Why are bank foreclosures of loans to builders now escalating? Why are banks foreclosing on builders with perfect records?
These are the questions raised in a Naked Capitalism post in response to a New York Times article, Banks Foreclose on Builders With Perfect Records. Here is what I think is going on:
Why Now? You can’t foreclose on a loan that’s not in default. Virtually all land, development, and construction loans are structured so that the borrower’s cash goes in first, and enough loan funds are set aside for interest reserves so that no additional cash from the borrower is required during the term of the loan. So, there were many deals which were clearly going to have problems which weren’t actually in default until the reserves ran out. Also, many of the deals which matured early in the collapse appeared to have equity a year ago (based on appraisals using pre-collapse comparables) and were restructured to provide additional interest reserves in the hope the market would recover. The result is there are now a lot of deals which are clearly upside down and which need to be marked to market. If a bank needs to mark to market there is not much reason to forbear from foreclosure.
Why Foreclose on Builders Who Have Perfect Records? Most builders of any size have relationships with more than one bank (the case cited in the NYT story involved GMAC and JP Morgan Chase pursuing a builder). And almost all of these types of loans have guarantees. If a builder has some viable assets, it’s very tempting for the first lender who has a maturing loan which is upside down to foreclose and go after the guarantor for the shortfall. It’s a classic Prisoner’s Dilemma problem. If GMAC and JP Morgan Chase cooperated, the overall recovery would probably be higher, but there is an incentive to be the first defector. Often, Prisoner Dilemma situations are iterative and reach a cooperative equilibrium because the parties know they will play the game more than once (for example, a vendor won’t cheat a buyer who is likely to be a repeat customer). In this case, banks are fighting for survival and it’s not clear they will be around to play the game again.
The difficulty of achieving cooperation compounds when the number of creditors increases. This is a Tragedy of the Commons problem, where the builder’s resources are the common resource. Again, cooperation is difficult to achieve.
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