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Saddled With Bank-Owned Properties? Try Financing the Buyers of Your REO

As financial institutions across the country confront mounting piles of repossessed properties, Sovereign Bank in Dallas is using an unusual strategy to clear its inventory and clean up its balance sheet.

The $760-million-asset bank is giving financing to the buyers of these properties money they would have a hard time finding elsewhere. Nonperforming assets get replaced on the books with performing ones overnight.

Though Sovereign's holdings of "other real estate owned" more than doubled from a year earlier, to $10.9 million at March 31, Roy Salley, its chairman, said that last quarter it unloaded $6 million worth of these properties, taking nominal hits, by funding the buyers.

"With the constraints in the financial markets, banks are going to have to finance their way out of some of these," Mr. Salley said. "I think that is going to become a prevalent tool to get nonperforming assets off balance sheets. It's still on the balance sheet, but they are performing, and we are still earning interest on it." Former regulators said the strategy can be iffy, especially if real estate prices continue to deteriorate and the new borrower has not put up enough equity.

"Regulators are going to look at transactions and make sure banks are not taking one problem and turning it into another one," said Samuel P. Golden, the head of Alvarez & Marsal's financial industry advisory services and a former ombudsman at the Office of the Comptroller of the Currency.

Though he was not familiar with Sovereign's deals, Golden said, as a general matter, "banks need to make sure their borrower has enough staying power because you don't want to end up with a bigger classified asset than you started with."

In a notable recent precedent, Merrill Lynch & Co. (which Bank of America Corp. bought at the beginning of this year) financed 75% of the $6.7 billion purchase price for a portfolio of collateralized debt obligations Lone Star Funds bought from it last September.

The portfolio had a face value of $30.6 billion, and Merrill's only recourse for the loan was the portfolio itself.

Randall James, a banking consultant and former Texas bank commissioner, said seller-funded loans can be good loans to make if the buyer puts some money into the deal.

"If there is money down and the credit is good, then it makes sense," he said. "Bankers are looking for people to put up their good name and credit and take some of that off their books and make it quick. Still, it can be a ticklish deal in today's market because the ultimate buyers aren't there."

Mr. Salley said Sovereign has been staying within regulatory guidelines by requiring buyers of its seized properties to put up at least 20% of the purchase price.

The bank recently sold 210 finished but unbuilt lots in Fort Worth to LGI Homes in Conroe, Texas.

Sovereign funded a loan to the homebuilder for the land purchase and a line of credit for construction.

"When I went to meet with the president of the bank, I said, 'We don't have to talk about price unless you are willing to provide financing because I can't do it without financing,'" said Eric Lipar, LGI's chief executive officer. "We're starting 15 houses this week."

Mr. Lipar said his company bought the lots for 80 cents on the dollar.

Industry watchers said many banks are getting to the point where they realize pricing will not bounce back as quickly as they had thought so that moving properties off the balance sheet now makes more sense than holding them.

Several observers said another rare strategy that they expect to become more common among community and regional banks is creating a limited liability company to hold troubled assets.

Steve Brown, the president and chief executive officer of Pacific Coast Bankers Bank in San Francisco, called this a variation on the "good bank, bad bank" strategy of the 1980s and early 1990s in which bad assets would be moved off the books into a newly formed corporation so they could be worked out over time.

(This year, Citigroup Inc. hived off a collection of noncore businesses and $301 billion of loans, securities and unfunded commitments subject to a loss-sharing agreement with the government into a repository it dubbed Citi Holdings. It said the move would help it shrink and simplify.)

This time around, Brown said, instead of corporations, banks are creating LLCs because they serve the same purpose and are quicker and easier to form.

"It's a refined technique," he said. "It is essentially 'good bank, bad bank,' taking problem assets on bank books and transferring them somewhere else that can handle them for a longer period of time than you can on a bank's books."

In one variant of the LLC strategy, private-equity investors put cash into the new entity, equal to 5% to 20% of the assets' value.

Mr. Brown said this is likely to be an attractive option for many banks that are looking to clean up their balance sheets. "We are nearing a precipice where banks are going to do it to get it out and off their books," he said.

Banks will have to come to terms with where the property is now valued, he said. "We will get through the summer and then you will see more of it accelerate."

Golden of Alvarez & Marsal said his firm is advising banks on the process of forming LLCs and how to handle nonperforming assets.

Jim Gardner, the chairman of Commerce Street Capital LLC in Dallas, said community banks he is talking to cannot justify the legal costs of forming a new company to hold problem loans.

So instead, they are leaving problem assets on their balance sheets and treating them differently, he said. "They put a circle around them and ask the regulator to look at the assets with a circle around it instead of as individual assets."

"If the total isn't impaired, then maybe you don't have as bad of writeoffs as you do if you have to write each one down if it fails to meet the regulator's tests."

The OCC and Federal Deposit Insurance Corp. did not return calls seeking comment.

Sovereign also sees additional opportunities for using the LLC, but for different purposes. Mr. Salley said he has plans to raise $75 million to $150 million. His bank would use about three-quarters of the money to fund an LLC that would house bad assets from failed banks it hopes to buy from the FDIC. Marissa Fajt is a reporter with American Banker