Archive for the 'Real Estate Finance' Category

Is the Slow-covery in Trouble?

Last week, the Fed’s Open Market Committee said the pace of the economic recovery had “slowed” and that growth “is likely to be more modest in the near term than had been anticipated.  The Fed announced it was going to take some of the payments it has received from CMBS bonds and other assets it purchased as part of the stimulus, and reinvest them in Treasuries – effectively holding down mid-term interest rates –  in an attempt to stimulate the economy further. The Fed noted that high unemployment, modest income growth, lower housing wealth and tight credit were holding back household spending.

Sudeep Reddy of the Wall Street Journal explained succinctly how the Fed’s plan is supposed to work:

“After cutting short-term interest rates nearly to zero in December 2008, the Fed essentially printed money to expand its portfolio of securities and loans to above $2 trillion, from $800 billion before the global financial crisis. Its purchases of mortgage-backed securities and U.S. Treasury debt, aimed at keeping long-term interest rates down, were discontinued in March. The Fed began talking about an “exit strategy” from the unprecedented steps it took to prevent an even deeper recession.

But on Tuesday, the Fed shifted its stance. It said it would act to keep its securities holdings constant at around $2.054 trillion, the level on Aug. 4. Had the Fed not acted, its mortgage portfolio was set to shrink by $10 billion to $20 billion a month, as mortgages matured or were paid off early. Now, the Fed will reinvest those proceeds in U.S. Treasury securities of between two- and 10-year maturities.

Some Fed officials have been uncomfortable with the size of the Fed’s position in the mortgage market. To assuage their concerns, the Fed won’t be enlarging its mortgage holdings.”

Will this further stimulus work? No one knows. But this move is generally not being seen as a good sign for an economy we’ve been repeatedly told is recovering.

The idea that the “recovery” isn’t going so well has been common for months across the bleaker reaches of the economic blogosphere (such as the comments sections of the Calculated Risk blog, or the ZeroHedge blog, or David Rosenberg’s well considered newletters for Gluskin Scheff — where he suggests today that we may not be headed for a double dip because the recession may not, in fact, have ever ended).

However, concern about the pace of the recovery has recently been cropping up more frequently in the mainstream media – especially since the Fed’s announcement. For example, in Saturday’s New York Times, Jeff Sommer questioned whether a double dip recession is likely, asking, “Will the economy pick up momentum or slip back into recession?”

 After noting that Ben Bernanke had recently called the current economic outlook “unusually uncertain”, that Lakshman Achuthan, Managing Director for the Economic Cycle Research Institute agreed that “growth has definitely slowed” and that Bill Gross of bond manager Pimco said, in essence, that the momentum of the economy from the first to the second quarter was downhill, and that it’s possible we’re close to a double-dip recession, Sommer stated:

“Still, the economic signs are ambiguous. . . . What’s been lacking is broad consumer demand, a revival of the housing market and sufficient business confidence in large-scale hiring.  And, of course, there are deep structural economic problems — the highest ratio of public debt to gross domestic product since World War II, for example — that will need to be dealt with over many years.”

At the risk of stating the obvious, with so many folks worried about their jobs, or underemployed, or paying down debt, and so many companies sitting on money but not hiring, it’s simply not clear what new business developments are likely to spur sufficient “consumer demand, a revival of the housing market and sufficient business confidence” to lead to large scale hiring.  I have a sneaking suspicion that we ultimately will regret greatly allowing so many jobs to be outsourced, especially manufacturing jobs – ultimately our economic viability as a country boils down to whether we can produce things that others want to buy — and in doing so, whether we can keep our own citizens employed.

Keeping interest rates down to stimulate the economy seems to work in smaller economic downturns, where there’s pent-up demand and ordinary folks can afford to buy things.  But, where so many households are wildly overleveraged and worried about their futures, the Fed may simply be “pushing on a string” – trying to create demand that simply won’t be there until the overhang of debt is paid off by borrowers, or written off by creditors (who of course then have to recognize their losses), or both.  (Maybe there’s another way to create demand and deal with that debt, but if so I don’t see it.)

And until the huge amounts of debt are somehow cleared or something else makes businesspeople more confident about hiring (and employees more confident about getting and keeping jobs), the current levels of distress in the commercial real estate market seem likely to continue and perhaps increase.  According to Costar’s Commercial Repeat-Sales Indices, the largest metro commercial real estate markets have been “attracting significant institutional capital and forcing prices upward over the first two quarters of 2010 . . . while the broader market has continued to soften. . . . This divergence of the two worlds may soon change as we are now witnessing a pause and softening even within the investment or institutional grade primary markets.”

Doesn’t sound much like a CRE recovery.

CoStar goes on:

Many of the opportunity funds continue to seek out distressed properties, which are affecting the prices shown here, but the expectations of a tsunami of opportunities have not materialized and overall transaction volumes remain below normal.

Distress is also a factor in the mix of properties being traded. Since 2007, the ratio of distressed sales to overall sales has gone from around 1% to above 23% currently. Hospitality properties are seeing the highest ratio, with 35% of all sales occurring being distressed. Multifamily properties are seeing the next highest level of distress at 28%, followed by office properties at 21%, retail properties at 18%, and industrial properties at 17%.

Since current governmental policies seem to be encouraging a “delay and pray” approach to resolving bad real estate loans, this approach (which I don’t think can really be called a strategy) seems to be to hope for a broad economic upturn.   It seems likely that the distress in commercial real estate won’t improve significantly unless hiring picks up, and the trend seems to be going the wrong way.  PRI’s The Takeaway reported that, according to Newsweek and Slate columnist Dan Gross :

“An unemployment rate of 9.6 percent in America may sound bad, but it doesn’t include millions of discouraged American workers. . . The real unemployment rate is closer to 16.5 percent . . . . That’s the Bureau of Labor’s U6 number, which takes into consideration so called “discouraged workers” who have given up looking for work, as well as people who are working part time but would like to be working full time. Overall, according to Gross, the number means that there is ‘one out of six adults in this country whose talents and time and skills are not being utilized anywhere near to the extent of their abilities.’ ”

I hope I’m wrong, or missing something about the economy, but it seems to me that the “Slow-covery” is getting even slower. Instead of a long hot summer, we may be looking at a long cold winter of discontent.

