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Chapter 3: Problem Loans

Things just went sour gradually all at once.

-Harry Wiley, Cornerman to Sonny Banks, after a fourth round defeat by the then Cassisus Clay

Dealing with problem loans is one of the first hairy tasks a credit analyst encounters. (In fact, dealing with problem loans is so hairy that some banks have employees whose sole job it is to work on problem loans. The standard lament when handing the loan over to the so-called work-out specialist is, of course, "The loan was good when I made it.") At Corus we do not have work-out specialists, primarily because we don't really have work-outs. When a business loan goes bad, a work-out is required. When a real estate loan goes bad, a foreclosure is required. Any idiot (with a lawyer) can foreclose a loan.

There is also a second, perhaps much more important, reason to have work-out specialists. It is to make certain that the people dealing with a past due loan are completely impartial in dealing with the situation. The officer who originated the loan may be tempted to present a rosy scenario to management in order to avoid looking like an idiot for making such a crummy loan. The natural tendency for an officer in that scenario is to put things off and pretend the end of troubles is just around the corner. In other words, he starts to act just like a delinquent borrower.

My first suggestion for when you start to deal with a problem loan is to make sure that you keep complete and accurate records of all your customer contacts and every decision that is made regarding the loan. Feel free to place more or less informal notations in the file. That way everyone who ever looks at it, including any horrible lawyers, will know what you did, and why it was the correct and legal thing to do.

To make sure that what you are doing is legal and correct, always make sure the loan officer is aware of any decisions you make, and indeed in any changes in the status of the loan. Officers dislike working on problem loans and so a lot of work on them is done by credit analysts. Officers dislike working on problem loans for at least two reasons: they are extremely time consuming and there is no profit in it. The best thing that can happen with a problem loan is that the bank does not lose money. People are promoted and paid for making money, not for failing to lose it.

If you are assigned to work on a problem loan begin by carefully reading the file. Try to determine what it is that might be going wrong. See if there are guarantors or others you can contact to correct the problem. See if there is some extra collateral that lessens the seriousness of the problem. See who made the loan originally. Curse him.

The next step is to get in touch with the borrower. Occasionally the problem is only a very temporary one, and the customer has an explanation for the tardy payment(s). And more importantly, a realistic plan for getting the loan current again. Of course, any borrower worth his salt will have a terrific reason why you shouldn't be worried about the repayment problems-and how they'll be solved any day now.

Despite the seeming uselessness of your conversations with the borrower, keep this communication channel open, and keep your borrower's feet to the fire. At this point, being a pain in the neck to the borrower is your job. The loan might be slipping toward foreclosure, and you want to do whatever you can to keep it from going in that direction any further or faster than it must. If that means being such a bother to the borrower that he would rather pay you then his other creditors, good for you.

The other important thing to do when a loan goes bad is to make a site inspection of the property. Of course, the property should have been inspected at the time of the last annual review, but if the loan was not delinquent then, the inspection, and indeed the review, could have been quite cursory. As I mentioned, loan reviews tend to become more or less mechanical exercises for performing loans. (I do not endorse this. I merely state it as fact.) Make a more thorough inspection of the collateral than you would for a normal loan review. If a property is showing signs of real neglect, e.g. bomb craters, you'll know that in all likelihood you are dealing with a serious problem. If, on the other hand, the property appears well managed and maintained it is more likely that the borrower has adequate capital and cash flow to solve the problem.

Once you have read the file, talked to the borrower, and inspected the property, you can make a plan for dealing with the problem. I have never met a good plan for dealing with a delinquent borrower. Usually the plan goes something like this: nag the guy until he falls 90 days past due, then foreclose on his sorry butt. Very rarely the bank will find a reason to restructure the note to bring the borrower current (perhaps by moving payment due dates until the maturity date or by advancing principal under the note). As I said this is very rare. The cardinal rule in lending is never advance principal to pay past due interest. Why? Because by adding to the loan balance you are making the fundamental problem worse. We call this putting out a fire with gasoline.

