Once a bank’s primary regulator has determined to close a bank, the Federal Deposit Insurance Corporation steps in to “resolve” it, usually by accepting appointment as the bank’s receiver. Before being formally appointed, the FDIC has typically engaged in substantial evaluation of the bank’s assets and liabilities and solicited bids from solvent banks or other entities that are interested in acquiring some or all of the soon-to-be-closed bank.
Once all bids have been submitted, the FDIC evaluates them in comparison to its estimated cost of liquidation to determine the least cost resolution. The purchase and assumption transaction, involving an agreement where a third-party institution purchases or some or all of the failed bank’s assets and liabilities, is the most frequently used and preferred method for resolving a failed bank. A transaction with the FDIC to purchase such assets and liabilities is not without risk to the acquiring, solvent institution. That institution is taking on assets of a bank that failed—and, while there may be some exceptions, banks that fail generally fail because they were having problems with many of their loans.
Accordingly, the FDIC introduced the concept of “Loss-Share Agreements” in the early 1990s. Under a Loss-Share Agreement, the FDIC, as receiver of the failed bank, will reimburse the acquiring institution for a large percentage of net charge-offs, minus recoveries, of shared loss assets, plus reimbursable expenses. In essence, the FDIC retains the risk of substantially all losses on the portfolio, while the acquiring institution assumes the responsibility for the management, administration, and recovery of the assets. This is based on the concept that these third-parties, rather than the FDIC, are uniquely positioned to maximize the total dollar recovery on a portfolio of distressed loans.
Loss-Share Agreements provide for different tranches of “Applicable Percentages” of shared-loss that the FDIC will incur, depending on when the loss occurs with respect to all of the other loans included in the Loss-Share Agreement. If there is a loss, the acquiring institution recovers from the FDIC the specified Applicable Percentage (e.g., 70% of the loss). On the other hand, if there is no loss, such that the recovery is more than the book value of the loan, the acquiring institution is required to pay to the FDIC the Applicable Percentage (e.g., 70% of the recovery over the book value). Therefore, the Loss-Share Agreement requires the FDIC to reimburse the acquiring bank for a portion of its losses, but also obligates the acquiring bank to share the same portion of its recoveries with the FDIC. This structure prevents the acquiring bank from obtaining a double recovery (i.e., from both borrower and the FDIC).