“Evidence” on the Foreclosure Crisis

Stan Liebowitz, an economics professor at University of Texas, Dallas, has an op ed piece in the Wall Street Journal touting the results of research he has done using “a huge national database containing millions of individual loans”. His conclusion:

The analysis indicates that, by far, the most important factor related to foreclosures is the extent to which the homeowner now has or ever had positive equity in a home.

My first reaction was, like Barry Ritholtz, “Duh”. If you have equity in your home and can’t pay your mortgage, you sell the home, pay the loan off and pocket the equity. Equity = No Foreclosure.

But, (as Barry also notes), the piece is weird:

A simple statistic can help make the point: although only 12% of homes had negative equity, they comprised 47% of all foreclosures.

Time out; that means 53% of all foreclosures are on homes that have equity. Does that sound right to you?

The accompanying figure shows how important negative equity or a low Loan-To-Value ratio is in explaining foreclosures (homes in foreclosure during December of 2008 generally entered foreclosure in the second half of 2008).

I think these are all legitimate contributing factors, but I question some of the conclusions Liebowitz draws. For example:

To be sure, many other variables -- such as FICO scores (a measure of creditworthiness), income levels, unemployment rates and whether the house was purchased for speculation -- are related to foreclosures. But liar loans and loans with initial teaser rates had virtually no impact on foreclosures, in spite of the dubious nature of these financial instruments.

Anyone involved in the crisis can tell you the liar loans and low teaser rate loans were the first to default. You wouldn’t expect to see many of them left by the second half of 2008 (survivorship bias at work).

Also, this a very mixed bag of contributing factors. Negative equity is a factor at the time of default (do I sell the property or allow it to be foreclosed?). A low down payment and a low FICO score are factors at origination. The unemployment increase in 2008 and rate resets happen after origination and before foreclosure. If I’m a low FICO score borrower with a low down payment, a rate reset, no equity, and I lost my job, what caused my foreclosure? Regression analysis can parse out the first four variables if done correctly, but how does the fifth variable enter into the equation? I suspect Liebowitz’s analysis is flawed, especially since he concludes more than half of foreclosed properties have equity.

Hoping for some answers, I checked out Liebowitz’s home page. There’s no reference to this research, and precious little on real estate at all (mostly copyright stuff). If one uses the word “evidence” in one’s title, shouldn’t the evidence be available?

I agree with many of Liebowitz’s conclusions, but it would be nice if they were coherently supported. Also, it’s depressing that some many bloggers have uncritically endorsed the piece without question.

Workout Strategies: “The Boss has Lost It!”

Suppose you were the only wealthy member of a very large extended family. A kidnapper takes a niece – would you pay the ransom? Of course you would. The next week the kidnapper takes a nephew, and you pay again. The third week a cousin is taken, and you realize as wealthy as you are, you can’t pay for everyone’s return. How do you break this cycle?

For lenders, loan modifications are like this. If you go strictly by the numbers, a lender will almost always lose more from foreclosing on a property than by modifying the loan. Going strictly by the numbers, however, is a slippery slope for lenders, because if borrowers believe you will always modify, you will end up modifying every loan. How do you deter the threat of default if borrowers believe you will always modify the loan to avoid a default?

One strategy is to act crazy. Ethan Bronner believes this was the strategy Israel adopted in it’s assault on targets in Gaza in December, 2008 and January, 2009. From his January 18, 2009 New York Times article, “Parsing Gains of Gaza War”:

The Israeli theory of what it tried to do here is summed up in a Hebrew phrase heard across Israel and throughout the military in the past weeks: “baal habayit hishtageya,” or “the boss has lost it.” It evokes the image of a madman who cannot be controlled.

“This phrase means that if our civilians are attacked by you, we are not going to respond in proportion but will use all means we have to cause you such damage that you will think twice in the future,” said Giora Eiland, a former national security adviser.

I would be surprised if any lender had an explicit policy to file irrational foreclosures or seeks deficiency judgments solely as a deterrent to other borrowers. But, modifications are generally the exception and not the rule, and the signal an action sends to other borrowers is always a consideration.

Why Are CMBS Multifamily Delinquency Rates So High?

The 60 day delinquency rate for multifamily CMBS loans is skyrocketing. From a Fitch release:

Declining performance, particularly in oversupplied markets, as well as in secondary and tertiary markets, has pushed the multifamily delinquency rate to 4.55%, the highest of all property types. Multifamily properties have been highly susceptible to default in CMBS during the current economic downturn.

Fitch seems to suggest the problem is the asset class, but there’s something else at work – delinquency rates on Fannie and Freddie multifamily loans are less than a tenth of the CMBS figure. From an MBA release on June 2:

Fannie Mae: 0.34 percent (60 or more days delinquent)
Freddie Mac: 0.09 percent (90 or more days delinquent)

Why are the agency loans performing so much better? I think there are several factors at work, but the main reason is the originators of Fannie Mae and Freddie Mac loans had much to lose by selling bad loans to the agencies.

Most of Fannie’s multifamily business has been originated through their Delegated Underwriting and Servicing program. Fannie agreed to buy multifamily loans which were within their underwriting parameters without prior review. The originating lenders retained the top 5% loss exposure, and shared losses after that to a maximum of 20%. A very limited number of lenders were allowed to participate (never more than 30 nationwide). Sell a bad multifamily loan to Fannie under the DUS program, and you not only shared in the loss, you risked losing a valuable franchise.

