|Workout time (July 2008)|
Loan workouts vary in the details, but all, by definition, are tough. Here, ABA BJ examines what’s effective, what’s less so, in the efforts to save borrowers and make lemonade from life’s sour fruit.
Call it an art, a science, or just a trip through the intensive-care ward. Loan Workout has returned to many banks. Experts provide guidance to those who’ve never seen such times
In chapter two of Tom Wolfe’s 1998 novel, A Man in Full, Atlanta real estate tycoon Charlie Croker has been summoned to the fictional “PlannersBanc” for a meeting. With his CFO and assorted staff in tow, he isn’t sure what to expect. He just knows his company has fallen behind on principal and interest payments on a mountain of debt—$515 million to PlannersBanc alone—and that things aren’t looking too good because one of his biggest new properties, Croker Concourse, isn’t doing well.
In inimitable (and often profane) prose, Wolfe describes the thoughts, words, and actions of the bankers, advisors, and borrower in the meeting. Croker, in better times, was wooed by PlannersBanc in wood-lined executive dining rooms, served gourmet fare; now, he finds himself in a windowless room, meeting at a nondescript table, facing orange juice in paper cups and inedible pastries.
There’s a plant in the room, but it’s dead.
And then the real leader of the meeting reveals himself. He is Harry Zale, whose trademark is a pair of suspenders bearing skull-and-crossbones. As described by Wolf:
“He was a workout artiste, and the workout artistes were the Marines, the commandos, the G.I. Joes of commercial banking. Or maybe the term should be D.I., for drill instructor, since Harry liked to refer to what was about to take place not as a workout session but as ‘boot camp’.”
The scene that ensues is one from Borrower Hell. Among the measures Zale orders the pinioned Croker to take is the sale of his beloved quail hunting plantation, “Turpmtime.”
Wolfe is known for his often over-the-top prose. Much in the scene he describes makes for a good novel, and shouldn’t be mistaken for reportage from real life.
But real-life attorney Thomas DeVine, of Snell & Wilmer, LLP’s Denver office, actually keeps copies of Wolfe’s book on hand. He gives presentations to client banks’ staffs, now and then, in the detailed basics of handling troubled loans. If someone asks particularly good questions, or answers DeVine’s own questions correctly, he bestows a copy.
But Wolfe’s book is more than just a freebie. DeVine uses this book, and the story in its second chapter, to convey a point that both lender and borrower need to understand when a credit has deteriorated to the stage where a loan has entered workout: “The party is over.”
Cleaning up after the party
Indeed, while DeVine’s meaning is specific to the individual credit under discussion, those words describe a new phase for many of today’s younger loan officers, too. They came up during the unprecedented boom times for the industry that have only recently passed. As a result, many have never seen the down-side of the business cycle.
“A lot of these folks are ‘good times’ bankers,” says DeVine.
Nicholas Ketcha, a former top FDIC and New Jersey banking official, is now a senior consultant with FinPro, Inc., Liberty Corner, N.J. He talks of a client with some loan trouble who is worried about the near future.
“He doesn’t have one loan officer on his staff now who has ever so much as charged a loan off,” says Ketcha.
By no means are many banks facing the brink, and in some banks there isn’t the trouble that has become commonplace in other regions. Ketcha notes that of his firm’s clients, western institutions are having more difficulties, while northeastern banks, which didn’t have as much opportunity to load up on commercial real estate, are not in the same straits. Nevertheless, he says, even in the Northeast there are pockets of trouble. Overbuilding in the New Jersey shore resort region, for instance, is one. Ketcha says some major projects there will never sell for what builders and lenders expected. And Ketcha predicts there will be failures where construction lenders got in over their heads.
In April, during an ABA telephone briefing concerning commercial real estate lending, Steve Fritts, FDIC associate director for risk management policy and examination oversight, touched on the need to be able to handle commercial real estate workouts.
“Bankers need to be sure that they have the infrastructure in place to perform loan workouts,” Fritts told listeners. He suggested that the costs of re-arranging talent, or hiring additional talent, to handle workouts, and setting up processes and procedures, would be balanced by savings for those banks that make the effort. (To order a CD of the ABA event, go to www.aba.com/ teleweb/tb042208.htm.)
“There is a shortage of workout specialists,” Ketcha says. “So there will be a scramble for them, and people with that type of experience are going to be getting premium salaries for a while.”
But, then, for some community banks, adding staff is out of the question. “I’m the workout department,” observed one CEO recently. For many institutions, workouts will be accomplished by existing staffs, who will become experts through training in the school of hard knocks.
