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.

Litigation Between Investors and Servicers

One of the impediments to loan modifications is the constraints servicing agreements place on servicers in restructuring loans. If a servicer makes a modification in violation of the servicing agreement, they run the risk the investor may sue them.

Some have argued this risk is not substantial. From Naked Capitalism (my bold):

I've been asserting for some time, based on the comments from mortgage counsellors, that mortgage mods that do not substantially reduce principal balances don't make enough of a difference to the borrower to change outcomes. And with banks and servicers looking at 40%+ losses on many foreclosures, they can reduce principal a lot and still come out ahead.
Mortgage servicers have been experiencing high recidivism rates on loan mods, leading commentators to say that mods don't work. However, it has been reported (Calculated Risk) that many of the so-called mods were payment catch up plans, and not true mods, but the composition of the balance was unclear. Thus it was similarly not certain whether my view was correct.
Some support comes from Wilbur Ross, no soft touch, but a distressed investor (they are not called vultures in polite company). He owns American Home Servicing, the biggest third party servicer in the US. He also offers a program for how to deal with the housing crisis.
Note that American Home Servicing has done a lot of loan mods. Ross makes no mention of the supposed legal obstacles to making mods. That suggests the issue is way overblown (as in investors in theory might sue, but no one is a big enough holder in any one trust for it to be worth the trouble).

The idea that no one is a big enough holder to make litigation worthwhile is wrong; between class action suits and the ripple effect a bad precedent would set, there is plenty for servicers to worry about. And the litigation has already started (including litigation against this particular servicer). Housing Wire reports a hedge fund suing American Home Mortgage Servicing over its REO disposition strategy:

A Greenwich-based hedge fund manager is in a desperate fight to keep his subprime MBS investment strategy alive. HousingWire peeled back the layers to uncover what’s really going on behind the scenes in what has become a vicious battle between the hedge fund and legendary investor Wilbur Ross’ mortgage servicing company, Irving, Tex.-based American Home Mortgage Servicing, Inc.

The lawsuit underscores just how complicated servicing non-agency securitized loans can really be, amid a push by legislators and regulators to put a common set of standards into place to help manage a housing crisis that as of yet shows little signs of slowing down.

Bruce Rose, who runs hedge fund Carrington Investment Partners LP – and who purchased a mortgage servicing platform of his own last year when former subprime high-flier New Century Mortgage went bankrupt – filed a lawsuit last month claiming that American Home Mortgage Servicing, the nation’s largest independent mortgage servicer, had been selling the REO homes it manages at ‘fire sale prices,’ because it needed cash to pay off its warehouse credit facility.

The REO sales push was hurting Rose’s hedge fund, because the loans on the homes are tied to mortgage-backed securities Rose had invested in. According to Carrington investors and sources familiar with Rose’s investment strategy, the hedge fund owns the junior tranches of the deals in question.

American Home is now fighting back. From Housing Wire:

After finding itself dragged into court by hedge fund manager Bruce Rose of Greenwich-based Carrington Capital, Irving, Tex.-based mortgage servicer American Home Mortgage Servicing, Inc. fired its own volley back at both Rose and Carrington on Thursday, suing for alleged acts of racketeering and a scheme to profit illegally from holding REO hostage at the servicing firm. American Home is owned by legendary investor Wilbur Ross’ WL Ross & Co., and is the nation’s largest independent residential mortgage servicer.

The allegations made in the complaint by AHMSI against Rose and Carrington show just how complex relations between servicers and investors can be, amid increasing pressure from lawmakers and regulators to find solutions to the nation’s housing mess.

Servicers are being sued on their modification strategies too. A NYT story on December 1, 2008:

On Monday, a hedge fund sued the Countrywide Financial Corporation, the giant mortgage lender, demanding that Countrywide compensate holders of some securities backed by mortgages if the lender changes the terms of the loans.

The fund, Greenwich Financial Services, said it and other investors stood to lose money if Countrywide, now part of Bank of America, modified loans under a settlement that it reached with 11 state attorneys general in October.