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Will your deal survive the Devil’s Triangle? (part 4 of Bank Failure series)

As noted in the last post, what ultimately happens to a creditor’s specific claim against a financial institution often depends on what type of claim it is, and what priority it has.  This differs depending on whether the creditor is a  depositor, borrower, trade creditor, landlord or letter of credit holder.

Deposit Accounts.  Deposit accounts are a favored class of liability — provided that the accounts in question are federally insured.  FDIC coverage may be affected simply by the balance on deposit in the account.  Many business accounts (such as cash management, impound or lockbox accounts, through which a business’ essential daily cash flow moves) are likely to exceed this limit.  Therefore, businesses should carefully consider the effects of a freeze of, or partial loss from, such essential accounts, and should also give serious consideration to the stability of their banks.   One indication that a bank may be troubled occurs if it offers unusually high interest rates, because institutions trying to increase capital reserves sometimes offer high rates to attract deposits.  Deposit accounts which are not fully federally insured likely will experience losses or delays if they are not quickly transferred in a resolution to a new, solvent bank.

Secured Loans.  Another type of contract to which the FDIC as receiver may show relative deference is a loan secured by legitimate collateral.  A nondefaulted secured real estate loan, for example, with an adequate loan-to-value ratio and proper documentation, can be a valuable asset to the bank.  Even if moderately diminished in value, it may have a strong chance of being packaged into an asset sale, and surviving with a new, stable lender. 

Also, regulators are somewhat limited in their ability to abrogate or change vested property rights.  The FDIC has stated that it usually will not seek to reject properly perfected and documented security agreements (including real estate mortgages).  However, the outer limits of that protection are not well defined.

Securities, Swaps and Forward Contracts.  Regulatory laws also provide some limited protection for some kinds of specific derivative, option, swap and forward contracts (defined as “Qualified Financial Contracts”) and for some kinds of “true sale” asset structuring transactions for securitization.  Although a lengthy description of these “QFCs” is beyond the scope of this article, these generally are contracts with sophisticated parties, often executed at high speeds and in large denominations to serve specific financial risk management goals such as foreign currency exchange exposure, and are thought necessary in order to keep capital markets working well.

Unsecured Loans and Open Contracts.  Counterparties that have ongoing unsecured deals with a bank, such as unfunded loan commitments, agent bank responsibilities, real estate leases or servicing contracts, are less protected.  Such counterparties should evaluate the likely attractiveness their deal has to the bank and its successors in a potential resolution.  As noted, the FDIC may seek to take on only favorable contracts, or may reform contracts, accepting only the “good parts.”  For example, the FDIC might continue to collect on amounts due under a partially funded construction loan, but repudiate the duty to fund any future advances.

Another common case of an unsecured bank contract is a real estate lease in which the bank is either a tenant or a landlord.  Here, as in corporate bankruptcy, either kind of lease may be re-evaluated by the receiver and accepted, rejected, transferred in a sale, or partially assumed and partially rejected.  As with other unsecured obligations, the careful and timely filing of a proof of claim may be important to preserve a creditor’s priority for possible reimbursement.

Multiple Lender Transactions.  Multiple lender arrangements also may provide some safety.  The receivership of one member of a syndicated loan’s lender group may not be highly consequential to the borrower or the other lenders.  While that lender’s receiver probably will not fund future advances under the loan (especially on a construction loan), the typical syndicated deal has provisions for lender replacement, so long as the lender satisfies certain eligibility requirements (or other lenders in the group can make up the share).  The failed lender that does not advance will become a defaulting lender, and likely will lose its voting rights and its right to distributions.

A deal originated by a lender and then sold (as in securitization transactions) is even less likely to be affected by a receivership of the originating lender after the loan has been sold to others.   If the originating lender has retained loan servicing rights, they may be transferred with the loan, or to a new servicer, either by FDIC action, or by the new owner or trustee of the relevant special purpose entity if the FDIC repudiates the servicing contract.

Letters of Credit.  Letters of credit, often considered a rock-solid commitment in business transactions, do not necessarily fare well in bank receiverships.  Letters of credit constitute a bank’s forward commitment to pay an amount on demand to a beneficiary, based on the credit of another (the “account party”).  However, unlike the FDIC statement about perfected collateral, the FDIC does not give a clean assurance about letters of credit.  The FDIC states that “payment will be made to the extent of available collateral, up to . . . the outstanding principal amount . . . of the secured obligations, together with interest at the contract rate . . .” and certain contractual expenses.  But an unsecured or undersecured letter of credit, with a credit-impaired account party, is at risk of repudiation, as the FDIC is likely to view it as akin to an unfunded loan commitment to a shaky borrower.   That is little comfort to the letter of credit beneficiary.  However, the FDIC’s rationale appears to be that the beneficiary accepted the letter of credit based on the creditworthiness of the issuing bank, and that it should take the risk of having erred in that assessment.  Counterparties relying on letters of credit may want to re-examine the stability and credit risk presented by the banks that issued them.

No magic bullet will keep a deal with a bank facing regulatory resolution or receivership from being terminated or changed.  The legal processes for resolution are complex and discretionary.  However, counterparties still can exercise vigilance and take some steps to recognize and protect against risks in their deal structuring with banks.