To help those facing that education, we sought out the voices of experience: bankers who lived through the oil patch and commercial real estate crises of the 1980s as workout officers; Ketcha, who served FDIC in those days; and attorneys with extensive credit litigation experience.
We present what we learned from them in question-and-answer fashion.
•Q. Where does workout begin?
A. Actually, it starts all the way back at the beginning, when a bank proposes, and then underwrites a commercial loan, according to veteran banker Dick Evans.
“It’s not something you start and stop. Workout is a continuous process,” Evans says. “The 1980s helped us learn that.”
Evans, chairman and CEO of $13.5 billion-assets Cullen/Frost Bankers, Inc., headed workout efforts at the San Antonio, Texas, bank through the oil patch crisis of the 1980s. Many banks shut down their “special assets” departments after the sweeping problems of that period were gone—along with many banks—but Frost has never shuttered the workout door.
“Although,” admits Evans, “it’s a department that I always hope isn’t busy.”
Evans insists that successful workouts find their foundation in banking fundamentals.
“You must think all along of the kind of portfolio you want to have,” says Evans. Frost Bank makes a science of relationship banking, and doesn’t like a dealmaker mentality. Once the bank has taken on a credit relationship with the kind of borrower it likes to do business with, keeping eyes and ears open plays a tremendous role.
“The solution to dealing with special assets is in heeding the warning signs,” says Evans.
Evans likes to tell his lenders that credit trouble is like treating a cold, versus treating pneumonia.
If you catch a common cold, he explains, the drug store has 100 nostrums to cure you.
But if you catch pneumonia, he continues, there are only two or three medications that will work—“and you might die.” So the lesson is, early detection leads to easier, and surer, cures.
Q. What’s the most important skill involved in workouts?
A. Arguably, it’s communication.
And communication, or lack thereof, constitutes not only a skill, but a warning sign that a hitherto performing loan may be on its way to nonperforming status. Attorney Tom DeVine says there are three warning signs of credit going awry: changes in payment pattern or history; changes in personnel or procedure by the borrower; and absolute silence.
“Suddenly they don’t want to talk to you,” says DeVine. Suddenly, quarterly financials don’t show up until asked for. Suddenly, a two-way conversation becomes an echo.
Internal communication is also very important. “You never want to shoot the messenger,” who brings news of a loan going south, says Evans. “You’ve got to have someone in the organization who will bring it up. That’s paramount. Indeed, you want to reward the messenger, not kill them.”
In a related vein, everyone in the organization must be on the same page, when it comes to a credit. Evans says an honest loan rating system is critical.
Ed O’Leary stresses the need for realism. He always told his lenders, “ ‘Come clean with your problems, fellas, and there will be amnesty. But if we find stuff that you haven’t surfaced, then we’ll deal severely with you.’ In good times you get comfortable and wink at stuff. You’ve really got to be ruthlessly candid.”
O’Leary, now an Albuquerque, N.M.-based consultant, worked in business lending positions in New York, Oklahoma, Texas, Florida, and New Mexico. He ran the workout portfolios at First National Bank of Midland, Texas, and Liberty National Bank of Oklahoma City during the oil-patch difficulties.
Q. What are the warning signs we should be watching for?
A. You might think the obvious place is in the bank’s credit numbers. But Dick Evans says that it’s too late to steer a commercial loan away from trouble when it shows up among the past dues. Instead, he counsels, look on the other side of the relationship: deposits.
“You can learn a lot by watching deposit flows,” Evans says. Let’s say a company routinely deposits in the range of $100,000 a week, but then weekly deposits fall to $50,000. The company’s relationship banker should be on the phone to the owner or the CFO, asking what’s going on: Are sales down? Is the principle going through a divorce? Are there other lifestyle changes that are siphoning off cash?
“My exhortation to bankers is that you’ve got to act quickly, because time is wasting,” says O’Leary. “I used to work for a guy who said that a problem loan gets better, or worse, with every day. And it’s up to you to be on top of it to make sure that it’s getting better, not worse.”
More generally, Evans observes that “problems come from bad management—personal or business” at a borrower.
Signs of such bad management, or other problems, can be gleaned from treatment of funds by the borrower, says Tom DeVine. Indicators will differ depending on the type of credit involved. For instance, a clear yellow light on the lender’s dashboard is the departure of a firm’s CFO, followed by a slowdown in collection of accounts receivable. If the bank has a line of credit with the borrower that is secured by accounts receivable, this means that the bank’s collateral position is deteriorating.
