Mortgage Banking Magazine
The Magazine of Real Estate Finance
Article - February 2011 Issue
Executive Essay Section
Is There a Doctor in the Bank?
A new treatment for problematic real estate loans!
No doubt, along with health care one of the hottest topics being discussed today is the economy. Wherever you find yourself in this discussion, I am sure you will agree that the banking sector is in need of some doctoring. This article presents a ‘health plan’ for banks that are ailing because of poor residential and commercial real estate lending practices. By following a simple process of examining, diagnosing, prescribing and ultimately finding a cure, you will have the loan workout guidance you need for a healthier financial institution.
Begin with the examination. The 'patient' would be a bank suffering from non-accruals, substandard loans or Troubled Debt Restructure (T.D.R.). Be thorough in your approach. Look at the asset evaluation of the original loan, the active collection position, the liquidity of the real estate, environmental issues, the overall net operating income and the historical performance. It is essential to do a global cash flow analysis as well as a collateral review. It is also important to examine the bank itself to consider whether the underwriting standards, assumptions and approaches in the evaluation process and workout strategies are sound and legal. Organize this information and put it in the context of current and forecasted financial and market conditions as well as their influence on the value of the credit. Remember, always look for the hidden agendas – there is more to be known than the borrower is willing to reveal.
The next move is from the 'examination room' to the 'diagnostic center'. It is here that a realistic assessment of the asset condition is provided - the “As Is” value. Focus on the collateral value and its financial performance while doing a risk rating evaluation of the loan and a property tax search.
Establish the credit worthiness of the borrower. Federal and state regulatory agencies will most likely not subject the borrower who is credit worthy to adverse classifications. A more aggressive approach such as a sheriff sale where there is no competitive bidding needs to be facilitated for a borrower who is not determined to be worthy. Along with this, determine debt service coverage to ascertain the guarantor’s likelihood of repayment. Also, diagnose weakness in the borrower’s credit, the loan’s cash flow, the willingness of the borrower to work with the lending institution and the bank’s own experience of negotiating and defending sub-standard loans. The bottom line is a” forensic” evaluation of the workout infrastructure. This makes us ready for the next phase.
Now, for the prescription. Consider every possible approach. Look at prudent workout actions and strategies, proper lien positions and workout plans with consideration to loan covenants. The right “medicine” comes in different doses. It all depends on the ailment. Any of the following might be prescribed: adjustment in debt service coverage, concession of interest rate, interest rate modification, principal forgiveness, renewal or extension of the loan – or any combination thereof. The case might also call for internal controls, regulatory reporting and accounting reserve requirements, strong workout policies, risk management, frequent evaluation of loan collateral (site inspections) and debt service coverage. Consideration of A and B notes, reworking marketing plans and maintaining “Loan to Value” consistent with market and bank policy might also be needed.
Finally, there’s the cure. There are two courses that are possible at this stage. One would be a performing loan with accrual achieved through repayment, renewal or restructuring the loan. This would always involve a six month test for a satisfactory payment schedule until the loan gets re-classified. The other course of action could be more radical and involve litigation against guarantors, charging off the loan principal, or commencing foreclosure. Along with this course, always consult local regulatory commissions such as planning boards, building departments and tax assessors for polices and procedures that are safe and sound. In the event that the borrower files for bankruptcy, the bank would need to “lift the stay” and proceed with legal remedies.
The process outlined here works even in the most difficult and complicated cases. Consider the case of a borrower who misused and abused the bank handling his loans. The individual in question had procured a loan collateralized by three individual apartment complexes having a total of 425 units with a blanket mortgage of $5.8 million.
He became delinquent in loan payments and ignored repeated efforts on the part of the bank to resolve the issue. At 90 days, a delinquency notice was filed and the default rate of interest levied by the bank.
The bank, began an examination of the case looking at the current collateral value and the financial condition of the borrower. This was a challenge since the borrower refused to update financial information and provide CPA – audited financial statements or sign off on updated credit analysis. After much resistance from the borrower, the bank prevailed and established a meeting to discuss a plan of action.
At that meeting I realized that the borrower was more interested in talking about his recent trip to a tropical country and golf game than any delinquency issues. He promised to bring the loans current but did not deliver. He remained unwilling to meet for site inspections and was a no show when inspections were scheduled.
The examination continued with a title search which showed a poor payment history on all utilities (gas, electric and water/sewer) for the mortgaged properties. However, no federal tax liens or even any mechanic liens against the properties were discovered since the bank was paying the real estate taxes directly under the mortgage terms. The bank did examine the legal documents (Note and Mortgage) to establish the bank’s recourse if foreclosure action was to be taken. Loan principal was put on the bank’s insurance reporting form.
Finally, the real estate itself was examined, anticipating a loss based on the estimated value of properties given the current market and physical condition of the buildings. As a result, the bank increased its the loan loss interest reserve account.
A forensic approach to the case yielded a diagnosis of commingling of funds. An examination of the apartment complex rent rolls showed that borrower was taking rental income from the bank’s properties and applying those funds to other projects not encumbered by the bank’s loans, claiming some vacancies that did not exist. A search of legal documents showed he fraudulently conveyed the loan title to his wife without notice to the bank. Finally, I hired a company to make an “off site” video taped recording of his activities which showed him removing appliances (washer/dryers, built-in air-conditioner, refrigerators and stoves) to his other properties not encumbered by the bank’s mortgage lien.
Although the borrower made sporadic payments over a 6 month period, the prescription was clear – file a delinquency motion in a timely manner to commence foreclosure. The bank’s legal team commenced foreclosure proceedings in State Court based on the loan being past due 180 days with no corrected action plan accepted by the borrower. The default interest rate was already in place and property title updates were completed. The foreclosure was accelerated in the State Court when the borrower threatened to declare bankruptcy. The borrower did file bankruptcy, allowing the bank to disclose all the discovered illegal activity in bankruptcy court. This led to “lifting the stay” of the bankruptcy and sending the case back to the State Court to complete the foreclosure.
It was proven in the State Court that the borrower acted criminally and violated the covenants of the mortgage documents. Proof of fraudulent conveyance of title to hide personal assets was also established, showing the overall intent of the borrower to defraud the bank, steal the income and abandon the real estate collateral.
The judge reviewed the video tape of the borrower stealing the appliances along with other evidence and granted foreclosure action to proceed. The borrower agreed not to contest foreclosure which resulted in the bank taking the properties back (no competitive bidding). A deficiency judgment based on the mortgage amount and current value of all three properties was filed against the borrower for all legal fees, bank fees, and accrued interest and delinquent utilities bills.
As part of the cure the bank came up with the following action plan:
· Hire a receiver to handle the properties
· Complete the vacant units and make them rentable.
· Hire a rental agency to commence marketing the vacant units.
· Hire a broker to start marketing the project for sale.
· Establish a timeline for the disposition of all the mortgage properties.
· Establish the cost to maintain real estate during the disposition period.
· Project the overall profit or loss to the bank to adjust the interest for bad debt reserve accounts which affect the bank’s bottom line.
The bank spent an additional $100,000 to improve the overall market value of the properties and achieved 85% occupancy on all three properties on the established timeline. Ultimately the bank sold the properties and was able to recover over 90% of the total outstanding principal balance of the mortgage loan and all related fees.
That is a healthy bank!
John G. Rubinacci is the President, CEO and founder - Loan Doc LLC based in Livingston, New Jersey - which offers forensic loan workout consulting for financial institutions. He can be reached at firstname.lastname@example.org.