February 13, 2013
To Own or Not to Own
by Jon Winick
Clark Street Capital
We asked Jason Kuwayama of Godfrey & Kahn to address how banks should approach the various strategies in resolving a problem real estate loan that cannot be easily rehabilitated, and when it makes sense to own the real estate.
“Every situation is unique, so it’s hard to apply a single strategy to every loan relationship. But, generally, a pre-determined strategy to settle with a borrower and bring assets into REO will increase the bank’s losses or decrease the net recovery on its portfolio.
Some people say this, but I witness it: A bank’s first loss often is its “best” loss. In the past five years, I have assisted clients in the sale of nearly $10 billion of distressed loans. Some of these loans, which failed to sell due to insufficient market prices, subsequently were taken into REO. This same REO, when it sold years later, usually resulted in a net sale price below the original offering price for the loan. Factor in carrying costs and quarterly accounting losses and the REO strategy was misguided.
Settling with a borrower can be a good idea if you are concerned about claims being raised against the bank or if the settlement will result in a diminished payoff that is satisfactory to the bank. But, if the “settlement” achieves only a token pay down in exchange for a release of a guaranty, then the bank simultaneously might have destroyed its path to recovery as well as the market price for the loan by removing a secondary source of payment (and, in turn, pricing).
When engaging in a settlement/REO strategy, a bank should consider the transaction costs and post-deed carrying costs. Among other things, a REO-centric strategy likely will require a bank to hire a foreclosure attorney, file a complaint, potentially respond to counterclaims and affirmative defenses, conduct an environmental survey, obtain an owner’s policy, insure the property, maintain the property, pay past and current taxes and assessments, and pay a real estate broker at a relatively high commission rate.
Loan sales eliminate most of the carrying costs associated with REO. A typical loan sale includes many assets being sold in a single portfolio, so the transaction costs on an asset-by-asset basis are relatively low. In addition, loan sale brokerage fees often are less than those charged by real estate brokers. And because a bank never takes ownership of the collateral in a loan sale, it avoids having to pay taxes or incur other expenses related to the collateral. So, the prices in loan sales might actually be better than you think after adjusting for costs associated with the settlement/REO strategy.
Of course, there are some circumstances in which a loan sale simply does not make sense because the carrying costs for an asset are projected to be low and the market price for the loan falls well below the bank’s ledger balance. Raw land, for example, is not likely to have a high carrying cost. So, if a loan secured by raw land fails to achieve a sufficient purchase price, then a bank is better off holding that REO until real estate prices recover.
Also, if a borrower is committing waste, then it leaves the bank with little choice but to take immediate control of the asset, including by appointing a receiver or demanding a deed on less-than-favorable terms. But, a ‘difficult’ borrower should not be confused with a borrower who is committing waste. Most borrowers can be difficult when negotiating with their lenders; the most difficult of borrowers should be warned that they can earn their loans a top spot in your next loan sale.”