Trust and Workout Negotiations

Two consecutive posts on trust showed up in my Google Reader (Trust, by Jonah Lehrer on Frontal Cortex, and A Matter of Trust, by Randy Pennington on the Sales and Sales Management Blog), which led me to think about the lack of trust inherent in most workout negotiations.

First, is trust a necessary condition to do a loan workout? No – people who don’t trust each other can reach an agreement. However, it is much easier to reach an agreement when one or both sides are not scrutinizing every detail of the transaction. And, if you don’t trust the counterparty, every potential circumstance down the road needs to be considered and addressed. Given the uncertainties in the real estate market that’s almost impossible to do, with the result that no agreement is reached.

Here are Pennington’s elements of trust and how they relate to real estate workouts:

Character: Every discussion of trust begins here. Character defines an individual’s approach for dealing with themselves and others. It is the demonstration of the values adopted for basic living. Individuals who embody basic principles such as honesty, trustworthiness, loyalty, justice, patience, and duty find that their ideas and recommendations are readily accepted. The nagging question of motive lingers when character is in question.

To know someone’s character requires you have a prior relationship with them. Sometimes borrowers and the people on the lender side of a workout know each other; much more often, they do not. Even when the borrower and the lender personnel have a relationship, there’s a good chance it has been a fair weather relationship. When formerly amicable relationships are tested by difficult circumstances, both sides often perceive the other as betraying the relationship.

Competence: How good are you at your job? How much do you know about your product? Can you answer my questions with confidence and authority? Professionals who earn my trust are competent. They recognize their individual strengths and weaknesses and commit to continuous growth in all areas of individual performance. An excellent reputation for honesty will be rendered useless if it is matched with incompetence.

Again, if you don’t have a track record with someone it’s hard to assess their competence, and in a workout situation there is generally plenty of doubt about the other party’s ability. From the lender’s perspective, the presumption is often the borrower’s incompetence has contributed to the current situation. On the lender side, workout people rarely have time to study the deal, and have very high caseloads leading to a lack of responsiveness. From the borrower’s point of view, this lack of familiarity and apparent indifference can easily translate into a conclusion the workout person is incompetent. 

Communication: Outstanding presentation skills contribute to effective communication. Unfortunately, too much emphasis has been placed on the importance of the pitch. Communication that builds trust is about listening. The ability to understand others creates a bond that encourages interdependence and enhances commitment. We tend to trust those who appreciate our goals, struggles, joys and situation.

There is usually surprisingly little actual communication between the borrower and the lender during a workout discussion. The borrower sends in a proposal, the lender reviews it and responds, and either an agreement is reached or negotiations break down. Face to face meetings are rare, and it’s pretty unusual for there to be more than two or three conversations of any length. Usually the communication constraint is on the lender’s side; workload considerations restrict how much time is spent talking about a deal.

Also, even when there is communication it often destroys trust instead of creating it. Many borrowers and lenders think posturing is an integral part of negotiating, and that it’s to their advantage to take a hard line. Sometimes that’s true, but more often it just makes it more difficult to reach an agreement.

Consistency: The sales professional that sold me my first car from Sewell impressed me with his competence and communication. That, combined with the company’s reputation for character, led to the initial buy decision. Purchases two through nine have been made because of consistency. Every person at every level has continued to perform in a manner that re-earns and maintains my trust. Confidence that your performance will be in line with past experience frees others from worry about protecting themselves from an unpredictable response. 

Verifying consistency requires multiple transactions. Workouts are usually one-off affairs, so neither party establishes a track record with the other. Given the opportunity I like to try to break my workouts into some incremental steps to establish some trust (for example, “You send in a payment while I get an updated appraisal, I will hold off from filing the foreclosure”). The more usual “dual track” approach (“I’ll file the foreclosure so I don’t lose any time and we’ll see if something can be worked out before the sale date”) is the antitheses approach.

Courage: Earning and maintaining trust in an increasingly competitive and demanding world requires courage. Challenges must be confronted head-on in a manner that respects diversity; demonstrates professional business practices; and maintains personal integrity. True courage requires commitment and the willingness to accept personal risk. It fosters admiration and sets in motion a series of events that influence long-term success.

