Understanding Bank Workouts — More Than Just a Loan
Loan economics are just one of many factors influencing the workout banker’s decisions in the complex arena known as commercial bank workouts. Workout bankers in many commercial banks manage risk, not just loans. Kristina Anderson continues her discussion on de-mystifying the workout banker’s motivations.
It goes without saying, not only is the workout banker responsible for recovering the money that the bank already has loaned, but he or she may also be charged with identifying and addressing any other risks that could expose the bank to further loss. By understanding what a workout banker considers risky and how he or she may react to those risks, companies and their professionals may be better equipped to develop turnaround strategies and workout proposals that not only avoid undesirable outcomes for the business, but that also garner acceptance and support from the workout banker.
Ancillary Bank Products and Services
Commercial banks provide an array of financial products and services other than loans, many of which are deeply embedded in a company’s operations. Companies, as well as their professionals, are sometimes surprised when a workout banker focuses on these ancillary bank products and services, some of which the company may rely upon in maintaining daily operations. Let’s examine a few common bank products that can raise the concerns of a workout banker.
Unfunded Credit Commitments — While considered a loan product, an unfunded commitment is not yet a loan. The most common example is a revolving credit facility, a loan product under which a company has the ability to borrow, repay and re-borrow loans up to a stated maximum amount. The unfunded credit commitment is the portion of the maximum amount that the company has not yet borrowed.
From the workout banker’s perspective, maintaining an unfunded credit commitment exposes the bank to additional loss should that commitment ever actually be borrowed. The workout banker may attempt to cap the bank’s risk by reducing or eliminating unfunded commitments, ensuring that they never become loans.
Does this mean a workout banker will not continue to provide revolving credit to a financially challenged company? Not necessarily, but in order to be convinced to maintain a committed obligation to lend without further specific consent, the workout banker will need to be convinced that the bank will in fact improve its recovery on the loans it has already extended by doing so.
To be successful, a company needs to present a credible plan designed to return the business to sustainable profitability. It should also be able to demonstrate that it has done everything in its power to generate liquidity from somewhere other than the bank to fund that plan up to and including implementing any and all available self-help measures, such as reducing expenses, to reduce its need for liquidity.
Interest Rate Hedging Agreements — Interest rate hedging agreements, commonly known as swaps, are financial contracts designed to mitigate exposure to changes in interest rates. In a floating-to-fixed-rate contract, which is often seen in workouts, a company and a swap provider, or counterparty, “swap” monthly payments. The company pays the swap counterparty a fixed rate, and the swap counterparty pays the company the prevailing LIBOR rate, which the company can then use to offset any LIBOR-based interest payments to its lenders.
It is important to understand that swaps are separate and distinct financial instruments from the underlying loan on which the company is trying to achieve a fixed rate. The company’s obligation to make all payments under a swap contract is independent of its payment obligations under its loan agreements. A bank that provides a swap could incur a loss on the swap even if a company never misses a payment on its loans.
While floating-to-fixed rate swaps can provide a valuable hedge against rising rates, they also lock borrowers into fixed borrowing costs, which — if interest rates fall — may be above prevailing market rates. Many companies are under the mistaken impression that a bank can simply “cancel” a swap if interest rates fall and immediately lower the company’s borrowing costs. However, swaps are market instruments; the contract is required to be marked to market if terminated early.
If interest rates have fallen, a swap may be “out of the money,” and the company will incur a mark-to-market payment obligation at termination. Conversely, however, if interest rates have risen, a company may be able to generate liquidity by terminating an “in-the-money” swap and receiving a mark-to-market payment, but the company should make certain that it can still service its loans at the higher market rate of interest after the swap is gone.
A workout banker might seek to mitigate the risk of loss on a swap by asking the company to post collateral or terminating the swap contract, potentially without the company’s consent if a default exists. It is advisable for a company and its professionals to review both its swap and credit agreements for cross default, security and termination provisions because they could affect liquidity, operations or restructuring negotiations.
Treasury and Payment Products — Many companies have complex treasury and payment systems that include such products as ACH payments or zero-balance account structures that, while providing efficiency and convenience, rely on operational processes that could expose the bank to potential loss. Even if the company has done nothing to increase the level of risk in its treasury products, a bank’s willingness to continue to accept the accompanying operational risks may decline when a company is experiencing financial stress.
A discussion of the mechanics that give rise to operational risks is detailed, lengthy and complex; it’s a separate discussion unto itself. Suffice it to say, the operational mechanics that make treasury and payment systems possible may introduce quantifiable and, in more complex situations, material risk to the bank.
Workout bankers may therefore seek changes to a company’s treasury services to reduce or eliminate operational processes that could expose the bank to loss. The company may be asked to pre-fund electronic payments, discontinue automated funding and concentration services such as master-sub or zero-balance structures, maintain minimum or target balances, or post collateral. The workout banker may also ask that the company close some or all of its accounts with the bank.
Changes to treasury processes could impact a company both financially and operationally. For example, if a bank terminates ACH services, a company may be unable to provide direct deposit of payroll. The company would need to create and mail physical payroll checks and maintain idle balances in bank accounts to fund unpredictable check presentments. These procedures could add cost and consume liquidity in comparison to direct deposit, as well as change the operational procedures associated with payroll payments. In addition, employees may consider it an inconvenience to go to the bank with physical paychecks, which could impact morale.
