Thinking of Reducing Your Bank’s Exposure to CRE? Here’s a How-To on Portfolio Sales

The drumbeat of warnings about commercial real estate (CRE) loans continues to echo around the industry. Banks are worried, and regulators and market watchers are weighing in. The Federal Deposit Insurance Corporation, for one, advised banks late last year of the growing risk CRE loans pose for defaults given declining commercial real estate values and signs of market dislocation. S&P Global Market Intelligence, meanwhile, estimated that 532 banks had exceeded their regulatory CRE limits as of Q4 2023. 

While disruption and loan losses in the sector may seem inevitable as building leases mature and space empties, banks taking a deliberate approach to managing the risk can limit the impact of damaging asset deterioration. One strategy in particular—the portfolio sale—can help them dispose of potentially troubled loans in bulk, limit future losses, and return vital cash to the bank today. 

The concept of a portfolio sale is simple: A bank selects loans that are no longer profitable or strategic, pools them together based on similar characteristics, and sells them in one offering to buyers in a large transaction. The goal is to get a higher price, better recoveries, and better efficiency and execution than if it had sold those loans individually. Offering a bigger asset should, in theory, attract more buyers and more competitive bidding, and reduce the time investment necessary to sell all those loans. 

Some banks lack the in-house experience to create and value the portfolio, and some have a hard time considering selling any loan at a loss, regardless of its risk exposure. While selling a pooled lot of loans is not for everyone, overcoming these blockers could make a big difference in loan-loss levels—and the bottom line—given the CRE challenges on the horizon. 

Building a Team and Portfolio 

 A portfolio sale can involve dozens of loans and hundreds of buyers, so it’s imperative that the bank assembles a team of professionals for the effort. It should include representation from a variety of disciplines across the enterprise. Most critically the team should include a workout leader/banker, an internal legal partner, a compliance professional, and a loan operations manager. Others can join, as needed, throughout the process, based on the transaction’s complexity. 

This team will engage and communicate with stakeholders, establish best practices, and assemble the portfolio, taking direction from leadership on matters including the size and scope of the sale. Once general parameters are in place, the team can start inventorying loans and assembling data, some for internal use and some for external distribution to advisors and potential buyers. 

These data are the raw materials from which you’ll pick loans for the sale portfolio. Start by excluding from the list loans that are a hard “no” based on policies or parameters from leadership. Review what’s left for preliminary approval to proceed.  

From here, you can start the fine-tuning. Generally, banks include loans they consider “non-strategic” based on considerations such as asset type, location, industry, risk, and customer relationship. They might, for instance, decide to exit loans to office properties in central business districts. Or they might make a specific decision to sell the criticized loan of a specific customer. Defining the criteria for exiting or retaining a loan is important for constructing the sale portfolio. 

Establishing a strong risk monitoring culture is also essential to understanding the quality of your portfolio and choosing the right loans to sell. The Federal Deposit Insurance Corporation advises tracking and grading loans in real time. If a loan has the wrong risk rating, then not only will it skew your loan loss reserves, but it can lead to the wrong business decision on the asset. 

Another possible metric to consider in your decision process is a loan’s risk-adjusted net present value (NPV). The NPV should include all costs to service the asset, collection costs (attorney / litigation fees), and asset protection fees (advanced real estate taxes, force-placed insurance, and auction and disposition fees in a replevin or foreclosure). 

A third-party loan sale advisor (LSA) can help in the valuation, structure, and pooling of the sale. It can provide experience, technology, and data security to protect sensitive information—and surface potential buyers.  

The LSA can work with the client to set a timeline and marketing plan for the sale. It can also fill in administrative gaps and backstop banks by ensuring that all the necessary documents and files are available, underwrite the assets, and provide a range of reserve prices to expect from the sale.  

Lastly, an LSA assembles a customized list of buyers from its network of specialized contacts and acts as market liaison for the seller. In this way the bank can focus on addressing issues related to the underlying loans and concentrate on servicing the assets. 