Neither side in a workout is typically up for taking much additional personal risk. The borrower has generally already experienced substantial losses and has exhausted his or her resources. On the lender side, it is much easier to look back and see the time and value lost when a workout attempt fails, and much harder to identify what might have been gained by a successful workout.

Considering the obstacles, it’s not surprising few deals are worked out.

Why Lenders Don’t Do Principal Writedowns

If only lenders wrote off principal on loans in default, our problems would be solved. Gretchen Morgenson  on her New York Times article So Many Foreclosures, So Little Logic:

If banks have written down the value of these loans to the 40 cents on the dollar that they are fetching on foreclosures — the only true value for these homes right now — then why don’t they bite the bullet and reduce the loan amount outstanding for the troubled borrowers? That type of modification would be far more likely to succeed than larding a borrower who is hopelessly underwater with yet more arrears.

And today The Big Picture quotes Mark Hanson of Hanson Advisors (via Barron’s) on why loan mods are not the answer:

Loan mods are designed to keep the unpaid principal balances of the lender’s loans intact while re-levering the borrower. Mortgage modifications turn homeowners into underwater, overlevered renters for life, unable to sell, re-buy, refi, shop or save. They turn homeowners into economic zombies.

The belief that principal writedowns somehow solve a problem that other types of modifications can’t is wrong. Overwhelming, loan defaults are caused by income curtailments – the borrower loses a job, households break up, people become ill (long post on this topic with additional links here). Such situations have two characteristics; (1) they are binary, in the sense that a borrower goes from being able to make a full payment to being able to make only a drastically reduced payment, or no payment at all, and (2) they are often temporary. These are the cases where lenders typically offer repayment plans which allow unpaid installments to be repaid over time, with the result that when the forbearance period is over the payments go up. Sometime that works, and when it doesn’t a different form of relief is necessary. But it would be just crazy for a lender to offer a permanent, irreversible principal reduction in these cases.

For those cases where a long term reduction in the payment amount is necessary, let’s look at the numbers. Let’s suppose the value of the property today is 50% of the amount owed:

The payment relief under these two structures is identical, so each borrower is in the same position to save and spend, and each is as likely to default if there is a further decrease in income. Each borrower can move if they want to: either can just walk away, or negotiate a sale with a buyer. In the case of the borrower with the payment modification, it will be a short sale, but lenders do those all the time.

There are really two issues. The first is a classic principal-agent problem; the borrower knows their true financial condition and is in a better position to know the value of the property than the lender. Lenders are understandably reluctant to lock in a loss under these circumstances. The second issue is, who gets the upside if the property is worth more than $200,000 or the value increases later? It’s the borrower with the principal writedown, the lender with the modification. Lenders are reluctant to give up the upside, because debt is supposed to be paid before the equity holder.

Please note, I am not saying that lenders are doing a good job of modifying loans (just the opposite; see Mortgage Modification Blues, for example). But, is there any reason to think lenders would do a better job processing principal writedowns? I’m saying that lenders need to get better at modifying loans where appropriate, and principal writedowns are not the solution.

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.

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).

Lender Conspiracy to Destroy Competition?

The developers of the Fontainebleau casino and hotel development in Las Vegas believe Deutsche Bank is out to get them. From Zero Hedge:

In a stunner of a development, Las Vegas casino operator Fontainebleau has amended its ongoing lawsuit against a set of banks, and has alleged that Deutsche Bank is now "seeking to destroy the Fontainebleau in order to minimize competition" with the Cosmopolitan Resort and Casino, which was acquired by Deutsche Bank in a foreclosure auction in September 2008 for $1 billion, after the casino had defaulted on a $760 million loan. Allegedly, DB is doing this by pulling Fontainebleau's revolver, making it impossible for the development-stage casino to survive…

As both the Fontainebleau and DB's Cosmopolitan developments are in their final stages of development, their "successful" opening would result in yet another flood of hotel rooms in the already oversupplied Las Vegas market. The Fontainebleau casino would provide 3,800 brand new rooms and condo units, while the Cosmopolitan would supply yet another 3,000 rooms and condos.

How plausible is this argument? This plan would require monumental stupidity at Deutsche Bank. Shutting down the Fontainebleau development would ultimately lead to a new owner who would acquire the development at a much lower basis than the current owner. This would allow the new owner to substantially undercut the Cosmopolitan, pulling that project down too. I’ve discussed this downward spiral effect in more detail in my post CRE Loans and the Death Spiral of Doom.