Nevertheless, talk to the officer about making a plan. Once the plan is made, make sure you communicate to the borrower what he needs to know. Threats from the bank will sometimes make a borrower come up with payments. The last thing you want to do is begin a foreclosure only because a borrower misunderstood your threats.

Loans that are not performing in some way must be reported to management. Loans that have a minor defect, but are not as yet that worrying, or that are recovering after a problem period, should be listed on the watch list. The watch list includes the following information for each loan on it: the loan number, the borrower's name, the loan's rating (see the loan policy manual for a discussion of loan ratings), the original loan amount, a description of the collateral, the appraised value of the collateral, the current balance and LTV, and the reason for listing. The watch list is updated monthly.

If a loan is performing so poorly it merits further attention than mere listing on the watch list, and it has a balance of more than $50M, then a problem loan report (known as a "P50", Problem loan, over $50M, get it?) must be prepared for it each month. A P50 has greater detail than a watch list entry, and it has two other sections: news from the last thirty days and action planned for the next thirty days. Often times the action plan for the next thirty days is to wait and see if things get any better. Finding a way to say this that makes it sound like you actually have a brilliant plan to save the bank's money is one of the great challenges of writing a good P50. The only thing worse than a P50 is a report for Other Real Estate Owned (an OREO report). This is the monthly report you have to write after the foreclosure is over, and you actually own the damnable property. Thankfully, I have never had the misfortune of preparing one of these, and to my mind the less said about them the better.

Foreclosure Process

I have thus far given only vague and useless advice but now wish to give you something more practical: a brief outline of the legal process of foreclosure. The process begins when the bank issues a demand letter to the borrower. This is a formal notice to the borrower that the loan is in default as of this or that date and that the following amounts are past due. Demand letters are tricky, and a copy should be forwarded to counsel. Or, better yet, the documents should be forwarded to counsel with your draft of the demand letter, so that the attorney can make sure you did everything right. Often multiple demand letters must be sent --- to guarantors, to borrower's counsel etc. As with all steps in a foreclosure, failure to do this one properly can mean that any following steps can be thrown out and the whole process must begin again.

One of the tricky issues of a demand letter is that of acceleration. Acceleration of a loan means that its maturity date is moved forward. The practical effect of acceleration is that it vastly increases the amount the borrower must pay the bank in order to cure the default. The bank may not wish to accelerate the loan and it will be happy simply to have the regularly scheduled payments brought current. On the other hand, the bank may wish to keep its legal action going, in which case accelerating the loan means that it can do so until the borrower has paid the last dime he owes. If there are funds that could be set off to pay the loan, a deposit account for instance, remember to always accelerate first and set-off second. If you first set-off you could cure the default that entitles you to accelerate the loan.

Another tricky issue is: What is the date of default on a loan? Here is the answer, and don't let anyone tell you different. The date of default is the first date the bank did not receive a payment that was due. Simple, no? But people try to make it complicated, citing the provision in the note giving the borrower a fifteen day grace period, or that the bank never declares a default on a loan one day past due, or some other red herring. The truth is the loan is in default the day a single payment is not made.

After all the needed demand notifications have been given the next step is to order the minutes of foreclosure. The minutes of foreclosure is essentially a title commitment. It is needed to determine who other than the bank has a recorded interest in the property. In order for other ownership interests in the property to be foreclosed (extinguished) they must be named in the foreclosure action.

After the minutes of foreclosure arrive the attorney can draft a motion to foreclose to take to court. In it the Bank will list the property owner and any other subsequent lien holders as defendants to its action. There are no real defenses for the delinquent borrower at this point. The borrower can pursue any number of delaying tactics, but unless the note is brought current, the judge will ultimately order a judicial sale.

One of the best delaying tactics is to file bankruptcy. While in bankruptcy there is an automatic stay on any action against the borrower, to give the bankruptcy trustee a chance to marshal (collect) the unfortunate's assets. This stay can be removed only if the bank can show to the court's justification (and by the way, now I am talking about federal court) that there is no equity in the property that could be used to pay off some other creditor, i.e. the bank's loan is worth more than the property. (I should interrupt here to point that the last sentence is even more of a ridiculous over-simplification than most of the others. The bank actually needs to show that the asset is worth nothing to the trustee, but it could still easily be worth more than the loan. For instance, a property worth $200M with a $150M loan on it might appear to have $50M of equity in it. But if the borrower has a $0 tax basis in the property, say it had been owned for years and depreciated to nothing, selling the property would trigger a capital gains tax liability that would eat up all the equity in the building.)

