Magazine article Journal of Commercial Lending

Dealing with the Borrower on Troubled Projects: The Workout Advantage

Magazine article Journal of Commercial Lending

Dealing with the Borrower on Troubled Projects: The Workout Advantage

Article excerpt

In this article, Dale Anne Reiss provides a trove of worthwhile information regarding troubled real estate borrowers. She examines the far-reaching effects of Banking Circular 255 and maintains that lenders should be on the lookout for a whole new real estate game. Reiss further states that a one-time borrower staple--the "white knight" who rode in at the last minute to provide more capital-- is a thing of the past and that that absence is something to which borrowers and lenders alike will need to adapt.

Workouts are nothing new in America. In fact, the first workout plan appeared in 1629 with the renegotiation of the 1620 Merchant Ventures Pact, which added ten years to the pilgrims' original repayment plan. Today, in economic downturn, the real estate market is one of the chief beneficiaries of a well-planned workout.

Traditionally, banks and other creditors have felt that the only way they can reclaim the value of their investment in a nonperforming loan situation is by pursuing legal avenues and forcing borrowers to file for bankruptcy. Nevertheless, lenders and borrowers who work together on a well-developed workout solution can gain rather than lose by spending a great deal of money on legal fees.

The Banking Industry

Today's commercial real estate market is overbuilt, residential building is rebounding slowly, and construction is at a standstill. In short, real estate is in a genuine slump. There is little or no liquidity in the market, and the slowdown is exacerbated by a lack of financing that is acute. Loans on properties are exceeding fair market values due to depressed rental rates and value perceptions.

What Brought on the Situation

This situation was brought on by banking activity in the past six years. To earn higher returns, commercial banks increased the number of real estate loans they made in the latter half of the 1980s. In fact, between 1984 and 1990, the annual amount of commercial real estate loans nearly doubled.

At the same time, the number of nonperforming real estate loans rose to 4.5% from an average of 2%. Take into consideration that the average bank equity is only 6.5% of total assets, and the situation became filled with risks. Regulators forced banks to book more reserves.

This had a disastrous effect on the value of bank stocks. In 1990, they fell 10% to as much as 93% (as was the case with the Bank of New England). At the time, the drop reflected a common fear that a banking collapse equal to that of the Depression was imminent.

Finding Investors

Recently, however, it has been difficult to find investors that are not interested in buying bank stocks. This interest level is related to government initiatives taken by regulators to remedy the current credit crunch.

Regulators have begun to change their perceptions and now feel that bank loan losses will soon stabilize. Regulator guidelines now allow banks to look at the long-term performance potential rather than the short-term cash crunch when evaluating properties.

Banking Circular 255

Until recently, banks have been very careful about working out troubled loans, due to concerns about reactions from federal regulators.

In late summer 1991, the Office of the Comptroller of the Currency (OCC) issued Banking Circular 255, a pronouncement that encourages banks to renew, restructure, or extend additional credit to borrowers as long as the banks adequately control the risk. Specifically, Circular 255 addresses medium-term commercial real estate loans, loan concentrations in certain industries, and troubled debt restructurings.

In addition, the circular indicates that there will be greater leniency in looking at practices with regard to returning a loan with a partial charge-off to accrual status, recognition of interest income on a cash basis, and enhanced disclosures of nonaccrual loans.

Circular 255 notes that it will criticize a bank for failing to recognize the reality of a troubled loan but will not criticize a bank that manages a troubled loan using a well-conceived and effective workout strategy, as long as making additional loans will result in avoiding further losses. …

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