REQUIRED READING: On Oct. 30, 2009, the Federal Deposit Insurance Corp. (FDIC) issued a Financial Institution Letter titled ‘Policy Statement on Prudent Commercial Real Estate Loan Workouts.’
The guidance comes at a time when, even though we keep pushing the start button, the engine of mortgage finance does not come to life. The engine grumbles and chokes, and then goes quiet. Instead, problems and questions seem to consume all of our attention.
Where did all the tenants go? When will the remaining ones go? Operating cashflows are down portfolio-wide, in many cases. Property values are compressed, with inflating cap rates. Market participants cannot collect payment, cannot rent, cannot sell, cannot refinance, etc.
Could there be a bright side to these conditions? The upside may appear only in the eyes of the regulators and only if their rules are followed to the letter. The focus is on the process of redoing the deals in a conscientious manner so as to improve the payment situation as much as possible while not being forced to adversely classify a loan or to needlessly write off a substantial debt balance.
Transparency – a worn-out term – will play a role here. Transparency is not something magical. It is something a prudent company should have striven for all along, and it is nothing more than having what you need and understanding what you have.
According to the FDIC's letter on commercial mortgage workouts, three key aspects should be considered for problem loans and loan workout arrangements: analyzing the repayment capacity of the borrower, evaluating guarantees and assessing collateral values.
To meet any of these requirements, good information on a large number of issues pertaining to each loan and property must be immediately available. The FDIC states that lenders must consider the facts and circumstances, tempered by good judgment, to reach a decision on treatment of problem loan assets.
Doing so involves the constant monitoring of the property and debt payment status, and the tracking of efforts and outcomes regarding the debt restructuring. Each segment of debt on a property must be individually understood and analyzed, in addition to the lender's specific segments.
If other segments are junior, their default will trigger a default on senior portions of the loan, and the holder of that note may end up owning the property and becoming the new borrower. If other segments are senior, the opposite situation will occur.
Getting your docs in a row
Perhaps the most important issue in securing the lender's rights to collect on a mortgage loan is the chain of loan documents and loan ownership documents. To highlight this fact, on Oct. 9, 2009, in the federal bankruptcy court for the Southern District of New York, a judge ruled on the issue of inadequate documentation and unproven legal standing.
In this case, the owner of the residential home loan and its representative could not produce documentation that proved they were the holders of the note due to previous assignments of mortgage and note for a securitization. The borrower had been paying its mortgage – and no one initially disputed the lender's claims – but the judge ruled to expunge the mortgage debt. In one stroke of the pen, the mortgage and note obligation were vaporized.Â
As is evident from that case and common sense, a complete paper trail is mandatory and must be physically secured. That much is a given. However, backup and availability of reference copies of the documents are also essential. Documents should be made available in secure electronic format capable of being reviewed when needed by any authorized party.
Key loan documents affecting ownership and protection of the secured interests of the lender include the mortgage, note and guarantees. These documents are essential – but not sufficient – in order to protect your interests.
Also needed is current title insurance (with most recent bringdowns and updates if the property was under construction). Property, casualty and liability insurance are critical, as is having the lender listed as mortgagee and loss payee.
The coverage must have been issued in full compliance with your lending program requirements. Key information on the coverage must be in the loan file for ready access and update.
Having the necessary paperwork squirreled away in a dusty file room is your ultimate backstop against documentation problems. At the same time, having the documents in readily accessible electronic form will speed your response to problems and provide what you need, when you need it. Opposing attorneys will be stunned that you both have the information and have it without delay.
Analyze the repayment capacity of both the property and the borrower. Being confident that you actually own the loan and can prove it are your primary concerns. With that assurance in place, you can focus on whether the borrower and its property cashflow can actually pay the debt – now and in the future.
In the case of mortgages, the past is always prologue for the story to be written. Monitoring past operating performance, approving major leases and marketing programs, and knowing trends in the market will show the regulators that you are aware of issues and know where the property is headed. Nothing should be omitted, and nothing should be left to chance.
Your information systems should help you track all of the following: financial statements and property condition; property operating statements, along with contract vs. market rental rates, current and project vacancies, operating expenses, and aged accounts payable and accounts receivable; and the availability and magnitude of reserves.
