Bankers should see bond market as solution to woes.

While segments of the Southern California economy are at last showing signs of recovery, one area still dealing with the recession and its aftermath is the commercial banking industry. Spurred by the need to improve profits and to comply with tougher capital requirements, bankers continue to write down and sell off underperforming real estate assets, mostly to so-called "vulture" funds and other bottom feeders.

In their rush to unload their classified loan portfolios, however, many Southland bankers are overlooking the potential rewards that could come from creatively restructuring and hanging onto these assets, at least until they begin performing at a level that would facilitate their eventual sale at a premium.

Now that the sell-off appears to be abating, some banks are finally taking the time to investigate and employ various new portfolio retention techniques developed recently by a number of investment banking firms.

The goal of these new techniques is not only to allow a bank to keep its real estate portfolio, but also to enhance its value prior to sale.

For example, First Interstate Bank of California recently restructured a $61 million portfolio of multi-family housing revenue bonds which helped pay for apartment projects whose developers have since had financial problems. The solution involved converting the fixed-rate bonds to cheaper, "floating rate" bonds adjusted on a weekly basis. In addition, a collection account was created to divert a portion of the cash flow from the multi-family projects to the bank, which in turn was applied toward the principal.

The result? A portfolio that was performing at less than 0.8 debt service coverage (where income after expenses is only 80 percent of the amount required to pay the mortgage) is today performing at better than 1.75, reports Michael Morris, vice president of First Interstate's Diversified Assets Group. "It was a highly innovative solution which required us to better understand the economic and accounting benefits that would result from the various techniques," Morris says, adding that First Interstate is now working on additional portfolios.

In another situation, California Federal Bank recently found itself exposed on a $16 million letter of credit used to guarantee the financing on a real estate limited partnership put together by Shearson Lehman in the mid-1980s. Debt service coverage on the underlying real estate had fallen below 1.0, and a year-long search for new credit enhancement proved fruitless.

The fact that bonds backed by the letter of credit would trade at less than investment grade without a higher-grade confirming letter of credit provided just enough challenge to the financing team. With the promise of interest rate caps, weekly "floaters" hovering near 2 percent and a pledge of additional cash collateral, Cal Fed became convinced that an attempt at restructuring was preferable to an almost certain foreclosure and bankruptcy.

Ultimately, Cal Fed received a restructuring fee, an increased letter of credit fee, some principal pay-down, and a new credit that serviced the debt at better than 2.0. "We were skeptical at first, but as the pieces came together, I became convinced that we could substantially improve our position," says Cal Fed Vice President John Searock. "Our efforts were rewarded not only with improved debt service coverage, but also accelerated reduction of principal."

Other banks are considering even newer products, such as fixed-rate adjustable maturity bonds ("frames") and conventional-to-bond mortgage "flips," both of which are designed to improve a bank's credit position. Although the bond markets provide an almost limitless palette of such options, many large money center banks are reluctant to employ such new techniques, which often conflict with their conservative corporate cultures.

Restructuring can also result in reduction or elimination of a bank's exposure to real estate risk through the use of "tiered" bond instruments. In the near term, high-yield bond funds have a growing appetite for bonds that are not backed by a credit enhancer, but instead offer stronger debt coverage, as well as a higher coupon rate. To the extent a bond fund can diversify its risk, tax-exempt yields on such bonds can exceed 10 percent, with only nominal principal exposure.

A tiered, unenhanced bond structure can be used to refund a letter of credit-backed bond issue, or to leverage a bond fund's rate of return. The better tiers can be sold rated, but without enhancement; medium tiers can be sold to a high-yield fund; and the credit provider need only retain the riskier portions of the financing, resulting in as little as 5 percent of the original exposure.

In many instances, a bank may lack sufficient credit to support an investment-grade bond, or such a grade would produce unacceptably high interest rates. In response, several domestic and European banks with highly marketable credit ratings have seized the opportunity to "wrap" (use their strength to guarantee) the credit of a weaker bank.

The result can be a win for both, particularly when the net interest rate is less than the weaker bank's trading range, minus the cost of the wrap. Even in cases where the cost produces a zero net gain, using a wrap can still be attractive. When markets weaken, for example, buyers tend to flee weak credits, turning a zero-gain situation into a major plus overnight.

As bond buyers scurry for higher yields, more opportunities exist for banks and other credit providers to reduce their exposure through restructuring of their own assets. During the past several years, they've done a good job of selling real estate and conventional mortgage loans to funds and private investors. As the supply of such assets dwindles, however, more creative bankers would do well to investigate reducing other forms of exposure via the bond markets.

Rosenthal is a principal overseeing the real estate restructuring practice at Los Angeles-based Saybrook Capital Corp., an investment banking firm specializing in debt financings.