A loan veteran’s suggestions for troubled credits
 
By Steve Cocheo, executive editor, This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
 
You may not be handling the remains of Lehman Brothers, but that doesn’t mean you haven’t got challenges

Ed O’Leary had seen the morning’s The Wall Street Journal last month, when the “Section C” front page blared, “Behind Lehman’s Big Property Struggle.” The article described how Alvarez & Marsal, the turnaround firm overseeing the Lehman bankruptcy, was working feverishly to restructure 900 commercial real estate loans. In all, a portfolio of $16 billion was involved.
 
But troubled commercial real estate credits are not solely the province of the Lehman cleanup crew. Large banks, savings institutions, and community banks all share the pain. The similarities stop there, however. O’Leary, a veteran workout banker, says that while large and small institutions may be playing the same game, they are doing so in different divisions. Big players will go about working out troubled commercial real estate debt in big, often sweeping ways, and nonbanks like Alvarez & Marsal won’t be subject to the oversight of banking regulators.
 
Community banks that have troubled CRE credits (or took commercial real estate collateral in the course of making other types of business loans), have been and will be playing a game of smaller moves, said O’Leary. The former banker, who worked through the worst of the oil patch, commercial real estate, and other debacles of the 1980s and early 1990s in places like Texas, Oklahoma, and New Mexico, said that community bankers face a huge amount of work going forward. Ideally, he said, regulatory forbearance would help banks give their borrowers more time. It helped during past crises, he said, and despite pronouncements by at least one senior federal bank regulator that forbearance is not on the table,
 
O’Leary thinks regulators may have little choice this time.
 
“Forbearance is really the key,” said O’Leary. “If you can forebear enough, you can come out OK.”
 
But commercial banks already face the necessity of dealing with problem loans now, and are unable to count on any such relief. So we drew on O’Leary’s experience to illustrate how bankers, especially those new to such troubled times, can attempt to navigate the workout process.

Realistically viewing troubled credit
Earlier this year, O’Leary, who blogs on credit issues on www.ababj.com’s “Talking Credit,”  presented a two-hour ABA Banking Journal Showcase Telephone Workshop, “Portfolio Paramedics: Improving Your Bank’s Workout Function,” which covered both organizing a community bank for workout conditions and techniques for working out individual credits. (CDs of the workshop are available for $150 at http://tinyurl.com/WorkoutCD.) This article draws on that event and on a follow up interview in mid-September.
 
Community banks have an advantage in many troubled commercial real estate deals, O’Leary said, as opposed to residential mortgages that have gone south, in that usually the status of the commercial deal isn’t tied directly to whether the families of the principals involved have a roof over their head. Personal assets may be tied up in the business, but generally, said O’Leary, “you have people across the table who want to get a deal done. They are not trying to protect their homes.”
 
On the other hand, for many banks, the true depth and breadth of exposure to troubled commercial real estate deals may not be firm yet. While examiners have been scrutinizing portfolios for some time now, CRE is not so far along the curve as residential. O’Leary says that while banks’ balance sheets have pretty much recognized the state of affairs on the mortgage front, conditions are less clear on the commercial side. Why this is so critical we’ll come to next.

Working out versus working with
While the overall subject of dealing with troubled credit is often referred to as “workouts,” O’Leary prefers to divide the actual process into two categories: “workout” and “work with.”
 
For O’Leary, “workout” is an aggressive effort to collect a problem asset. By contrast, “work with” involves a more conciliatory approach, wrapping up some forbearance with flexibility and cooperation from both sides. The end result can sometimes be the same, “but they are very different orientations,” O’Leary explained.
 
Which mode a bank is going to be in, as it makes its way through portfolio problems, depends on a number of factors, but a major upfront issue is the state of the bank. A bank not under a regulatory order, or perhaps under an informal one, has considerably more flexibility. It has more say over its own dealings and has the time, and can afford, to “work with” when it has a borrower who is a good candidate for it.
 
On the other hand, a bank that is under a formal order, or which has entered the progression of federal prompt corrective action, has lost most of its flexibility. Under a formal order, for instance, the board and management has a limited time to demonstrate to regulators how they intend to address credit issues, O’Leary said. The bank is likely already writing loans down and the board has generally been told to reduce the amount of troubled accounts.
 
But let’s say the bank is not in such straits. It has troubled loans, but it is still working its way out of trouble on its own initiative.
 
At that point, the bank has to take a hard look at the borrower and the loan. As O’Leary indicated earlier, the community bank attacking the troubled loan challenge is in for a great deal of individual crafting, when dealing with a commercial real estate loan—or any commercial loan, for that matter.
 
