Friday, December 31, 2010

From the Post-Crash Ashes

Who Gets to Rebuild America?

The Great Financial Panic of 2008-2009 is receding into the past. Most of our larger financial institutions appear, at least on the surface, to be on the mend. The economy looks to be on the road to recovery.

But not so fast. The saga of the financial collapse is not over. More damage is being done each day. It is a tale of quiet attrition wearing down the small businesses. There are still small disaster stories to tell, though they will not likely make big headlines. The legacy of loss lingers.

An Epochal Crash

By historical standards the 2007 residential real estate bust was big. Real U.S. home prices had nearly doubled between 1990 and 2006. From the rise to the fall, trillions of dollars of household equity has gone up in smoke. Home prices as measured by the S&P Case-Shiller Index of value in 20 cities is down 29 percent from the 2006 peak levels. Caroline Baum (Bloomberg Opinion from Dec 5, 2010) observed that “Owners’ equity in household real estate…fell from a peak of $13.1 trillion in 2005 to a low of $5.9 trillion in the first quarter of 2009, according to the Fed’s Flow of Funds report. That’s a whopping 55 percent decline in four years.”

While the money flowed through the US housing system and the real estate bubble inflated, land developers, home builders, banks, mortgage brokers, loan packagers, mortgage “securitizers” and rating agencies (among others) chose not to stay safely on the sidelines. We were all happily aboard the bubble machine. As a well known big banker noted, this was such sweet financial music that no one could afford to stop dancing before the music stopped.

The music stopped. And home builders, small AND big, got whacked.

Bank of Clark County, Vancouver WA

A chapter of this story began on Friday January 16, 2009 when the State of Washington shut down Bank of Clark County (“BOCC”) based in Vancouver WA. BOCC was one the first two US bank failures to occur in 2009 in a wave of closures that would see 140 banks closed in 2009 and over 150 banks closed so far in 2010.

BOCC was founded in 1999. It was a smaller bank with $446.5 million in total assets and $366.5 million in deposits. As with many community banks, BOCC had an exposure to commercial real estate in loans made to builders and developers; construction and development loans, particularly for residential development made up over 36 percent of the bank's total portfolio.

At the closure of BOCC, Umpqua Bank of Eugene Oregon agreed to assume the deposits and branches but decided not to take over the Bank of Clark County's $352 million loan portfolio. Umpqua in the past two years has very been shrewd in acquiring numerous failed banks but the BOCC commercial loans were apparently too hairy for Umpqua to take over. As a regional player, Umpqua probably had good market intelligence on the condition of BOCC portfolio.

FDIC “Multibank” Structured Transactions

To deal with the assets of failed banks that were not sold to FDIC-assisted banks via loss sharing, the FDIC has either auctioned off assets as-is in either pools or individually, or has employed a financial vehicle called the "structured sale" where the FDIC sells the assets into a joint venture with a private-sector investor/manager to wait out the bad real estate market hoping to realize higher assets price at a later date when the market had improved.

The FDIC commented in a July 2010 Bloomberg article explaining, “What we’re trying to avoid is creating the kind of financial incentives that cause the liquidation of the portfolio at fire-sale prices, which could further depress already distressed markets.... The structured transaction enables the FDIC’s managing partner to take a longer-term approach to the loans, allowing for an orderly workout period.”

The FDIC took delivery of the BOCC loans, and by the end of 2009 had pooled BOCC assets with the assets of 22 other failed banks into what the FDIC calls a “Multibank Structured Transaction” or Multibank Structured Transaction 2009-1 CML-ADC and Multibank 2009-1 RES-ADC Venture LLC (“Multibank”), in the case of BOCC. These structured transactions are but two of 16 completed and disclosed by the FDIC to date, involving the orphan bank assets of numerous failed institutions adding up to a total book value of over $18.7 billion.

The “ADC” in MULTIBANK 2009-1 RES-ADC VENTURE LLC and MULTIBANK 2009-1 CML-ADC VENTURE LLC stands for Acquisition Development and Construction Loans. These were credit facilities provided by banks and, in the case of the structured sale asset packaged by the FDIC, were loans made by smaller community or regional banks to local developers to finance the purchase, entitlement, horizontal and vertical development of raw land being transformed into residential or commercial property.

In February of 2010 the two loan pools (totaling $3.052 billion in book value) were acquired in a structured transaction by Rialto Capital Management LLC (a subsidiary of Lennar Corporation "LEN") in partnership with the FDIC for a combined (or “implied”) price of $1.22 billion, or about 40 cents of book value. The FDIC retains 60% ownership in the pool of assets, Rialto acquired a 40% position. The collateral for the acquired loans was a mix of residential and commercial land and construction projects in various markets across the US.

Deal Points

--The FDIC transaction provides the private-sector partner zero-percent financing, asset management fees to manage assets in the venture.

--In this deal the management fee is .5 percent of outstanding debt (the unpaid balance or UPB), roughly $15 million per year to begin with.