Freddie took a different approach. They didn’t require originating lenders to share in the loss, but the ability to sell to Freddie was if anything even more tightly controlled, with a limited number of lenders restricted to specific geographic areas (see current list here). Again, sell a bad loan to Freddie, and you risk losing your franchise.

By contrast, CMBS origination was wide open. But, that may be changing. The lead story in yesterday’s Financial Times:

Treasury plans strict rules for securitisation

The US Treasury is planning a sweeping overhaul of securitisation markets with tough new rules designed to restore confidence by reducing the incentive for lenders to originate bad loans and flip them on to investors…

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared.

Would such a rule have prevented bad CMBS loans? Probably not; I believe the risk of franchise loss was a much more important determinant of lender behavior. But, it’s a start.

How Much REO Should A Lender Have?

Bubble Meter notes this story from Business Week:

Buyers looking to purchase foreclosures should still have plenty of opportunities. Only 30% of bank-owned properties are listed on the multiple listing services, says Rick Sharga, senior vice president at foreclosure listing firm RealtyTrac. He figures banks still own as many as 500,000 properties that they want to sell but haven't put on the market.
A home many not be listed because the bank is wrestling with title, repair or owner right of redemption issues. (Several states such as Michigan and Wisconsin give the previous owners the chance to buy back a home that's been foreclosed on). Banks may also be holding houses off the market because selling them now would lower prices even further. Foreclosures typically sell at a 31% discount to similar homes whose owners aren’t in distress. Listing all those homes now, Sharga says, “would have a devastating impact on inventory and pricing." ...

Let’s take the last idea first. No doubt listing a lot of REOs at once does have a negative impact on the market. But, the idea that lenders are holding properties off the market to maintain prices suggests a level of cooperative action for the collective good which I don’t think is occurring.

Having 70% of your REO inventory sitting around unlisted sounds bad, but is it really? There’s always going to be some down time between the foreclosure sale and the listing (evictions, cleaning and painting, etc., say 45 days). Once it’s listed, say it takes 60 days to sell. Then, it takes a while to close (say 60 days). Taking into account these factors, what percent of your inventory at any given time will be listed?

A high percentage in the list stage probably means the properties aren’t moving because the list price is too high. If you’re running an efficient REO shop, having 30% listed at any given time sounds about right.

Given the inventory of homes for sale, is it possible to sell an REO in 60 days? Apparently it is in Phoenix. The NYT, via Calculated Risk:

The low end of the real estate market [in Phoenix] — and in some equally hard-hit places like inland California and coastal Florida — is becoming as wild as anything during the boom.
One real estate agent was showing a foreclosed house to a prospective client when a passer-by saw the open door, came in and snapped up the property. Another agent says she was having the lock changed on a bank-owned home when a man happened by, found out from the locksmith that it was available, and immediately bought it. Bidding wars are routine.

The New Yorker had an interesting story in their April 6, 2009 issue on the experiences of a broker in LA specializing in REO sales (abstract here).

The Problem With Partners

From Luke Johnson’s column in the Financial Times, “Time of Trial Brings Out Our Litigious Side”:

The truly vicious [lawsuits] are those where professional partners have a dispute…Falling out can arise through envy, through desperation, through honour, and a feeling that some are not pulling their weight. Writs are being served all over the place for non-payment of debts, warranty claims over failed acquisitions, unfair dismissal and who knows what. The air is thick with recriminations and resentment, as the Great Recession leaves lots of people broke, unemployed or looking stupid and out for revenge.

Partnerships in various forms (general partnerships, limited partnerships, limited liability companies, tenancy in common) are very common ownership structures in commercial real estate. Sometimes they represent equals pooling resources to acquire and operate properties larger than the individual partners could acquire on their own. More often, the partners bring different things to the table; for example, investors with money but without a lot of real estate expertise invest funds with a general partner that has expertise but not a lot of money.

This all works well until it doesn’t. When a property severely underperforms, few partnerships survive. If additional cash is required, the money investors often balk or expect the general partner to contribute an equal amount or step aside. Even if contributing additional cash to save the investment makes sense, too often partnership differences prevent an economically rational solution.

Lenders often depend on the financial strength of the investor partners, and don’t realize that more often than not the money partners will not support a deal when they’ve lost confidence in the general partner. The greater the number of partners, the greater the difficulty. The sad story of DBSI (see this link) is an extreme case which is being repeated on a smaller scale on a daily basis.

The safest ownership structure is a single experienced, financially strong operator. If you can’t have that, a partnership of equals is your best bet. Partners with unequal resources are their own source of trouble when the going gets tough.

What Should Lenders Do With Maturing CRE Loans?

We’ve had some conversation in the comment thread on this post about what lenders should do with maturing loans. Today I will attempt to address that question in more detail, starting out with what I would do if it were my money, and moving on to some of the reasons lenders adopt different strategies.