A key element, however, is that action must be taken quickly. O’Leary likes to quote an old boss who gave him a credit maxim to live by; adapted to today’s circumstances, it goes like this:
 
“A problem asset gets better or worse every day. It does not remain static, and in the current national economic environment, it’s seldom getting better on its own.”
 
To which O’Leary adds, “and if you are not on top of it, it’s getting worse.”

Needs and attitudes
In dealing with troubled borrowers, a strong dose of reality is necessary. In his workshop, O’Leary told how, in his days working out troubled credits in the Southwest, his wife worked as a hospice volunteer. She passed on to him the “five stages of grief,” from On Death and Dying by Dr. Elisabeth Kübler-Ross. O’Leary adapted it to deteriorating credits:
 
1. Denial Troubled borrowers will attempt to put off talking about their problems, hoping to fix things up. The lender’s duty is to avoid confrontation, but to be firm and get the borrower to see where things stand.
 
2. Anger Next the problem borrower will be angry, and at a time like this it’s possible that a banker may unwittingly fall into a lender liability accusation. Care in speech and action help. While the borrower most likely has to pass through this stage to cope, the banker has to avoid making it worse.
 
3. Bargaining At this stage, the banker and the borrower, so long as the borrower is being straight, can begin to find some meeting of the minds. Issues to improve or at least address the situation can be raised. For instance, the lender might swap the release of a spousal guaranty for the borrower’s willingness to cure some deficiencies in the bank’s documentation. New money might be advanced for a legitimate purpose that might help turn things around or at least get them into better order. Discussions might even advance regarding liquidation, if that is necessary, and whether the borrower or the banker is better suited to take that on.
 
4. Depression This can be a stumbling block to successful negotiations. One example O’Leary cited was the spouse of a troubled borrower who was guarantor. She fell into a depression over the impending collapse of the family business, and “it slowed us down quite a lot,” said O’Leary.
 
5. Acceptance “This is the phase where the workout will most likely occur,” said O’Leary. The banker has to maintain a diplomatic tone.
 
“Manners and cordiality are important in getting to this phase,” he explained. “Manners are the air in the tires of life.”

What works, what doesn’t
While there are stages where the banker can work to improve things, O’Leary notes that some forms of relief are better than others.
 
For example, simply giving “relief of the calendar,” that is, a time extension, in an economy as we have now, rarely helps much by itself.
 
O’Leary said it merely punts a problem into the future, and even that will only happen if the bank’s situation is such that the regulators will stand for such strategies.
 
On the other hand, he said, interest forgiveness, of some degree, may do some good. Again, the bank has to be in the position to be able to do this.

Importance of a game plan
The bank that finds itself in workout mode must have a workout plan. This can be simplified down to three steps: understand the causes of the bank’s dilemma; identify the deficiencies the bank faces—and understand what the fix for them is; and, finally, implement the fix, working out or working with as warranted.
 
O’Leary said it is important to take some steps to establish to the community and the bank’s own staff how the overall game is going to be played, from the bank’s side.
 
It may be important to establish that the bank is serious about cleaning up its portfolio. In that case, the banker has to look for “low-hanging fruit.” These are loans or assets that can be moved quickly, to showcase how the bank will handle problems.
 
The latter strategy becomes particularly important where the bank has no choice but to take tough measures to keep regulators off its tail and its fate in its own hands. In this case, the bank is likely in workout (as opposed to work with) mode, and is playing hardball.
 
“You can’t give them an inch, then,” said O’Leary. “If you do, they will take it, and it will then be you under attack by the regulators.”
 
“When you are in workout mode, word gets around,” said O’Leary.

From plan to action
Indeed, once conditions have reached such a stage, it may be in the bank’s best interest to explore liquidation of the borrower’s business, as indicated above.
 
In some cases the borrower, due to knowledge of their business or other factors, may be able to dispose of assets best. In other cases, the bank may want to look at a firms that buys distressed assets. This gets the loan off the bank’s books.
 
O’Leary warned, however, that selling off a loan must be handled carefully. Should the price be too low compared to the original value, the resulting loss could make the action unsafe and unsound in examiners’ eyes.
 
Along the way with the whole process, top management has to realize what approaches, systems, and issues helped usher the bank into trouble in the first place. O’Leary insisted that this is time to remedy shortcomings.
 
“If you find things that need fixing,” O’Leary said, “do so promptly. They need attention—and may have needed fixing for a long time.”
 
This is no truism or wishful thinking. In the end, said O’Leary, being in workouts and work-withs represents a series of new underwriting decisions. Thus, getting systems and approaches fixed on the fly is part of the cleanup. BJ

Web Extra
Ed O’Leary’s advice on how to tell when a good customer is going bad. Read warning signs at http://tinyurl.com/Olearys Egg

The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj1009/index.php?startid=38

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