I’ve previously posted on how driving away borrowers can leave a bank in a better position to handle losses on the remaining portfolio (link here). Here is the simplified balance sheet side of the math:
In this example, $250,000,000 in loans are paid off and used to reduce liabilities. The loss reserve and equity are unchanged, but have increased in size relative to the remaining portfolio, so the bank is in a better position to absorb losses in that portfolio.
This suggests that a bank could sell loans at a discount without damaging its ability to deal with future losses. Here is the same transaction above, but the bank sells the loans at an 11% discount:
Note that there is an actual loss of $27,500,000 which needs to come from somewhere in order to pay off the liabilities. In this example, it comes from cash and a reduction in the cash held in the loss reserve (but still maintaining a reserve level of 2% of remaining loans). Even though they took an 11% hit, the banks ability to weather additional losses remains unchanged. However, note the bank’s cash position has declined substantially.
What happens when the discount is 22%?
The bank is in a worse position, and has wiped out it’s cash position.
The real world is obviously much more complicated, but the rule of thumb is a bank can take a 10% hit on a note sale without much pain because the capital and loss reserves are already on the balance sheet to handle the loss. In general, as the market deteriorates banks have been building reserve levels, and specific loss reserves are being taken against some assets. To the extent these reserves exist, bigger discounts can be taken.
According to Zero Hedge, the FDIC commercial loan auctions are clearing at a 50% discount. For a bank to take that kind of hit on a note sale of any size, they would need to have built up very large reserves, or have substantial excess capital, or both. There aren’t many (any?) banks with substantial CRE exposure in that position, hence there are not a lot of note sales going on.
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