If you view an income property submarket as an ecosystem, the whole system does best when all the competing properties have similar cost structures. When a predator property with a much lower cost basis enters the system (as a result of a greatly discounted purchase out of a foreclosure or note purchase, for example) it can offer much lower rents, which in turn can destabilize other properties. Eventually a new equilibrium is established, but at a much lower level than before the system was destabilized.

If Deutsche Bank is really trying to shut down Fontainebleau to benefit Cosmopolitan, it’s shooting itself in the foot.

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.

Value, Cash Investments, Equity, Cash Out Refinances, Anchoring, and Sunk Costs

When I’m talking to a borrower about a loan workout, there is often a major disconnect between the reality they see and the reality I see. One of the disconnects almost always relates to the equity in the property.

Let’s say Bill Ant buys a property in 2005 for $10,000,000, and I make him a 75% LTV loan. Here are the numbers:

Bill’s equity is the difference between the value and the debt, and is equal to his cash investment.

Now, let’s roll forward to 2007. Values have increased 20%:

The cash investment remains the same, but Bill’s equity has increased 80% (the magic of leverage).

Now it’s 2010, and values have decreased 50% (think that can’t happen? Here’s my post, “Commercial Property Values Down 50%?”):

Here is when the disconnect occurs. When you talk to Bill Ant, he will refer to his $4,500,000 or $2,500,000 of equity in the property. Borrowers tend to anchor on their equity at peak value of the property, or on their cash investment in the property, instead of the equity based on the current value. Bill doesn’t have equity in the property any more – all he has is a sad story.

But, he does have $2,500,000 in sunk cost on the deal. Is that worth anything when it comes to his decision to continue to make the payments in a workout context?

Let’s say Tom Grasshopper did the same deal in 2005, and refinanced in 2007, pulling out all his cash investment with a new loan based on 75% of the higher value, and spent the proceeds on a big house and a boat. Here are the numbers:

Now, it’s 2010. I’ve put Ant’s and Grasshopper’s situations side by side for comparison purposes:

Some people think borrowers who have done cash out refinances are less committed to the property and less likely to support the loan than people who never pulled their cash out. After all, Grasshopper no longer has a sunk cost, and he can walk away and keep his house and boat, while Ant has nothing.

This makes sense in theory, but I can tell you with absolute certainty that in practice both of these borrowers are equally focused on their loss from the peak value, and are equally angry, in denial, willing to bargain, and depressed (depending on what stage of the process they’re at). Grasshopper is more likely to default and is likely to default earlier than Ant, but that’s because he owes more relative to the current value of the property, not because he has less commitment to the property.

To recap, borrowers anchor on what they had to start out with or at the peak of the market, measure their losses from those points, and are not much influenced by any gains they made along the way if they end up underwater.

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.

Turning Around the Creston Apartments

Here’s an interesting account of efforts to turn around a high crime, poorly maintained apartment project in Kansas City which was affecting the entire neighborhood. The short version:

• Aggressive policing
• Political involvement
• On site security
• Maintenance

I’m not sure if this can really be categorized as a success story though, since it apparently ends in the demolition of the project.

Why Fewer Reasons Are Better; Dead Cats and Cul de Sacs

When turning down a workout request or a loan application, you need to explain why. Borrowers expect a fair reason for being turned down, and loan officers and underwriters can learn from each experience and hopefully prevent reoccurrences in the future. You have a choice – you can try to provide a comprehensive understanding of your entire thought process, or you can relate just the factors which are the most important to your decision. In my experience, the latter approach is better, because what people remember won’t be your best reasons.

For example, back in the mid-1980’s I worked for Cambridge Capital originating multifamily loans (the company is long gone and not related to any of the Cambridge Capitals currently doing business). The principals were very hands-on, bright guys who personally inspected every deal we did, and I know I learned a lot about real estate from them. But, my only specific recollection is one deal which was turned down because, when the principal did his inspection of the property, there was a dead cat in the parking lot. I’m sure there were other things he didn’t like about that deal, but I don’t remember them.

