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COP's August Oversight Panel Has Advice for Bank Acquirers

Posted by Wendell Brock on Thu, Aug 27, 2009

The Congressional Oversight Panel (COP), tasked with monitoring the Treasury's progress combating the financial crisis, has released an update on the continued risk of troubled assets in the banking industry. While the report doesn't address bank organizing groups specifically, its content does emphasize the challenges of evaluating target banks during this financial crisis.

Those challenges include valuing the target bank's troubled assets and identifying the reasons why those assets became troubled in the first place. In the general sense of the term, troubled assets are loans or securities that no longer meet (or perhaps never did meet) acceptable underwriting standards. The credit risk on these assets exceeds acceptable levels, repayment is questionable, and the aggregate asset value is far lower than originally assumed. Troubled assets commonly include:

 Mortgage-backed securities

 Whole mortgages in the bank's portfolio

 Securities backed by credit card receivables

 Securities backed by commercial mortgages

Community banks generally have more exposure to troubled whole mortgages.

Underlying causes

The bank organizing group does have a certain level of negotiating power when the target bank's balance sheet is weighted down with too many troubled assets. That's where the advantages end, however. Even before the negotiating begins, organizers must identify the underlying causes of the bad assets:

 Were these assets bad from the start, due to lax underwriting or borrower fraud? Did the bank willingly overlook missing documentation or red flags on credit histories? Was it simply an over-reliance on the assumption that collateral values would continue to rise over time?

 Or did these assets become troubled over time due to extreme weakening of collateral values or borrowers' credit qualifications?

Procedural changes and capital requirements

The organizing group is then tasked with devising the underwriting, workout and procedural standards that will:

 maximize the return on existing troubled assets

 add new, high quality loans to the portfolio

 minimize the addition of new troubled assets

Obviously, these are relatively complex objectives in this economic environment. Unemployment is still rising and the outlook for property values, particularly commercial property values, remains uncertain. Excessively timid underwriting can minimize the creation of new problems, but it's counter-productive; banks have to make loans to survive. The new management team simply has to find a way to originate loans that make sense.

Setting appropriate capital requirements is also a key step in evaluating the target bank. Ample capital can be a buffer for future loan losses, but organizers have to balance the capital needs with the availability of investor funds. Under current conditions, it is possible for organizers to meet their capital raise targets-but it isn't easy. The process takes planning, knowledge and expertise.

Next week, we'll discuss the accounting for troubled assets, as discussed in the COP report. You can access the full COP report here:

Topics: Buy a bank, regulators, Bank Regulators, Loans, bank investors

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