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COMMERICAL FINANCE ISSUE

NOV/DEC 2010
VOL. 8, NO. 8

For the Commercial Finance Professional

Understanding Bank Workouts


More Than Just a Loan
BY KRISTINA L. ANDERSON

Loan economics are just one of many factors influencing the workout bankers decisions in the complex
arena known as commercial bank workouts. Workout bankers in many commercial banks manage risk, not
just loans. Kristina Anderson continues her discussion on de-mystifying the workout bankers motivations.

I
KRISTINA L. ANDERSON
Managing Director,
Carl Marks Advisory
Group LLC

t goes without saying, not only is the workout


banker responsible for recovering the money
that the bank already has loaned, but he or
she may also be charged with identifying and
addressing any other risks that could expose the
bank to further loss. By understanding what a
workout banker considers risky and how he or
she may react to those risks, companies and their
professionals may be better equipped to develop
turnaround strategies and workout proposals
that not only avoid undesirable outcomes for the
business, but that also garner acceptance and
support from the workout banker.

Ancillary Bank Products and Services


Commercial banks provide an array of financial
products and ser vices other than loans, many
of which are deeply embedded in a companys
operations. Companies, as well as their professionals, are sometimes surprised when a workout
banker focuses on these ancillary bank products
and services, some of which the company may
rely upon in maintaining daily operations. Lets
examine a few common bank products that can
raise the concerns of a workout banker.
Unfunded Credit Commitments
While considered a loan product, an unfunded
commitment is not yet a loan. The most common
example is a revolving credit facility, a loan

Many companies are under the mistaken impression


that a bank can simply cancel a swap if interest rates
fall and immediately lower the companys borrowing costs.

product under which a company has the ability


to borrow, repay and re-borrow loans up to
a stated maximum amount. The unfunded
credit commitment is the por tion of the
maximum amount that the company has not
yet borrowed.
From the workout bankers perspective,
maintaining an unfunded credit commitment
exposes the bank to additional loss should
that commitment ever actually be borrowed.
The workout banker may attempt to cap
the banks risk by reducing or eliminating
unfunded commitments, ensuring that they
never become loans.
Does this mean a workout banker will
not continue to provide revolving credit to a
financially challenged company? Not necessarily, but in order to be convinced to maintain a committed obligation to lend without
further specific consent, the workout banker
will need to be convinced that the bank will in
fact improve its recovery on the loans it has
already extended by doing so.
To be successful, a company needs to
present a credible plan designed to return the
business to sustainable profitability. It should
also be able to demonstrate that it has done
ever ything in its power to generate liquidity
from somewhere other than the bank to fund
that plan up to and including implementing
any and all available self-help measures, such
as reducing expenses, to reduce its need for
liquidity.
Interest Rate Hedging Agreements
Inte r e s t r ate h e dging ag r e e m ent s,
commonly known as swaps, are financial
contracts designed to mitigate exposure to
changes in interest rates. In a floating-to-

fixed-rate contract, which is often seen in workouts, a


company and a swap provider, or counterparty, swap
monthly payments. The company pays the swap counterparty a fixed rate, and the swap counterparty pays the
company the prevailing LIBOR rate, which the company
can then use to offset any LIBOR-based interest payments
to its lenders.
It is important to understand that swaps are separate
and distinct financial instruments from the underlying loan
on which the company is trying to achieve a fixed rate. The
companys obligation to make all payments under a swap
contract is independent of its payment obligations under
its loan agreements. A bank that provides a swap could
incur a loss on the swap even if a company never misses a
payment on its loans.
While floating-to-fixed rate swaps can provide a valuable hedge against rising rates, they also lock borrowers
into fixed borrowing costs, which if interest rates fall
may be above prevailing market rates. Many companies
are under the mistaken impression that a bank can simply
cancel a swap if interest rates fall and immediately
lower the companys borrowing costs. However, swaps are
market instruments; the contract is required to be marked
to market if terminated early.
If interest rates have fallen, a swap may be out of
the money, and the company will incur a mark-to-market
payment obligation at termination. Conversely, however,
if interest rates have risen, a company may be able to
generate liquidity by terminating an in-the-money swap
and receiving a mark-to-market payment, but the company
should make certain that it can still service its loans at the
higher market rate of interest after the swap is gone.
A workout banker might seek to mitigate the risk of
loss on a swap by asking the company to post collateral
or terminating the swap contract, potentially without the
companys consent if a default exists. It is advisable for a
company and its professionals to review both its swap and
credit agreements for cross default, security and termination provisions because they could affect liquidity, operations or restructuring negotiations.

