The experience of representing, advising or even banking companies that hit a bump in the road and get transferred to the bank’s workout department is increasingly common in today’s challenging economic environment. Most associated professionals — bankers, attorneys and advisors — likely have encountered this scenario at least once in the past few years.
Borrowers may have strong reactions to being moved to workout as it sometimes comes across as an abrupt change in a bank’s posture and behavior. Even seasoned professionals sometimes find themselves asking why the workout banker is interested in strategies that sometimes seem at odds with the borrower’s financial challenges or might even come across as non-economic. How does one best partner with the workout department to successfully put a troubled client back on the road to financial health?
The fact that a workout banker’s behavior actually is economically driven, both on an institutional and a personal level, might come as a surprise to many. Simply put, a workout banker’s view of the economic world may not be congruent with that of their borrower, so developing an understanding of how a workout banker’s world works can make the process easier for all parties involved.
The Rules Change in Workout Scenarios
When a loan moves from “the line” to workout, the rules of the game change. While a transfer to workout does not necessarily mean that the bank has decided they don’t want the business anymore, it does mean that at a minimum the bank has a heightened level of concern about the borrower’s ability to continue to comply with the terms of their loan agreements.
As a result, the bank’s focus shifts from new business development to principal preservation. Borrowers and their professionals can find themselves in unfamiliar territory. Understanding how to navigate this territory is critical to successfully negotiating through the workout.
It’s important for professionals and their clients to keep in mind that a transfer to a bank’s workout department doesn’t have to be interpreted as a declaration of war. It also doesn’t always signal the end of a borrower’s relationship with that bank. In many institutions, it is not a foregone conclusion that a transfer to workout means the bank wants to kick the borrower out.
Though many workouts admittedly don’t have a happy ending, workout bankers rarely approach a situation with a singular desire to simply foreclose and sell their collateral. While it can be difficult for a borrower to understand and accept the bank’s concerns, the workout banker and the borrower really are fighting for the same thing: They both want the business to prosper. If the business does well, the bank’s loan gets repaid and both the borrower and the bank make money. Workout bankers do however have economic considerations influencing what they can readily agree to or provide.
Understanding the Workout Banker’s Position
Workout bankers and the banks they represent are no different than any other economic animal, including their borrowers. Everyone (well, almost everyone) is in business to make money, and we all know that money is made by creating positive economic value — this formula is universal. However, what is viewed as positive economic value is definitely not universal.
When things are working as expected, banks typically measure economic value in a traditional and easily understood sense: interest and fee income. However, when a loan moves to workout, a bank begins to incur additional expenses directly attributable to that loan. Even if interest and fees are still being paid by the borrower, a loan in workout may not be profitable on paper due to the way the bank must account for it. Therefore, a workout banker’s economic contribution is often not top-line focused; their most valuable contribution often comes in the middle of the bank’s P&L.
Workout bankers create positive economic value by reducing or eliminating loan-specific expenses and protecting — rather than enhancing — the bank’s bottom line, and their personal compensation may reflect their success in doing so. In order to understand why the workout bankers behave as they do, one must have a basic understanding of how a bank is economically impacted when a loan deteriorates.
Risk Impacts Capital Requirements
Most institutions have some sort of risk-adjusted profitability model by which they measure individual loan profitability. A bank’s “cost of goods sold” is its financial capital, so a key driver of loan profitability is how much capital that particular loan consumes. The more capital that must be devoted to the loan, the more fee and/or interest income the loan must generate to cover the cost of that capital and make the loan profitable on paper. But how does a model know how much capital is required?
Banks have an internal scale — a risk rating system — that they use to quantify the level of risk associated with each loan. As the performance of the borrower deteriorates, so do the risk ratings associated with that borrower’s loans. The riskier a loan is rated, the more capital the bank must hold against that loan to protect against loss. As capital requirements increase, so too does the expense associated with the loan. This can be calculated by plugging the risk rating into the bank’s profitability model. Without increasing pricing, the bank cannot offset the increased cost of capital triggered by deterioration in risk ratings.
This explains why a workout banker might be concerned about a loan, even if the borrower has never missed a payment. Simply because a loan is paying timely interest doesn’t mean the bank believes it is making money on that loan. It also illustrates why workout bankers might want to increase interest rates at a time that likely will seem illogical to the borrower — when they’re having trouble. While economics may not be the sole motivation behind changes in pricing, without raising rates, the workout banker may view the loan as a money-loser on paper.
Non-Performing Assets and Losses
Simplistically, a non-performing loan is an accounting classification for loans that are 90 days or more past due, or loans for which the bank believes the ultimate collectability is in doubt. This definition does not require that the borrower miss payments. If the bank believes that the loan is likely to result in a loss, then the bank should consider classifying the loan as non-performing even if the borrower has never missed a payment. Though bank regulation is a separate and lengthy discussion unto itself, suffice it to say that a bank cannot afford to gamble its reputation with its regulator by failing to properly recognize and classify risk.
