Tough Times for Lenders : Financial Services Lawyer & Attorney : Winstead Law Firm : Finance, Banking, Bankruptcy

Overlooked by the recent focus on health care reform, and now by the financial reform bills (see my recent blog posts, is draft legislation prepared by Representative Minnick(D-Idaho). Known as "The Community Bank and Commercial Real Estate Stabilization Act of 2010," his draft legislation has circulated on the Hill but has NOT been introduced into the legislative process.

His bill is based upon this premise: the "too big to fail" approach, which bailed out the largest banks and supported the CMBS market, largely ignored one very powerful economic engine.

Who is this "lost" or forgotten group?  Hints:

• They have the highest concentration of commercial real estate loans (relative to risk based capital) among lenders
• They extend credit to a broad range of customers (not just real estate related)
• They are located near you - even on your Main Street
• Every week, the FDIC seems to close 5-10 of them

The answer: Community Banks.

Hundreds have failed over the last several years; and hundreds will fail in the new future - currently, the FDIC lists 775 banks on its list of of "problem" banks (nearly 10% of all FDIC-insured banks).

I agree with Richard Suttmeier's assessment that community banks are the next key to economic recovery.

In his recent blog posting, he articulates the important role played by community banks -

• The economy on Main Street is driven by small businesses, the housing market and local construction - none of which are "too big to fail" but when taken together . . .
• These are the engine of job growth in the private sector
• Without job growth on Main Street, the economy will struggle [my editing here: Suttmeier predicts a "double-dip"], and consumer spending will suffer
• Community banks are the key to lending to small businesses
• Thus, community banks are crucial to the economy on Main Street

Representative Minnick's bill seeks to address this oversight (or perhaps simply the relative inability of community banks to pull political levers, when compared to Wall Street and the largest banks).  Briefly, his draft legislation addresses two related goals:

• Jump start new lending on the small-balance commercial real estate sector

Here's a quick summary of his bill (as of several weeks ago - so this could change):

• Six-month pilot program of $3 billion, if successful, may be expanded to three years and upsized
• Only community banks will be able to access that part of the program aimed at seriously delinquent loans and REO
• US Treasury will guarantee bonds backed by pools of small-balance commercial real estate loans, including REO properties at community banks
• Program administered by a Board consisting of Treasury Secretary, Fed Chairman, SEC Chairman, FDIC Chairman and four industry experts appointed by President
• $10 million maximum loan size (or appraised value) per property
• Conservative loan underwriting and pricing
• Rating agency involvement to provide an independent view on underwriting and structure
• Treasury will charge a “guarantee fee” similar to Fannie/Freddie, of between two to three percent annually
• Any profit participation back to the originator must be earned over time

I also attach a much longer "term sheet" describing the proposed bill (there might be a more current version).

So, what do you think?

Please post your comments below.

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For most commercial real estate lenders and loan servicers, it is important to quickly stabilize and then promptly sell property after acquiring  title to collateral.  The typical REO (definition) business plan includes the need to move the REO off the balance sheet by selling REO in an orderly manner—after coordinating loss recognition with an increase in capital reserves, with any loss sharing agreement, etc.

The sale of REO is the stuff that all of the “opportunity” or distressed investment funds target, and have been waiting for during the last 24 months.

Those funds and investors, of course, recall the quick profits realized in the late ‘80s\early ‘90s by those who purchased properties from the government (acting through the Resolution Trust Corporation or RTC), or from failing banks and savings and loan associations.

How did the RTC quickly sell the thousands of commercial real estate properties that it owned, or the mortgages on those properties?  The RTC often held auctions.

The RTC experience proved that auctions are a good way to quickly move a lot of REO off book. 

In 2009, we worked on several CRE auctions.  For 2010, we anticipate (finally) being involved in more auctions by commercial lenders—after they  take back collateral through foreclosures and deeds in lieu of foreclosure (link to prior postings on deeds in lieu).

Auctions are back.

Auction companies come in all shapes and sizes. (Google search).  There even are specialists: DebtX focuses on loan sales using an on-line bidding process (The Debt Exchange).

While DebtX's online model has proven successful, and has been well-received by note buyers, I favor a blended approach: (i) real, “live” auctions in a local ballroom combined with (ii) online bidding.  And, of course, like a pure online model, any auction should utilize online due diligence tools.

This series will help you understand commercial real estate auctions; and how technology now plays a key role both in auctions (and during the on-going "life" of the asset).

In this series, I interview Bill Vaughan with CREAuction Group) (e-mail Bill at bill@creauctiongroup.com), an expert in commercial real estate auctions; and Mike Shanley with Realworkspaces) (e-mail Mike at mike.shanley@realworkspaces.com), an expert in online due diligence tools and electronic document storage.

Bill and Mike will educate and show us how CRE auctions in 2010 will be executed.  Parts of it will be very different from the RTC auctions of the late ‘80s & early ‘90s.  And that’s a good thing.

But before we get into the details of auctions and the role of technology in auctions, let’s take a quick look at two high-level pieces furnished to me by Bill Vaughan and Mike Shanley.