Q. Does the original loan officer or relationship manager have any role in workouts? Or does the loan have to move to another banker, or to a workout specialist on staff?
A. At Frost Bank, because management stresses relationship banking, officers have some running room to work with a borrower that is in difficulty.
However, “when a loan gets classified, it goes to Special Assets,” says Evans. “We draw a line.”
The reason is to eliminate emotional involvement on the lender’s part.
Tom DeVine says relationship officers can be involved in early, pre-workout help, such as negotiating modifications in the original loan structure.
“Rarely does a loan go from performing to nonperforming, and then move to the workout group all in one step,” DeVine explains.
Sometimes, he says, a “softer workout” can be handled by the original loan officer. This might take the form of helping the borrower find an alternate lender willing to refinance the loan and take the bank out of the relationship.
But there’s more to the decision to leave the original banker on the case or not, beyond that particular credit. Ed O’Leary says managers must make some hard choices. That’s because most banks with troubled loans are still in the new-loan business, too.
“Maybe you don’t need to form a separate workout group,” says O’Leary, “but you sure don’t need to leave your best credit people, your best business-development people, having to deal with problem assets in the morning and good credit in the afternoon. After a while, they don’t know which hat to wear, and all they’re going to see is doom and gloom.”
Likewise, he advises against leaving a younger lender in workouts too long; it may taint their viewpoint for years.
O’Leary advocates establishing two loan committees once workouts represent more than a decimal point of the portfolio. One of his banks maintained both a New Business Committee and a Problem Assets Panel. Officers presenting to the two committees better understood the difference in mission and attitude and it helped lead to better decisions in both categories.
Q. What procedural steps should the bank take before putting a loan into workout?
A. Tom DeVine says, along the way, if the bank has given some ground, exercised some forbearance, modified the contract, what have you, it should receive a chip in return. This is a “release and waiver of claims.” Simply put, by granting this, the borrower and the borrower’s guarantors each release and waive any claims and other related rights relating to the lender in the course of the loan or any workout agreement. (At the same time, the bank generally does not waive any of its own rights.)
“You want to make sure that you have a clean trail behind you,” says DeVine, “that you have not left your bank open to a counter-claim from the borrower.”
This measure isn’t foolproof, DeVine acknowledges, because a borrower might claim that the agreement was signed under duress.
However, one helpful fact is this, according to DeVine: “There isn’t a lot that lenders are obligated to provide to borrowers under loan documents, except to provide funds.”
The experts also agree that it is extremely important, prior to getting into discussions with the borrower, to ensure that the loan file is in order. The bank needs to make sure all security agreements and other documents have been executed properly, and that everything that should be documented has been.
“You want to be sure that you have all the rights in the collateral,” says DeVine.
Sometimes, items are missing, but all is not lost. These holes can sometimes be filled by horsetrading with the borrower, according to O’Leary.
“Honey will attract more flies than vinegar,” O’Leary says. “If I need the customer to do certain things to improve the bank’s position, then I’m probably going to have to negotiate and trade and concede and compromise with them. But I find that, generally speaking, if you treat the customers like gentlemen, they will respond like gentlemen.”
O’Leary looked for the quid pro quo, where he could. “‘I’ll renew you for 90 days and give you a little more time, if you’ll help me cure this little documentation omission’,” is one example from O’Leary of the dealing that can go on when all wish to cooperate.
Q. What philosophical shift should we be making, as a loan goes into workout?
A. Don’t expect logic to be the only guiding force, or even the main force, when a loan heads into workout.
“You are dealing with human beings,” says attorney Steve Turner, “and human emotions drive the decisionmaking.” When the workout borrower is a small company, recognize that the owner’s life and livelihood is likely going down the tubes, Turner explains. He is chairman of the Financial Transactions Section and the Bankruptcy and Financial Dispute Resolution Group at Baird Holm, LLP, Omaha, Neb.
From the bank’s side, there is often also an emotional element. Turner says lenders frequently feel betrayed by the borrower and may go into a workout with a “scorched earth” attitude. At the outset, emotion may have the bankers involved thinking of not only forcing the operation into liquidation to salvage all the value they can, but also suing any guarantors who signed onto the deal.
Put that aside and think logically, advises Turner: “The best advice, early on, is to understand what your deal is, and what will get your bank the best return.” Banks with special asset departments, with bankers who did not have a previous relationship with the troubled borrower, typically operate very professionally and focus on best returns, Turner says, and other banks can do well to emulate their example, even if they don’t employ a full-time workout officer or team.