It is advisable for a company and its professionals to review the agreements that govern treasury services and consider the potential operational and liquidity impacts if changes to those services become necessary.
What is a workout banker trying to tell a company when it raises pricing? A pricing increase could certainly be economically driven — an attempt to cover the increased capital expenses associated with an identified problem loan.
However, the workout banker could also be trying to give a company a reason to find another lender. Pricing a loan above prevailing market rates often provides a solid economic incentive for a company to leave the bank voluntarily if it can find another willing lender.
Some companies and their professionals may overestimate the negotiating value of reputational risk, thinking that if they drag the bank through a public battle, the bank will be shamed into accommodating the company on the company’s terms. That reputational risk cuts two ways, however. Obviously, no business desires negative publicity, but by backing off under visible pressure a bank can also earn the unwanted reputation of not enforcing its agreements when pushed.
The workout banker and his or her management team are challenged to ensure that they protect their good reputation in the marketplace while carefully balancing the potential negative impact to the bank’s ability to collect its loans if the bank responds to threats or publicity campaigns.
Institutions have differing views regarding accepting litigation risk. There are quantifiable staff and legal costs involved with simply being engaged in litigation, in addition to reputational considerations, regardless of whether the bank is the defendant or plaintiff. Some institutions will avoid litigation risk at all costs, while some will make a financial decision to accept litigation risk where the expected financial outcome outweighs the cost, and others will stand on principle and accept broad litigation risk to “send a message,” even if litigation is a net money-losing proposition.
It is impossible to know which factors motivate an individual workout banker, but it is important to know that his or her institution’s view of litigation risk will influence his or her workout decisions.
Banks are required to periodically conduct an analysis of the value of their identified problem loans. If the loan is found to be impaired, a bank may “write down” the loan’s balance on the bank’s books. It is a myth, however, that a workout banker will be motivated to accept any payment that will clear the remaining book balance of a loan if that loan has been written down.
While internal write-downs change the value of the loan on the bank’s books, they do not reduce the borrower’s legal obligation to pay. By asking the bank to take a discount, a company is asking a bank to pay — to incur expense — to make the problem go away. A workout banker will generally view a request to forgive principal, interest, fees, or reimbursement for out-of-pocket expenses similarly, as each requires the bank to incur an expense it is not contractually obligated to bear.
The workout banker’s decision as to whether or not that expense is justified is often independent of the loan’s book balance. A company and its professionals need to convince the workout banker (who, in turn, will probably have to convince one or more managers or internal committees) that any proposal requiring the bank to discount any amount it is owed represents the highest and best value that can be achieved from all the realistic strategic alternatives.
Workouts: The Big Picture
Workout bankers are charged not only with collecting loans, but also with reducing the bank’s overall risk exposure to a financially challenged company. Anticipating what the workout banker will analyze and knowing what issues influence his or her decisions should help the company and its professionals prepare to address potential issues before they become operating emergencies.
Understanding where a workout banker sees risk could give a company negotiating options to offer up a “win” to the workout banker, which may be of little operational consequence to the company. For example, a company may be able to voluntarily terminate risky products that are not critical to operations in exchange for maintenance of others, allowing the workout banker to champion an overall reduction of risk within their institution. In other cases, a company may be confronted with the need to quickly address important financial functions when the workout banker is not able or willing to maintain existing arrangements.
While this article examines numerous risks in isolation, the fact is that these issues are complex and intertwined, and decisions on how to address them cannot be made in isolation. Workout bankers will endeavor to carefully balance the need to eliminate risk with the potential that eliminating risk in one area in fact increases risk in another and impacts the ability to achieve an overall solution to the problems facing both the company and the bank. This can make the development of a successful workout strategy extremely complex. It requires the company, the workout banker and both parties’ professionals to carefully and methodically examine the impact of each potential strategy on the company’s operations and enterprise value to ensure that each decision will in fact advance both the bank and the company towards a mutually acceptable resolution.
Kristina L. Anderson, managing director at Carl Marks Advisory Group LLC (CMAG), has nearly 20 years of financial transaction experience working with both healthy and distressed companies, including ten years negotiating, structuring, implementing and managing the restructuring and rehabilitation of distressed debt for the commercial banking industry. She has been involved in the resolution of numerous distressed debt investments for both public and private companies across a broad range of industries and outcomes. Anderson has worked extensively in distressed syndicated transactions with complex capital structures and diverse stakeholder constituencies in roles such as sole lender, participant, steering committee member, and agent. In her position with CMAG, Anderson focuses on financial restructuring transactions.
Prior to CMAG, Anderson spent 19 years with SunTrust Bank, where she most recently held the position of SVP and manager of the Corporate and Investment Banking Special Assets Group. Anderson also served as director of SunTrust’s Corporate and Investment Banking Special Assets Group, and held previous positions with SunTrust as VP of Debt Capital Markets, VP and relationship manager of Corporate and Investment Banking and AVP of Commercial Credit. She began her career in banking with the Bank of Boston Connecticut. Anderson graduated with honors with a B.S. in Finance from the University of Illinois at Urbana-Champaign.