The FDIC’s use of loss-sharing agreements has grown into a huge multi-billion dollar program that almost guarantees profits for the purchasers of failed banks. Originally introduced in 1991, loss-share agreements have now become a standard tool of the FDIC for moving failed bank assets into the private sector.
Loss sharing is a common feature of purchase and assumptions agreements used by the FDIC to move failed bank assets into the private sector. Under a loss share agreement, the FDIC agrees to absorb a certain portion of losses on a failed bank’s assets that are purchased by an acquiring bank. From the FDIC’s standpoint, loss share transactions are simpler, reduce their immediate cash outflows and allow troubled assets to be sold or restructured in an orderly fashion instead of being sold at steep discounts in a poor market.
Under a loss share agreement, the FDIC agrees to absorb losses on up to 80% of a failed bank’s assets that are purchased by an acquiring bank. The loss protection provides the incentive for private equity investors or other banks to purchase failed banks from the FDIC. Through the end of June 2010, the FDIC has entered into 167 loss sharing agreements covering $176.7 billion in assets of failed banks acquired by other institutions. The FDIC estimates that it has saved $11 billion by using loss share transactions instead of simply liquidating failed bank assets through an outright cash sale.
From 2007 to date there have been 254 banking failures with the FDIC taking into receivership $616 billion of failed banking assets. With potentially hundreds of additional banking failures and weak property markets, the FDIC has had to provide generous loss-sharing agreements on the majority of banking failures since 2007.
The FDIC insists that loss-sharing agreements save the FDIC’s Deposit Insurance Fund money. From the FDIC’s standpoint, loss share transactions are simpler, reduce cash outflows and allow troubled assets to be sold or restructured in an orderly fashion instead of being sold at steep discounts in a poor market. To investors in failed banks, the program means huge potential upside gain with very limited downside loss. It will be some time before the results of the loss share programs can be evaluated, since certain assets are covered by loss share agreements for up to 10 years. The cost of expected losses on a failed bank’s assets covered by a loss share transaction is included in the FDIC’s estimated cost of a banking failure.
According to the FDIC, their competitive bidding process is the most efficient way to ensure that the best sales price is obtained on a failed bank. In addition, a financial analysis of asset values is performed by the FDIC which dictates the terms and conditions of the loss-share agreements. Nonetheless, as has noted by a number of bank analysts in the past, there are examples of buyers of failed banks reaping huge profits due to the loss protection guarantees provided by the FDIC:
The FDIC has used the loss-share program to unload failed banks which has resulted in huge gains for certain investors, while the losses on the failed banks have ultimately been borne by the taxpayers. The ultimate gain or loss by the FDIC on their long tailed obligation to absorb losses on the ultimate disposition of failed bank assets is impossible to predict. Only if property markets significantly recover will the FDIC’s losses be less than estimated. If property markets continue to weaken and credit losses are more than expected, the FDIC could be liable for billions of dollars in additional payments, exposing the American taxpayer to additional losses.
Meanwhile, the Deposit Insurance Fund, which is used to cover banking losses, has been depleted and currently has a negative balance of $20.7 billion. The boost the cash reserves of this fund the FDIC has resorted to charging its members future insurance premiums. The most recent assessment represented a three-year premium advance.
How does loss sharing work?
The FDIC uses two forms of loss sharing. The first is for commercial assets and the other is for residential mortgages.
For commercial assets, the agreements typically cover an eight-year period with the first five years for losses and recoveries and the final 3 years for recoveries only. FDIC will reimburse 80 percent of losses incurred by acquirer on covered assets up to a stated threshold amount (generally FDIC’s dollar estimate of the total projected losses on loss share assets), with the assuming bank picking up 20 percent. Any losses above the stated threshold amount will be reimbursed at 95 percent of the losses booked by the acquirer.
For single family mortgages, the length of the agreements tend to run for 10 years and have the same 80/20 and 95/5 split as the commercial assets. The FDIC provides coverage for four basic loss events: modification, short sale, foreclosure, and charge-off for some second liens. Loss coverage is also provided for loan sales but such sales require prior approval by the FDIC. Recoveries on loans, which experience loss events, are shared in the same proportion as the original loss.
The FDUC website provides the following responses to the multiple questions surrounding loss-share transactions:
Does the FDIC receive any benefits if the acquiring bank makes money on the covered assets?
Yes. If asset losses are lower than anticipated, then the FDIC receives the majority of the benefit. The acquirer will reimburse the FDIC for the difference either at 80% or 95% depending on what was booked.
What types of losses on the assets are covered, and when does the FDIC reimburse the buyer for those losses?
The FDIC covers credit losses as well as certain types of expenses associated with troubled assets (such as advances for taxes and insurance, sales expenses, and foreclosure costs). The FDIC does not cover losses associated with changes in interest rates.
For single family loans, the acquirer is paid when the loan is modified or the real estate or loan is sold. For commercial loans, the acquirer is paid when the assets are written down according to established regulatory guidelines or when the assets are sold.
How do you know that the FDIC is getting the best deal with loss sharing?
When the FDIC is preparing the sale of a failing bank or thrift, the FDIC reaches out to numerous potential bidders for the deposit franchise and the institution’s assets. The sale relies on a competitive bidding process. In addition, the FDIC uses financial advisors to estimate asset values.
Does loss sharing put the taxpayer on the hook for additional losses down the road?
When the FDIC calculates the estimated cost of a failure, it takes into account expected losses on the assets covered in loss share agreements. Thus the cost of expected future payments is included. If credit losses are less than expected, then the FDIC will lose less than anticipated; if credit losses are more than expected, then the FDIC will lose more than anticipated. Actually, loss sharing has proven to be effective in the past.
Why don’t you use loss sharing for all failures?
Loss share agreements are just one way the FDIC has for selling assets of a failed bank, and may not be the best alternative for every troubled bank. For each resolution, the FDIC analyzes all available alternatives and accepts the least costly bid. Sometimes the results indicate that the loss share bids are more costly, and sometimes the FDIC does not receive a loss share bid.