While the process of foreclosure is going on, the bank may ask the court to name it mortgagee in possession. The bank requests this position in order to preserve its interest in the collateral. By granting the bank this status the court is not making any judgement as to whether the foreclosure itself is valid, but acknowledging that the bank has an interest in maintaining the collateral. There is sometimes a question about whether or not to ask the court for this status. I am here to tell you there is no reason not to be, and lots of reason to do it. Credit analysts hate it for the same reason borrowers do, it means the foreclosure is really underway. Once this happens your workload on the project will double or triple or more because you just became the building manager.

Why would the bank want this? To make sure the building is being run properly. To put more pressure on the borrower. To begin to collect rents from whatever tenants are in the building. To prevent the borrower from stripping all the copper pipes to sell as scrap. Some of the things you'll have to do at this point include: 1. Having all the utilities (gas, electric, water, phone, cable, etc) changed from the borrower's to the bank's name. The utilities will all be happy about this, since most of them will have been unpaid for some time. They'll try to get you to pay the entire back bill. No chance. You'll pay from the day of the court order onward. 2. Notify all the tenants of how their rent should be paid henceforward, i.e. to the Bank. They are all entitled to see a copy of the court order, so they know they're not being scammed. They will call. They will become confused. Sigh. 3. Contract to have janitorial services, garbage pick-up, extermination services, etc provided to the building. 4. Fix everything at the building that's broke. 5. Listen sympathetically to all the dirt-bag tenants when they complain about everything that has been wrong with the building that has nothing to do with you and how that entitles them to withhold rent from now until eternity.

Credit analysts (and even officers) sometimes construct bizarre and tortured arguments as to why the bank should allow the borrower to keep managing the property. I cannot blame them, but I have yet to hear a decent reason.

Finally the great day of the judicial sale arrives. On this date the court orders some title company to sell the building to the highest bidder and pay off the lien-holders and other valid claimants. If the bank's debt is worth more than the property, its bid (the entire indebtedness including legal fees, court costs, management costs, expenses associated with the building, etc.) will be the only one. The sale will be confirmed about 30 days later, and the thing is done. If on the other hand, o happy day, someone else bids more than the Bank, then that sucker will own the building, and the bank will be repaid in full. And your job will be (mostly) over.

If the Bank does end up owning the building it becomes an OREO, for Other Real Estate Owned. (Other than the Bank's own buildings obviously.) At this point, you've got to try and sell the building. It'll be good for you. You'll learn lots about how the real estate market works. And you'll learn how annoying it is to work with other bankers. Always making promises about how they'll be ready to close and get you your money and then putting it off. Jerks.

The borrower can prevent the nightmare of the foreclosure process in two ways. He can just sit on his duff and ignore the whole thing. No one is actually going to throw him in debtor's prison after all. That's illegal, silly. Or, he can sign a deed in lieu of foreclosure. Why would he want to do that? Because by granting the bank a deed to the property he will eliminate any potential liability he might have to the bank when the foreclosure is over. If the bank completes the foreclosure process and sells the building for $100M less than it was owed it can sue the borrower for it personally. If the bank is then awarded a judgement it can start doing mean stuff like garnisheeing his wages. Ouch. No one wants his wages garnisheed.

Well, now the whole thing is over. The bank has recovered its money without losing a dime. A problem asset has been taken off the books and the Bank has a nice lump of cash instead. No tenants are suing. The borrower is a wretched wreck of his former self. You deserve a big pat on the back, and a nice bonus too! Forget about it. As I said, no one ever earns a bonus or a promotion for foreclosing cleverly.

Return to Chapter 2: Documentation - Continue to Chapter 4: Construction Lending