Sunday, November 9, 2008

Workouts 101: Hold'em or Fold'em?

Income property workout people have been idling for many years now, but it looks like those days are over. This seems an opportune time for a series of posts outlining what I learned the last time around (1989-1994).

I will be laying these rules out in a series of binary choices - one or the other, true or false, yes or no. Obviously, there are a lot of moving parts to every income property workout, and it is tempting to try to weigh all the factors which could influence the outcome (formally, this is a Bayesian approach). The binary approach seems simplistic, but there is compelling evidence it can lead to decisions almost as good as more complex rule systems, and it's much simpler (important when you're up to your waist in alligators). If you want to delve into this topic further, a couple good books are Simple Heuristics That Make Us Smart by Gerd Gigerenzer and The Either/Or Investor by Clark Winter.

So, Hold'em or Fold'em? Although this decision applies at the individual loan level too, first the decision needs to be made at the portfolio level, i.e., do I liquidate the portfolio as quickly as possible (through a portfolio note sale, for example), or try to maximize value working out individual loans? There is no right answer - subsequent events which are unknowable at the time of this decision will determine whether or not the right decision was made, and even later the answer may not be clear. Here are some implications of an immediate liquidation:

  • Liquidation will almost certainly result in a higher immediate loss than holding the portfolio. The buyer is going to make a determination of the value to be realized from working out the portfolio, and this is almost certainly going to be less than the value a lender might reasonably justify to a regulator. For example, a lender might mark a loan to the value of the underlying collateral, but a buyer of the distressed note will start with the value of the collateral and then deduct a further haircut for the risk and time required to realize that value.
  • Since an immediate loss is involved, you probably wouldn't liquidate the portfolio unless you believed the market was going to continue to fall for a material time period. If the market turns around shortly after the sale, the buyer will have a windfall and the seller will have an unnecessary loss and will look stupid in the bargain.
  • It is much easier to make the decision to dump a portfolio if you were not around when it was originated. Prior involvement creates all kinds of biases which tend to keep people in situations once they've committed to them (see endowment effect, post-purchase rationalization, status quo bias, sunk cost effects, loss aversion, optimism bias, and valence effects). If you're the guy who is brought in to clean up the mess, it's much easier to attribute the problem (and the loss you take from the liquidation) to the old regime and move on.
  • Frequently if your organization is publicly traded the market has already built in the full loss (and maybe more) into your stock price, and a liquidation will actually improve the value of your stock (see, for example, SL Green's divestiture of their interest in Gramercy). This has some interesting implications if you are working out debt with a publicly traded borrower. You might assume they are interested in maximizing value, while they might see more value in dumping the collateral and disassociating themselves from the problem.

To summarize, although liquidation might result in a large immediate loss, there are some compelling reasons to consider it. This is especially true if it looks like the downturn is going to be protracted (as it does this time around). So why aren't many lenders liquidating their positions now? I think at this stage it's because there have not been senior management replacements at many institutions, and because many institutions cannot afford the hit.