You gotta know when to fold 'em: here's what you need to know about the secondary...

FDIC's "C&D" called it "failing to obtain adequate collateral," among other things. But Ron Whitcomb boils it down to the essentials: "We were financing Ho Hos and Ding Dongs."

Whitcomb doesn't have anything against these baked treats themselves,

but saw them as symbols of a predicament. He found himself up to his ears in loans to people who sold the snacks--convenience stores and gas stations--many of them nonperforming. EastBank, based in Minneapolis, had opened its doors in 2000, and, mostly through word-of-mouth advertising, found a niche lending to such businesses. Unfortunately, this concentration, in time, hammered results, as many of the small businesses got into trouble. Things grew bad enough to prompt the regulatory action and the board's hiring of veteran banker Whitcomb out of retirement to put the bank back on its feet, and out from under the cease and desist order.

Whitcomb had two immediate challenges.

First, he had to restore liquidity. EastBank had hit a loan-to-deposit ratio in the range of 107%. And it had reached that level with heavy reliance on wholesale funds. Even before things were official, "you started getting street talk," says Whitcomb, and when official word of the order got out, brokered funds dried up.

The second challenge was the sheer volume of troubled loans. More than half of the bank's portfolio was in some degree of pain. Too many balls to juggle, Whitcomb realized.

The solution to both challenges was identical: selling off loans.

Liquidity improved almost immediately by selling about 3% of the overall loan portfolio, to reduce that lending ratio and get some dollars into the bank. Then Whitcomb cut his workout challenge to a more suitable size by selling off about 5% of the troubled loans. "We were able to do this at a relatively modest discount," he says. He shopped the loans selected around the secondary market for troubled debt, and found a buyer.

Having cleared the decks a bit, Whitcomb and his staff dug in, and began working out the rest of the bank's problem credits.

"If I hadn't sold off that pool of troubled loans, we'd still be doing workout stuff," Whitcomb says. Instead, only nine months after the C&D came down, FDIC saw the improvement and lifted it. Whitcomb says the move was strategic for the $24 million-assets bank. "I needed liquidity and I needed time," says Whitcomb. Selling off loans brought both.

Answers are out there

There's a growing consensus that the well-publicized troubles in the subprime markets may be only the beginning of broader trouble with other types of bank credit, including commercial loans, commercial real estate loans, construction loans, and additional categories of residential credits. This possibility converges, bankers and observers agree, with some other trends.

One is that many of today's lenders haven't seen bad times, and haven't had any experience handling loan workouts.

"It will be a shock to a lot of younger loan officers who have never seen a downturn," says Catherine Ghiglieri, president of Ghiglieri & Co., Austin, Texas. Ghiglieri served as the state's chief regulator in the 1990s and as a senior regulator in the Comptroller's Office.

Another trend is that the market for distressed debt of many types has grown Sources run the gamut, including large players representing themselves and sometimes also investors who want to buy on the cheap and realize the rewards of patience--a luxury banks don't always have. It also includes those attempting to develop a securities-like market for troubled debt, specialized consultancies who will help evaluate and market loans or pools of loans, and community banks that have made a business out of acquiring and working out troubled loans.

Getting over stigma, annoyance

For many community banks, selling off troubled debt rather than working it out to a better, or a bitter, end, remains untried ground. But some have been finding the practice represents a kind of outsourcing. You pay in discounts from par value, rather than for services, but you gain efficiencies and quick remedies.

Many bankers queried say they see more inquiries from players in the bad-debt market, both by mail and cold calls.

"It's a logical process for banks to sell troubled assets, because it's a chance for them to change their inventory," says Joel Daste, head of the Gulf National division of Gulf Coast Bank & Trust Co. "Sometimes it's smart to sell it at a discount and focus on what your bank does best." The $668 million-assets bank's division buys troubled debt from other lenders and works it out using the bank's own staff. Daste adds that larger banks sell off troubled loans quite routinely, having learned that it often makes sense to offload such credit rather than spend staff resources on debt that has gone bad.