Preparation for the Sale 

Once the approvals and price indications are set, the sale team can engage bankers and their teams to kick off the sale process. This stage is perhaps the most critical of the transaction. It’s at this point when loans are examined for their suitability in the sale by the relationship managers that know them best. It’s also when critical documentation is collected.   

Bank leadership can weigh in here on the significance of the sale and stress the role of the relationship manager in providing thorough review and disclosure.  It’s up to the team leader to review portfolio criteria and provide clear and detailed guidance to the relationship managers about how to satisfy their obligations in the process and when to speak up about loan issues. Legal partners should be available to provide answers to any legal questions that arise. Clear and consistent communication is important during the collection of loan and due diligence materials.   

Depending on the complexity of the portfolio, the entire selling process can take 60 to 180 days. Given this amount of time, bankers must continue to service their loans as usual. For reputational and relationship reasons, they must not disclose to the customer that their loan might be sold. If there are material changes to the loan during this time, such as loan modifications, defaults, waivers, and other changes to the servicing, it is imperative that those materials make it into the due diligence files. If they don’t, the bank exposes itself to liability since they ultimately could affect the price and valuation of the loan. A buyer would have recourse to the bank in the event the omission damages its ability to service and collect the loan.  

For example, assume a loan is part of the portfolio auction, and the loan officer executes a discounted payoff agreement at 70% of the principal balance of the loan. If the loan buyer pays 80% of the unpaid loan balance to the seller but isn’t aware of the discounted payoff agreement, it is losing not only the 10% difference it is obliged to honor as the new owners of the loan, but it can no longer collect the 20% principal balance. The bank would most likely need to make that buyer whole plus damages. That’s why it’s important to set a cutoff date for any loan modifications on assets included in the portfolio sale. If those modifications can’t be completed by the cutoff date, then the loan should be pulled from the sale. 

Making a Final Decision 

Once the document collection and review phase is over, the LSA can underwrite the portfolio and provide reserve prices on the loans. In addition to setting the prices, it can initiate valuable portfolio and asset discussions that will be useful to the portfolio sale team as they draft the sale justification document for bank leadership to approve. In any loan sale resulting in a loss, the portfolio sale team should run a Net Present Value analysis demonstrating that the sale at the expected reserve is accretive to the bank’s shareholders. If the net price/cash received from the sale is greater than under the alternative scenarios—such as retaining the loans or foreclosing the assets—then the sale is accretive and justifiable.  

Furthermore, the portfolio sale leader should be engaging with the bank’s accounting group to: (i) prepare loans for the transaction; (ii) be ready to process the accounting impacts; and (iii) obtain the current allowance for credit loss on each asset (loan loss reserve). The allowance represents the loan loss reserve held on the bank’s balance sheet for each asset and is based on the loan’s grade and risk rating.  

Comparing the loan loss reserve to the actual loss helps management reach a conclusion (assuming the loan grades are correct and the reserve is accurate). In some cases, the loss incurred on the sale is less than what is reserved, resulting in a release of excess reserve once the loan is sold.  

Once the bank finalizes its list of specific assets to sell, a sale justification memo is submitted to bank leadership for the necessary approval signatures. Accounting rules require that it move the loans to a held-for-sale status and that they are marked to market.  

All stakeholders, the deal team, credit approvers, loan operations personnel, and especially the relationship managers should be notified that the sale was approved and will be launched to the market.  

Sale Launch and Buyer Due Diligence 

With the decision to sell made, activity shifts to the LSA, which will run the sale and engage potential buyers. The LSA will vet buyers and manage confidentiality agreements, but the bank should do its own buyer review for reputational or compliance risk. The bank will want to understand who the potential buyers are to make sure they do not represent a reputational or compliance risk to the bank. This can be done by running background/litigation checks. The bank should exclude any buyers that have a history of improper collection practices (outside allegations that are standard defenses offered by debtors during litigation), judgments, or criminal actions. The bank will have reputational problems if it sells its loan to a firm that doesn’t respect or honor loan documents and/or collection laws.  