• Bill Vaughan gives us this advertisement for a December 2009 auction held by CREAuction Group.  This ad points to the importance of local, “live” auctions in your REO sales strategy. [download advertisement]
• Mike Shanley can not compete with Steve Jobs on creating a gee-wiz video of cool technology doing great things [Link to iPad announcement].  However, this picture clearly shows that using an electronic process for collecting and sharing due diligence materials results in an entirely new ecosystem—both during the auction and continuing throughout the life of the asset (i.e., the electronic file should "follow" the ownership through all stages of ownership, operations and management)

In the next posting (and series), we’ll jump into the details of auctions and how technology makes it all possible.

If you have a question, comment or war story on the topics of commercial real estate auctions and the uses of technology in it, please post a comment below.

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On October 30, 2009, the Federal Financial Institutions Examination Council (FFIEC) issued a policy statement that was adopted by the OCC, the Fed, the FDIC and the Office of Thrift Supervision as Guidance on Prudent Commercial Real Estate Loan Workouts (FFIEC's Guidance under the OCC Bulletin 2009-32).  The policy replaced the Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans that banks have been operating under since November 1995.  (For a copy of the policy statement, see our earlier posting [link].)

OVERALL TONE
The overall tone of the Guidance is to provide prudent but pragmatic guidance on risk assessment, allowing financial institutions in the present environment to actively engage in CRE workouts without undue fear of reclassification by examiners.  For example, the Guidance states:

"Financial institutions that implement prudent loan workout arrangements after performing a comprehensive review of a borrower's financial condition will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classification."

While there are a few hard and fast prohibitions in the OCC bulletin, as a general matter its cornerstone is flexibility and pragmatism in working out distressed commercial real estate credits. Institutions are encouraged to consider both the asset and Borrower/Sponsor capacity for repayment of the credit.

The Guidance establishes protocols encouraging institutions to apply prospective, "forward thinking" to the cash flow analysis of distressed real estate projects.  Additionally, it discourages "second guessing" by examiners on such items as assumed cap rates, lease renewal assumptions, lease-up periods and other forward looking market conditions. The Guidance also reinforces, and in some cases clarifies regulatory and GAAP reporting requirements.

KEY POINTS

The Guidance includes the following key points:
 

• Renewed or restructured loans to borrowers who have the ability to repay their debts according to reasonable modified terms will not be subject to adverse classification solely because the value of the underlying collateral has declined below the loan balance.
   
• In general, renewals of maturing loans to responsible borrowers who, because of the present financial crisis, cannot locate a source of refinancing, should not suffer adverse classification.
   
• Separating a single loan into an "A/B" note structure (with impairment and/or non-accrual hitting the B note only) receives a regulatory "stamp of approval" under appropriate circumstances illustrated in the Guidance.
   
• Troubled debt restructuring (TDR) contains a two-prong test in which both prongs must be met: (a) the borrower is experiencing financial difficulties (examples of what this means are provided in attachment one of the Guidance) AND (b) the lender grants a concession that it would not ordinarily grant except for the status of the real estate and/or economic conditions.
   
• "Fair value" vs. "Market value" - Fair value is still required under impairment situations (pursuant to FASB 114) and for properties deemed to be TDR. "Market value" (i.e. predictable future values) can be considered if consistent with the facts and circumstances of the workout.

• Clarifies Allowances for Loan and Lease Losses (ALLL) calculations utilizing fair value; existing guidance remains in place.
   
• The concepts of "market interest rate" become of paramount importance in: (i) classifying or reclassifying the credit, (ii) going on or off of accrual basis, and (iii) booking losses (examples of what is considered and not considered "market rate" are illustrated in Attachment One to the Guidance).  Market interest rate calculations should:
  
  - Take a forward-looking view at the cash flows, rent rolls and property type analysis
  
   - Be influenced by the credit quality of both the borrower and the real estate
  
   - Be adjusted (positively or negatively) by the existence of quality loan guaranties utilizing current financial information
  
   
• "Interest only" concessions for periods beyond one year in order to allow the property's cash flow to service the debt will be frowned upon, and likely not deemed "market."
   
• Generally "second guessing" by examiners is discouraged and will be viewed as inappropriate in the analysis of certain specified forward-looking circumstances.
   
• Overall, the Guidance encourages bank institutions to be proactive and forward thinking in applying their analytics at the property level.

In summary, the Guidance stresses the need to examine each commercial real estate loan on its own merits; examining borrower, sponsor and guarantor credit and payment capacity, as well as the current and projected quality and durability of asset level cash flows.  The examples contained in Attachment One to the Guidance demonstrate that this process will inevitably involve subjective judgments.  Although there is a definite change of tone, the regulatory construct remains fundamentally unchanged.

It will be interesting to see how banking institutions and their examiners react to the October 30th announcement.  Given the general and subjective nature of the subject matter, and that guidance is provided largely through examples, implementation may well prove to be uneven among banking institutions.

As we move into the next phase and begin to work with the Guidance, we encourage you to share your comments and experiences.

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