Considerations for an Acquiring Bank in Loss-Share Transactions With the FDIC

The economy, to put it lightly, has not been the best in the recent years.  One potentially lucrative by-product of the economic downtown was the opportunity for prospering banks to acquire failed banks from the FDIC at an incredible discount.  The purchasing bank, in acquiring the failed bank, will likely enter into a Loss-Share Agreement (LSA) with the FDIC.  Essentially, Loss-Share Agreements give the purchaser the benefit of the FDIC absorbing a large percentage of the losses realized on the acquired receivables.  The purchasing bank, generally speaking, only incurs around 20% of the losses with the FDIC incurring the remaining 80%.  While this seems like a “no-brainer” agreement, entering into a LSA—much like every contract—requires scrutiny to maximize revenue and avoid potential lawsuits.  Beyond the general advice of reading every word prior to signing a contract, this Blog post identifies five things an inquiring bank needs to know about LSAs.

1. The FDIC is not in the business of giving out money.  Loss-Share Agreements were designed to address the concerns of the unknown risks associated with purchasing the failed bank’s loans. Loss-Share Agreements resolve this fear by typically absorbing 80% of the losses—on covered assets up to a stated threshold amount, which is usually the FDIC’s estimate of the total projected losses – for a three to five year period.  While the loss share period is running, a shared recovery period is concurrently running.  During this shared recovery period, the acquiring bank pays the FDIC 80% of any recoveries, subtracting any recovery expenses.  This shared recovery period runs another one to three years longer than the loss sharing period.  According to an FDIC publication, Managing the Crisis, the FDIC “hoped to pass most of the failed bank’s commercial and commercial real estate loans to the acquirer while still receiving a substantial bid premium for the bank’s deposit franchise.”  While LSAs and only absorbing 20% of the losses sounds great, the FDIC is attempting to make the most out of a bad situation.  When there is a recovery on assets previously charged off by the failed banks, the purchasing bank will reimburse the FDIC for 80% of the recoveries.
2. Entering into a Loss-Share Agreement is not a guaranteed profit.  The FDIC coverage on commercial loans associated with the 2008 bank failures expired in 2013.  Once the coverage expires, any failed loans left are the sole responsibility of the assuming bank.  According to an article in American Banker as coverage is falling, so are a bank’s revenue from loss sharing.  Entering into a Loss-Share Agreement with the FDIC may result in some short-term gains, but there is little long-term benefit holding onto the loans.  While the acquiring bank has the obvious benefit of reduced risks and likely profit associated with purchasing the loan, this likely profit is reduced, if not negated, as a result of the greater interest from competing banks seeking to acquire the failed bank.  The FDIC does not hide this fact, as previously mentioned the FDIC hoped to pass most of the failed loans onto the acquiring bank while still receiving a substantial bid premium for the bank’s deposit franchise.
3. Loss sharing does not begin immediately upon having the winning bid.  When loss-sharing beings depends on the nature of the winning bid.  If the bid was negative, loss-sharing begins immediately upon recognition of the losses. If the bid was positive, instead of the winning bidder paying the FDIC, the winning bid becomes a first-loss tranche, absorbing losses before any loss-sharing begins.  The determination of whether the winning bid is positive or negative is based on an FDIC computation at closing.    
4. To comply with the FDIC reporting requirements, an increase in staff is almost inevitable.   One of the FDIC’s goals with LSAs is to have the acquiring bank operate and manage assets in a manner aligning with the interests and incentives of the FDIC.  To accomplish this there is a laundry list of reporting requirements the FDIC mandates.  For example, a report is required each month on single-family loans and each quarter for commercial loans.  The FDIC sets forth the information required in each report and, needless to say, the requirements are extensive.  According to an FDIC publication, one of the negative aspects of the loss sharing structure is that it requires the acquiring bank to “take on additional administrative duties and cost in managing the loss sharing assets throughout the life of the agreement.”  Additionally, any prior accounting systems are not able to handle the accounting requirements; essentially mandating the acquiring bank to upgrade the technology used.
5. Loss-Share Agreements can be (relatively) irrelevant in litigation.  Borrowers sometimes attempt to discover whether and how much the FDIC has reimbursed the acquiring bank for losses under the foreclosed loan.  Borrowers hope to claim their liability should be off-set by any amount the acquiring bank has received.  In a recent Florida Second District Court of Appeals case, Branch Banking and Trust Company v. Kraz, LLC., recognizes that the amount paid by a third party to purchase a loan does not affect the amount owed on that loan.  Other aspects of Loss-Share Agreements—expressly disclaiming third-party beneficiaries and the collateral source rule—do not allow a borrower to base a claim against the acquiring bank on any provision of a LSA since the borrower is not an intended beneficiary.  In a North Carolina Superior Court, the precise wording of the Loss-Share Agreement is determinative of the borrower’s rights.  Additionally, that the acquiring bank must fight a claim prior to the FDIC getting involved—of which the FDIC will not reimburse any costs or fees incurred.

While the argument can be made, quite easily, that entering into a loss-share agreement is essentially a “sure thing,” a closer look says otherwise.  Loss-Share Agreements were intended to primarily benefit the FDIC and the acquiring banks secondarily.  The FDIC acquired assets from failed banks of $41.4 billion from September 1991 to January 1993, and approximately $18.5 billion was covered by loss sharing.  According to the FDIC’s own numbers, 88% of failed bank assets were passed to acquiring banks while only 12% were retained by the FDIC.  A closer look at LSAs reveals that they are anything but a “sure thing.”

In navigating through the loss-share transaction or collecting on any loss-share assets, the acquiring bank should seek to engage experienced counsel in assisting on risk management analysis and loan loss mitigation.