Over the past nine months, and especially during the last three, clients have been inundating our offices with questions regarding their distressed real estate. These clients are trying to figure out a way to either re-position or buy back their non-performing or sub performing loans at a discount. Other clients with strong cash positions are looking to buy these sub performing loans, hoping to profit from the future upside potential. The key to both clients’ success remains the same: the current lender.
This article seeks to ferret out the thinking behind the processes we have found in both regional and national banks as it pertains to distressed assets. Some of the observations may seem obvious at first, but their outcomes are continuing to shift as new realities crop up in the marketplace. And while there are several questions that interested parties must ask as they approach these opportunities, one in particular jumps out: “What is going on at the bank?” Because different asset classes each confront their own difficulty, I will focus on one that seems the most popular: condominiums. The following are the most common questions we are asked.
1) “Some banks are selling condo construction notes, others are foreclosing and holding the assets as REO’s and still others are appointing receivers. Why?”
Simply put, the banks are learning and adjusting as they go. The note sale scenario is easiest for the bank but may provide the least amount of net proceeds. Buyers of notes will typically need to foreclose on the notes wiping out the original Sponsor. As a hedge, they build in legal costs to their offer, thereby reducing the offer price and net proceeds to the bank. The upside to the bank in this method is that it provides the least amount of risk because the bank never takes possession of the asset and they do not appear in the chain of title.
Another option is for the bank to foreclose and take back the property as an REO. We have discovered that bank attorneys are trying to steer away from this course rapidly because of lender liability issues. Robert Smylie, a Los Angeles based attorney whose firm, Robert Smylie and Associates, specializes in workouts for borrowers has brought the matter to the forefront in discussions with lenders.
Mr. Smylie has stated that, initially, lenders felt they were exempt from long term construction defect liability as it pertains to “new for-sale housing development projects and especially those that require further construction to complete and/or to repair”. Because condo projects have ten year sunsets for the filing of actions in regards to construction defects, and most of those actions occur after eight years, it is very possible that the homeowners’ attorneys will file suit and name the banks that foreclosed on finished or partially finished condo projects within the 10 year window.
Mr. Smylie has concluded that the appointment of a receiver is the best course of action for a bank when compared to an REO or note sale. He states, “the appointment of a receiver to complete and sell a new for-sale housing project allows the developer entity to remain in place in the event of a construction defect claim, and keeps the lender and/or its related entities off title, thereby creating a layer of liability protection for the lender.”
2) “What kind of stress is the bank facing?”
It’s not new news to say banks are under considerable stress when it comes to condominium projects they financed. Because of the lack of financing available to buyers, rising unemployment, and the glut of new units in certain areas, the buyer pool has shrunk considerably. Many investors are looking at the condo project as apartment buildings with a future condo sales exit after a 2-5 year horizon.
While these banks know they have bad assets, they are reluctant to admit it. If they do they must reserve for these loans (charge-offs) or a portion of these loans or real estate owned (REO) in the future (non-performing assets). The amount of the “provision” that goes into the reserve is a charge against current earnings and therefore reduces the banks capital. Because banks must keep a certain amount of capital to meet regulatory requirements they are wary of classifying and asset as non performing. The FDIC is sending auditors from bank to bank to be sure that the banks are not under reserving for this non performing loans.
3) “What are the banks doing?”
They are either selling the loans (or REO), getting very creative, or hiding it. For example, a national bank has unveiled a new program for its existing clients. Assume a scenario where the current loan is $10,000,000. They will approach the client and offer a three year, non-recourse bridge loan at a high rate in return for a $2,000,000 pay down. The lender will then sell a B piece of say $1,500,000 of the remaining $8,000,000 bridge loan to a mezzanine player who has agreed to participate in its program. They will then keep the remaining $6,500,000 A piece on their books at a lower spread than the one being charged to the borrower. The key to this scenario is that the $6,500,000 A piece must be within the regulatory range so that it conforms, and the bank has solved its problem.
On the flip side of creativity is denial. We have seen some banks refuse to file NOD’s on non-performing notes for the simple reason that they do not have the internal reserves to set aside. If certain banks actually marked all their non-performing assets to true market values, the banks would be insolvent. As a means to reduce the shock to the banking system, it appears that regulatory agencies are allowing this to happen, if only for the time being, hoping the market will recover and the bank has a chance to get healthy again. This course of action is akin to throwing a Hail Mary pass on the last play of the game. The problem is that the only receiver anywhere downfield is one that handles dispositions; not the one that wins games.
In the end the market is grinding on. Transactions are occurring, but not on a level or velocity anyone thought at this stage in the game. While that could change quickly in relation to government action, the likelihood is more of the same will play out in the months to come.