Servicing is a low margin business which only makes money when everything goes smoothly. The downturn has already severely strained servicers; Housing Wire again:

“With the dramatic increase in loan delinquencies come staffing and capacity issues, portfolio risk related to adjustable-rate mortgage resets, and the accompanying pressure to find effective loss mitigation strategies, including loan modifications,” said residential servicer analyst Richard Koch, a director in Standard & Poor’s servicer evaluations group.

“In addition, the spike in foreclosures and real estate owned assets, in our opinion, has stretched the limited number of vendors that service the industry to capacity — and as more loans move through foreclosure into the REO category, the need to make loan advances has placed yet another financial strain on servicers.”

The last thing servicers need is subjecting themselves to the tsuris of litigation with deep pocket investors. Expect them to adhere to their side of the servicing contracts.

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.

Single versus Multi-Asset Borrowers

One of the most irritating workouts I’ve participated in happened in Los Angeles in 1992 while I was Assistant Director of Special Assets at Home Savings (then the country’s largest S&L). Irritating, because the problem was largely self-inflicted.

We had made 17 loans secured by apartment buildings to Shashikant Jogani. At the time, Shashi was one of the largest apartment owners in Southern California. From a later court filing:

In 1979, plaintiff Shashikant Jogani (who prefers to be called Shashi on appeal) began investing in residential apartment properties in and around Los Angeles County. By 1989, he owned properties having a fair market value of $375 million and a net equity of $100 million. Because of an economic recession that started in the late 1980’s and continued into the mid-1990’s, Shashi faced defaults and foreclosures on valuable properties.

We knew some of our deals with Shashi were struggling, but we thought most of the loans would weather the storm. However, Shashi and his advisors asked for a meeting and presented an ultimatum – modifications to all his deals, or he would file bankruptcy.

At that point in the recession we were well acquainted with bankruptcy proceedings; in fact, sometimes we required borrowers to file bankruptcy to confirm our workout plan so if there was a subsequent default we wouldn’t have to go through an adversarial bankruptcy filing then. So, the threat of a bankruptcy filing ordinarily was not something that concerned us. Shashi’s case was a different, because he held almost all of his properties as an individual. A bankruptcy filing would not just involve our 17 properties, it would involve more than 50 properties and more than a dozen lenders. It would be a procedural nightmare, and there was a good chance our properties which had equity would end up supporting other lenders’ problem properties. Shashi of course knew this, and used it as leverage to negotiate with all his lenders.

We ended up agreeing to split the properties into three groups. For the most severely troubled properties Shashi stipulated to the appointment of a receiver and did not oppose our foreclosures. The marginal properties got substantial modifications (a significant reduction in interest rate for an extended period). For the properties which were performing adequately we agreed to an interest only period and allowed the excess cash flow to support Shashi’s other deals. And, we required Shashi to form separate legal entities for the properties which received modifications and transfer ownership to those entities so if the modifications didn’t work out we would not be facing the same nightmare again. As it turned out that requirement was a good idea, because Shashi subsequently defaulted on the marginal group.

Most lenders require a single asset borrowing entity to avoid these kind of entanglements. However, this ownership structure can protect owners too. The Pierce County Housing Authority recently learned this lesson; lawsuits related to mold at one of its apartment complexes put the entire Authority into bankruptcy a few months ago. From the Tacoma News Tribune:

 

The Pierce County Housing Authority prefers to declare bankruptcy rather than fight multiple lawsuits over a mold-ridden apartment complex in Puyallup.

 

The agency’s six-member board of commissioners voted Monday to take the step. If approved, bankruptcy protection would prevent 81 current and former residents from collecting damages they say they suffered from mold at Eagle’s Watch, a 193-unit complex on South Hill.