Foreclose on properties the borrower is driving into the ground. At this point in the cycle there is no point in giving an extension or modification to a borrower who is taking actions (or inaction) which is hurting the value of the collateral. A recovery is not imminent, and if a borrower is deferring maintenance or is ineffective at leasing the property, an extension will just result in a bigger loss down the road. This situation can come about for a variety of reasons, and often  the borrower is not the villain. Usually, it’s because a borrower is under severe financial pressure on other deals, or lacks the experience to deal with difficult market conditions.

Foreclose on properties when the submarket is in a downward spiral. No matter how good a borrower is at property operations, it is very, very difficult to compete when you owe $100,000 a unit on a property and the building next door has gone through a foreclosure and the owner next door only owes $50,000 a unit, because the new owner can substantially undercut your rents and still get a good return. For an example with numbers that shows how this works, see my post CRE Loans and the Death Spiral of Doom. If your property is in a submarket with multiple foreclosures in process you will probably minimize your loss by foreclosing too.

Extend loans which have experienced, solvent borrowers in relatively stable submarkets when the property can pay a reasonable interest rate. You want an experienced borrower who is not tapped out because fundamentals will probably get worse before they get better, and you want someone who can make the right decisions and kick in some cash if necessary. You don’t want to be in a downward spiral submarket for the reasons discussed in the paragraph above. To keep the borrower motivated, you need to offer an extension long enough to get through this part of the cycle (2 years minimum, 3 or 4 more likely). A reasonable interest rate is hard to define in this market, but I think the best structure is a floating rate deal around 3% over your cost of funds, which, if you’re a bank, will probably result in a rate of 4% to 5%. I would keep the structure interest only, but require 50% of any excess cash flow to go into a reserve account to cover operating deficits, capital costs, and perhaps pay down principal if the reserve account reaches a threshold level (maybe 5% of the loan amount). This structure gives you a reasonable return, gives the borrower an incentive to maximize cash flow, and gives you both a piggybank to draw from if conditions continue to deteriorate.

These are the strategies which I think would give you the best recovery on individual deals. However, not all banks and investors pursue them, for a variety of reasons.

The lender or investor wants out of the asset class. Right now banks and institutional investors pay a price in their market value and ability to attract new investors if they have heavy CRE exposure. There is a lot of value created if you can say a problem is behind you. To create this value, the lender sells notes or forecloses on deals for less than they might realize with a hold strategy.

Regulatory Direction. Many banks are under pressure to reduce their CRE exposure. An REO may create a loss, but at least the asset is gone. A modified loan, on the other hand, will be reviewed by examiners every time.

Your First Loss is Your Best Loss. Many lenders follow this strategy on all loans until it is clear a recovery is underway (more detail here).

Avoiding Second-Guessing. Many modifications don’t work out (see this post on single family modification failures; in my experience the CRE modification failure rate is even higher). If you modify the loan and end up taking the property back anyway it’s probably because conditions have continue to deteriorate and you will recover less than you would have if you had foreclosed to begin with. It’s easy to quantify that loss, and it looks like poor judgment. On the other hand, if you foreclose, no one will quantify how much you could have saved by modifying the loan.

Pooling and Servicing Agreement constraints. If the loan is a CMBS loan, the servicing of the loan is governed by a Pooling and Servicing Agreement. Generally, in a maturity default the special servicer is charged with maximizing recovery for all investors. Although this could mean doing a long term extension at a lower interest rate, given that there’s an excellent chance the investors that actually own the loan may want out of the asset class or believe in the “first loss is the best loss” strategy, a special servicer is vulnerable to second guessing. Foreclosure is a safer strategy. Thompson Hine has a good summary of CMBS modification and extension procedures here.

Dual Track Costs. Many lenders will not begin negotiation until there is an actual or imminent default. This may be a function of a Pooling and Servicing Agreement, or the lender could just be hoping the borrower will find a way to pay the loan off. Once a default happens, many lenders will start the foreclosure while negotiating an extension so no time is lost if an agreement is not reached. This adds costs, and frequently at least some payments are not made because the borrower is also not sure an agreement will be reached. As a result, to close the extension frequently a substantial amount of money needs to be paid, and borrowers sometimes decide to walk at that point.

Workload. Modifications are enormously time consuming. The deal needs to be negotiated, approved, and documented, and frequently multiple rounds occur. A complex deal can be a full time job for an asset manager for months. It is much simpler from an asset manager point of view to foreclose. If the justification for a modification looks marginal or the borrower is difficult, this factor can swing the recommendation to foreclosure.

Given all these hurdles, it’s not surprising few long term extensions are done. If an extension is offered, it’s usually short term (90 to 180 days) and predicated on progress being made towards marketing or refinancing the property.

CRE Problems: Rate Structure, Maturity, and Vintage

Zero Hedge’s post, “The Special Servicing Problem,” talks about the ballooning transfers to Special Servicing status. The post includes a table of large CMBS loans which have been transferred, which I think gives a nice snapshot of the types of loans which are in trouble:

(Click on image for a larger version in a new window)

Rate Structure. The only floating rate loans in this group are loans which have matured. Given the very low floating rates today, we are not going to see many payment defaults, but given the decline in values, tightening of underwriting standards, and lack of financing available for CRE deals, many floating rate loans can’t be refinanced or sold for the outstanding loan balance at maturity.