I did something similar during a presentation sponsored by a chapter of the Earthquake Engineering Research Institute in Oakland. After the Northridge Earthquake I did consulting work for the Los Angeles Housing Department, and one of the things I did was a drive-by inspection of all the red and yellow tag structures damaged in the earthquake. This was an inductive approach to learning – after you look at a few thousands damaged buildings you start to see patterns. A lot of these patterns were obvious. For example, proximity to the epicenter, hillside or liquefaction zone locations, and brick construction are all know risk factors, and the audience didn’t react when I relayed that information. I did get a reaction, though, when I told them that cul de sac streets were a risk factor. On reflection, this isn’t surprising. Orientation of the structure to the ground motion wave is an important variable, and on a cul de sac one or more structures are guaranteed to be oriented for maximum damage. Also, in Los Angeles a cul de sac is usually related to e geographic risk factor (the cul de sac terminates at a drainage ditch prone to liquefaction or a hillside, for example). But, I didn’t explain this during the presentation, and I know there are people out there who remember me as the idiot who thinks earthquake damage is linked to cul de sac streets.

There is a neurological basis which explains why people lock in on unexpected reasons. From Jonah Lehrer’s “How We Decide”:

The brain is designed to amplify the shock of these mistaken predictions. Whenever it experiences something unexpected – like a radar blip that doesn’t fit the usual pattern, or a drop of juice that doesn’t arrive – the cortex immediately takes notice. Within milliseconds, the activity of the brain cells has been inflated into a powerful emotion. Nothing focuses the mind like surprise.

This is why if you tell a loan officer you’re turning down his loan because the borrower lacks liquidity, the building is poorly maintained, the income is trending down, and there’s a dead cat in the parking lot, you will forever be remembered as the guy who is fixated on dead cats. Unless that’s what you want, you’re better off keeping that reason to yourself.

Underperforming Assets, Workouts, and Management

Via Newmark's Door, Secretgeek on "The Deadly Cycle of Meetingitis." Here’s an excerpt:

 

1. Q:What do managers do when they're stressed?
   • A:They call a meeting.
2. Q:What gets managers stressed out?
   • A:When projects are not making progress.
3. Q:When do projects fail to make progress?
   • A:When people spend too much time in meetings.

Secretgeek is talking about programming code crises, but the cycle applies to any situation which creates manager stress. The important part of this cycle is the root cause – it’s not the status of the project, it’s the manager’s stress.

Underperforming assets and workouts are inherently stressful to management, and are particularly prone to meetingitis (and it’s nephew, reportitis). Some managers are not comfortable unless they know the status of every deal, all the time. Secretgeek’s solution:

Communicate more, in order to meet less. Be proactive in your communication. Don't wait for them to call a meeting. Tell them what's going on. Produce regular reports. Don't "promise" to produce regular reports -- just produce them. Let them listen in on some of your day to day chatter. If you have daily standups, bring the manager in. Stop baffling them with technical mumbo jumbo. Feed them edible slices of information. Walk them through it in bite-sized chunks. Give them documentation tasks to keep them feeling important. Give them communication tasks. Draw pictures for them to stick on the wall of their office.

This approach might work for coding, but I don’t think it works very well for special assets. In my experience managers only calm down when they develop confidence their workout people are on top of their deals and elevate issues when necessary. It takes time and positive experience for workout people to develop that kind of credibility with their management (more on that here). Unfortunately, that level of confidence may never develop if the manager believes progress is a result of their involvement and not their staff’s work.

The CRE Downward Spiral: Fire!

Real Property Alpha has a good post on deteriorating CRE fundamentals, but the conclusion points in a dangerous direction. Two excerpts:

This analysis, however, is not focused on providing a historical explanation for the office market weakness. Rather, I note the weakness of the fundamentals in order to provide counsel to lender clients with commercial properties on their books. Unfortunately, the downward trajectory of the graph on page 1 shows a market with a steep downward trend. Bank sellers failing to timely dispose of non-performing assets in this environment risk further deterioration in fundamentals and the resulting price decline. Simply based on fundamentals, office pro forma values are off 38% since Q108. The 38% decline is significant as it likely destroys any equity to debt coverage which was assumed during the initial underwriting, assuming that the deal was financed in the last few years…

Despite the tremendous liquidity problem in the financial industry today, I believe that making proactive moves to dispose of non-performing assets will provide reward for banks with the will to do so. Banks that can expedite the process of disposing of non-performing assets will be the first to clean up their balance sheet and begin lending again. The reward for these banks will be a risk environment in the new lending which will be significantly improved from the landscape we see today.