 

Charlie Gray, deputy director of the Housing Authority, said Wednesday that bankruptcy is the only way the agency can continue to operate and provide affordable housing for about 8,000 clients throughout the county

 

…[The Housing Authority] owns 1,123 apartment units in 13 complexes throughout the county, along with 134 homes.

Had Eagle’s Watch been owned by a single asset entity, it’s likely damages would have only attached to that single asset.

Isolating ownership of multifamily projects makes sense for both owners and lenders.

Workouts 101: Lender Liability

As I discussed in a previous post on discovery and attorney-client privilege, when lenders attempt to collect more than the collateral, income property borrowers almost always raise a wide range of defenses and counterclaims. The list below covers the most common ones.

Few lenders go into litigation knowing they’ve done anything wrong, and borrowers are rarely successful in obtaining substantial damages. However, lenders need to understand that their handling of the loan and borrowing relationship will be examined very thoroughly. The borrower’s counsel is looking for leverage to force a favorable settlement, and there are few loans which are documented and executed flawlessly. I will be discussing some of these claims in more detail in subsequent posts.

• Bad faith
• Breach
• Breach of commitment to fund or extend loans
• Breach of confidentiality
• Breach of contract
• Breach of fiduciary duty
• Breach of good faith and fair dealing
• Breach of interim agreements (final agreement differs)
• Breach of oral commitments
• Defamation
• Detrimental reliance/Fraud in the inducement
• Duress
• Estoppel and waiver
• Failure to comprehend documents signed
• Fraud
• Inconsistencies between written agreement and course of conduct
• Intentional affliction of emotional distress
• Interference
• Interference with contractual affairs
• Interference with corporate governance
• Misrepresentation
• Negligence
• Negligent denial of loan
• Negligent grant of loan
• Negligent Loan processing
• Negligent Misrepresentation
• Negligent Servicing/Administration
• Overreaching and Unconscionability
• RICO Violations
• Fraudulent rate of interest
• Refusal to extend credit
• Third party causes of action
• Control of borrower (third party damaged)
• Fraud
• Good faith and fair dealing - third party creditor subordination
• Tortuously inducing breach of contract

WORKOUTS 101 – Discovery and Attorney-Client Privilege

Usually income property defaults follow an orderly sequence. There is a default, the lender initiates the foreclosure and seeks the appointment of a receiver, the borrower files bankruptcy, the lender eventually obtains relief from stay and completes the foreclosure, and the property thus becomes REO. The only argument which occurs is over the value of the property during the bankruptcy proceeding, and even that is a gentlemanly debate between appraisers. I've been involved in any number of these when there is literally not a single discussion between the lender and the borrower during the entire process. A single lender workout officer can handle a lot of these simultaneously (during the early 1990's our group typically had 70+ loans per asset officer).

This situation changes radically if the lender decides to pursue a deficiency judgment or a guarantee. Every time I've done so there has been all out litigation warfare complete with lender liability claims, discovery, depositions, and sometimes even trials. If you know in advance you will never pursue remedies beyond your collateral you can stop reading. But, if you might go after a borrower, there are some procedures you should follow in advance of the fight which will save you heartache later on.

Discovery. These lawsuits are almost never settled before extensive discovery takes place, because the borrower is looking for something that will take them off the hook and there's no point in paying up until he or she is satisfied there is nothing there. This means the borrower's legal team will be looking at pretty much every piece of paper, email, electronic document, and report which mentions the loan. The cost of producing these documents is substantial and probably won't be recovered, and the more there is, the more likely it is that the borrower will latch onto something to use as a defense. Therefore, it makes sense to follow two simple rules when it looks like a loan may be headed for trouble:

1. Keep the number of people involved to a minimum. Some banks like to get a group together to discuss their problem loans, which means everyone in the group will need to produce all their documents and emails related to the loan. It's much better to have a single officer responsible for the loan, so that only that officer and the manager(s) above that person are involved. In particular, restrict copies on email; if you send an email with a bunch of people copied, they will all be sucked into the process too.
2. Keep written and electronic communication to a minimum. There are obviously action plans, loan rating forms, etc. which need to be completed, but the fewer the better.

