The Hidden Costs of a ‘Successful’ Workout

A full payoff on a troubled loan can feel like a clear win. Principal is back, accrued interest and fees are recovered, and in some cases the bank even books incremental income when the difference between legal balance and book balance reverses. But industry veteran Jason Alpert argues that banks should be more careful about how they define success in a workout. 

His point: Time and capital have costs, and distressed loans can quietly destroy shareholder value even when they eventually pay off in full. 

A few key themes: 

The real drag often starts well before a loss is realized. Once a loan is downgraded, the bank’s accounting system must increase its allowance for credit losses. That increase runs through earnings via the loan loss provision and appears on the balance sheet as a contra-asset. Under CECL, this effect arrives even sooner because banks must reserve for lifetime expected losses “as soon as a loan’s risk profile deteriorates,” even if the borrower is still paying as agreed. 

A performing loan can still become far less profitable. Alpert’s example is a $10 million commercial loan booked at a fixed 6% rate with a 3% cost of funds. At origination, the economics are solid. But if the loan is downgraded to criticized status and the reserve requirement rises from 1% to 3%, the additional allowance materially changes the economics. Interest income stays the same, but the effective cost of capital rises, pushing the loan closer to breakeven—for as long as troubles at the borrower persist—even before added servicing or workout costs enter the picture. 

The economics can get much worse in distress. Reserve growth is often exponential as loans move into substandard or non-accrual categories. In his example, a reserve of 15% on a non-accrual loan ties up more than $1.5 million in loan loss reserves. Combined with the bank’s original cost of capital, the result is a distressed asset that is “losing” about $100,000 per month to carry. 

Time is not neutral in a workout. Workout loans are “notorious for taking longer to resolve than expected,” whether the path is refinance, restructuring, or Chapter 11. Every extra month adds economic cost through legal fees, protective advances, management time, and lost opportunity cost. Alpert adds that if a relationship manager is also acting as workout lender, the bank must account for the time that banker is not spending “out generating new business.” 

The takeaway: Alpert’s warning is that the “cleanest payoff” is not always the best outcome. “Your first loss is your best loss” may sound harsh, but his larger point is that workout strategies should be judged on a net present value basis. A full payoff, if it takes too long and ties up too much capital, can become “a Pyrrhic victory that quietly destroys shareholder value.”