Maturity. There are four loans in the group which are five years or older (i.e. originated before 2005). All of these loans have matured. There are not many old loans in the table because many older loans were successfully refinanced during the boom years. The remainder were underwritten conservatively enough that they have been able to make their payments, but in the current environment they can’t be refinanced or sold without a loss.

Vintage. The vast majority of the loans in the table are fixed rate loans underwritten in 2005-2007, at the peak of the market and when underwriting standards were weak. With the decline in fundamentals these loans are having trouble making their payments, and can’t be refinanced or sold.

It may be possible to work out the first two groups with term extensions. The only hope for the last group would be a drastic reduction in the interest rate (for example, switching to a floating structure).

Successful, Until You Aren’t

Lansner on Real Estate reports Pacific Property Assets has defaulted on the interest payment due on $90,000,000 in notes held by its investors. PPA has a 2,400 unit multifamily portfolio in Southern California and Arizona. Some excerpts:

Company CEO Michael Stewart said interest payments on about $90 million in notes would be suspended for an undetermined period, adding that he’s hoping investors will bear with the firm to give it “breathing room…”

“We’ve never missed a payment in over 10 years. It’s probably the toughest decision (we’ve made),” Stewart told the Register.

The fact that no payments were missed for ten years doesn’t mean much. I was Chief Credit Officer at ARCS Commercial Mortgage from 1997 to 2006, during which time we originated about $2B a year in multifamily loans with virtually no delinquencies, foreclosures, or losses. I would love to believe that was a result of my stellar judgment, and maybe it was. But, I’ll never know for sure, because during the time I was there any bad decisions I made were bailed out by declining interest and cap rates. Periodically, someone would complain we should do a risky deal I had turned down, because the fact we had no defaults indicated we weren’t taking enough risk. My response was that if the average CRE default rate was 2%, that was arrived at by 9 years of no defaults and one year of 20% defaults.

Commercial real estate performance, to paraphrase the quotes about airline travel and war, is years of boredom punctuated by periods of terror. If you’re a CRE investor who never missed a payment between 1995 and 2008, that puts you in the same class as 99% of all CRE investors. If you never missed a payment between 1979 and 1982 or between 1990 and 1994, I’m impressed. I expect 2009 to 2012 will be another period where never missing a payment will be something to brag about.

One of my grandmother’s sayings was “You don’t know if your roof leaks until it rains.” It hasn’t rained hard in the CRE world since the early 1990’s, and many lenders and owners (like Mr. Stewart) have assumed that, because they weren’t getting wet, they had a good roof.

Here’s a link to another story about Mr. Stewart during happier days just 8 months ago, in which he explains PPA’s decision to diversify into the Phoenix market (oops!), and how risks were lower in October 2008 than when he started PPA in 1999.

Problems Mounting in Orange County Multifamily

Lansner on Real Estate reports it’s taking twice as long to rent vacant units in Orange County, rents are falling, vacancies are rising, and landlords are looking the other way on tenant credit issues and cutting back on maintenance.

None of this is surprising; all these things go together in a softening market. But, it’s nice to see an article which puts all the symptoms of a soft market in one place. For more on the relationship between rents, vacancy, and turnover time, see Multifamily Occupancy Rates: Four Things to Think About. For a discussion of the nasty feedback loop cutting tenant credit standards and maintenance creates, see The Slippery Slope to Default.

General Growth Properties’ Bankruptcy: An Example of a Balance Sheet Default

I’ve previously posted on the difference between an operating statement default (when deteriorating income means a borrower can no longer service its debt) and a balance sheet default (when a maturing loan can’t be paid off through sale or refinance). General Growth Properties’ bankruptcy filing is a result of a balance sheet default. From their press release announcing the bankruptcy filing:

The decision to pursue reorganization under chapter 11 came after extensive efforts to refinance or extend maturing debt outside of chapter 11. Over many months, the Company has endeavored to negotiate with its unsecured and secured creditors to obtain the time needed to develop a long-term solution to the credit crisis facing the Company. Unable to reach an out-of-court consensus, the Company reluctantly concluded that restructuring under the protection of the bankruptcy court was necessary. During the chapter 11 cases, the Company will continue to explore strategic alternatives and search the markets for available sources of capital. The Company intends to pursue a plan of reorganization that extends mortgage maturities and reduces its corporate debt and overall leverage. This will establish a sustainable, long-term capital structure for the Company…

“Our core business remains sound and is performing well with stable cash flows. We believe that chapter 11 is the best process for restructuring maturing mortgage loans, reducing the Company’s corporate debt, and establishing a sustainable, long-term capital structure for the Company,” said Adam Metz, Chief Executive Officer of the Company. “While we have worked tirelessly in the past several months to address our maturing debts, the collapse of the credit markets has made it impossible for us to refinance maturing debt outside of chapter 11,” he said.

Look for many more bankruptcy filings on CRE properties by borrowers with similar goals.

Maturity Kills: Operating Statement Defaults Versus Balance Sheet Defaults

No question CRE rents are falling and vacancy rates are rising, and these trends are getting a lot of attention (see, for example, Calculated Risk posts here, here, and here, and Zero Hedge posts here, and here). However, this threat is minor compared to what’s happening on the balance sheet side of the business.