The Devil’s Triangle of Bank Failure (part 2)

In the last post, I discussed the FDIC’s three roles, as bank regulator, insurer of certain deposits and receiver for failed banks, and how hard it is to figure out from official sources if a bank is in trouble.   One final related point: although it can be difficult to figure out if a bank is in trouble, there are some sources that can help one make that determination.  There are certain private “watch lists” that, for a fee, will disclose to you their opinions about a bank’s health based on their proprietary research.   In addition, the Calculated Risk blog,  which periodically (usually on Fridays) posts an unofficial list of troubled banks among the many other treasures of economic data in that blog.

In this post, I’ll discuss the five basic options that the FDIC has to handle a failed bank and its process for doing so.

The five options are:

1. open bank assistance;

 2. management change;

 3. purchase and assumption transactions;

 4. receivership; and

 5. depositor payoff.

These options are described, along with some commentary about the FDIC’s choices of methods, in the FDIC’s Resolutions Handbook.  Though a bit dated because it was last updated in 2003, the Resolutions Handbook provides an extensive description about the FDIC’s official resolution process. 

FDIC  process.  The FDIC “resolution” process usually takes about 90 to 120 days, but much of this process occurs in secret before the official closure of a failing bank, and typically without notice to most of the bank’s employees.  

Once the FDIC gets the needed data about the bank, a team of FDIC resolution specialists analyzes the condition of the failing bank.  This team estimates the value of the bank’s assets, generally using a statistical sampling procedure to populate valuation models (because it does not have enough time to assess every asset).   For each category of loans, the FDIC identifies a sample, reviewing selected loans to establish an estimated liquidation value based on discounted future cash flows and collection expenses.   A loss factor for that category of loans is derived and is applied to all of the failed bank’s loans in that category.  

Least costly resolution is required.  Since 1991, the FDIC has been subject to federal laws that require it to use the type of resolution process that is the least costly of all possible options. The FDIC’s determination of which resolution will cost the government least, over time on a net present value basis, governs its choice.

 The cost to the FDIC can vary depending on a wide range of factors, including the premium paid by the acquirer that is agreeing to purchase the deposits and perhaps the assets (loans of the failed bank), the likely losses on contingent claims, the estimated value of the failed bank’s assets and liabilities, the levels of insured and uninsured liabilities, any cross-guarantees available against the failed bank’s affiliates, and the cost of collecting on assets not transferred in purchase and assumption deals.

Any losses are to be borne first by equity investors (shareholders) and unsecured creditors, who are supposed to absorb all losses before the depositors.  The remaining loss is shared by the FDIC and customers with uninsured deposits, as the FDIC shares all amounts it collects proportionately with uninsured customers. 

Open Bank Assistance (“OBA”) and Similar Devices.  The FDIC can leave a troubled bank open and pump assistance into it.  This option has not been used frequently by the FDIC since the savings and loan crisis in 1989, when the FDIC started comparing the cost of such OBA proposals against selling failed bank assets via competitive bidding, and found that selling assets usually cost less. 

In addition, in a 1992 policy statement, the FDIC announced that its concerns about bank soundness would require that it make certain positive findings concerning the competency of management of an institution after an OBA transaction.   In 1987, the FDIC was first authorized to establish free-standing “bridge banks,” meaning temporary banks created to service a failed bank’s assets prior to their sale.  A bridge bank provides the FDIC more time to find a permanent solution for resolving a significant collection of assets.  These and other policies changed the FDIC’s preference from leaving a troubled bank’s assets in the hands of its original management.  As a result of such less expensive policy options, OBAs are no longer commonly used, unless required by threatened systemic risks to the financial system, as seen in late 2008 and early 2009 when the Troubled Asset Relief Program provided billions of dollars to banks deemed by the government as “too big to fail.”

A number of similar programs, which amount to propping up or deliberately overlooking some of a troubled bank’s failings, also have been used from time to time. These include net worth certificates, essentially a temporary fiat that the bank will be deemed to have more reserves than its examination verifies; and other forms of income maintenance and regulatory forbearance in which a bank is acknowledged (at least privately between the regulators and the bank’s management and board) to have defects in its balance sheet or sound practices, but permitted to continue to operate, generally subject to certain conditions.  Few of these methods, though, preserve the possible value of a troubled bank’s assets — or minimize the running losses — as quickly as an asset sale (“Purchase & Assumption”) transaction, so in the current decade, these older options tend not to be favored.

Management Change.  While this option is not found in the FDIC’s official resolution playbook, the FDIC appears to use it with some frequency.  As a regulated industry, banks always are subject to “safety and soundness” supervision, and to continuing vigilance over the qualifications, competency and absence of conflicts of interest of a bank’s senior management and board of directors.  The wide-ranging powers of a bank’s principal regulators to unilaterally remove a bank’s management are difficult to challenge.  This uneven power relationship is rarely far from the minds of senior management; a bank’s reduced health often gives the FDIC a control-change hair trigger to use in negotiations.  Most of the large-scale bank merger and sale transactions accomplished at the beginning of the current wave of resolutions in 2008 clearly were regulator-instigated.  News reports  suggest that even management of some buying institutions may have felt that that their jobs were threatened if they did not accept federal bank regulators’ urgently suggested rescue transactions.  In their business dealings with banks, counterparties should be sensitive to the bank’s loss of flexibility and other changes in tone;  such changes can indicate trouble is brewing.

Purchase and Assumption Transactions.  Purchase and Assumption transactions currently are the FDIC’s most favored procedure for resolution. Through this procedure, the failed bank, or some of it, is sold to a healthy acquirer.  The buyer assumes certain liabilities (deposits foremost), in return for assets and, usually, some federal assistance/risk protection. 

If the FDIC decides that a Purchase and Assumption transaction is the most cost-effective resolution, it will choose whether to sell the failed bank as a whole or in parts, what assets should be offered for sale, how to package them, whether loss sharing will be offered, and at what price the assets should be sold. Operating under strict confidentiality prior to the bank closure, the FDIC markets the failing bank as broadly as possible to its list of approved potential acquirers.  Acquirers, who must have adequate funds, may be either financial institutions or private investors seeking a new bank charter. 

