Over the past several years reports of someone extending credit to a community bank holding company were similar to sightings of the Yeti in the Himalaya, you might hear about it but you never actually saw one. The number of bank failures and the consequent insolvency of many bank holding companies has led to a natural reluctance on the part of many lenders to provide such financing. The losses that many lenders suffered on such loans has raised some interesting questions about the loans were structured to begin with. The typical loan documentation for such a credit usually has traditionally had only a few financial covenants. The obligation to maintain well capitalized status for both the bank holding company and the subsidiary bank has been the primary focus on the assumption (not altogether incorrect) that maintaining a strong capital base cures many sins. Other covenants might address the ratio of non-performing loans to total capital, the ratio of the Allowance for Loan and Lease Losses to classified assets or simply the bank’s Texas ratio.
Historically, banks generally use financial covenants in loan documents as a signal to either cause the borrower to take immediate action to right the ship or to allow the lender to exit the relationship. In theory, the “early signal” approach works in many types of businesses and industries. It has proven, however, to be problematic in the banking industry. The issue that lenders have run into is that a loan to a bank holding company is unlike any other type of loan they might make. In a nonbanking environment the lender might seek to take control of the assets and liquidate them. At the end of the day the lender is free to liquidate assets and apply the proceeds toward the loan within a broad framework provides by general contract law and the UCC. A loan secured by a controlling interest in a bank presents a different situation.
When the subsidiary bank gets into financial distress the lender to the bank holding company can be presented with a difficult dilemma. During this past recession, it was not unusual to see banks downgraded from 2 to 5 on the CAMELS ratings in one examination cycle and to fall from being well capitalized very quickly. Thus, the early warning nature of the traditional financial covenants were of almost no assistance whatsoever to the lender. Once the subsidiary bank was considered “troubled” and prevented from making dividend payments to the holding companies, bank holding company loans quickly moved into default and in many cases had to be written off completely. Another particularly damaging element was the use by banks of interest reserves for loans in the ADC portfolio. Interest reserves served to mask a decline in the quality of the underlying loans in that a loan may show as current on the bank’s books while in reality the real estate project has stalled.
Assuming for a moment that the bank did not fail but remained in a troubled condition, the lender in a loan secured by bank stock could theoretically attempt to sell the stock of the bank to a third party under a UCC foreclosure sale. That sounds technically possible but raises interesting practical problems. First, you have the problem that the bank is probably not going to cooperate in the sale, meaning that any prospective purchaser is going to have a very difficult time doing any sort of due diligence on the bank’s assets. True, they can review what is publicly available in the FDIC Call Reports but those reports tell a very limited story. That level of diligence does not give one a high degree of certainty about what might still be lurking in the loan portfolio. Another option, particularly for unsecured loans or a secured loan that is only partially secured, is the involuntary bankruptcy case but this also suffers from the problem that the bank may not have any perceived value by possible bidders. In a possible worst case scenario, the lender ends up taking back the stock itself with the unfortunate baggage that the Federal Reserve provides strict timeframes for disposal of the foreclosed collateral, requires certain filings, and the possible risk that an overly assertive regulator could go even further.
If the lender is going to avoid any of these scenarios we believe that it needs to ask itself whether the old traditional financial ratios really work today. If they don’t provide the early warning signal that financial covenants are intended to provide is there something else that could be substituted.
We think that there were several lessons from the bank failures that provide some guidance in this regard. First, what is the business plan for the bank? Is it primed for fast growth? That may sound like an unrealistic concept in today’s slow growth economy but a business plan that shows a growth rate greater than the local overall economy might suggest that the bank is reaching outside of its market area for growth opportunities. Second, does the bank have an excessive concentration in a particular category of loans? Outsized concentrations in any given area could accelerate problems. The concentration does not need to be in CRE, however, it could be some other niche business that the bank has developed. The point is that a diversified loan portfolio protects the bank better from market shocks. Third, how is the bank managing other, less obvious areas of risk. A bank taking substantial interest rate risk could find itself hamstrung by a turn in rates and suddenly unable to provide dividends. Finally, do you feel comfortable with the bank’s financial reporting function in order to rely on its numbers?
Translating all of that into loan covenants would mean that the borrower should provide annually a copy of its business plan for review by the lender. Banks typically require their commercial borrowers to provide copies of the current and updated business plans and there is no reason why a lender to a bank holding company should not do the same. Next, the lender may want to consider the bank’s concentration in ADC, CRE, multifamily or some other specialty area and consider whether a percentage limitation of total assets for any particular category might be appropriate. The banking regulators pointed out in 2006 that they would apply greater scrutiny to banks having ADC concentrations greater than 100 percent or CRE concentrations greater than 300 percent when the outstanding balance of the institution’s CRE portfolio has increased by 50 percent or more during the prior 36 months. It would certainly not be out of line for a lender to require that the subsidiary bank hew to targets that were much lower than these. Finally, the lending bank can look to its own policies to provide covenants and reporting requirements for areas like asset-liability management and changes in auditors.
Every loan is a negotiation. The lender is seeking to properly underwrite the credit risk while the borrower is seeking favorable terms and the ability to operate its business with as few restrictions as possible. Some lenders will have a higher appetite for risk than others and typically as we move through the economic cycle loan covenants typically become looser. Many lenders compromise covenants simply by providing short-term loans so that the condition of the bank does not have time to change (arguably) from the time that underwriting takes place. The negotiation becomes a bit easier when both sides understand what the other side is attempting to accomplish. The negotiation is also easier when the parties are both represented by counsel who understand banking. The framework of the regulatory environment that banks and bank holding companies must operate within is not something that every commercial lending lawyer will understand.