There are two ways a CRE loan defaults; an operating statement default, or a balance sheet default. Here is a typical CRE deal illustrating an operating statement default:

The assumptions are an initial interest rate of LIBOR+2.25% with a 30 year amortization, no changes in interest rates or cap rates, but a 25% decline in NOI. This results in negative cash flow, which could lead to a default (one would hope on a $10,000,000 deal the sponsor could cover a shortfall this small, but that capability is not something CRE lenders focused on). The takeaway point is, even with a major decline in NOI the shortfall is not huge, and because there is equity on the balance sheet the problem can be solved with a sale of the property.

Here is an example of a balance sheet default with the same structure, but a smaller decline in NOI coupled with an increase in cap rates:

Note that the operating statement side of the equation is fine; the borrower can still make the payments. However, the increase in cap rates has wiped out the equity in the property, and if the loan matures the borrower can’t repay it. The takeaway here is that cap rate changes have a much bigger impact than operating statement changes (for a more thorough analysis of this point, here’s a link to Philip Conner’s and Youguo Liang’s Income and Cap Rate Effects on Property Appreciation).

Here is what things are actually looking like for 2010 – a substantial decline in NOI and an increase in cap rates, combined with a substantial decline in interest rates:

Note that the operating statement is fine; the decline in interest rates more than offsets the decline in NOI, and cash flow has actually improved since origination. However, the decline in NOI combined with the increase in cap rates creates a huge balance sheet problem, and if the loan matures the problem can’t be solved with a refinance or sale of the property.

This is why there is so much concern over upcoming loan maturities. Here’s a link to a Deutsche Bank CRE presentation which goes into more depth (the maturity discussion begins on page 25).

This Time is Very Different: Attack of the Zombie Properties

The last time we had a severe CRE downturn was 1990 – 1995. For those of us who were around, the current situation feels similar – plummeting employment, deteriorating income fundamentals, spiking cap rates, and loss of liquidity in the market. However, there are some huge differences this time which have important implications.

First, some history. Here is a chart of cap rates taken from a paper by Philip Conner and Youguo Liang (Income and Cap Rate Effects on Property Appreciation, worth checking out):

Current value cap rates bottomed at around 6.7% in 1990, were around 8.25% in 1992, and peaked at around 9.5% in 1995. Based on the sales and appraisals I’m seeing and talk with colleagues, current cap rates seem to be in the 8% to 8.5% range, so today is somewhere around 1992 levels.

Now, let’s consider interest rates. A typical variable rate CRE deal in 1990 used an 11th District Cost of Funds index (COFI) plus 2.25%. An equivalent CRE deal in 2007 would have been priced at 30 day LIBOR + 2%. Here is how the interest rate would have changed on those two deals over the last 2 years:

Interest rates this time are much lower. In 1992, the cap rates were right around the interest rate, which meant a property with no equity also probably couldn’t make it’s payment. Today is much different; cap rates are 5.5% to 6% higher than the interest rate. This means a property could be severely under water and still make it’s payment. Here’s an example:

In an ordinary world, a property overleveraged to this extent would be foreclosed on and sold, but because interest rates are so low it can continue to make its payments.

What are the implications?

• CRE loans are collateral based, so under FAS 114 the bank probably needs to recognize the loss even though the loan payments are current. If the loan term is long enough, it’s possible the bank can make an argument the value will recover, and avoid recognizing the loss. But regulators and accountants these days tend to be pessimistic in their outlook, so the bank is probably stuck with recognizing the loss.
• If a bank attempts to foreclose on a basis other than a payment default (for example, loan maturity or a non-monetary covenant violation), the borrower will probably file bankruptcy. It is very difficult to obtain relief from stay and foreclose on a borrower willing to make their contractual interest payments (more on that here). So, the bank is probably stuck with the deal until interest rates go up and there is a payment default, unless they sell the note.
• If the bank sells the note for the collateral value, the return to the note purchaser is equal to the cap rate (in the example above, 8.25%). Note buyers are looking for returns in the 20% range, so these deals won’t appeal to them either.

I believe the result is we will have a lot of zombie loans on bank books, and a lot of zombie properties that are grossly overleveraged, but which can’t be cleared to market values because the borrowers can make the payments at today’s incredibly low rates.

Workouts 101: Bankruptcy Basics and the Problem With Non-Monetary and Loan Maturity Events of Default

CRE lenders who have led sheltered lives often believe the events of default listed in their deed of trust and loan agreements will allow them to foreclose on a property if a breach occurs. A material adverse change in the borrower’s financial condition? Unauthorized subordinate liens? The loan has matured? Let’s foreclose!

Sorry, it doesn’t work that way. Here are some bankruptcy basics (and I mean really basic; feel free to skip sections if you know about the topic headlined).

The Automatic Stay

If a borrower file bankruptcy, your foreclosure is automatically stayed. From the US Courts website, Bankruptcy Basics-Chapter 11:

The automatic stay provides a period of time in which all judgments, collection activities, foreclosures, and repossessions of property are suspended and may not be pursued by the creditors on any debt or claim that arose before the filing of the bankruptcy petition. As with cases under other chapters of the Bankruptcy Code, a stay of creditor actions against the chapter 11 debtor automatically goes into effect when the bankruptcy petition is filed. 11 U.S.C. § 362(a)… The stay provides a breathing spell for the debtor, during which negotiations can take place to try to resolve the difficulties in the debtor's financial situation.