Typically, all bidders are invited to an information meeting, sign confidentiality agreements, and are provided with an information package prepared by the FDIC’s resolution team.  The deal terms usually focus on the treatment of the deposits and assets held by the failing bank. 

Once the bidders’ due diligence is complete, each bidder submits its proposal to the FDIC.  A typical process might require bid submission 1 – 2 weeks before the scheduled closing.  The FDIC evaluates the bids to determine which is the least cost bid, and compares them to the FDIC’s estimated cost of liquidation.

We’ve been informed that many of the FDIC deals are structured essentially as “as – is” deals, with negotiation allowed over price, and possibly downside loss protections, but not much negotiation of other terms.  This makes some sense in light of the large current and anticipated volume of resolution transactions facing the FDIC, and its desire to assure lowest-cost outcomes by letting the market set the prices, thus reducing the risk that the resolution will be second-guessed later. 

The FDIC submits a written request for approval of the negotiated Purchase and Assumption transaction to the FDIC Board of Directors.  Following Board approval, the FDIC notifies the acquirer (or acquirers, if assets of the failed bank are split up), all unsuccessful bidders and the failing bank’s chartering agency; arranges for the acquirer to sign all needed legal documents; and coordinates the mechanics of the closing with the acquirer.  After the FDIC closes the bank, typically on a Friday, the acquirer reopens, usually on the next business day. If the Purchase and Assumption Transaction includes continuing help, such as loss sharing, from the FDIC, then the FDIC monitors the assistance payments until the agreement expires, which may take several years.

If the resolution of a failing bank  is not completed before the bank fails, or before there’s a run on the bank or other liquidity crisis for the bank, the FDIC may not have time to conduct the careful valuation and analysis needed for a Purchase and Assumption transaction.   In that case, the FDIC must use its other options, by electing to pay off the insured deposits, to transfer the insured deposits to another bank or to form a bridge bank.  To avoid those typically more expensive and therefore less desirable results, the FDIC prefers speed and relative secrecy in its Purchase and Assumption deals.

Receivership.   If a Purchase and Assumption transaction is the FDIC’s “carrot,” its power to undo a failed bank’s deals in a receivership is the “stick.”  Most bank receiverships are administered by the FDIC who, as the insurer and protector of the bank’s depositor claimants, represents what often is a troubled bank’s largest creditor group. 

The formal rules of a receivership proceed much like a corporate bankruptcy: based on a finding that the institution is insolvent, the “receiver” takes over for the bank’s management, many claimants are required to make their claim known rapidly in a formal process or lose their rights, the receivership can “stay” litigation against the bank and undo fraudulent conveyances, the regulator can clean up or reject many of the bank’s liabilities using other special legal powers that change or ignore the bank’s legal obligations, and the regulator can sell off, liquidate or close pieces of the bank’s business or the entire business as a whole. 

But there are some serious differences between receivership and conventional bankruptcy.  But there are some tremendous differences between receivership and conventional bankruptcy, so the analogy only goes so far.  For one thing. the finding of insolvency, which generally comes from the institution’s lead regulator, e.g., the OCC for national banks, OTS for thrifts, etc., is discretionary to the regulator, and based on special regulatory accounting principles (not GAAP).  Receivers simply do not have anywhere near the same degree of responsibility, liability or obligation to listen to creditors, as typically are enjoyed by creditors in a corporate bankruptcy.

Another significant unique feature of bank insolvencies is the special priority of deposit accounts, in an insolvent bank’s estate, under the National Depositor Preference Act and FDIC insurance rules. Whatever funds are available in the bank’s resolution or liquidation will, after receivership costs, generally be applied first to pay off insured deposits.  This means that there’s a whole (and usually large) class of creditors ahead of general unsecured, contract and trade creditors of the bank, who may get nothing, unless the assets are sufficient to pay off all of the depositors in full first.

The avoiding powers that an FDIC receiver has, under 12 U.S.C. Section 1821, also are far broader and more powerful than those in an ordinary bankruptcy.  Ongoing contracts with a bank may be “repudiated” (e.g., broken) if the regulator simply decides that they are disadvantageous to the bank, within a “reasonable” time; or if the regulator is dissatisfied with the bank’s original level of paperwork and approval of the contract. These expanded powers may overturn ongoing leases; the unperformed parts of partially completed contracts, including loan funding commitments; and apparently the bank’s issued letters of credit.  A party can sue the receivership for its damages for a repudiated contract … but only “actual” (not consequential or punitive) damages are allowed, and the claims will be paid off as a general unsecured claim with the same dubious after-the-depositors chance of payment as the trade creditors.  Finally, the FDIC as receiver can prevent a counterparty from enforcing most contract clauses that are specifically triggered by a bank insolvency or receivership.

Depositor Payoff.  The backstop option for the FDIC — which it tries to avoid –– is a straight payoff of federally insured depositors from the FDIC’s insurance funds.  As this option comes at relatively high cost to the insurance funds, and occurs when total assets fall short and there is no lower-cost option, other counterparties of the bank frequently lose their rights.

Practical and Tactical Considerations in a P&A.  Three things should be noted in connection with this currently most common form of resolution.

First, it creates some interesting asset purchase opportunities for institutions and investors.  Like any regulated government bidding process, careful attention to the rules, and speed, and the advice of experienced counsel with regulated assets expertise, is essential.  Qualifying as a bidder, at the right time and place, and navigating through the precise offer being made, require agility.