Additionally, the bank should run internal checks on each buyer so it doesn’t inadvertently violate federal regulations by selling a loan to a known insider or an affiliate entity (see Federal Reserve Regulation O and W). This may not be an issue for smaller institutions; large, complex institutions may have more exposure.  

At this stage the marketing plan is key. The bank and the LSA work together to develop a strategy aimed at achieving the highest value through tactics such as pooling similar loans. Typically, pooling loans with similar characteristics attracts more buyers to those loans since investors tend to focus on specific asset types. Financial institutions, for instance, will only be able to buy performing loans given their regulations, while private funds may only focus on a region or specific asset class.  

By segregating and categorizing these loans, it is possible to bring more buyers to a sale than there would be by only offering a “take it or leave it” approach (and, as noted, more potential buyers can translate into a higher selling price). The bank can also allow combination bidding to drive buyers to buy several pools at once. However, the bank must be sure not to splinter borrower loans into separate pools as it can create a reputational problem if it sells multiple loans from the same borrower to separate buyers (creating a hardship on the buyer and potential conflicts within the loan documents).  

Bid Day and Closing 

Bid day is the climax of the sale process. Auction mechanics can differ based on the needs of the bank, the assets, and the recommendation of the LSA, but formats include a “sealed bid auction,” indicative and best final bids, and open outcry. 

Once all the bids are finalized and reviewed, the LSA will share them with the bank, which has the ultimate authority over the bids it accepts. If the bids exceed the approved reserve amount, then a bank would likely move forward, unless it finds problems with the buyer(s). If certain loans didn’t meet the reserve, the bank can choose whether to accept those bids, realizing that the losses will be bigger than expected and that it will need to secure additional approvals from leadership. At the final point of acceptance, the LSA will notify the buyers that they were successful, and will hold the non-refundable deposits in escrow through closing.  

At this point, the loans are technically sold. The bank cannot modify them. The allocation of the final net proceeds of the sale should include the loan operations and accounting groups so that once the cash proceeds are received the loans can be closed in the bank’s systems.  

At closing, all borrower billing should be suspended and electronic access to the loan cut off. Because the loan was not paid off, no collateral or confidential information about the sale can be released.  

At this point, the bank will execute loan sale agreements, allonges, and any lost note affidavits and obtain original blue ink loan document files from storage. These should be sent to the LSA, which will hold them until the funds are received. On the closing date, the bank will need to send a formal closing notice—also known as a “goodbye letter”—to the customer notifying them of the sale, the new loan holder, and new servicing instructions. No one at the bank should discuss the rationale for the loan sale, only that it made an investment decision in the best interests of its shareholders. Additionally on the closing date, final data and loan payment history should be obtained and sent to the LSA and buyers for a final reconciliation. Any payments received by the bank before or after closing should be monitored and remitted to the new buyer.  

All Done 

Prudent gardeners prune and trim their vineyards and orchards so that they can be more productive and bountiful. The same is true of banks that have stale or unprofitable loans on their books that are draining resources and freezing capital. Considering potential stresses facing the CRE loan sector, banks must be flexible about shedding problem assets. 

While the industry may have considered these loans illiquid and hard to sell in the past, new technology and the development of secondary markets make it possible to manage loan holdings without offering huge discounts. The portfolio sale is one way to resolve asset issues efficiently and potentially deliver higher returns on assets than by selling loans individually. It can also help banks avoid the long and arduous process of rehabilitating a borrower or foreclosing on a loan.  

Jason Alpert is the Managing Partner of Castlebar Holdings, a distressed debt investor and financial institution consulting firm (not a loan sale advisory firm). He is a member of the RMA Journal Editorial Advisory Board and author of “The Workout Window” column.

Please send any comments and questions to jason@castlebarholdings.com or at 813-293-5766.