Sheila's March Through Georgia (Part 1)

Loan Participations and Too Big to Fail

Loan participations provide smaller banks, including community banks, the ability to compete with their “too big to fail” brethren in providing loans to business entities needing credit in excess of the smaller bank’s legal lending limit.  As historically structured, the originating bank agrees to lend its large customer an amount in excess of its own legal lending limit.  Before the loan is advanced the originating bank sells participation interests in the loan to one or more other banks, retaining only a credit exposure within its legal limits.  On paper, the borrowing customer need not know that the loan is in fact being funded in part by other banks.  As far as the customer is concerned, it is dealing with its own bank which has the ability to meet the customer’s needs on an equal footing with its “too big to fail” competitor. 

Silverton Bank, N.A. was a Georgia bank that failed in early 2009.  Silverton originally started doing business in the 1980s as the Georgia Bankers Bank.  As a “bankers’ bank” one of Silverton’s principal businesses was facilitating participations by its small bank customers, either by purchasing participations or connecting those customers with other Silverton customers interested in buying participations to diversify their loan portfolios or to invest surplus funds.

Because of the unique nature of Silverton’s business, the FDIC was unable to find another bank to take over Silverton in a typical purchase and assumption transaction.  Thus, Silverton’s closure was essentially treated as a deposit pay out and liquidation with the FDIC as receiver.  The FDIC’s treatment of other parties involved with Silverton in participations has caused major disruptions in the operations and credit exposures of banks throughout Silverton’s markets.

As receiver, the FDIC’s current mantra is “least cost alternative.”  That language comes from thrift crisis amendments to the FDIA aimed at minimizing resolution costs.  It seems as if FDIC receiver personnel spend most of their time developing facts to support their file closing memos, demonstrating they complied with “least cost alternative” requirements in resolving a particular problem or asset.  The difficulty with this approach is that problems and assets are not always isolated.  For example, the cheapest way to get rid of a diseased tree in the middle of a forest may be to burn it, and you can write a very convincing “least cost alternative” memo closing the file on that tree if you ignore the fact that you burned down the forest.

One of the major participation problems resulting from the Silverton receivership relates to unfunded commitments.  Construction loan commitments are made before construction commences and are funded as the project is built.  Participated construction loans require each participant to fund its share as draws are approved.  When a real estate recession hits, pending construction loans cause major angst.  Because the economic assumptions on which the project was based have changed, the project is likely to be worth less upon completion than its total cost.  Yet, the only thing that may be more distressed in a real estate recession than an empty completed project is an abandoned uncompleted project.  Whether to complete the project and accept your loss or stop construction and abandon the project is a difficult decision which depends on the peculiarities of the project and the progress of construction when the recession hits.  There is never a “right” answer, but a bank with a partially funded commitment must make a decision knowing that it likely has a loss either way.  If it stops funding, and assuming the customer has not breached the commitment, it will most certainly lose what it has already funded and will be liable to the customer for damages, which may be quite substantial.  If it funds, and the project is completed, the bank also usually has a loss because the project is in a single purpose entity with limited assets other than the project, and the loan guarantors, who probably had large net worths centered in real estate when the loan commitment was made, have seen their net worths go deep south as a result of the recession.

Whichever the decision, generally accepted accounting principles (“GAAP”) require that a bank fully recognize its expected loss when the facts first show that a loss will result.  Thus, assuming Silverton reported earnings in accordance with GAAP as required by the FDIA, its imbedded losses in outstanding loan commitments should have been booked at the time of its failure.  Thus, one would assume that those losses would be absorbed by the receivership, like all other losses incurred by Silverton before it was closed.  That is the “macro” view.  However, that is not apparently a view shared by the FDIC’s “least cost alternative” asset managers.

I know of at least two instances where the FDIC as Silverton’s receiver has simply refused to fund its legally enforceable participation obligations, leaving the originating bank, which contractually is the only bank directly obligated to the borrower, to fend for itself despite legal lending limit, credit concentration and other safety and soundness issues.  In the FDIC asset manager’s view that is the “least cost alternative” because any damages caused by its breach will be subordinated to the FDIC’s preferred position resulting from the “National Deposit Preference Act,” and the injured banks will recover nothing.  Thus, for the FDIC, the previously recognized existing loss becomes a profit to the receiver paid by the shareholders of the lead bank of as a result of the FDIC’s beggar thy neighbor powers as interpreted by the asset managers.  The risk of loss knowingly assumed by the failed insured bank is shifted by that bank’s insurance carrier to another bank which intentionally refused to assume that risk of loss.  In response to the suggestion that the jilted bank is left with a legal lending limit violation, the FDIC has publicly argued that the originating bank should have included a provision in its loan commitment permitting it to refuse to fund the customer’s draw request if any participant breached its funding commitment.

How exactly is a smaller bank supposed to compete with one “too big to fail” if it must tell its customer that its loan commitment depends on the whims of other parties the customer doesn’t know and that their whims can destroy the customer’s project unilaterally without recourse to any remedy?  Shelia?  Oops, I didn’t mean to interrupt when you were talking to Ben and Tim.