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Monday, March 14, 2011

Interesting Loss Sharing

Is your home already packaged and loan paid out by FDIC?

What is loss sharing?

Loss sharing is a feature that the Federal Deposit Insurance Corporation (FDIC) first introduced into selected purchase and assumption transactions in 1991. Under loss sharing, the FDIC absorbs a portion of the loss on a specified pool of assets which maximizes asset recoveries and minimizes FDIC losses through least-cost approaches. Loss sharing also reduces the FDIC’s immediate cash needs, is operationally simpler and more seamless to failed bank customers and moves assets quickly into the private sector.

Does loss sharing put the taxpayer on the hook for additional losses down the road?

When the FDIC calculates the estimated cost of a failure, it takes into account all expected losses on the assets covered in loss share agreements (LSAs). These current market assumptions are built into the cost of failure at resolution. Thus, the cost of all expected future payments are recognized at the time of bank failure and no losses are deferred. Any loss sharing payments are made from receivership funds from the specific failed bank or thrift or, if those are insufficient, from the FDIC's Deposit Insurance Fund (DIF). The DIF is funded by assessments paid by insured banks and thrifts. It is not taxpayer funded.

How does loss sharing work?

The FDIC uses two forms of loss sharing. The first form is for commercial assets and the second for residential mortgages.

For commercial assets, the LSAs typically cover an eight-year period with the first five years for losses and recoveries and the final three years for recoveries only. The FDIC will reimburse 80 percent of losses incurred by the acquirer on covered assets up to a stated threshold amount (generally the FDIC's dollar estimate of the total projected losses on loss share assets), with the acquiring bank absorbing 20 percent.

For single-family mortgages, the LSAs tend to run ten years and have the same 80/20 split as the commercial assets. The FDIC provides coverage on some second lien loans for four basic single-family mortgage loss events: modification, short sale, foreclosure, and charge-off. Loss coverage is also provided for loan sales but such sales require prior approval by the FDIC. Recoveries on loans which experience loss events are split evenly between the acquirer and the FDIC.

Since the inception of LSAs, the basis for sharing losses with an acquirer has undergone some change. Until March 26, 2010, the FDIC shared losses with an acquirer on an 80/20 basis until the losses exceeded an established threshold defined in the LSA, after which the basis for sharing losses shifted to a 95/5 basis. Sharing losses on a 95/5 basis was eliminated for all LSAs executed after March 26, 2010.

Does the FDIC receive any benefits if the acquiring bank makes money on the covered assets?

Yes. If asset losses are lower than anticipated, then the FDIC receives the majority of the benefit. The acquirer will reimburse the FDIC for the difference at 80 percent.

What types of losses on the assets are covered and when does the FDIC reimburse the buyer for those losses?

The FDIC covers credit losses as well as certain types of expenses associated with troubled assets (such as advances for taxes and insurance, sales expenses, and foreclosure costs). The FDIC does not cover losses associated with changes in interest rates.

For single-family loans, the acquirer is paid when the loan is modified or the real estate or loan is sold. For commercial loans, the acquirer is paid when the assets are written down according to established regulatory guidelines or when the assets are sold.

How do you know that the FDIC is getting the best deal with loss sharing?

When the FDIC is preparing the sale of a failing bank or thrift, the FDIC reaches out to numerous potential bidders to bid for the customer deposits and the failing bank's assets. The sale relies on a competitive bidding process. In addition, the FDIC uses financial advisors to estimate asset values.

After the bids are received, the FDIC selects the least costly option. To facilitate that analysis, the FDIC dictates the terms and conditions of a loss sharing arrangement and the assets to be covered when potential acquirers bid on a failing bank. This allows the FDIC to more quickly analyze and compare each of the bids to determine which is the least costly to the DIF. The terms and conditions also enable the FDIC to monitor the LSAs effectively.

Isn't loss sharing more costly? If not, then how does it save money? Aren't you still selling the assets?

Loss sharing saves the FDIC's insurance fund money. In today's markets, asset prices are low, and the prices frequently include steep liquidity and risk discounts. These agreements enable the FDIC to sell the assets today, but without requiring that the FDIC accept today's low prices. Instead, the FDIC sells to acquirers in a way that aligns their incentives with the FDIC and reduces the liquidity and risk discounts. The acquirers have the capacity and incentive to service the assets effectively and minimize losses.

How big is the loss share program? How much money has the FDIC saved?

Through September 2010, the FDIC has entered into 200 loss sharing agreements, with $159.2 billion in assets under loss sharing. The estimated savings exceed $38.5 billion, compared to an outright cash sale of those assets.

Why don't you use loss sharing for all failures?

LSAs are one way the FDIC can resolve the assets of a failed bank, and may not be the best alternative for every troubled bank. For each resolution, the FDIC analyzes all available alternatives and accepts the least costly bid. Sometimes the results indicate that the loss share bids are more costly or the FDIC may not receive a loss share bid.

What type of oversight does the FDIC have over the LSAs?

The FDIC periodically conducts on-site reviews of records of covered losses and overall compliance with the LSA. It also requires acquiring banks to provide quarterly reports to ensure compliance with the program and to monitor the performance of the assets. Lastly, the FDIC must approve the bulk sale of any covered assets, and the loss share coverage is not transferable to the new owner.

For LSAs that cover single-family loans, must the acquiring bank honor the FDIC's loan modification program?

The FDIC requires that acquirers modify loans using the Home Affordable Modification Program (HAMP) if they are approved HAMP servicers. If the acquirer is not a HAMP approved servicer, the acquirer, as part of its LSA, may be required to modify loans using the FDIC's standard modification program for failed bank single-family, owner-occupied, loans. Both programs adjust the current loan terms to achieve an affordable payment by first reducing the loan interest rate, then extending the loan term, and, where necessary, offering forbearance of principal. The goal is to provide an affordable monthly payment based on a debt to income ratio for housing equivalent to 31 percent of the borrower's gross monthly income (including taxes and insurance payments).

The acquirer can propose an alternative loan modification program that will achieve the goals of providing affordable payments consistent with cost effectiveness. If the FDIC concurs, then the acquirer can adopt the alternative program.

Where can I get additional information about the history and use of loss sharing?

In 1998, the FDIC published the book "Managing the Crisis" detailing the FDIC and RTC experience from 1980 through 1994. Chapter 7 is devoted to loss sharing and can be accessed at:

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