Second, from the viewpoint of a bank’s borrower, creditor or contractual counterparty, use of P&A transactions will quickly sort out that entity’s deal into either a pool of assets and obligations to be sold, and thus very possibly ride through the bank’s resolution as just another special case of a change of lender, or into a bucket of the bank’s operating obligations.  In the latter case, the survival, repudiation or other future fortunes of that entity’s deal depend on the receiver’s choice whether to sell the whole bank or the parts of its business relevant to the deal.  If a bank asset or obligation is not transferred to an acquiror, that asset or obligation will likely be handled by the FDIC through the resolution process, and this is likely to be very slow from the point of view of the original bank’s counterparty.

Finally, it cannot be emphasized enough that the current FDIC prefers speed, and usually, relative secrecy, in its P&A deals.  Recently, Calculated Risk ran a helpful pointer to an interview in the Orange County Register in which one healthy bank CEO describes his actual experience with shopping for an bank asset sale. The buyer indicated interest, assembled a quick bid, quickly conducted the diligence with the FDIC on-site under the nose of the (unknowing) troubled bank’s employees, and wrapped it all up in a few days:

“We finished up on a Thursday and had to provide a bid the following Tuesday. The next day (Wednesday June 24) they asked for some clarification … Thursday … they notified us that our bid was accepted. … Then it happened that Friday at 4 p.m. They went in and took over the bank and we followed them.”

In a later post, I’ll discuss some of the impacts the FDIC resolution of a bank  can have on various counterparties who were doing business with the failed bank before it was closed.

The Devil’s Triangle of Bank Failure (part 1)

What happens if a bank is on the other side of your deal, and then the bank fails? Most people have not spent much time thinking about this – but now more and more of us who are involved in the CRE world must do so. 

37 banks have failed to date in 2010, after 140 such failures in 2009.  All of these banks have been closed by the FDIC.  More bank failures are expected as commercial real estate loan defaults increase, and high unemployment keeps the economy limping along at best.  What legal impacts will those failures have on you and your business?  To assess that, you need to understand the FDIC and its role in “resolving” failed banks. 

This set of posts will first provide an overview of how the FDIC handles bank failures, then will discuss how a bank’s failure and resolution by the FDIC might affect an entity that is doing business with a bank in various capacities (as borrower, landlord, etc.).   (The topic’s a bit dense, so I can’t fit it into one post.  I’ll try to describe it as clearly as possible.)

What is the FDIC and what does it do?  

The FDIC is a bank regulator.  The Federal Deposit Insurance Corporation oversees U.S. insurance funds for depositary financial institutions.  It has several functions.  The FDIC is one of several regulators responsible for banks and thrifts.  Others include the Office of the Comptroller of the Currency, which is responsible for supervising national banks, the Federal Reserve, which is responsible for supervising both state member banks and holding companies, the Office for Thrift Supervision, for S&Ls, and various state agencies. (For purposes of this set of posts, I’ll simply refer to all such institutions as “banks.”) 

The FDIC is an insurer.  As the insurer of certain deposit bank accounts, the FDIC manages and controls risks to two separate deposit insurance funds, the Bank Insurance Fund and the Savings Association Insurance Fund, and protects the depositors in FDIC-insured institutions. When a federally insured depository institution fails, ultimately the FDIC pays out insured bank deposit accounts (if no other resolution is less costly). 

The FDIC is a receiver for failed banks.  In addition, the FDIC acts as receiver, conservator or liquidating agent for failed federally insured depository institutions, as well as for most state-chartered financial institutions, in order to promote the efficient and expeditious liquidation of failed banks and thrifts.  In this capacity, the FDIC has broad power and authority:  

  • it can  “resolve” the problems of the failing institution, through asset sales or a number of techniques discussed later; or 
  • it can put such an institution into receivership, and close it; or
  • it can combine a partial resolution with a receivership.

The FDIC has two main goals: to maintain stability and public confidence in the U.S. banking system, and to minimize the government payout of monies from the FDIC insurance fund.  The FDIC’s actions become more understandable when one understands these priorities. 

Overview of bank failure.  Like other businesses, which are subject to bankruptcy when they fail, failed banks are subject to a legal regime for sorting out their balance sheet, their commitments and their inability to honor them.  U.S. insolvency law for financial institutions is similar to, but quite different from (and excluded from), conventional corporate bankruptcies under Title 11 of the U.S. Code. To some extent, workout lawyers will recognize the process: it looks like a horse, and runs rather like a horse, but it’s a zebra, and some parts are very different.  Federal bank regulators handle troubled banks with two principal public policy goals in mind: special protections for the benefit of depositors (who are a protected class), and the need to protect systemic soundness of the financial markets.  As a result of the latter, regulators enjoy far more discretion in working out a troubled bank’s obligations than in a typical corporate bankruptcy. 

Few early stage warnings.  It can be difficult for a counterparty to anticipate a bank’s  failure.  A bank’s creditors and contractual counterparties should be aware that, long before any official “resolution” process, troubled banks may be subjected to special rules or limits on their transactions.  Additionally, the “supervisory” correspondence, examination reports and warnings from a bank’s regulators often are explicitly confidential. 

Banks are obliged to maintain both “capital adequacy” and balance sheet solvency.   However, those calculations are rarely simple, and sometimes they are not wholly transparent to outsiders.  Complex banking regulations relating to capital adequacy complicate evaluation of a bank’s assets and liabilities.   So, for example, a bank with inadequate capital — which inadequacy might occur passively by negative revaluations of investment assets in the bank’s portfolio — may not have the ability to make new loans or extend more credit to existing borrowers.   Or interest rate or similar restrictions on permitted loan terms may be imposed by regulators on a troubled bank, if the regulator feels that the bank’s interest rate practices or exposures are questionable. 