Q. What about the borrower’s mindset?
A. “The borrower has got be a realist,” says Dick Evans of Frost Bank. Getting a borrower to understand that life has changed and that they are in trouble is similar to a person dealing with the four stages of death: denial, anger, sadness, and acceptance.
Both borrower and lender must accept where things are, now, and be willing to deal with what the problem is, says Evans. No workout plan can progress until both sides have reached that acceptance.
Q. The story at the start of this article makes workout sound like a pretty nasty business. Does it get that bad?
A. Much of the atmosphere of the workout process will hinge on the state of the bank itself, according to Ed O’Leary. Some institutions he worked for were in regulatory difficulties, had less flexibility, as a result, and had to play hardball from the beginning.
But where that wasn’t the case, “I was ready to work with the customer, that is, I was able to work with him, rather than just work him out,” says O’Leary.
It isn’t unusual for additional funds to be part of a deal. “New money is almost always part of doing something curative,” says O’Leary.
“There’s a little speech I used to use” at the beginning of most workouts, he says. “I used to say, ‘Look, we can do this two ways. We can do it my way. Or we can do it your way. But, ultimately, we are going to do it my way, and going my way, we are going to get there. Now, let’s start there, because it will be easier on you’.”
O’Leary did have his share of confrontations.
“I always got a certain satisfaction out of verbally roughing up a guy who was giving me a hard time. If I gave him reasonable alternatives, and was really working with him, and he spit back in my eye, well, it was Katie bar the door,” O’Leary recalls.
At such times of noncooperation, he says, yes, he had to play hardball.
Give and take can work wonders, too.
At one bank, for instance, O’Leary had to handle a director of the bank itself who hit trouble in the oil business. On top of it, he was a fraternity brother of the bank’s CEO.
“He was always a gentleman to me,” says O’Leary. “But initially he was not terribly cooperative, because he wasn’t used to not having things his way.”
The director came from a rich, proud family. “And one day,” says O’Leary, “I made a concession to him that earned me his trust and support, and made the rest of the workout relationship over the next two or three years pleasant, even though it was still a workout.”
The concession was this: The director was a member of an exclusive country club. To have to sell his membership—worth about half what he’d paid for it at the time—would have meant a terrible loss of social standing among his peers.
“He asked me if I would not foreclose on that stock, and I told him I would do my very best, unless the president of the bank himself ordered me to,” says O’Leary. “He never lost his stock, so he could still go to the country club and that meant more to him than anything else I could have done. It cost me nothing, so why wouldn’t I do that if it made him my friend?”
Things weren’t always so smooth.
Adds O’Leary: “I always enjoyed working in the environment where I had some latitude to play good cop, if I had the opportunity to play it.”
Q. Can we sell off our bad loans, and skip the workout stage altogether?
A. Yes, this is possible. About a year ago ABA Banking Journal ran an article about selling troubled loans, which you can find in the August 2007 Digital Magazine at the following address: Nxtbook.com/nxtbooks/sb/ababj0807/index.php?startid=18
However, there are several points to be aware of. Buyers of loans make their money by purchasing at so much on the dollar, and then working the credit to maximize recovery. So, “the discounts make it very unattractive,” says Nick Ketcha of FinPro. The bank has to balance the costs of carrying a troubled credit against the discounts.
In addition, the bank must determine what accounting and related capital considerations will apply.
Q. With the workout talent pool so small, should we be looking for outside talent, sort of a “workout consultant”?
A. It’s possible to find outside help. Ex-regulator Nick Ketcha says you need “people who know when to give a little, when to take a little,” not professional “legbreakers.” Allied to this is the need for strong loan review. The bank that has a strong handle on its portfolio stands the best chance of making workout work, because it will be honest about what it’s got, and can deal with the cleanup better, says Ketcha. If a bank lacks the talent internally, it can hire loan-review help, he says; often, retired examiners are doing this today. Banks that aren’t taking this cold, hard look at portfolios have been having examiners do it for them, according to talks with bankers and regulatory experts. That’s not so good.
Q. ABA Banking Journal has run several articles about e-mail archiving and related issues over the last year. Is workout an example of the need to carefully archive all electronic communications?
A. Put down your Blackberry and push away from your keyboard.
“You have to slow down to speed up,” says Frost Bank’s Dick Evans. The CEO constantly has a Blackberry strapped to his hip, he admits, but while “e-mail is good, it is a terrible thing for credit. I do not believe in discussions about credit on e-mail.”