In addition, the systems must track capital requirements (both projected sources and uses); initial and evolving debt structure and capital availability; construction and renovation needs; and rent rolls and leases, including historic changes in tenancy, tenant bankruptcies, expiring leases, and improvements in and deterioration of rental terms in surviving leases.
This information is necessary for understanding assets. For a lender, having this information and using it in an analysis of debt-paying ability will show regulators that you are on top of any problem.
Building information files
Real estate assets are only part of the deal, and they are only part of your initial underwriting and mediation of risk. Borrowers and guarantors that were present when the loan was originated may be around when the loan becomes distressed, but they may be a little battered at this point. Avoid asking the borrower for statements of financial condition after a problem develops.
Examine how the borrowers and guarantors have done since the loan was written. An ongoing review of their financial condition and a periodic documentation of that condition should have shown the development of trouble and can be used to quickly develop a plan for returning a troubled loan to performing status.
Documentation should be reviewed and maintained with the loan files. Examine the borrowers' and guarantors' net worth and income statements; the cashflow and value of the borrowers' and guarantors' other assets; and other sources of repayment, such as net proceeds from a borrower's sale of subject and other properties.
When a serious problem occurs in a loan, a loan officer may be tempted to return to the consulting reports from the start of the deal. These documents can be briefly checked, but it is also critical to order an updated appraisal and market study, a current property condition report and another Phase I environmental study.
Knowing the cashflow and the net realizable value of the property will make both the lender and the regulators more comfortable that a turnaround will occur, or that a projected cashflow will be available to support the modified terms of a deal.
With all of these documents, keep all of the information that you know and discover. Throw nothing away. Put the documents and information in a system that is at your fingertips and can be shared with management, your attorneys and relevant parties.
All of this information will be valuable when you are developing a plan of resolution and negotiating a restructure, if necessary. When all else fails and the borrower stops paying, you may be forced to resort to the courts to claim your collateral.
At issue will be the classification of each loan, in terms of its current and ultimate collectability. Do – or did – the problems exist internally to the bank when the loan was originally underwritten or in the follow-on servicing of the loan? As you review the loans, consider any weaknesses and whether they will affect the loan.
If all is going fine, be thankful – for now. However, is there deterioration in property cashflow or value that has led, or may soon lead, to irregularities in debt-service payments? Can your borrower survive and continue to support the loan? To the extent that you can determine, how are the competitors dealing with the current economic climate?
What changes may be needed to turn around or stabilize the payment situation (e.g., changes with the property and/or changes with the loan)? Are issues with the property and local market so severe that some degree of loss is expected and the loans, or portions thereof, must be classified as substandard or doubtful?
Items for review
To demonstrate that you are informed and understand the situation, you must assess the following loan information: payment history; other senior or subordinate debt; significant operating expenses, such as insurance or vendor payments; and current property financial information and physical condition.
In addition, assess the current borrower and guarantor, considering the financial condition and net worth, payment history on other obligations, and a demonstrated willingness and ability to advance payments to support the property.
Finally, consider an updated collateral value with alternative scenarios, including refinancing at the currently reduced property market values and under the current lending criteria, foreclosure and net realizable value after costs, and adjustment of allowance for loan losses.
Following a thorough review, you might conclude that your best option for maximizing the realizable value of the loan is to do a loan restructuring. For the loan to receive troubled-debt restructuring treatment, a number of factors must be evident:
- The borrower is experiencing financial difficulties, as shown by missed payments, deferred maintenance on the property, extended payables and depleted cash accounts;
- The borrower has proven an inability to refinance the debt on reasonable terms or to sell the property for at least the amount of the debt;
- The lender has granted payment concessions to the borrower, or modified the payment terms of the debt;
- The lender has already realized a deterioration in the debt by having a charge-off against loan loss reserves or income; and
- The lender expects full repayment of principal and accrued interest because the property value (plus any borrower advances and collections on guarantees) will prove insufficient.
Charles E. Calhoun is director of client services at New York-based Rockport Group. He can be contacted at ccalhoun@rockportllc.com or (646) 502-9351.