Lifting the Automatic Stay

How do you get your foreclosure going again? You need to file a motion to lift the stay:

Under specific circumstances, the secured creditor can obtain an order from the court granting relief from the automatic stay. For example, when the debtor has no equity in the property and the property is not necessary for an effective reorganization, the secured creditor can seek an order of the court lifting the stay to permit the creditor to foreclose on the property, sell it, and apply the proceeds to the debt. 11 U.S.C. § 362(d).

It is very difficult to obtain relief from the automatic stay if there is equity in the property. The bankruptcy judge determines if there is equity or not based on evidence presented by the lender and the borrower. The lender presents an appraiser who thinks the value is low, the borrower presents an appraiser who thinks the value is high, and typically the judge decides somewhere in the middle. At this point in the cycle it is not hard for a borrower’s appraiser to support a high value given the value downturn has just started, so in most cases lenders will have a tough time getting relief from stay.

Adequate Protection

So you can’t foreclose. How long might this go on? The best case is for single asset entity real estate debtors (other debtors get longer to file a plan):

On request of a creditor with a claim secured by the single asset real estate and after notice and a hearing, the court will grant relief from the automatic stay to the creditor unless the debtor files a feasible plan of reorganization or begins making interest payments to the creditor within 90 days from the date of the filing of the case, or within 30 days of the court's determination that the case is a single asset real estate case. The interest payments must be equal to the non-default contract interest rate on the value of the creditor's interest in the real estate. 11 U.S.C. § 362(d)(3).

Bolding mine. This provision poses an obvious problem for non-monetary and maturity defaults – the borrower has been willing all along to pay you the interest payments. In fact, their plan will be to pay you your full contractual interest payments for a period they project will be required for the market to recover. That is a very confirmable plan, and as long as the borrower performs under it, no foreclosure.

So why do lenders put nonmonetary default provisions in their documents? In theory, they allow a lender to take action in a deteriorating situation before there is an actual monetary default. That works fine in a stable or rising market, because the threat of a foreclosure might motivate the borrower to sell or refinance. However, it doesn’t work well when the borrower has no exit.

The best use of non-monetary default provisions is to trigger an event other than foreclosure which enhances your security (for example, unauthorized liens often cause a non-recourse loan to become recourse). That might get you somewhere. Foreclosing on a matured loan or a non-monetary default rarely works out favorably for the lender in a declining market.

Workouts 101: Complete the Project!

If you have a construction loan in trouble, your focus needs to be on completing the project. Lansner on Real Estate tells the sad story of Atherton Newport’s Stonehaven development here.

An excerpt details the consequences of the project shutting down while on partially complete:

• After a year of standing idle, the development now is undergoing “forensic” inspections, examining the wood, the concrete slabs and the site to see what needs to be replaced and what can be salvaged.
• “There obviously is some weather damage and vandalism that has occurred,” Patton said. “Luckily, all the roofs are on.”
• Eight buildings have been standing with exposed wood framing and rusting nails. Seals around windows have been flapping in the wind, and drywall is stacked on floors inside the walls that have yet to be enclosed with tarpaper.
• Once inspectors determine the scope of materials that need to be replaced, the new owner will treat the structures for mold and termites and recertify the slabs.

Sometimes a project shutdown is triggered when the lender stops advancing funds. That was the case on a Staybridge Suites hotel in Chicago.

As described in this Chicago Real Estate Daily.com story from October, 2008:

Though the building’s shell is largely complete, construction crews walked off the job over the summer, a sign that CapitalSource had stopped advancing funds for the project. Subcontractors have filed liens with the Cook County Recorder seeking payment of more than $2.5 million for work on the building.’’

The loan was “out of balance,” and CapitalSource demanded that the joint venture come up with another $5.9 million in equity to bring the loan back into balance, according to the foreclosure complaint, which was filed earlier this month in Cook County Circuit Court.

The lawsuit doesn’t specify how the loan fell out of balance, but the loan agreement indicates that cost overruns could have pushed the construction budget higher than its original figure of $52.3 million, leaving the project with a funding shortfall. The loan is in balance only if remaining funds can cover remaining costs, according to a loan agreement filed with the complaint.

Often, if a bank is taken over by the FDIC there are transition problems. From a Nation’s Building News story in November, 2008:

Home builders with outstanding construction loans are reporting that they are having to stop work on new housing developments and are losing sales as the result of failed banks and thrift institutions being taken over by the Federal Deposit Insurance Corporation (FDIC).

“Builders with outstanding loans that are placed under FDIC control are frequently unable to contact a decision maker to deal with routine but time-sensitive matters related to loan draws or extensions,” NAHB President and CEO Jerry Howard said in a Nov. 20 letter to FDIC Chairman Sheila Bair…

Earl Snyder, a veteran FHA/VA home builder in Englewood, said that he has run into problems finishing eight homes in various stages of construction ranging from slab to almost finished. Six of the homes have already been sold to buyers with FHA mortgages. Although he was never late on loan payments, after being taken over by the FDIC his bank gave him 60 days to repay a $2.5 million construction loan.