Bank regulators usually work very hard to keep a troubled bank’s predicament quiet to prevent a run on the bank, to preserve systemic economic confidence, and to obtain the best price for the bank’s assets in any arranged deal.   In some cases, regulators issue an order requiring the institution to take certain actions (usually to increase its capital within a certain period of time),  but it is still difficult to determine the status of the bank’s compliance.  Often, the only public advance signal of a bank failure is a securities filing from the bank itself that it cannot continue as a going concern, which usually comes only days before serious regulatory action occurs. 

Since the government is given broad discretion in making decisions about banks, there is also some risk that the contracts of a healthy bank may be altered for public policy reasons, particularly in a difficult economy.  See, e.g., the consumer home mortgage forbearance and reformation provisions in FDIC Financial Institutions Letter 36-2009 (the Obama Administration’s home mortgages protection initiative). 

The beginning of an official “resolution”, comes with the issuance of a “Failed Bank Letter” to the FDIC by the agency which charters the bank, stating that the bank is failing or is in imminent danger of failing, and will be closed.  (This typically happens when a bank becomes critically undercapitalized, insolvent, or unable to meet requests for deposit withdrawals.)  As a practical matter, these notices are not likely to be a timely source of guidance or warning for the bank’s creditors and counterparties.  Once the official resolution phase has started, using one or more of the specific methods described later, the cow already is out of the barn. 

In the next post, I’ll discuss what the FDIC’s options are for “resolving” a failed bank, and which of these options it uses most often. 

 Note:  Many thanks to my co-author and partner Ed Karlin of Seyfarth Shaw LLP and to my co-author James Bryce Clark, General Counsel of Oasis-Open.com, who both coauthored with me a shorter version of this material in an article entitled “Take it to the Bank” which appeared last October in Los Angeles Lawyer Magazine, and to LA Lawyer Magazine for its permission to reuse some of the same material.
 
 
 
 

  

 
 

 

Distressed Note and REO purchases (part 2)

Part 1 of this series dealt with representations and warranties that are typically provided in distressed note purchases and distressed REO purchases.  This post gives an overview of some of the diligence issues that must be addressed in purchases and sales of (whole) distressed notes.   (Other issues arise in the context of sales or purchases of participations in notes, which are not addressed in this post.) 

Why do due diligence?  When a lender chooses to sell, rather than to enforce, a distressed note secured by CRE, it may have made that decision for any one of a number of reasons.   For example, the lender’s regulator may have decided that the lender is carrying too many distressed real estate loans, and may have told the lender it needs to quickly rebalance its portfolio.  Or the lender may need to improve its liquidity quickly, and may determine it can do so faster by selling one or more distressed notes rather than by enforcing them, then selling the distressed REO after it is foreclosed upon by the lender.  Or it may have decided to get out of a given type of lending business, and therefore to sell all its loans in that line of business.  It may be rebalancing its risks geographically, or based on changes in the market.  Alternatively, the lender may need to improve the overall quality of its portfolio quickly.   Or it might be selling to change its yield and duration risks.   It might be selling the note due to its merger with another lender.  Another reason a lender might sell is because it thinks it will have a tough battle with the borrower to enforce the note, and does not want to commit the time or money.  Or the property may carry with it liabilities of one sort or another:  for example, foreclosing on a retirement home or a hospital may create public relations problems for a lender; or the lender may simply not want to, or have the resources to, manage certain types of property, such as land not yet subdivided; or a property may have environmental problems that concern a lender.   Or, in a declining market, the lender may decide it ultimately can collect more in a fast note sale (or lessen its costs — such as property taxes and other costs it must advance — to hold the declining property) than in a slow foreclosure (and possible bankruptcy). 

A potential buyer simply does not know why a lender is selling a distressed note, and so it needs to do diligence at two levels to understand and price the risk it is taking by buying the loan: 

  • First, it must do diligence to determine the status of the note, the other loan documents, the borrower, any guarantor, and the relationship and actions to date taken by the borrower and the selling lender, because the buyer will be stepping into the shoes of the selling lender; and
  • Second, it must do diligence to determine the status of the real property and any other collateral securing the note as if it were buying that property, so that it can understand, evaluate and price the current value and possible risks inherent in foreclosing upon that collateral.

“Due Diligence” defined.  Although most of you probably know what “due diligence” is, a simple definition is that “due diligence” means an appropriate investigation about all aspects of a note or an interest in property on behalf of a person or entity who plans to purchase an interest in it.  Generally, in commercial real estate transactions, the rule is “Buyer Beware!” which means the buyer must ferret out all the information it needs about what it is buying to make sure it is actually getting what it thinks it should be getting in its deal.

Lender/Seller’s position on due diligence.  A lender typically will agree to some diligence concerning the loan:  it should be willing to provide access to and copies of  its loan documents, correspondence to and from borrower and related parties, and loan file (other than any privileged documents and any appraisals) to the buyer and its counsel for review after a loan purchase agreement has been negotiated and before the buyer (and its deposit money) is irrevocably committed to complete the purchase.  Typically, a lender will require a buyer to enter into a nondisclosure and confidentiality agreement prior to providing such information, which is usually a reasonable thing to require.

It is in the lender’s interest, up to a point, to have the buyer do its own diligence on the loan documents and underlying collateral:  the lender’s goal is to get as close as possible to an “as-is” sale, and a lender will typically insist that the buyer make express representations that it has had the opportunity to perform diligence on the loan and on the collateral, and that the buyer is relying solely on its own diligence in electing to purchase the note.  Structuring a deal that way provides a selling lender some comfort that the sale will truly be final, and the buyer will not later be able to argue that the seller should be liable if the buyer has problems with the loan it buys.

Recommended due diligence for distressed note purchases.  While it’s pretty straightforward to review a lender’s loan file (assuming a complete loan file can be located), the process for evaluating the underlying collateral can be more complex. 