I agree, and disagree. When the banks dispose of their nonperforming assets, those assets become the comparables for and the new basis the remaining portfolio competes against, so those assets are now overleveraged and are disposed, and so it goes. An aggressive disposition strategy reinforces the downward spiral, so unless you get out of the asset class completely, you continue to suffer losses. A disposition strategy that looks smart for an individual asset can magnify your losses in the remaining portfolio. And remember, it’s not just you – the market won’t stabilize as long as other banks are making significant dispositions.

Also, an aggressive disposition strategy is smart, until it isn’t. If you sell an asset and the market continues to fall, you were smart, but if this downturn is like all the rest at some point the market will stabilize and values will start to rise. There is always someone selling at the bottom.

In a perfect world the most highly leveraged assets and the assets controlled by weak operators would be liquidated, and lenders would restructure the debt on marginally overleveraged deals with good operators to allow them a reasonable return and some upside in exchange for maximizing the asset value during the downturn. It’s like a fire in a theater; more people will get out in an orderly exit than if everyone tries to get through the door at once. Of course, we live in a far from perfect world, and at this time it’s hard to argue with Real Property Alpha’s conclusion that lenders should be running for the door.

The Inevitability of Errors

Errors are inevitable – no matter what the stakes, no matter how much you practice, things are going to go wrong a certain percentage of the time in any complex task or decision. The New York Times has an article with an excellent example: basketball free throws.

There is nothing in sports as straightforward as a free throw; the equipment is always the same, the geometry is constant, and there is no defense interfering. The only variables are the player’s concentration and control over his or her body. And yet, at the highest level of the game, it goes wrong 25% of the time, year after year after year:

In the National Basketball Association, the average has been roughly 75 percent for more than 50 years. Players in college women’s basketball and the W.N.B.A. reached similar plateaus — about equal to the men — and stuck there.

The general expectation in sports is that performance improves over time. Future athletes will surely be faster, throw farther, jump higher. But free-throw shooting represents a stubbornly peculiar athletic endeavor. As a group, players have not gotten better. Nor have they become worse.

“It’s unbelievable,” Larry Wright, an adjunct professor of statistics at Columbia, said as he studied the year-by-year averages. “There’s almost no difference. Fifty years. This is mind-boggling.”

And it’s not like the stakes aren’t high:

Last season, Memphis was 38-2 despite making only 61 percent of its free throws, missing an average of nearly 10 a game. The Tigers lost the national championship game after missing 4 of 5 free throws in the final 72 seconds against Kansas, which had made a late 3-point shot to tie the game and won in overtime…About two-thirds of a winning team’s points in the final minute typically come from the free-throw line…

Obviously, we need to work to eliminate mistakes and design systems to minimize the chance of them occurring. But, a certain percentage of the time errors will happen. Learn what you can from them and move on.

Literally Underwater Property, Workouts, and Maintenance

You can temporarily fix almost any plumbing link with an inner tube and two hose clamps. Cut a strip of rubber long enough to cover the leak and wide enough to wrap around the pipe. Orient the long edge of the patch opposite the leak and clamp on either side of the leak. Here’s how it should look:

I know this from inspecting the aftermath of a ceiling collapse in an apartment building we had foreclosed on. The water lines were corroded, the borrower was strapped for cash, and rather than replumbing, the borrower simply slapped another patch on every section of pipe which sprang a leak. By the time we took the property back there were more patches than there was visible pipe. The cost to repair the water damage was double what it would have cost for us to advance the funds to replace the water lines.

Most of the concern expressed over underwater properties (i.e., properties whose value is exceeded by the mortgage debt) is that the borrowers have become “mortgage slaves” (see, for example, this Calculated Risk post). But, the situation has risks for the lender too. If a property is under water (i.e., the borrower has no equity), what incentive does the borrower have to maintain it? If all the cash flow from a rental property is taken for debt service, what happens when the roof starts to leak?

A frequent mistake lenders make in trying to restructure debt is to leave no incentive for the borrower to maintain the property. Best practices are to allocate enough cash flow to a controlled capital account so funds are available for repairs, and to structure some up side for the borrower if the property value improves. In the short term this results in less cash flow and a larger loss for the lender, but preserving the collateral value generally results in a higher ultimate recovery.