Evans insists that his people confine such discussions to the phone or in person. “In workouts,” he continues, “there is the need for more face-to-face communication, and I think technology can be a negative.”
Workouts can be complicated and detailed, he warns, and e-mail, which can be faster than the speed of thought, can set up the bank and the borrower for situations, attitudes, and decisions that both will regret later on.
There are other schools of thought on e-mail.
“Most people tend to be more casual and informal in e-mail correspondence than they would be in writing a letter, and we are becoming a text-message society,” acknowledges attorney Tom DeVine. Blackberry “conversations” can be terse, and words sent this way, without qualifying phrases, can come across harsher than intended. While this is a caution against e-mail, he says it can have a role, when used appropriately.
“I encourage bankers, in dealing with distressed credits, to use the same formality as in a letter,” DeVine continues. “Don’t say anything in an e-mail that would raise expectations or signal a willingness to do something for the client that you can’t unilaterally do.” There is a certain amount of legal “boilerplate” that a bank would put into a letter involving a workout, he adds, and this should be part of any e-mail that is necessary to send.
“But as the situation becomes more and more desperate, borrowers will read and hear what they want to read and hear,” warns DeVine. So, again, think about calling or meeting.
Q. Does the bank face any “lender liability” risk in pursuing a workout?
A. Attorney Steve Turner hates the very phrase, “lender liability.” While commonly used, he says, it is not a legal term. No one gets sued for “lender liability,” he maintains. They are sued for breach of contract, for instance, but not “lender liability.”
“Nobody thinks lender liability these days,” says Ed O’Leary, “but with old-timers like me it’s never far from your mind, even though when I use lender liability as an issue in a deteriorating asset environment, people look at me as kind of strange.”
O’Leary explains that the risk of liability arises from the change of the bank’s behavior towards the borrower before and after workout commences.
Take overdrafts. Suddenly the borrower that routinely had an overdraft of $50,000 or $75,000 without having to clear it has been put into a different category, with the credit committee ordering staff to clean up the overdraft.
“Suddenly you are returning the guy’s checks to Uncle Sam and his mortgage lender,” says O’Leary, “and suddenly he’s in a world of hurt. And all you’ve done is enforced the letter of the contract—which you didn’t do for a year before that.”
Q. Should a borrower be represented by counsel during workout negotiations?
A. “It’s better off if they have counsel,” says Steve Turner. In fact, Turner sometimes advises his bank clients to advance further money to a troubled borrower so they can hire a lawyer to represent them during the workout, if they can’t otherwise afford one.
What does the bank gain from providing such “legal aid”? Turner says having attorneys on both sides of the table can lead to a better deal, and one that the borrower will more likely understand.
Q. What are the odds that a workout will succeed?
A. Understand that “success” is a relative term. Attorney Steve Turner works extensively with farm lenders, but his scenario fits most borrowers.
“There isn’t any magic to getting out of financial trouble,” says Turner. “They earn their way out, they sell their way out, or they find additional capital.” Alternatively, when none of those strategies work, the bank is looking at liquidation, to protect the lender’s interests. “Liquidation may be the last option,” says Turner, “but often it’s not the best.”
Short of that, from the bank’s perspective, workout means such measures as recovering from sales of some assets; advancing additional funds to support a recovery plan; writing off some principal; and reducing interest rates.
Ed O’Leary says workouts succeed in about 75% of the cases. “It takes a patient banker, a creative banker,” says O’Leary, “but it also takes an improving economy. A rising tide lifts all ships.” That’s what ultimately happened in the oil patch and with the big commercial real estate downturn of the late 1980s-early 1990s period, he notes.
Q. Assuming a workout doesn’t result in liquidation, is there potential for a continuing relationship with a troubled borrower once the workout has run its course? Or is the well poisoned?
A. There are mixed views on this point.
Frost Bank’s Dick Evans is very upbeat, based on his experience.
“I’ve seen lots of good relationships come out of serious problems,” says Evans. “When someone gets their back against the wall, you see their real character.”
Some companies Evans worked out turned out to be headed by people of poor character, and they’re out. But in other cases, the borrowers proved their mettle, survived, and bank with Frost to this day.
On the other hand, Ed O’Leary thinks much depends on the institution. “In some credit cultures, the credit people have memories like elephants,” he says, “and they’ll remember a company was substandard way back when, and they’ll think, ‘By God, I’ll never trust that company again’.” At one big bank he worked decades ago, that was the mindset.
Sometimes, he says, “when you get the credit rehabilitated, you have to do your customer a favor: Find him another bank.” BJ
The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0708/index.php?startid=26
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