In the case of the Stonehaven project, the the project seems to have been caught up in a much larger bankruptcy case. In a multicreditor bankruptcy action it can be difficult to fund additional advances to complete a project even if a lender wants to do so. Or, perhaps the developer realized they had no upside to the development and saw no point in working on it while the bankruptcy proceeded.

In any case, shutting down a partially completed project is one of the fastest ways to destroy real estate value.

CRE Loans and the Death Spiral of Doom

When CRE markets start to decline, they can spiral downward dramatically over time. Let’s start out by looking at the underwriting for loans on two identical adjacent apartment projects in Los Angeles in 1989:

The two projects are identical, but the lenders underwrote differently – the Bad Lender used a 3% vacancy factor, but more importantly leveraged the deal to the breakeven point. This was very typical of the market then, and was usually accomplished either by underwriting on the pro forma appraisal income instead of the actual operations and/or by underwriting to a 1.25 DSC on a teaser start rate on a variable rate loan and a 1.00 DSC on the fully indexed rate. The theory was the borrower would refinance when the reset occurred (does this all sound familiar)? The consequence of this approach is the bad lender loan about 80% of the asset value, while the Good Lender loaned 64% LTV.

Let’s go forward to 1991. There have been huge employment losses in the market, and rents have decreased while vacancy has increased. Perceived risk has also increased so cap rates are up too. Here are the numbers (the 1989 Bad Lender underwriting is included for comparison purposes):

Rents are down 5% and the vacancy rate has increased to 15%, creating substantial negative cash flow for the Bad Lender borrower. He defaults, and the combination of lower net operating income and higher cap rate results in the Bad Lender takes a 24% loss. The cash flow for the Good Lender borrower has also taken a hit, but because her deal was not leveraged as highly to begin with, she does not default.

Things start to get interesting when the Bad Lender sells the REO property:

The REO buyer bases their purchase on a higher cap (it’s REO, after all) and suffers an additional loss bringing the overall loss to 33%. The Bad Lender finances the sale at 80% LTV. Note that since cap rates have risen relative to interest rates this level of leverage now has substantial debt service coverage.

By 1992 the REO buyer has dropped his rents 10% in order to capture the best quality tenants and reduce his vacancy factor – the result is his cash flow remains about the same and he has a better quality tenant base. The effect on the neighboring building is profound – this borrower already had negative cash flow and can’t match the rent decrease, so her vacancy goes up. The negative cash flow is too great, she defaults, and the Good Lender takes a 33% loss based on the market cap rate established by the first REO sale. When the Good Lender sells (at a higher cap rate, because it’s REO), their total loss is 40%.

REO Buyer 2 now has a much lower cost structure than REO Buyer 1, and can afford to drop rents below REO Buyer 1’s levels to recapture tenants. Do you see how this cycle reinforces itself? I foreclosed on some buildings 3 times over a five year period as the market spiraled down.

The market will eventually reach an equilibrium again – in LA this occurred when job growth finally returned and virtually all the highly leveraged buildings had been foreclosed upon. But, until an equilibrium is reached it’s impossible for anyone to predict the stabilization level. Those who talk about setting a new price level in CRE don’t seem to grasp that it’s a dynamic, multi-step process and not a one-time mark.

Also, note that the conservative lender actually took a larger loss in the example above, because their default occurred at a point further down the spiral. This is why many lenders consider their first loss to be their best loss, and are reluctant to modify loans.

Americans On the Edge: Income Curtailment, Foreclosures, and Modification Redefaults

One of my earliest posts talked about the root cause of most loan defaults; household income curtailment, typically the result of a job loss, illness, or divorce. Subsequently I’ve posted on the interplay between income curtailment and home values, and the use of home equity as a piggybank when income is curtailed and how the decline in home equity has eliminated this safety net. I’ve also talked about the role income curtailment plays when borrowers who have received loan modifications default again.

So how close to the edge are American households? Way too close. From Housing Wire:

Want a stunning figure? Half of Americans now say they are only one month or less away from not being able to meet their financial obligations if they were to lose their job — just two paychecks or less. And of these, more than half — 28 percent of all Americans — say they could not survive financially for more than two weeks without their current job.

This disturbing data comes courtesy of the 2009 MetLife Study of the American Dream, released Monday, which looks at how the financial crisis has affected the American Dream and consumer perceptions. It’s all the more disturbing considering that unemployment in the U.S. has already surged to 8.1 percent, with 651,000 jobs lost last month alone.

Is it any wonder a large percentage of borrowers receiving loan modifications subsequently redefault?

Does the Relationship Between Median Income and Home Values Explain the Housing Bubble?

It’s taken as a given that one of the reasons housing is in crisis is that home value increases have significantly outstripped income growth (see, for example, these posts at The Big Picture, Option Armageddon, and Calculated Risk). Here’s a chart from Calculated Risk showing the relationship over time:

(Click on image for a larger version in a new window)

An excerpt from Option Armageddon explains:

Ask yourself, what is a housing “bubble” and how is one created?  The term “bubble” suggests that prices were, objectively speaking, “too high.”  Clearly this was the case.  A chart of house prices relative to median income makes it abundantly clear.  House prices can’t continue to expand forever, not unless incomes expand at the same time.  If prices are expanding faster than income, then prices are “too high” relative to what people can actually afford to pay for shelter.  In other words, we have a bubble.

