collection results for both borrower and the bank.

 

Much as I found this a valuable book, I didn’t agree with 100% of what Sheehan thinks. His overall view is that bank lending staffs lack the requisite skills to maximize successful resolutions with borrowers. While my own experience tends to confirm some of his overall conclusions, they seem too pessimistic.

For example, I disagree with Sheehan’s observation that negotiating skills are generally lacking in workout officers. Veteran bank lenders may not be experienced in troubled debt negotiations--but it is simply neither fair nor accurate to characterize them in a blanket way as inexperienced negotiators.

Negotiating skill is a fundamental competency of a successful lender. Adapting such skills to a problem asset context can be taught on an urgent and priority basis to the staffers closest to the problem borrower.

This leads to another important and useful point that infuses the book in a variety of ways. The author correctly and consistently notes that successful resolution of problem assets requires a somewhat different set of resources than the production of a portfolio of performing credits. These resources are often unavailable or insufficiently available to community and small regional banks. Such skills include specialized asset managers, appraisers of real and personal property, accounting, legal, and deal structuring competencies. These are expensive, especially if they are acquired on an outsourced basis, and yet they are essential. How many bankers have learned how truly expensive it is to deny their staffs adequate resources based on misplaced concern over expense budgets in urgent and time stressed environments.

In addition to explaining the lender to the reader, Sheehan also undertakes to explain the troubled borrower. I can honestly say that I think I’ve met all of these people at one time or another in my problem asset work. The characterizations are pretty accurate and appropriate and will help any problem asset practitioner do a better job of appreciating and responding to the unique stresses and strains weighing on the troubled borrower.

 

Optimizing Distressed Loan Books makes an interesting and informative read. It contains the accumulated experience and wisdom of Sheehan’s 20 year-plus career in problem asset resolution and it strikes many responsive chords with my own experience over the years. If there are overarching take away lessons here they are to me the following:

• Speed is essential. The quicker each problem asset situation can be stabilized, the quicker a resolution can be accomplished. This applies both to individual loans and to portfolios taken as a whole.

• Resources must be matched to the situation. Often they are not or they are deployed too late.

•  Bank culture can prevent success. This isn’t to say that bank cultures are not effective but when a business model changes drastically, elements of the old culture need to step aside and not inhibit different ways of acting and thinking.

•  You’ve got plenty of company. The non-performing loan problem is huge and it’s worldwide. Solutions will be not be quick as the issues permeate the banking system internationally and are not contained in easy-to-isolate environments of the banking industry’s business base.