"It's a pretty big decision in most community banks' cultures to sell off a loan," says consultant Tim Holt, a former banker. However, it can make much sense, particularly if the alternative is sliding down the slope that led EastBank, say, into regulatory trouble. Holt's Profit Resources, Inc., Sarasota, Fla., recently helped a client, a community bank that determined it had to move a batch of nonperformers off the balance sheet, to find a buyer for the loans.

Holt advises thinking in terms of putting the bank's capital back to more productive use, and of thinking of loan sales as an opportunity for a troubled borrower to gain time, with a new creditor.

Time to take the cure?

Banks that haven't gone the sales route often have some gut reactions against it. The "I made it and I'll fix it" argument is one. Another is the fear of losing the underlying customer relationship.

Joel Daste counters that a loan that has deteriorated so badly that the bank is entertaining selling it probably really represents a relationship that isn't doing the bank any good anyway. Another consideration is that some problem borrowers pose reputational traps for the lender. A loan to a pastor with a faithful flock or a loan to a big employer carries baggage.

Better than foreclosure

Loan selling isn't just for those with regulatory troubles. Sometimes a bank just has a "stone in its shoe." Take the experience of Greensboro, N.C.'s Carolina Bank. The bank had a commercial real estate loan fraught with troubles, some of them outside the borrower's control. The underlying property, a small shopping center, had had a run of hard luck, including a burst sprinkler system. The owner, involved in multiple properties, had spread itself too thin to ride out the troubles.

Dan Hornfeck, executive vice-president and chief credit officer at the $438.3 million-assets bank, says they attempted to work out the loan directly. Refinancing with another lender was explored, as was selling the property. Neither effort came to anything. Hornfeck says the bank considered foreclosing, but the expense of doing so, and the possibility of getting stuck holding a problem property, looked pretty bleak.

So the bank decided to begin contacting some of the steady stream of loan buyers that routinely called on the bank.

"We knew we would have to take a discount," say Hornfeck, "because the property wasn't cash flowing." In the end, the bank sought formal bids from three firms, and chose a broker who offered a decent price, but who also impressed the bank with its professionalism and its understanding of banking. The final price was decent enough, and within a few months, the loan was off the bank's books, in spite of some late kinks, such as liens the bank hadn't known existed.

Hornfeck says a lesson learned in the process was that moving to sell sooner might have garnered a better price.

Weighing the decision

Knee-jerk selling at the first sign of trouble isn't being endorsed here. Former regulator Catherine Ghiglieri stresses to clients the importance of annual review of all borrowers, even those who have banked with the institution for a long time. This shouldn't be a cursory once over, but a genuine effort by Loan Review to have a fresh look at how the borrower stacks up financially.

"Banks become complacent," warns Ghiglieri, "especially with customers they have known for a long time." Red flags:

* For borrowers once known as big depositors, have the balances dwindled? Are they overdrawing? Are large checks being sent back?

* Are loan payments consistently arriving a few weeks late?

* How is the business itself doing? Are sales still on track with past results ?

But, supposing that the bank truly has nonperformers, and that selling them looks attractive, consultant Rob Peacock suggests a four-step process to making a decision. Peacock, a veteran banker, is managing director at FinPro, Inc., a consulting firm based in Liberty Corners, N.J.

1. Assess collateral coverage and the bank's lien position. If the situation looks manageable, don't think of selling yet, but go on to the next step.

2. Find out if the journey is worth the payoff. Determine the bank's best estimate of how long a workout would take, how much the bank is likely to recover at the end of the process, and what the present-value of the recovered funds would be. If the final number doesn't look too promising, says Peacock, "that's clearly a loan to sell early."