This is common sense. But is it true? If it is, you would expect that there would be more foreclosures in markets where the ratio was higher. But that’s not necessarily the case.

Via Creative Class, a study from University of Virginia researchers found:

In San Francisco, for example, median value of owner-occupied housing in 2007 was 9.7 times median family income, yet the foreclosure rate was a mere 0.24 percent. In the District of Columbia, housing values were 6.8 times family income, yet the foreclosure rate was 0.12 percent. And in New York City, housing values were 12.3 times family incomes in Brooklyn (foreclosure rate 0.38), 11.7 times income in Manhattan (foreclosure rate 0.04 percent), and 10.3 times family income in the Bronx (foreclosure rate 0.28 percent). Other central cities lacked such extraordinary house value to income ratios, but in no instance were low foreclosure rates associated with low house value to income ratios (Table 4).

Here’s the table:

If the relationship is true, why does San Francisco, which has a value-to-income ratio triple the national average, have a foreclosure rate that is 1/3 the national average?

There is clearly something going on that can’t be expressed in a simple ratio. My suggestion is that bubble markets tend to have relatively low income levels and relatively high concentrations of single family rentals (see this post for a more detailed explanation).

Abandoned Homes, Troubled Neighborhoods, and Foreclosures

This photo (hat tip Zillow) is the World Press Photo of 2008:

According to jury chair MaryAnne Golon:

 

The strength of the picture is in its opposites. It’s a double entendre. It looks like a classic conflict photograph, but it is simply the eviction of people from a house following foreclosure. Now war in its classic sense is coming into people’s houses because they can’t pay their mortgages.

That’s an interesting take, but it’s not what’s going on. The original caption for the photo says:

When Detective Cole finds a home that is already abandoned or vacant, he enters with his weapon drawn, to guard against squatters.

Squatters in abandoned homes are a much bigger risk than former owners and tenants, and abandoned homes are a major detriment to neighborhoods (more about that here). But, it’s not quite as dramatic as imagining warfare between the state and people who have lost their homes.

The photo is part of a great series you can see here.

Recourse and Judicial versus Non-Judicial Foreclosure

Many are firmly fixed on the idea that making a loan recourse reduces default risk. Here is Greg Mankiw, for example:

How might the feds ensure repayment of these mortgages? One possibility is to make them recourse mortgages (that is, the lender would have recourse to the borrower's other assets, if the borrower defaults and the house value falls below the mortgage principal).

In my experience this is not the case; I've talked about why here. In a nutshell, there are factors far more influential than potential loss of other assets that drive borrower behavior (for example, ability to pay).

Another reason recourse is rarely pursued by lenders is because it is invariably a judicial process. Non-judicial foreclosures through trustee sales are just that – non-judicial, with a fixed time frames, no hearings, and precisely known fees. Once you get attorneys, judges, and even juries involved in a process, both costs and uncertainty escalate dramatically.

This is especially true when judges are on unfamiliar territory. Back in the early 1990’s while working for an income property lender we were in court many times every week getting receivers appointed. Ordinarily this kind of work is allocated within a county to one or two judges, and given any kind of volume the attorneys and judge quickly get on the same page as to what’s expected and what the results would be. However, when the judge normally handling receiverships was on vacation, results were all over the map, because the substitute judge was not familiar with receiverships.

Processes and results also vary wildly between jurisdictions. Receiverships were routine in California, but almost impossible to obtain in Florida. A bankruptcy case which would have been resolved in 6 months in San Diego took 4 years and an appeal to the U.S. Supreme Court to resolve because it started out in Shreveport, Louisiana.

Finally, it is often the case that a lender’s effort to strip the borrower of their assets in addition to seizing the collateral gets a cool reception from judges and juries. From a recent MBA Newslink article:

Terry Hutchens, president of Hutchens, Senter & Britton, Fayetteville, N.C., told participants yesterday at the Mortgage Bankers Association's National Mortgage Servicing Conference and Expo that while lenders or mortgage servicing firms in the past might be given the benefit of the doubt in the event a home foreclosure case went to court, juries and judges in the current unfriendly judicial environment do not feel as inclined to cut mortgage firms or their attorneys any slack whatsoever.

"There has been a climate change," Hutchens said. "The pendulum has swung too far and we are not being treated fairly."

Recourse lending is not a panacea.

Best Article Yet on the Residential Housing Collapse

George Packer has written a great article, The Ponzi State, in the February 9 New Yorker (the link is to the abstract but the full article requires a payment if you’re not a New Yorker subscriber). Here is an excerpt:

Driving around Florida’s ghost subdivisions, if feel not just that their influence is waning but that they are physically hollowing out. In a place like Lehigh Acres, near Fort Myers, where half the driveways are sprouting weeds, and where garbage piles up in the bushes along the outer streets, it’s already possible to see the slums of the future. More and more of the residents in Hamilton Park will be renters like Lee Gaither. The vacant houses in Country Walk will be boarded up. The St. Augustine grass in the front yards of Tanglewood Preserve will grow three feet high. The open fields with street lights but no houses will become dumps.