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BirdsEye View

I borrowed the title and some of the content of this article from Dan Harris of Dime Savings Bank in Brooklyn.  He sure knows his stuff!

 I can’t think of any bank in the country today that doesn’t have to manage a higher-than-normal load of problem real estate loans.  It’s a sign of the times.  The purpose of this article is to offer a framework and tactics to manage problem loans more effectively.

Set the stage

I’ll start with a controversial proposition:  your first step to effective problem loan workout is removing the Relationship Manager (RM) from the driver’s seat on the resolution.  A third party should own the workout file.  It could be another RM, but not the one who originated the credit.  It’s extremely difficult for the originating RM who developed a special relationship with the borrower to negotiate aggressively or play hardball with the borrower.

Gather information

Review the entire loan file, of course, but especially comb through the title, payment default section, notice provisions and personal recourse language of the loan agreement.  Then visit the property – first hand impressions are priceless.  Research the borrower thoroughly as well:  are they having other problems?

Develop and execute a strategy

There are only two ways to address a problem loan: restructure it or foreclose on it.  To maximize effectiveness work both tracks concurrently:  start the litigation process while communicating your willingness to restructure under appropriate terms (be careful of TDRs, or at least be aware of what restructuring steps will get you there).  Procrastination is costly here: document the default, comply with the notice provision and hire counsel.  Waiting will dissipate your leverage.

If the property value and cash flow are sound, play hardball.  Let the borrower know early and often that you expect full compliance with the loan documents or else you’ll seek full legal remedy including aggressive pursuit of the guarantors.

While borrowers are reluctant to sign anything in a default situation, it is imperative to get a pre-workout agreement signed.  The agreement says that discussions on the loans in no way modify the written documents; that the RM has no authority to bind the bank; that litigation will not be delayed or modified based on on-going discussions; and that nothing is agreed until put in writing and signed by both parties.

Never meet the borrower alone.  Always have a witness from the bank.  When you meet, be thoroughly knowledgeable of the situation and the numbers.  Always request current financials before the first meeting and discuss them at the first meeting.  I know it’s a challenge, but if you refuse to continue a meeting without financials they’ll get the message:  no financials, no meeting!

Spend much time preparing for a negotiation.  Anticipate the borrower’s position and have your responses outlined.  This is the most productive way to spend your time prior to the negotiation.

Being a good negotiator is a critical skill set here.  I often joke I’m a rug merchant, having come from the Levant.  Perhaps it’s in my blood.  Knowing negotiation strategies is important both to practice on your side and to diffuse when they are used against you.

Assume you will own the property at the end of the workout.  This approach will strengthen your negotiation position.  Let the borrower know you want to own the property; it is up to the borrower to convince you that there is a better option for you.

The RM negotiating at the table should never have the last word.  They should always defer to the bank and “their manager” as the last authority, which reins them in and gives you another bite at the apple.

Managing litigation

Choose counsel effectively.  There must be a fresh independent look at the documents and unbiased advice, even if the bank is tied in with several law firms.  Also, your counsel must have relevant experience in real estate, litigation and bankruptcy.

Use counsel only to do what you can’t do: draft pleadings and advise on litigation procedures and the law.  You do not need counsel to strategize on the workout itself – that is senior management’s job.  The RM or the workout manager should be the bad guy.  Let your counsel play the good guy; they are less likely to play the pit bull here, lest the borrower become their client in the future.

Never accept money without a non-waiver letter once a default has been called.  If you do you’ll have to start the default process all over again.

Doing a deal

Cash flow is king, so find out what the real cash flow is here, and go from there.  Verify the numbers and determine what payments they will support.  Go line by line through the financials with a critical eye.  Watch out for unreported cash rents and expenses that really belong to the borrower’s other assets, such as shared employees.

Don’t do a restructure unless you improve your position.  At a minimum, confirm that the borrower has no other defaults under the loan documents as of the date of restructure.  This will help avoid future arguments during foreclosure.

Use pay rates with accruals to give cooperative borrowers some time, but don’t book accruals.  Cash is king!  Value is nice, but it doesn’t pay the mortgage.  Consider realistic valuations based upon cash flow, but that will likely mean increasing your specific reserve against the loan, charge-off or loan rating downgrades.

Leave some cash for the borrower.  Otherwise the deal will fail even if signed.  The borrower must see the light at the end of the tunnel.

On the other hand, don’t be bullied by threats of bankruptcy, or swayed by offers to purchase the note at a discount below market rate.  Bankruptcy can offer faster resolution than foreclosure, and discounts are OK so long as they correspond to current valuations and you have the capital to withstand them.

Be cautious of environmental issues.  Those translate directly to costs.  If these issues are very serious, you may choose to walk away from the property.  If you do so, make sure it’s before you assume ownership!

Owning the property

First create a separate entity to own the asset to limit your liability.  Then recognize there are professional property managers, and you aren’t one of them (we hope J).  Manage your property manager aggressively.  Demand detailed monthly reports, visit the property and the manager regularly and provide bonuses for good performance.

Hire a qualified broker to sell the property, someone who knows the area as  well as this specific property type.  Interview several brokers, especially for larger assets.  Ask, “Who is your best competition and why are you better?”.  Offer higher commission for higher sales price so long as you control the negotiation.

Institutional issues

Loan ratings and reserves must be updated and be kept confidential.

TDRs are a serious issue from a perception standpoint.  Manage carefully!

Report frequently to management (I’m sure it’s a requirement these days), and do so confidentially and honestly.  Also use your time to review the remaining portfolio, even if it’s current.  Too often these days they switch from current to doubtful overnight...

 Bulk sales

No one likes bulk sales, but sometimes they offer the best path to put the past behind you and start focusing on the future.

Hire an experienced bulk sale advisor and, if at all possible, get valuations and advice on structure from several firms.  There are many creative structures in the market today, as well as much money waiting on the sidelines.  Proceed with caution, but give it full consideration.

Bulk sales can be considered in different combination:  one large pool; several pools; sprinkling some good loans to lift the price of the entire pool; including equity and like-equity vehicles in the price; etc.  Be flexible to optimize the results.

Conclusion

Loan workouts are exciting, challenging and very stressful.  They require a unique skill-set and much expertise.  Effective loan workout departments can save their banks millions of dollars by turning a bad situation into a tolerable, even a profitable, one.  Ultimately there is a single goal here:  Maximize the value of the loan.  There are many paths to get there.  A true workout professional will find the way.