Acquisition of Bad Debt Loans

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November 30, 2009

Lenders, as we all know, continue to be saddled with under-performing and non-performing commercial real estate mortgage loans. A quick internet search will reveal that many are predicting future defaults on billions and billions of dollars of loans. Amongst many other implications for both the lending institutions and the economy at large, carrying these loans impacts reserve requirements and, in turn, available capital. Potentially, we have the makings of a classic “vicious cycle.”

Not surprisingly, many lenders are trying to sell these loans and we assume many more will be doing so in the future. Depending on a variety of factors such as the size of the selling lender’s inventory of bad loans, how desperate it might be to raise cash or otherwise remove these assets from its balance sheet, its willingness to have its business transactions generally known to the public, and of course its conclusion as to the sales method most likely to maximize the net sales proceeds received, these assets might be sold as part of large bulk packages, as part of much smaller packages, or individually, and, regardless of the size or number of individual assets being sold, might be auctioned or sold in conventional private transactions.

To those engaged or who contemplate engaging in the acquisition of discounted debt there obviously is great profit potential, but there are also numerous potential pitfalls. This article contains a few items any potential purchaser of discounted debt might want to think about.

First a quick word about profit strategies. There are at least the following five possibilities:

  1. The debt might be paid off by the borrower in the ordinary course.
  2. After acquiring the debt from the lender a discounted repayment from the borrower might be accepted resulting in a quick profit Although perhaps counter-intuitive, it absolutely is the case that on occasion it is possible to acquire debt from the lender at a price below what the borrower is willing to pay to retire that obligation.
  3. After acquiring the debt, foreclose and if bids exceed the price paid for the debt by an acceptable margin take your profit through the foreclosure process.
  4. After acquiring the debt, foreclose and “credit bid” the property, resulting in property ownership and the limitless opportunities that come along with it.
  5. This last possibility is a wee bit different than the others. In many instances although the exact value of the collateral won’t be clear, the fact that the borrower has no equity will be. After acquisition of the debt, or in some cases as a condition thereto, it might be possible to obtain a deed from the property owner (which for whatever reason the borrower would not deliver to the lender, or the lender did not want to accept) in exchange for a release of any personal obligation or a relatively minimal payment. By acquiring the debt at a discount and the fee for a nominal amount the buyer ends up with free and clear fee ownership and hopefully has paid far less than the property is actually worth.

And now some things to think about.

  1. Pricing – In pricing the value of distressed debt the same underwriting factors as are used in conventional lending – inherent value of the collateral, track record of the borrower, physical status of the collateral, environmental status of the collateral, rent roll, etc. – are the factors in determining what the property, and accordingly the debt, might be worth. However, the curtailed time period in which the buyer might have to act so as to capitalize on a given opportunity, the lack of good (or any) due diligence information, the lack of representations from the selling lender, and the increased likelihood of having to carry the property during the pendency of all defensive proceedings, and the cost of addressing those defensive procedures all make the valuation process exceedingly more difficult than in conventional circumstances. The general uncertainty in today’s commercial real estate market and the fear of not being able to price assets accurately only exacerbates these realities. So if one is not careful, the time and costs associated with any investment quickly may turn a “bargain” into a bad investment.
  2. Foreclosure or Accepting a Deed-in-Lieu – From a procedural point of view, foreclosure has always been a hyper-technical remedy. Now, in the press and in certain courts, it is a politically unpopular one too. So the technicalities must be observed rigorously. This increases the costs associated with that remedy. And defenses (real or imagined) based on consumer legislation or general principles of equity or claims of lender liability can be expected (even if the borrower knows it has no equity, it also knows the more roadblocks it can establish the bigger settlement check it can obtain). This also increases costs. And if a “deed-in-lieu” is contemplated the investor must think through other issues, such as losing the inability to “wipe out” junior encumbrances.
  3. Bankruptcy – In a further effort to preserve its asset (or increase its buy out price) the borrower might elect a bankruptcy filing – and might elect it on the very eve of the foreclosure sale after that battle has been fought and won. Although a valid mortgage should survive a bankruptcy filing, the investor still faces potential time delays and increased costs.
  4. Income Taxes – Determining the proper tax treatment for the acquisition, holding, foreclosure, and re-sale of debt, coupled with whatever might be happening with acquiring a fee interest in the collateral, is not necessarily straight forward or obvious. Unforeseen results will of course impact contemplated yields.
  5. Legal Due Diligence – The documentation evidencing the loan may contain hidden pitfalls (limitations on assignability, limitations on remedies, etc.), the default notices which have been sent to the borrower might be legally insufficient, a pending foreclosure proceeding might be subject to defenses, a critical lease is expiring, the title report might reveal potential problems, and other deal-specific issues might be present.

The bottom line is this – the buyer of distressed debt faces many potential pitfalls. It has to do its best to forecast its potential costs and downside with the available information so as to value the available asset as accurately as possible.