"Buy low and sell high" doesn't solely apply to individual investors. It's also great advice for banks looking to grow when times are tough.
Consider Bank of the Ozarks (NASDAQ:OZK). In 2010 and 2011, the bank opportunistically bought up assets from seven failed banks. Without even breaking a sweat, the bank added hundreds of millions of dollars of assets and low-cost customer deposits to its balance sheet.
But what about the risks? Don't banks fail because they have bad assets to begin with?
Well, yes. The assets of failed banks typically are of questionable quality. The failed bank knows that, the buying bank knows that, and even the FDIC -- the government agency that manages the failed bank post-mortem -- knows that.
Mitigating all the risk
To make these acquisitions more palatable to banks, the FDIC will negotiate a loss-share agreement, promising to limit the downside risk the bank faces on those sketchy assets. The exact amounts of the guarantees vary, but they are designed to be just sweet enough to allow deals to get done.
Too good to be true? Nope! These agreements come standard on most deals involving failed banks. The idea is pretty straightforward. The FDIC doesn't want to operate a failed bank; it would much prefer to sell the troubled institution to another, stronger bank. But stronger banks are strong for a reason: They don't mess around with assets that are likely to fail.
Thus the loss-share agreement was born as a solution to this problem. The FDIC agrees to cover a certain percentage of any losses incurred from those assets from the failed bank. The acquiring bank can now minimize (and quantify) the risks from the failed bank, making the acquisition much more palatable. At the same time, the FDIC removes the uncertainty of the failed bank's assets and can now sell the bank for a higher price. That offsets the FDIC's costs to insure the deposits of the failed bank. It's a win-win.
Bank of the Ozarks' loss-share agreement
According to Bank of the Ozarks' most recent quarterly filing with the FDIC, about 10% of the assets covered by the agreement -- the really sketchy assets, including foreclosed houses, failed construction projects, and a ton of nonperforming commercial real-estate loans -- are foreclosed, and another 10% are loans that are more than 90 days past due. As far as loan portfolios go, that is really ugly. In total, about $277 million of assets are covered by the loss-share agreements in place.
So Bank of the Ozarks had a government guarantee of 80% on any losses incurred on those ugly loans and foreclosures. Why, then, would Bank of the Ozarks negotiate an early end to that loss-share agreement with the FDIC, as it did recently? The bank even agreed to pay fees to the FDIC just so it could back out of the contract.
I see two reasons, both of which are related to Bank of the Ozarks' obsession with keeping expenses as low as possible. The first reason is that the bank is rapidly shedding these assets. The bank got rid of 30% of its covered assets in the first nine months of 2014. Since the fourth quarter of 2011, those assets are down 69% -- that's over $600 million.
Second, and more importantly, I think the bank's management is tired of paying, quarter after quarter, for the complex audits, accounting, and account management required by the loss-share agreements.
Often, the only way to get rid of a failed construction project is to invest the capital to finish it, on the bank's dime. And if the bank holds a large portfolio of foreclosed single-family homes, it's on the hook to pay insurance on those homes, to maintain their curb appeal, and to pay property managers, brokers, and appraisers to constantly market and manage the bank's accounting requirements. Then toss in swarms of independent accountants and consultants to monitor the portfolio for the FDIC; those professionals cost a pretty penny.
These expenses add up to millions of dollars every single year. That kind of money moves the needle, even with Bank of the Ozarks' $6.5 billion in assets.
Now that the Bank of the Ozarks has endured the battles of the financial crisis and the recession, it can exit from these "wartime" agreements, shed some expenses, and focus on moving the bank onward and upward.