Publications & Resources
March/April 2009
Focus: Got Capital?
Non-Performing Assets: The Keep Versus Sell Decision
By Stephen Trauner
Whether in good times or bad, making a decision about how to manage a portfolio of nonperforming assets is never easy. Working out distressed credits can be complex and time-consuming. Making a decision about whether to work out an asset requires an ability to ignore the original lending decision and focus on what can be salvaged. This can be quite challenging as this also requires the bank to evaluate whether the borrower can recover and still remain attractive as a customer. So, the bank not only needs to decide whether to work out or sell the credit to a third party, but also if the decision is made to sell the credit how to maximize the price it will receive for the asset.
In order to be able to decide whether to work out or sell the credit, the bank must compare taking the offer price of the buyer and redeploying the proceeds at an expected rate of return over a certain time period versus the expected net future recoveries and revenue flows that might be realized by working out the asset. The net future recoveries are calculated by subtracting the Incremental Operating Expenses from the Net Carrying Value (Unpaid Principal Balance of Portfolio less Current Reserve) of the portfolio. Clearly, the results of this analysis hinge on the assumptions, and the assumptions will drive the accuracy of whether or not to keep or sell the portfolio.
For example, Bank ABC has a portfolio that has a mixture of substandard and doubtful assets. The Unpaid Principal Balance (UPB) of the portfolio is $40 million and there is a weighted average reserve against this portfolio of 25% or $10 million. The bank estimates that it will receive an offer for the portfolio of 50%, or $20 million.
The bank assumes that it will take three years to work out this portfolio, so the keep vs. sell analysis would be as follows:
Keep: The Net Carrying Value, or Estimated Recovery, of the portfolio is calculated by subtracting the Current Reserve from the UPB of the portfolio, which is $30 million. The bank assumes that the incremental operating expenses (cost of carry, taxes, administrative) to work out this portfolio will be 5% of the UPB per year or $6 million for the three year period. Thus, if the bank chooses to workout this pool of assets, it will recover $24 million after expenses. Remember, not selling a portfolio is a decision to invest in that portfolio. Sometimes it makes sense to invest in the portfolio, and sometimes it does not. That depends on what type of returns the bank is looking for and what are the bank’s alternative uses of capital and the commensurate returns on those assets.
Other factors to consider include the impact keeping the assets will have on the bank’s performance ratios and what this may mean for the bank’s share value and relationship with the regulators.
Sell: If the bank targets a return on equity of 15% for loan originations, and by selling this portfolio the bank redeploys the $20 million into earning assets, the bank will generated an incremental $10.4 million in revenue for a total value of $30.4 million.
After doing the analysis, Bank ABC makes the decision to sell this portfolio of assets.
At this point, the bank should focus on the following issues to make sure that the bank realizes the best price for the portfolio:
If a bank chooses to employ a Loan Sale Advisor (LSA), take the time to do some due diligence and find a reputable LSA. In today’s environment, there are many fledgling operations that do not have the experience, expertise and contacts required to market and sell complex transactions. Using less reputable LSAs will adversely impact the pricing of your assets.
Second, auction bids typically do not get the seller the best price. In a buyers’ market where there are so many opportunities competing for capital, you may not get the attention of viable buyers in a “best and final” auction process, and the probability of achieving a successful price is lower.
Third, be wary of bidders that reflect higher indicative bids to get the deal, as their final bids will often end up in line with the market following due diligence after you have tied up time and resources in trying to consummate a transaction.
Lastly, explore and employ alternative strategies in conjunction with the sale of assets that may help offset the sale of the assets. For example, are there some less strategic branches that your bank may want to sell? Are there some performing loans that you can add into the portfolio?
In sum, while the thought of selling assets can often be disconcerting and intimidating, the reality is that if you take time to analyze and think strategically about your portfolio, selling assets can be a very effective and productive tool to help manage your portfolio through all credit cycles.
Stephen Trauner is a founding partner of Beltway Capital Management, a firm that invests in, manages and works out commercial and industrial, commercial real estate and residential mortgage non performing loans. He can be reached at 410-403-2066 or at strauner@beltwaycapital.com.
Unauthorized reproduction of all or part of this material without the express written consent of the author is strictly prohibited. All rights reserved.