To review a loan file, one must carefully read (and preferably also have counsel read) all of the loan documents and all of the correspondence between the lender and the borrower.   The purpose of this review is to confirm the basic business terms of the loan (its amount, times and terms for payment, etc.) as well as the legal effects of the loan:  that the loan was made and documented properly, that it appears to be enforceable against the borrower and the property, and that the security documents work (create liens against the property that is collateral for the loan, whether personal or real property).   It’s usually a good idea to run a litigation search on the borrower to see if it or its principals have a history of litigation — that can be an indication of how hard it might be to enforce the loan.  Further, a legal analysis of the likelihood that the borrower has defenses to payment or other leverage (such as a fraud or other lender liability claim) that it could use to oppose the enforcement of the loan should be done by competent CRE counsel.  For example, my group has a standard form CRE loan checklist that we use to review loan documentation; it is quite long and detailed, and reminds us to check (and to document in summary form) a wide range of issues that can hamper the enforcement of a CRE loan.  After we complete initial diligence for a loan purchase, we provide that checklist (as well as an executive summary of it) to our client, so that it can make its internal determination about what to follow up on.  It is not uncommon for an initial round of diligence both to resolve certain issues and to uncover other issues that must be investigated further in order to really understand the risks of enforcing a particular loan. 

Typically in a loan purchase transaction, the buyer’s lawyer first looks at the lender’s loan file; if there are insurmountable problems in it, then the deal may be terminated before review of the collateral takes place.  But if the loan file seems okay, then the next order of business is typically the due diligence review of the real estate collateral securing the loan.

Diligence concerning the real property collateral should ideally be essentially like diligence on any purchase of real property.   What amount of diligence is “due” depends upon the circumstances, including the risks created by the prior use of the property, the risk tolerance of the buyer, the monetary value of the transaction, and the budget available.  The type of investigation that a buyer and its lawyer should perform in any real estate transaction depends upon both the type of transaction and the kind of land which is being purchased or encumbered.  However, some basic questions common to all types of land are outlined below:

  1. What interests in the property collateral are encumbered by the loan?
  2. What is the value of these interests?  Are they sufficiently valuable that if the note borrower fails to pay the note, the buyer can collect the amount owed by foreclosing on the land or taking other allowed liquidation actions?
  3. Who owns the property collateral? (Generally, it should be owned by the borrower.)
  4. What is the property used for? (This information is very important in determining the value of the land and the likelihood that it is environmentally contaminated.)
  5. Where is the property located? And can it be located with specificity on a survey? Has it been subdivided (so that it can be resold after a foreclosure if necessary)?
  6. How has the property been used in the past? (Also very important when determining environmental risks.)
  7. If it were to have to foreclose, what use could the buyer make of the land?
  8. Does anyone other than borrower (and typical easement holders, like utilities) have any rights to all or parts of the land?  If so, could such interest holders block buyer’s use of the property after a foreclosure?

The common goal of all of these questions is to find out precisely what the seller is selling and what the buyer is buying. This sounds simple but is not.  The key is to be able to find out about the property while relying only on sources of information that are known to be highly accurate (and, if possible, on sources that carry liability insurance against their own errors).  I could go on and on about the specifics of due diligence, but won’t:  just understand that in order to know whether it makes sense to buy a distressed CRE note, a buyer must do diligence on the collateral property as well as on the note. 

Key due diligence provisions in note purchase and sale agreement.  In negotiating the due diligence provisions of a note purchase and sale contract, the parties usually have to negotiate several points:  (a) the length of time the buyer has to  complete its due diligence; (b) whether the buyer can do environmental testing or physical inspection of the underlying property collateral (both are very important, but frequently the would-be note buyer’s access to the property is constrained by the seller/lender, which may itself only have limited rights to access the property; (c) the amount of cooperation during the diligence process that the selling lender must provide; (d) what happens if the buyer completes its diligence, then new information comes up about the status of the loan or the property collateral; and similar issues.  These issues and others are typically negotiated in the note purchase and sale agreement; once negotiated, both seller/lender and buyer must comply with those terms.

What we’re seeing now.  We’re seeing generally an uptick in distressed note purchases and sales.  However, there are fewer of these sales than one might expect.  It appears that regulators who in other CRE downturns might have pushed lenders to sell notes to maintain their liquidity, are instead allowing them to wait longer or go through foreclosures and other enforcement actions instead of doing faster note sales.  Many lenders think they can get a better return by enforcing the notes themselves, through foreclosure, then selling the real property collateral.  Further, there seem to be a lot of would-be investors in distressed notes relative to the number of distressed notes on the market, so there seems to be a fairly stiff competition to buy these notes — and many investors seem to be buying them at prices that do not take into consideration the potential costs and likelihood of enforcing these loans through foreclosure, or even despite a borrower bankruptcy; so it is unclear if many of these deals are actually healthy for the buyers.

Distressed REO and Note Purchases (part 1)

As more borrowers default on commercial RE loans, more lenders are starting to sell either the defaulted notes or, after foreclosing on the property securing the loan, the REO (real estate owned) properties.  These deals are typically “as is” deals, subject only to certain negotiated representations and warranties from the lender/seller to the buyer. 

I thought it might be useful to outline some of the typical representations and warranties we’re seeing in these deals; and also to set forth a reminder about the due diligence that should be done by buyers so they know what they are getting, and don’t just become knife catchers.  In today’s post, I’ve outlined typical reps and warranties.   I’ll outline typical due diligence issues in the next post.

First, at the risk of stating the obvious, there’s a big difference between buying foreclosed REO and buying a distressed note.   If you’re buying REO property, the borrower has already been foreclosed upon, and therefore you as buyer will not have to either foreclose the loan or take the risk that the borrower will file for bankruptcy.  If you are buying a note, however, you as buyer are taking those risks.  This means that a buyer of a note must take additional precautions and do additional diligence in order to make sure that the distressed note is actually worth what the buyer is willing to pay for it.

