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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2008

Defusing Defaults

In today’s climate, a foreclosure isn’t always the best route to maximize recovery

c_2008-09__harp_spotWith the summer’s economic stress, commercial real estate loans -- especially those for construction and development -- have seen an increase in defaults. The Federal Deposit Insurance Corp. and other supervisory authorities have expressed concern and noted the need for close attention and creative problemsolving to limit loan losses. Brokers should take heed.

Every commercial loan provides for legal and equitable remedies in the event of default. Lenders and their lawyers, accustomed to relying on the remedies contained in their loan documents, often do what is expected: When a borrower falls behind on payments or violates debt-coverage ratios or other loan covenants, the lender declares a default, imposes an increased interest rate, accelerates the indebtedness and begins foreclosure or other loan-enforcement proceedings.

Does this make sense in today’s environment? Does it maximize recovery?

Sometimes, yes. Sometimes, no.

More frequently, the answer is no.

A critical analysis often is necessary to calculate what action will maximize recovery. Property values are declining because of a glut of defaults, increasing storefront vacancies, tightening credit standards and skittish capital markets imposing higher yield requirements to offset increasing risks. More lenders are asking themselves: If I successfully foreclose this property, what am I going to do with it? What is my expected recovery?

Declaring a default and mindlessly proceeding with foreclosure proceedings may be exactly the wrong solution.

For brokers, it’s often wise to consider the lender’s position in matters such as this when vetting a deal for the possibility of securing funding -- and for the feasibility of a default.

Understanding the borrower

A legal maxim also applies to lenders: “Ut vos reperio vestri in lacuna, subsisto fossura,” which roughly translates to “When you find yourself in a hole, stop digging.” In other words, what works during good or even “normal” economic times may not make economic sense during an economic downturn.

To survive a sizable loan default during times of widespread economic weakness, a broker must think differently. Your lender will focus on damage control, with the objective of avoiding -- or at least minimizing -- loss. You need an elevated business acumen.

First, try to communicate with your borrower and understand what is going on in the borrower’s business that has resulted in this default. It is often more effective to look for solutions than it is to threaten the borrower with forced collection and foreclosure.

Ultimately, put the loan default in context. This is not personal. Typically, borrowers are not trying to rip you off. Borrowers are unlikely to use business proceeds to live the high life at your and your lender’s expense. They’re likely under stress -- and potentially, embarrassed by the lack of payment.

Try to understand the nature of the problem, with an eye toward finding the most effective solution.

Ask a few questions:

  • Is this just a temporary cash-flow problem? Did the borrower’s primary tenant or customer slow down its payments? Did a key tenant file bankruptcy or close its business? Is the government, fuel costs or an essential vendor to blame?
  • If the borrower’s cash-flow problems are temporary, does it make sense to declare a default? Will this maximize your recovery?
  • Can the borrower pull through the current economic conditions and get back on track with a temporary, working-capital line of credit or with an increase of an existing line of credit? Will lending this borrower more money help or hurt you and your lender’s chance at full recovery?
  • Is a loan-modification agreement appropriate?

The answers to these questions could turn up remedies that are potentially less risky than foreclosure proceedings.

Looking at rates

Instead of boosting the borrower’s interest rate in case of default, a possible workout could include extending the repayment schedule or reducing the borrower’s effective interest rate, agreeing to reduce the amount payable now and accruing the rest.

Consider an example where the loan’s interest rate is 8 percent and the default rate is 12 percent. If borrowers with cash-flow problems can’t afford payments at 8 percent, how could they afford an increased rate?

In a loan-default setting, one of the most-misapplied financial maxims is: “Higher risk requires a higher rate of return.” There is no question that a loan in default presents a high financial risk. But the default rate is more a disincentive for default. Should it be imposed when a default is beyond the borrower’s practical control?

The “higher risk/higher rate” maxim is really a principle of capital attraction. To “attract” capital for debt or equity financing, higher risk really does require a higher rate of return.

Unless your lender is selling the defaulted loan, however, attracting capital is not the issue.

You have already funded the loan. The task now is to maximize recovery.

Minimizing loss

At the very least, it’s essential for the broker and lender to recover the principal. If you can recover your costs of collection and accrued interest, better still. Ideally, you will recover it all, including your higher rate of accrued default interest.

Recognize, however, that what is ideal may not be what is realistic. Once again, the guiding light is maximizing recovery. Sometimes, making a profit is not an option. Minimizing loss may be the only viable strategy.

For a borrower with temporary cash-flow problems, instead of increasing payments to cover 12-percent default interest, consider if it would make more sense to base payments on 4 percent and accrue the other 8 percent until the situation improves.

If you determine that the borrower’s cash-flow difficulties are permanent and the best solution is to liquidate the collateral, consider whether your lender will recover more through a foreclosure sale or through sale as a going concern.

What must you do to facilitate sale as a going concern? Who should run your borrower’s property or business in the meantime? Will the extra cost of appointing a receiver or trustee result in a greater recovery for you?

The thing to consider is how realistic it is for the borrower to raise more capital and whether it will solve the underlying financial difficulties. If the borrower does not have its own funds to invest, where will the additional capital come from? What rate of return will prospective investors require to induce them to inject more capital into the borrower’s already struggling enterprise? How will this high rate of return be realized?

Ultimately, it is best to recognize how all of these affect you and your lender’s recovery in the long run.

Employing a consultant

As we start down the path of considering a loan workout, it is essential that we obtain a clear and accurate picture of the borrower’s true financial circumstances. If you are not sure about the quality of the financial information you are receiving from your borrower, consider requiring that the borrower engage an independent financial consultant.

The consultant should be professional and qualified. This consultant also should understand that it owes a fiduciary duty to report to the lender.

Consultants are not cheap, but you always should pick one that knows your borrower’s business or can learn it quickly. Require a strict and frequent reporting schedule. If you determine the borrower’s financial situation is not going to improve, be ready to pull the plug and realize that your lender will do what it must to maximize recovery.

If the borrower won’t agree to engage a financial consultant, your lender may declare a default and require the consultant as a condition to entry into a forbearance agreement. A forbearance agreement is a good idea in all events. It should include an acknowledgement of the loan default and a waiver of defenses as conditions to the lender’s workout plan.

While you and your lender gather information and work with the borrower, an attorney often will review your loan file to ensure that the lender has what it needs if it resorts to forced collection and foreclosure. At a minimum, the note, mortgage, security agreement and guaranties should be signed, the mortgage should be recorded and the lender’s security interest should be perfected.

Require current financial statements from the borrower and each guarantor. Determine whether the borrower has additional capital available or additional collateral to pledge to secure the loan. Ensure that all necessary corporate resolutions and other authority documents are executed and in the loan file.

As you work with the borrower, you also always must consider the risk that the borrower may file bankruptcy. Understand the consequences.

Bankruptcy proceedings are often expensive. They may degrade rather than enhance your lender’s recovery, even if your lender is secured.

•  •  •

To maximize lenders’ loan recovery, brokers and lenders must exercise good business judgment. Blind adherence to conventional remedies for breaches of contract may not be the best answer.

Be creative and focus on what will maximize recovery in a way that does not expose you or your lender to liability. At all times, you must maintain your role as a broker acting responsibly. Avoid any action that may transform you into a role tantamount to that of a business partner. This is not difficult, but it may sometimes require you to walk a fine line.

Taking a creative approach to loan defaults and focusing on ways to work with your borrower are often essential elements to minimizing loan losses and maximizing recovery. This is the essence of an effective loan workout.  


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