--The partnership does not allow for a partial sale or liquidation of the assets. The loans are to be "worked out".

--The FDIC’s profit split increases to 65% (from original 60%) upon the “First Incentive Threshold Event” when a 25% annualized yield has been achieved and to 70% (from 65%) at the “Second Incentive Threshold Event” when a 35% yield has been hit.

Limited Price Discovery in a Less Than Arms-Length Sale

The use by the FDIC of low cost leverage that has many outcomes, not the least of which is to increase the price of the assets. The widely held consensus is that sans the FDIC's backstopping of these deals, the assets would have likely sold for half what was paid by the venture. 

As the Wall Street Journal noted in February 2010, “Undoubtedly, if someone had to purchase this with all cash, it would be 20 to 25 cents on the dollar". "The sale may prove an important bell-weather transaction for home builders and other opportunistic investors looking to take advantage of the housing carnage and snap up land on the cheap. But it may not provide much clarity about the value of commercial real estate clogging the books of the nation’s banks."

Structured Deal Workout Strategy: Opportunistic Buyers Buy High and Sell Even Higher

The FDIC/Rialto business plan is to “resolve" the loans. The loans may be either restructured with the current borrower or foreclosed on by the investor and become real estate owned (OREO) by the FDIC/Rialto partnership. The annualized yield on the investment will depend on how many years it takes to resolve the assets, how long it takes to convert the assets to cash. The seven year investment horizon is long. The expectations are for a healthy, double digit return. The math is simple. The loans or the real estate securing the loans (once foreclosed on) are a commodity that a large investor/ builder like Rialto/Lennar are expert at valuing, developing and ultimately selling.

One “Multibank” Borrower

One company that got swept up into the MULTIBANK 2009-1 vortex we will call “SmallCo”. SmallCo is a local homebuilder operating in one of the major Pacific Northwest US markets. The company had a $3 million development loan from Bank of Clark County secured by a 45-lot residential subdivision.

As SmallCo told the local press, their effort to refinance the residential development loan with other banks proved fruitless. For the most part banks today are not making new real estate loans but are purging their balance sheets as they can of any real estate development and construction loans, even if their borrowers have somehow managed to preserve their creditworthiness. Residential or commercial real estate collateral is an anathema to banks that no strong banking relationships can alter. The regulators in most cases require these loans to be written down because the value of the collateral (land) is much less than the outstanding loan balance.

SmallCo reported that it was able to refinance a few other of its bank construction loans on other projects, probably after the former bank loans had been sold by the FDIC to individual investors at all cash auctions or the banks may have 'sold' the deeply-discounted assets themselves. The cash spot market has resulted in outright assets sales, at more deeply discounted prices, providing more room to bring in new investment at a lower and sustainable cost basis.

Individual asset sales are outright do not have long term investment structure that the Multibank transactions do. The Multibank structure prohibits speculative asset sales (perhaps rightly) but the premium pricing paid for the assets may not provide for the same room and flexibility to negotiate discounts as the FDIC individual outright asset sales have.

SmallCo Gets the Word from Multibank

These are eight words no developer wants to hear from their bank: “Your loan is due and payable in full.”

SmallCo and other Multibank borrowers got this message. It has been reported that the Multibank venture had filed suit against SmallCo and other Multibank borrowers for the full amount of the money owed on their real estate loans. Multibank is likely acting well within their legal rights. Most development and construction loans are short term loans.

SmallCo told us that the value of the lots in question are now half of where they had started. At the peak the residential lots were were $100,000 each, but now were valued at closer to $40,000 to $50,000 each. Not too bad when you consider that some troubled residential developments are currently considered worthless (where the estimated cost to finish the project exceeds today's value). SmallCo offered to pay the loan off at a discount with new capital, offering 70 cents on the dollar to pay off the loan (a healthy markup on the 40% portfolio average price).

They told us they even flew to New York to meet the Multibank representatives to see if something could be worked out but no compromise could be reached.

SmallCo employs a handful of workers and has had to cut back on his crew. A foreclosure on the 45 lot property might mean bankruptcy for the company.

Small and Big But Not That Different

When you stand back and look at SmallCo and BigCo together they are not all that different. Both were building homes into the bubble and both got caught short when it burst. The big difference is simply in the vastly different scale of the respective operations, not what the small and big companies were doing.

Lennar was the second largest national builder and, at the peak in 2006, closed sales on about 50,000 homes per year and in the downturn has managed skillfully to survive and navigate the treacherous waters of the economic storm (with some help from above), positioning itself to thrive as the residential market starts to recover.

SmallCo is a family operation running just of handful smaller projects at any one time. What is missing for SmallCo is the access to the same type of financial resources (once provided by community banks) and the governmental support afforded the larger company. Resources that might help SmallCo too to weather the storm and buy time in an extremely tough economic and impossible financing environment. 

Who will get to rebuild America?