3. Consider the bank's reserves position for the loan. It's more than likely the bank has reserved something based on performance of such credits. Peacock posits a hypothetical case to illustrate his concept. Say a $100 million-assets bank has $10 million in bad debt, and that a regulatory memorandum of understanding requires the bank to get that down to $2 million in 90 days.

Could $8 million in bad debt be successfully worked out in one quarter? Not very likely. So, he continues, let's say the bank shops the loans to a buyer, and obtains an offer of 40 cents on the dollar on $8 million. That sale would accomplish the regulatory purposee: but it means that $4.8 million "is gone forever, a real loss." Whatever the price, and loss on sale, the bank has to weigh that against many factors both financial and nonfinancial.

Now, suppose the bank charges off the $8 million against the allowance for loan and lease losses. Remember that some loans do wind up being recovered in part after being charged off, says Peacock. So the bank may not have to bid farewell to as much as in a sale, especially if time is the main ingredient needed to heal things. And there may be tax advantages, as well. To do this of course, the bank must have a healthy reserve, and must have enough capital to maintain acceptable ratios after the charge is taken.

4. Weigh capability--assess your team's talents and workload. Workouts can be very costly in terms of time.

Once the bank decides that, the time has come to sell a loan or pool of loans, management may want to obtain professional guidance regarding the regulatory and accounting treatment of a so-called "sale."

Pricing decisions

"Distressed debt" covers an awful lot of ground, from moderately troubled to outright stinkers, and buyers price based on many factors.

"Prices could range from pennies on the dollar, up to par," depending on what the buyer sees before them, says Gulf National's Joel Daste. Loan sale advisors play a significant part in pricing. The less commodity-like an asset is, the more important their role, and the more they may be able to do for a seller. A rough rule of thumb, according to Steve Cohen, managing director at Nautilus Capital LLC, Mauldin, S.C., is a 15 cents on the dollar haircut.

"We can take on virtually any loan, at some price," says Mike Mulder, president and CEO of PrinsBank, Prinsburg, Minn., which manages troubled debt acquired from other lenders, through a partnership between bank management members and CarVal Investors. (See the digital edition at www.ababj.com for "Community banks find success squeezing others' lemons into lemonade.")

CarVal's Lena Motz, vice-president, manages investment partner relationships, including that with PrinsBank's management team, and specializes in what CarVal dubs "credit-intensive assets." She explains that many factors go into the pricing decision. For the partnership, the four key points are the loan's performance; the loan's "story"--what it's about, how it came to be made, why it made sense at the outset; the loan's contractual terms; and the quality of the collateral and the certainty that the lender really has rights to it.

Geography can play a part, because the ease of making loan recoveries can vary from state to state. FinPro's Rob Peacock points out, for instance, that it is much harder for a creditor to gain control of a property in a debtor's possession than in some other states. What current appraisals have to say about collateral property makes a big difference, too. A weak appraisal can drive the price of a loan down to the 60s on a dollar, says Laird Minor, managing director, Nautilus Capital

And plain old supply and demand also plays a part in pricing, according to J. Kingsley Greenland II, president and CEO of The Debt Exchange. More buyers of troubled debt are out there now, looking for opportunities to snap up salvageable loans. (Debt Exchange runs an electronic debt marketplace on the internet, www.debtx.com. See the digital edition for additional coverage.)

Doing it yourself

While outside firms can smooth the process of finding buyers for troubled debt, simply shopping a loan around using the bank's own resources isn't out of the question. A local investor may be interested in acquiring certain types of credits, for instance, or some other source may be within arm's reach.

"What the regulators want to see is that it isn't an insider deal, that the price that the bank received was reasonable," says Catherine Ghiglieri. "Also, the regulators want to understand what the thought process of the board was in deciding to handle it the way the bank did."

Still, companies in the business naturally see advantages to hiring professionals who watch the markets for a living.

"We believe loans are sold," explains The Debt Exchange's Kingsley Greenland. In this context, tech remains a tool, not a service unto itself.

By Steve Cocheo, executive editor