workout banker may also ask that the company close some
or all of its accounts with the bank.
Changes to treasury processes could impact a company
both financially and operationally. For example, if a bank
terminates ACH services, a company may be unable to provide
direct deposit of payroll. The company would need to create
and mail physical payroll checks and maintain idle balances
in bank accounts to fund unpredictable check presentments.
These procedures could add cost and consume liquidity in
comparison to direct deposit, as well as change the operational procedures associated with payroll payments. In addition, employees may consider it an inconvenience to go to the
bank with physical paychecks, which could impact morale.
It is advisable for a company and its professionals to
review the agreements that govern treasur y ser vices and
consider the potential operational and liquidity impacts if
changes to those services become necessary.

Treasury and Payment Products


Many companies have complex treasury and payment
systems that include such products as ACH payments
or zero-balance account structures that, while providing
efficiency and convenience, rely on operational processes
that could expose the bank to potential loss. Even if the
company has done nothing to increase the level of risk
in its treasury products, a banks willingness to continue
to accept the accompanying operational risks may decline
when a company is experiencing financial stress.
A discussion of the mechanics that give rise to operational risks is detailed, lengthy and complex; its a separate
discussion unto itself. Suf fice it to say, the operational
mechanics that make treasur y and payment systems
possible may introduce quantifiable and, in more complex
situations, material risk to the bank.
Workout bankers may therefore seek changes to a
companys treasury services to reduce or eliminate operational processes that could expose the bank to loss. The
company may be asked to pre-fund electronic payments,
discontinue automated funding and concentration services
such as master-sub or zero-balance structures, maintain minimum or target balances, or post collateral. The

Reputational Risk

The workout banker and his or her management team are


challenged to ensure that they protect their good reputation in
the marketplace while carefully balancing the potential negative
impact to the banks ability to collect its loans if the bank
responds to threats or publicity campaigns.

Loan Pricing
What is a workout banker trying to tell a company when it
raises pricing? A pricing increase could certainly be economically driven an attempt to cover the increased capital
expenses associated with an identified problem loan.
However, the workout banker could also be trying to give
a company a reason to find another lender. Pricing a loan
above prevailing market rates often provides a solid economic
incentive for a company to leave the bank voluntarily if it can
find another willing lender.

Some companies and their professionals may overestimate


the negotiating value of reputational risk, thinking that if they
drag the bank through a public battle, the bank will be shamed
into accommodating the company on the companys terms.
That reputational risk cuts two ways, however. Obviously, no
business desires negative publicity, but by backing off under
visible pressure a bank can also earn the unwanted reputation of not enforcing its agreements when pushed.
The workout banker and his or her management team are
challenged to ensure that they protect their good reputation
in the marketplace while carefully balancing the potential
negative impact to the banks ability to collect its loans if the
bank responds to threats or publicity campaigns.

Litigation Risk
Institutions have differing views regarding accepting litigation
risk. There are quantifiable staff and legal costs involved with
simply being engaged in litigation, in addition to reputational
considerations, regardless of whether the bank is the defendant or plaintiff. Some institutions will avoid litigation risk
at all costs, while some will make a financial decision to
accept litigation risk where the expected financial outcome

outweighs the cost, and others will stand on principle and


accept broad litigation risk to send a message, even if
litigation is a net money-losing proposition.
It is impossible to know which factors motivate an individual workout banker, but it is important to know that his
or her institutions view of litigation risk will influence his
or her workout decisions.