One way to determine the value of a distressed note, is to evaluate the market value of the underlying real estate collateral, then to take a discount from that in the amount estimated to reflect the likely cost to enforce the loan (possibly all the way through a borrower bankruptcy), adjusted by the likelihood that the borrower (and guarantors, if any) will fight the foreclosure.  This requires both a business and a legal analysis — the latter to determine if there are any defects in the loan documents that would make the loan harder or easier to enforce.

In purchases and sales of distressed REO, the terms of the deal are basically like other purchases and sales of real estate, with a few exceptions.  The seller of REO, typically a lender which has foreclosed upon the property, will not usually make a lot of representations about the property because it is not as knowledgeable as the typical seller — the lender’s position is usually that it made a loan, and will make representations about its ownership of the loan, but not about the underlying real property.  So most sellers of REO will generally represent and warrant as follows:

1.  that the lender/seller has the authority to enter into the sale of the REO, and that the agreement to sell the REO is enforceable against it;

2.  that no interests in the REO have been previously conveyed to others by the lender/seller;

3.  that there is no litigation concerning the REO  other than as disclosed in writing in an exhibit to the purchase and sale agreement;

4.   that the information provided by the lender/seller is true, complete and correct to the extent it has been created by the lender/seller (note that a lender/seller will usually provide copies of third party reports, such as environmental reports, but expressly will not accept liability for their accuracy — buyers need to either engage the provider of such original reports for downdates of them so that they can rely on such reports, or to have new reports done for them); and

5.  other representations typical in CRE purchase and sales agreements may be included.

If a distressed note is being sold, rather than REO, additional representations of lender/seller may include:

6.  that the lender/seller has provided to the buyer copies of all of the contents of its loan file, including all loan documents, modifications and copies of all correspondence relating to the loan;

7.  that the lender/seller is selling the whole loan (or, if the sale is of part of a loan, what part);

8. that the lender/seller owns the distressed loan, and has not conveyed any interests in it to any third party (except as disclosed in writing in the agreement).

In both REO and distressed note sales, there may be more representations and warranties running from the buyer to the lender/seller than in a typical CRE purchase agreement.  In a sale of REO property, in addition to the standard representations that the purchase contract is enforceable against the buyer and the buyer’s signatory has the authority to execute the contract,  the following representations may be included:

1. that buyer has investigated and completed its due diligence on the property, and will rely only on that diligence in electing to purchase the property;

2.  that the buyer expressly agrees its purchase of the REO is “as is, where is”;

3.  that the buyer complies with the Patriot Act;

4.  that the buyer is not an insider or affiliate of the lender/seller.

Sometimes in distressed note sales, a buyer will also represent that it is a sophisticated investor, and can bear the risks of purchasing a distressed note.  These lists of representations are not exhaustive, but should give you an idea of the sorts of reps you’ll typically see in these deals.

Next post:  Due diligence needed for purchases of REO and distressed CRE notes.

Happy Holidays, 2009: CRE is Scrooged

I’ve thought the market was overvalued, and that a wave of foreclosures was coming, for several years.  I was wrong in 2005 and 2006; by 2007 a fair number of folks thought the CRE market was overvalued, but we did not see many defaults, at least here in Southern California.  In 2008, the CRE  market seemed to be generally stuck.  This felt very similar to 1991 — everyone knew values of CRE had fallen, but no one wanted to take action — as if denying reality might make it go away. 

But many of us, including me, have been surprised by how long it has taken for the weakness in the overall economy to affect the CRE market this time, and how long it has taken before an uptick in defaults, workouts and foreclosures.   In some parts of the country, like Michigan and Florida, the wave of foreclosures brought on by falling values has already hit.   But in California, where we have generally seen only limited CRE foreclosures in 2009 (but a lot of modifications), it looks like we’re in the trough of activity looking up at the crest of the wave now.

Just today, in connection with a discussion of a consensual workout of some prominent San Francisco real estate, Bloomberg reports

“Commercial mortgage defaults more than doubled in the third quarter from a year earlier as occupancies fell, according to Real Estate Econometrics LLC.  .  . Property sales financed with commercial mortgage-backed securities plunged 95 percent from a record $237 billion in 2007, according to JPMorgan Chase & Co. “

Bloomberg goes on to quote Moodys, as saying that values “may fall 55 percent from their peak” due to a lack of securitized debt.

 Third quarter 2008 was bad enough:  double that default rate is ugly. 

A drop of CRE values anything like 55% obviously will be even worse news for highly leveraged projects — and could gouge the LTV ratios for even the most conservative lenders.

Probably we’ll see a greater number of underwater owners giving back their properties to lenders, either by deeds in lieu, agreements to not fight foreclosure, or the like.  Often these graceful surrenders are made in  exchange for limiting guaranty exposures.   In the case of CMBS loans, we’re starting to see lots of resales of the property made consensually through a receiver to a willing buyer/new borrower who is willing and able to assume the existing loan, as modified.    These can be fairly simple and effective workout deals, if documented correctly to avoid the traps presented by California law.  We’re also seeing some lenders who don’t want to battle through foreclosures quietly moving to sell their loans to buyers willing to undertake those legal fights in exchange for a discount on the note price.

True to 1991 form, we don’t seem see borrowers or lenders completely capitulating to reality yet:  there’s still a persistent gap (though a diminishing one) between what lenders are willing to sell distressed debt or foreclosed property for, and what buyers are willing to pay.

That’s what we seem to be seeing now, as we go into the holidays.  I’d be interested in hearing whether you are seeing that too — or seeing something different.  Please let us know by posting a comment.


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Attorney Advertising. This blog is a periodical publication of Maura O'Connor, a partner of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have. The contents are intended for general information purposes only and represent the individual views of Maura O'Connor only. Any tax information or advice contained herein is not intended to be and cannot be used by any taxpayer to avoid tax penalties that may be imposed on the taxpayer.