Beyond regulatory considerations, what are the economic reasons this performing/non-performing classification matters to the workout banker? The answer is simple: Non-performing loans are a double-whammy to the bank’s bottom line — they both reduce revenues and increase expenses. How?
First, generally speaking and with few exceptions, when loans are classified as non-performing, banks are not permitted to recognize revenue such as interest and fees on those loans, even if the borrower is still making payments. Any payments on a non-performing loan, irrespective of whether those payments are made on account of interest or principal, will be applied internally on the bank’s books as a reduction of principal. This is invisible to the borrower; the borrower’s legal obligation under the loan document does not change.
Second, a non-performing loan hovers at the top of the bank’s risk spectrum, and as discussed earlier, riskier loans require increased capital reserves. Capital costs money, so a loan that demands more capital means the loan creates more expenses.
As a result, a non-performing loan becomes a capital-consuming asset on the bank’s balance sheet and contributes only expense to the bank’s P&L. Less revenue and more expenses make the bank’s bottom line a dull, or potentially negative, number. Investing capital in activities that create negative returns does not foster positive economic value for any business, and a bank is no different.
Losses, otherwise known as charge-offs and the one bank accounting concept almost everyone understands, are additional economic factors that influence decision making during a workout. A bank’s loans are no different than a corporation’s accounts receivable. If the loan receivable doesn’t get paid, then the bank incurs a dollar-for-dollar loss on the amount it couldn’t collect. Banks do build and maintain reserves for loan losses, but as the risk profile of a bank’s loan portfolio deteriorates, so does the demands on those reserves and the expenses required to maintain them, especially if they are depleted by escalating losses.
The Workout Banker’s Perspective
Having now examined the material economic impact of risk ratings, capital requirements, non-performing loans and loan losses, one can begin to understand why asking workout bankers for a payment holiday or a discounted principal repayment is a troubling request from their perspective. If they agree to these types of requests, they could be creating new expenses or forgoing existing revenue, both of which have an immediate negative effect on the bank’s bottom line.
This also explains why the workout banker often doesn’t readily see the wisdom in lending more money to a financially challenged borrower. Increasing the capital at risk in an identified problem situation is contrary to the workout banker’s charge of protecting the bank’s balance sheet and minimizing loan-related expenses. New money has the potential to amplify the negative impact of an already economically challenging situation for the bank, both immediately and over time. Immediately, the bank will realize additional expenses related to the cost of capital it must invest to fund a new money loan, and this cost may or may not be fully offset by interest and fee payments from the borrower. Over time, the bank could incur additional loan losses because it has put additional capital at risk, which it cannot be assured, will be fully repaid.
As a loan moves up the risk spectrum, the amount of attention it draws from both inside and outside the bank, increases significantly. Riskier loans require more frequent and more complex reporting. Regulators and auditors, both internal and external, are more likely to review the file. More players throughout the institution may want to participate in the oversight of the loan. Decisions at this stage, especially with respect to advancing new money, carry significant personal risk for the workout banker that recommends them.
This is just scratching the surface. The additional visibility and administrative burden of a problem loan is significant, and the personal impact the increased “hassle factor” may have on the workout banker is not to be underestimated. Workout bankers are people too, and if people are asked to do things that attract negative attention or create additional burdensome tasks, they often don’t jump at the chance to do them.
Making a Workout Succeed
Does all this mean that the workout banker can’t work through a problem cooperatively with a borrower? Certainly not. It just means that solutions that seem simple or obvious to borrowers and their professionals can be fraught with negative consequences for the workout banker.
To convince a workout banker to take the personal and economic risks of accommodations, particularly if asked to advance new money, a borrower has to make a compelling case that the accommodation will in fact reduce risks and ultimately be economically beneficial to the workout banker versus the other achievable alternatives. Borrowers and their professionals need to convince the workout banker that the plan not only will return the business to sustainable profitability as quickly as possible, but that the borrower has done everything in its power to generate liquidity from somewhere other than the bank. Difficult questions about such sensitive issues as relationships with vendors, management’s compensation, staffing levels and the economic requirements of ownership should be expected.
Be prepared, communicative and transparent with a workout banker; trust and credibility is the name of the game in a workout. Think carefully about whether or not requests are really beneficial to everyone, including the bank, because for any deal to work, everyone has to perceive a benefit. The better a workout banker understands the situation and the more comfortable he or she becomes that the borrower has taken all available self-help measures, including possibly enlisting the help of specialists in turning around or restructuring distressed companies, the more equipped a workout banker will be to help develop a solution that he or she can advocate within their institution.
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.