Book Balances
Banks are required to periodically conduct an analysis of
the value of their identified problem loans. If the loan is
found to be impaired, a bank may write down the loans
balance on the banks books. It is a myth, however, that a
workout banker will be motivated to accept any payment
that will clear the remaining book balance of a loan if that
loan has been written down.
While internal write-downs change the value of the loan
on the banks books, they do not reduce the borrowers
legal obligation to pay. By asking the bank to take a
discount, a company is asking a bank to pay to incur
expense to make the problem go away. A workout
banker will generally view a request to forgive principal,
interest, fees or reimbursement for out-of-pocket expenses
similarly, as each requires the bank to incur an expense it
is not contractually obligated to bear.
The workout bankers decision as to whether or not
that expense is justified is often independent of the loans
book balance. A company and its professionals need to
convince the workout banker (who, in turn, will probably have to convince one or more managers or internal
committees) that any proposal requiring the bank to
discount any amount it is owed represents the highest
and best value that can be achieved from all the realistic
strategic alternatives.

Workouts: The Big Picture


Workout bankers are charged not only with collecting
loans, but also with reducing the banks overall risk exposure to a financially challenged company. Anticipating what
the workout banker will analyze and knowing what issues
influence his or her decisions should help the company and
its professionals prepare to address potential issues before
they become operating emergencies.
Understanding where a workout banker sees risk could
give a company negotiating options to offer up a win
to the workout banker, which may be of little operational
consequence to the company. For example, a company
may be able to voluntarily terminate risky products that
are not critical to operations in exchange for maintenance

of others, allowing the workout banker to champion an


overall reduction of risk within the institution. In other
cases, a company may be confronted with the need to
quickly address important financial functions when the
workout banker is not able or willing to maintain existing
arrangements.
While this article examines numerous risks in isolation,
the fact is that these issues are complex and intertwined,
and decisions on how to address them cannot be made
in isolation. Workout bankers will endeavor to carefully
balance the need to eliminate risk with the potential that
eliminating risk in one area in fact increases risk in another
and impacts the ability to achieve an overall solution to
the problems facing both the company and the bank.
This can make the development of a successful workout
strategy extremely complex. It requires the company, the
workout banker and both parties professionals to carefully
and methodically examine the impact of each potential
strategy on the companys operations and enterprise value
to ensure that each decision will in fact advance both the
bank and the company towards a mutually acceptable
resolution. abf J
KRISTINA L . ANDERSON , managing director at Carl Marks
Advisory Group LLC (CMAG), has nearly 20 years of financial transaction experience working with both healthy and
distressed companies, including ten years negotiating,
structuring, implementing and managing the restructuring
and rehabilitation of distressed debt for the commercial
banking industr y. She has been involved in the resolution of numerous distressed debt investments for both
public and private companies across a broad range of
industries and outcomes. Anderson has worked extensively in distressed syndicated transactions with complex
capital structures and diverse stakeholder constituencies in roles such as sole lender, participant, steering
committee member and agent. In her position with CMAG,
Anderson focuses on financial restructuring transactions.
Prior to CMAG, Anderson spent 19 years with SunTrust
Bank, where she most recently held the position of SVP and
manager of the Corporate and Investment Banking Special
Assets Group. Anderson also served as director of SunTrusts
Corporate and Investment Banking Special Assets Group, and
held previous positions with SunTrust as VP of Debt Capital
Markets, VP and relationship manager of Corporate and
Investment Banking and AVP of Commercial Credit. She began
her career in banking with the Bank of Boston Connecticut.
Anderson graduated with honors with a B.S. in Finance from
the University of Illinois at Urbana-Champaign.

2010 Xander Media Group, Inc. ABF Journal is an Xander Media Group (XMG) publication. The views and opinions expressed in this publication throughout are not necessarily those of XMG management.
Reprinted with permission from ABF Journal, Nov/Dec 2010, Vol. 8, No. 8 by IPA Publishing Services 800-259-0470 (12079-1210) For web posting only. Bulk printing prohibited.