Value Based Management of Troubled Loans

A bank is able to serve as a financial intermediary in the economy through, in part, the government granting it a franchise (charter) that allows it to leverage its loan assets. Typically, banks can have a leverage ratio of 20 to 1 vs. 2 to 1 for other companies. However, this leverage franchise comes at a price. First, the assets need to be low risk/low reward (yield). Second, banks invest in long-term assets with short-term borrowings (deposits) that are guaranteed up to $200,000 by the FDIC, short-term brokered deposits, or inter-bank loans. The result is that banks are subject to margin calls much like an investor that borrows against his/her stock portfolio.

When pricing a loan, a bank will include a credit risk premium in the interest rate. This covers the “expected” losses that are inherent in the type of loans. The unexpected losses are absorbed by the bank’s equity. Basel I & II requires that banks maintain an overall equity ratio equal to 8% of assets. The 8% percent can be comprised of preferred stock or common equity. Not all loan assets have the same level of risk. Some assets may be funded with 2% equity and 98% interbank borrowings or bank deposits while other loans may use more equity, say 10% or 12% of the asset. The amount of equity allocated is a function of an obligor/obligation risk rating assigned to each loan. The objective is for the equity to absorb any unexpected losses so that the depositors/interbank lenders do not suffer the loss. The less the cushion to absorb the losses the more costly and scarce the depositors/interbank lenders become.

As losses are recognized on any given loan, the amount of the cushion that banks hold are reduced. If the bank intends to stay in business, then it must assure regulators, depositors, and inter-bank creditors that the original cushion of 8% that was exhausted through charge-offs is going to be replenished with new equity. For example, a loan of $100 is financed with $92 of debt and $8 of equity. In a subsequent period, the loan asset is worth $50. Depositors represented by the FDIC or other regulator, or an interbank creditor, makes a margin call. Under the terms of your franchise the bank can borrow 92% of the value of the asset so the bank can borrow $46 and must pay $46 to reduce the loan balance as $92 - $46= $46. The bank now has invested the original $8 of equity, plus the additional $46, for a total of $54 in equity in the $100 loan. The $100 asset is now financed with 54% equity and 46% borrowed funds and this changes the cost of capital dramatically.

The effect of a loan gone badly is that the bank loses its cost of capital advantage because of it can no longer leverage the asset to the same degree. Failure to recognize that the cost of capital has increased dramatically may lead bankers to mismanage their loan portfolio under the mistaken notion that they still maintain a cost of capital advantage. If the true economic cost of capital is taken into consideration, then the bank will use higher discount rates to determine the present value of the asset and make a more sober determination of its ability to create value for the shareholder.

The objection is often raised that a loan that is partly or fully “charged off” no longer employs capital and therefore no longer has a capital cost. This notion begs for an answer.? First, for the sake of conceptual clarity, it is helpful to view a bank as operating simultaneously as a three-ring circus answering to three ringmasters: regulatory & taxation, GAAP, and shareholders. To complicate matters, these rings do intersect insofar as what occurs in one may affect what occurs in another. Second, it is important to note that, GAAP and Regulatory prescriptions notwithstanding, an owned asset begins its economic life as such when it is acquired (or originated in the case of a loan) and ends its economic life as an owned asset when it is sold or liquidated. The short answer to this question then is that each ring has its own rules and outcomes. Nothing will illustrate this point better than noting the disparity between the market capitalization of a company and its reported GAAP and Regulatory Net Equity.? For our test subject we note that its reported equity as of 12/31/23 was $2.025 billion or $23.86 per share whereas the concurrent closing stock price on NASDAQ was $28.46 per share resulting in a market value (capitalization) of $2.416 billion. As of the day of this writing the market cap was $1.922 billion. As you can see, the market value of the equity is different and is determined by estimating the present value of future cash flows.

Similarly, a loan asset has a value that is independent of the accounting or regulatory prescriptions and should be either managed to maximize its market value or sold to realize its current value. This demands that we accurately determine its value utilizing the correct cost of capital and furthermore, that we measure the effect on value of any proposed loan restructure or collection effort. To increase value, either the proportion of debt to equity (leverage) needs to increase per regulations, or higher cash flows are needed to compensate for the higher cost of capital.

In order to determine the value of a loan we need to discount the future cash flows utilizing the bank’s Weighted Cost of Capital.? The WCC is composed of a Cost of Funds and a Cost of Equity.

The 10K report for 2023 for our test bank provides most of the information needed to determine the cost of funds with the exception of the overhead costs associated with deposit gathering activities. Below is the calculation of the Cost of Funds.

Test bank funds 91.87% its $12.97 billion in earning assets with bank deposits with the balance funded by equity. Of course, those deposits have an acquisition cost over and above the interest rate they pay. ?Since this bank is primarily a retail and commercial banking operation, we have loaded most of the non-interest expense as a percentage of deposits (3.06%). It can be argued that, since the test Bank’s earning assets are fully funded by deposits and equity, there is no need to include the other sources of funds.? This may not always be the case, so we include all funding costs for this illustration.

Now that we have determined the Cost of Funds, we need to determine the Cost of Equity.?

The current yield on a 5 - year treasury note is 4.608%. According to Yahoo Finance, the Beta for this stock is 1.16 and the annualized market return for the S&P 500 for the past 5 years is 14.53%.? Utilizing the CAPM we calculate the Cost of Equity is 16.2%.

Consequently, the weighted cost of capital on the original $100 loan asset would be (.92 x 4.56%) + (.08 x 16.2%) = 4.208%. After a reduction in the net realized value of the asset to $50, the amount of equity is increased so that the capital stack is now 54% equity and 46% Cost of Funds.? The Weighted Average Cost of Capital to the cost of capital would be (.46 x 4.56%) + (.54 x 16.2%) = 10.85% rounded. It has more than doubled.

What this means is that, if it takes 5 years to collect the $50 asset realizable value through a litigation process at a cost of $5, then the present value of the asset would be $26. The imperative then is, that the cashflows from any restructure be discounted at the appropriate rates determined above so as ascertain if the exercise is creating value for the bank or if the bank should look at alternatives such as a loan sale. This, of course, is an internal management exercise not to be disclosed publicly.

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By: Frangel Cannizzaro