Loss-Sharing Agreements

Loss-sharing agreements (“LSA”) have become more common over the last few years. However, LSA’s were first introduced by the FDIC in 1991 to reduce the Deposit Insurance Fund’s (“DIF”) costs and to enhance the attractiveness of closed bank franchises. The FDIC’s goal when using an LSA is to sell the majority of a failed institution’s assets to an acquiring bank, while having the purchaser manage the assets in a manner that will mutually benefit the acquiring bank and the FDIC.

BENEFITS FOR THE FDIC

• LSAs reduce the FDIC’s immediate cash needs.
• As the number of banking failures have increased over the past few years, the FDIC’s immediate cash needs have become an increasingly important issue. At the end of 2009, in order to bolster the DIF, the FDIC required insured institutions to prepay 3 years of FDIC insurance premiums which raised about $46 billion. Despite this additional assessment, at the end of the first quarter of 2010, the DIF reserve ratio was negative $20.7 billion, the lowest ratio in the history of the FDIC at that time.
• Provides stability to customers of failed banks by providing them with a simpler and more seamless transition to a performing bank.
• It also provides for a quick solution to move assets into the private sector to help stimulate the economy.

BENEFITS FOR ACQUIRING BANKS

• · FDIC loss coverage provides substantial downside protection against losses on covered assets, i.e., the FDIC typically shares in 80% of the loss of assets covered by the LSA.
• There are very little credit risks that arise from the portion of assets covered by the FDIC’s protection.
• Generally, examiners will not subject the portion of assets covered by an LSA to advers classification or other criticism provided the acquiring institution complies with the terms of the LSA.

STANDARD LOSS-SHARING AGREEMENTS

• LSAs come in two forms, with both types covering credit losses and reimbursement of certain types of expenses, e.g., advances for taxes and insurance, sale expenses, and foreclosure costs associated with troubled assets. The FDIC does not cover losses associated with changes in interest rates.

• The first form is for commercial assets.
• LSAs typically cover an eight-year period.
• The first five years are for losses and recoveries.
• The final three years are for recoveries only.
• For losses on covered commercial assets, the acquiring institution is paid by the FDIC when the assets are charged off in accordance with the banking agencies’ supervisory standards, or when the assets are sold.

• The second form is for residential mortgages.
• For single family mortgages, LSAs normally run 10 years.
• The FDIC provides loss coverage on three primary single-family mortgage loss events: modification, short sale and foreclosure. For certain junior liens, loss coverage is also provided for charge-offs. An acquiring bank will also receive compensation when the real estate is sold.

• The FDIC receives a benefit if the acquiring bank makes money on the covered assets. If asset losses are lower than anticipated, then the FDIC receives the majority of the benefit. The acquiring bank will reimburse the FDIC for the difference either at 80% or 95% depending on what was booked.

Losses under bulk sales for both commercial assets and residential mortgages are only allowed if the FDIC approves the sale ahead of time. In other words, a lender must obtain the FDIC’s consent prior to a sale.

• Cash payment to the acquiring bank is determined by the following three factors.
• The asset premium (discount bid);
• The franchise value bid for the failed institution’s deposit base; and
• The difference between the book values of the assets acquired and the liabilities assumed from the failed institution.

• If the combination of the factors is negative, the FDIC makes an offsetting up front payment to the acquiring bank. If a combination of these factors items is positive then the acquiring bank makes an up-front payment to the FDIC for that amount.
• A positive number would typically result in a “first loss tranche.” A first loss tranche is essentially a deductible, where FDIC loss coverage is provided only after losses exceed the amount of the fist loss tranche.

• Typically, the FDIC reimburses 80 percent of the losses incurred by the acquiring bank on covered assets, with the acquiring institution absorbing 20 percent (once the first loss tranche, if any, is exhausted). Once losses exceed the FDIC’s stated threshold amount – generally the FDIC provides 95 percent loss coverage.

CONSIDERATIONS FOR REVIEWING LSAS DURING BANK EXAMINATIONS

• Examiners will consider the impact of LSAs when performing the asset review, assessing accounting entries, assigning adverse classifications, and determining CAMELS ratings and examination classifications.

• Importantly, the FDIC’s reimbursement for losses on assets covered by an LSA is measured in relation to the asset’s book value on the books of the failed institution on the date of its failure, not in relation to the acquisition date fair value at which the covered assets must be booked by the acquiring bank.

• Assigned CAMELS ratings should represent an institution’s overall condition, with consideration given to the LSA. Depending on the volume of covered assets relative to the institution’s total assets, the indemnification provided by the FDIC may have a favorable impact on its CAMELS rating, especially on the asset quality and capital component ratings.

CONCLUSION

Supervisory issues involving LSAs will be encountered over the next several years as acquirers of failed institution assets utilize the FDIC’s loss protection for existing and prospective bank resolutions cases. From a supervisory perspective, LSAs provide significant risk mitigation for acquirers while the agreement remains in force because credit losses on covered assets can result in substantial reimbursements from the FDIC.

If you would like more information relating to FDIC loss-sharing agreements or any other banking or finance need, please do not hesitate to contact me at arome@grglegal.com or by phone at 312-428-2740.