Before you write anything, you need to pause and think about the fact the borrower's attorney will be reading it at some point in the process. When it comes down to it, beyond what is necessary for regulatory records there is not much that needs to be written down when working a problem loan.

Attorney Client Privilege and Work Product Doctrine. In general, information exchanged between you and your attorney is not subject to discovery. Similarly, materials prepared in anticipation of litigation are also generally not subject to discovery. But, as soon as you start sharing the information with people other than your attorney there’s an excellent chance you will lose these protections. The commonest mistake in real estate litigation relates to new appraisals of the collateral. Most lenders are smart enough to have their attorney order the appraisal – so far, so good. But when the appraisal comes in they promptly give it to the appraisal department for review and put the value in memos and reports which are sent to managers, accountants, etc. D'OH!! Again, keep the number of people involved to a minimum and ask your attorney before you disseminate information.

WORKOUTS 101 – Where Will the Money Come From? Where Will It Go? Down the Legal Black Hole?

When an income property loan gets into trouble, you need to take a few minutes and realistically assess the sources of funds for the deal and how they should be used.

Potential Sources of Funds

• Income from the property (NOI)
• The property itself, i.e., you foreclose upon or take a deed in lieu of foreclosure on your collateral
• The sponsor's outside resources (any cash or property the sponsor might contribute which is not your collateral)

Potential Uses for Funds

• Your debt (principal, interest)
• The property itself (operations, capital requirements)
• Your attorneys and third party foreclosure costs
• The sponsor's attorneys
• The sponsor's outside obligations (other properties, living expenses, etc.)

Eventually I will discuss each source and use in more detail, but for now here are the two most common mistakes lenders make:

Starving the Collateral. If the sponsor is asking for a workout, the property has probably been on the slippery slope to default for some time. If you end up taking back the collateral, your recovery is going to be even worse if the property continues spiraling down. Spending pennies on the property during the workout period will save dollars in the end.

Over Reliance on Attorneys. Lenders tend to forget that money spent on attorneys does not get spent paying their debt and/or stabilizing their collateral. To the extent you minimize legal involvement, there is more money available for you. This is not to say attorneys shouldn’t have a role – they do. You need the attentive participation of an experienced attorney when:

• You are an inexperienced workout person and you do not have full access to someone who is (e.g., a supervisor). In my opinion if you have not been directly involved in 50+ workouts you are not experienced. Pick your own number, but be aware people are generally overconfident of their own abilities.
• You are absolutely certain you will recover every nickel of what you're owed plus costs. In this circumstance, it doesn't matter how much you spend, so litigate away. If you think this guideline fits your case you are almost certainly not experienced and should be hiring an attorney anyway.
• You are too busy to focus on the deal; go ahead and outsource at $200 an hour if your organization is too stupid to staff its workout group adequately.
• You work for an organization where you need to cover your ass. Even successful workouts tend to disappoint, and losses if a foreclosure or bankruptcy ensue almost always grow over time. No matter how experienced you are or how well you handle a situation, in some organizations it will not be good enough. If you work in such a place, you need an attorney participating in the deal to function as a lightening rod.
• You have a realistic chance of extracting more outside resources from the sponsor if you litigate. Like certainty of collection, inexperienced people tend to think this is true more often than experienced workout people do.
• Without litigation (a receiver, etc.) your sponsor is going to divert property income, waste the collateral, etc. Most lenders assume this will happen and are too quick to pull the trigger. If your sponsor believes he or she is the best person to run the property and that the deal can be saved, a receivership action is a direct route to a bankruptcy filing. That might be inevitable – in fact, if you think the sponsor is unfit to run the property you might as well get it over with. But, if you have time to monitor your deal and a cooperative, competent sponsor you are better off holding off on the receiver.
• It’s time to document the agreement you've worked out. No matter how good you are, it's never a good idea to enter into an agreement without review by experienced counsel.