Why Loan Modifications Don’t Happen: The Kubler-Ross Model Effect

It takes two to modify a loan; the borrower, and the servicer. The presumption is the servicer is the obstacle; why wouldn’t a borrower want a modification? The reality, however, is that often borrowers default and make no effort to reach an agreement, or they start negotiations for a modification but don’t pursue them. Why does this occur?

I think part of the answer is explained by the Kubler-Ross model. When someone loses something significant, the person goes through five stages to come to grips with the loss:

1. Denial - “This house is still a good investment!”

2. Anger - “How could this have happened?!”

3. Bargaining - “With a little help I can make this work.”

4. Depression - “This is going to wipe me out.”

5. Acceptance - “I’m moving on.”

Stage 3 is the stage at which a modification might happen – the rest of the time, a borrower’s mental state is not conducive to reaching an agreement. What are the odds of a borrower at that stage of the process connecting with someone at the servicer and working something out? Pretty small.

Workouts 101: Loan Modifications and Interest Accrual

In a previous post, I discussed when a loss has to be recognized on a modified loan. A related question which recently came up on Bronte Capital is, when can interest on a modified loan be recognized, and when is the loan no longer considered a non-performing asset?

The answer, as you would expect, is a fairly involved accounting issue, but the short answer is there needs to be a credible evaluation the payments can be made, and a sustained period (minimum of six months) where the payments were made.  The source is the FFIEC: Reports of Condition and Income Instructions Glossary Pages A-59 to A62. In part:

A loan or other debt instrument that has been formally restructured so as to be reasonably assured of repayment and of performance according to its modified terms need not be maintained in nonaccrual status, provided the restructuring and any charge-off taken on the asset are supported by a current, well documented credit evaluation of the borrower's financial condition and prospects for repayment under the revised terms. Otherwise, the restructured asset must remain in nonaccrual status. The evaluation must include consideration of the borrower's sustained historical repayment performance for a reasonable period prior to the date on which the loan or other debt instrument is returned to accrual status. A sustained period of repayment performance generally would be a minimum of six months and would involve payments of cash or cash equivalents. (In returning the asset to accrual status, sustained historical repayment performance for a reasonable time prior to the restructuring may be taken into account.) Such a restructuring must improve the collectability of the loan or other debt instrument in accordance with a reasonable repayment schedule and does not relieve the bank from the responsibility to promptly charge off all identified losses.

Workouts 101: Loan Modifications and Loss Recognition

Comments on some recent posts dealing with loan modifications suggest some people believe lenders can avoid recognizing losses by modifying loans (see Naked Capitalism "Cramdown and Future Mortgage Credit Costs", Mr. Mortgage "WAMU's New $1 Million 5-Year 1% Balloon Loan Mod", Credit Slips "Cramdown and Future Mortgage Credit Costs: Evidence and Theory") .

This is not the case.

The operative question is whether or not the modification constitutes a Troubled Debt Restructure (“TDR”). From a Center for Audit Quality guidance on the Application of FASB Statement 114:

3) How should an entity determine if a modification of the terms of a residential mortgage loan would be considered a troubled debt restructuring under Statement 15?
In accordance with paragraph 2 of Statement 15, “a restructuring of a debt constitutes a troubled debt restructuring … if the creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession to the debtor that it would not otherwise consider.”

This covers virtually all material modifications (certainly substantial interest rate reductions or bankruptcy cramdown modifications).

If a loan is a TDR:

Statement 114 provides guidance on how an entity should measure impairment. Specifically, paragraph 13 of Statement 114 states: “…a creditor shall measure impairment based on the present value of expected future cash flows discounted at the loan's effective interest rate, except that as a practical
expedient, a creditor may measure impairment based on a loan's observable market price, or the fair value of the collateral if the loan is collateral dependent. … The creditor may choose a measurement method on a loan-by-loan basis. A creditor shall consider estimated costs to sell, on a discounted basis, in the measure of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan.”

All of which is to say the loan needs to be marked to market. So, while a modification may postpone the actual cash loss on a deal, on the financial statements the loss needs to be recognized at the time of the modification.

Is it possible a lender could use overly optimistic cash flow assumptions to defer and/or minimize losses? Absolutely, but examiners are sensitive to this possibility, and TDRs get a lot of scrutiny during exams.

Crowe Horwath provides a good general overview of TDRs here.