L:MSRMSRE West AdminULI Market Distress PresentationULI Market Distress Presentation v8'pptA2XP15 AP - PowerPoint PPT Presentation

Title: L:MSRMSRE West AdminULI Market Distress PresentationULI Market Distress Presentation v8'pptA2XP15 AP


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Financial Distress 101 What Happens When Good
Investments Go Bad
Kevin Fisher, Paul Hastings Josh Myerberg, Morgan
Stanley
22 April 2008
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Financial Distress 101 What Happens When Good
Investments Go Bad
Table of Contents
Section 1
Executive Summary
Section 2
Introduction to Distress
Section 3
What Happens in Default
Section 4
Conclusion
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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 1
Executive Summary
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Executive Summary
Financial Distress 101 What Happens When Good
Investments Go Bad
Executive Summary

• The market environment has significantly
  deteriorated over the past year, triggered in
  large part by the subprime crisis, decline in the
  residential housing sector and an increase in the
  overall risk premium (and declining availability
  of credit)
• Economy
• Overall economic environment remains challenging
  according to leading economic indicators
• Unemployment rate has increased to 5.0, up from
  its cyclical trough of 4.4 (a move of such
  magnitude has predicted a recession in 10 out of
  10 cases in the postwar period with no false
  positives and no false negatives, per Goldman
  Sachs)
• 4Q07 GDP growth of 0.6
• Credit Markets
• All credit markets have been disrupted, with real
  estate markets hardest hit
• CMBS spreads have gapped out with AAA and BBB-
  spreads currently trading at 346bps and 1,571bps,
  respectively (versus 84bps and 207bps one year
  ago)1
• CMBS issuance has effectively shut down, with few
  transactions priced in 2008 thus far
• What Could this Mean for Real Estate Owners?
• Higher borrowing costs
• Declining fundamentals
• Falling asset prices

1

• Notes
• Source Morgan Stanley Fixed Income Research
  Securitized Products / US CMBS for the week ended
  April 16, 2008

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Executive Summary
Financial Distress 101 What Happens When Good
Investments Go Bad
Economic Headwinds Leading to Recession

• Economic growth has fallen below average during
  2007 driven in part by the housing correction and
  the financial markets turmoil
• Current challenges likely to persist through 2008

Current U.S. Economic Headwinds

• Consumer-led downturn
• Continuing and intensifying weakness in the
  homebuilding sector
• Negative consumer psychology surrounding housing
  markets
• More restrictive lending environment
• Decelerating retail sales
• Ongoing challenges likely to depress growth in
  2008
• Housing market expected to remain challenging
  through 2008 and possibly through 2009
• Weakening labor market
• Retail sales growth likely to moderate further
  due to negative wealth effect from housing
• Signs emerging of spillover into corporate sector

Forecast
Source Morgan Stanley forecast as of 10 March
2008
Forecast
Source Morgan Stanley forecast as of 10 March
2008
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Executive Summary
Financial Distress 101 What Happens When Good
Investments Go Bad
Tailwinds Limit Downturn

• A bearish case is made throughout this
  presentation. However, there are several
  important positive catalysts for the economy
• Principal tailwinds
• Continuing global growth
• Weak dollar
• Strong export growth
• Strong business investment
• Rising consumer incomes
• Risk of much sharper slowdown if housing issues
  not contained and global growth slows

Current U.S. Economic Strengths

• We believe the downturn may be modest and brief
  in duration
• Excesses to be unwound are modest
• Housing recession already part-way over
• Corporate environment has been lean hiring and
  capital expenditure increases have been modest
• Government acting quickly and strongly to spur
  growth
• The Fed has cut rates and engaged in other
  actions to relieve stress in the financial
  markets
• Congress passed a 165Bn economic stimulus bill
• Weak dollar providing some support to the economy
• Export growth remains healthy, import growth has
  slowed
• U.S. is a more attractive investment destination
  given the weak dollar, notwithstanding the
  current cyclical downturn

Forecast
Source Morgan Stanley forecast as of 10 March
2008
Forecast
Source Morgan Stanley as of 10 March 2008
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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 2
Introduction to Distress
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 1 Rising Interest Rates
Financial Impact

• Examples
• Commercial Market
• Refinance of existing mortgages
• Housing Market
• Re-set of Adjustable Rate Mortgages

Base Assumptions
Asset Value 100
EQUITY 20
Net Operating Income (NOI)
7.0
Less Debt Service (80 x 5 interest rate)
(4.0)
DEBT 80
Levered Profit (Loss)
3.0
Effects of Distress
Interest Rates Increase to 10
Net Operating Income
7.0
Less Debt Service (80 x 10)
(8.0)
Levered Profit (Loss)
(1.0)
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 1 Rising Interest Rates
Evidence In the Market

• Credit spreads have widened substantially in the
  last year
• Borrowers having trouble refinancing at rates
  that are covered by operations
• In the broader economy, credit markets are
  significantly wider then historical levels (1)
• 10Y swap spread 61 bps current vs 40 bps
  historic average
• Baa corp spread 310 bps vs 240 bps
• Junk bond yield spread 850 bps vs 620 bps
• Housing market is facing 1.2 trillion of ARMs
  re-setting in the next 5 years

2,500
2,100
1,571
1,071
871
346
Source Morgan Stanley Fixed Income Research
Securitized Products / US CMBS
Source Deutsche Bank / Loan Performance, UBS

• Notes
• Source Merrill Lynch on 03/20/08

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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 2 Falling NOI
Financial Impact

• Examples
• Commercial Market
• Orange County office market
• Retail market / retailer bankruptcies
• Housing Market
• Falling wages

Base Assumptions
Asset Value 100
EQUITY 20
Net Operating Income
7.0
Less Debt Service (80 x 5)
(4.0)
DEBT 80
Levered Profit (Loss)
3.0
Effects of Distress
NOI Drops by 50
Net Operating Income (7.0 x 50)
3.5
Less Debt Service (80 x 5)
(4.0)
Levered Profit (Loss)
(0.5)
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 2 Falling NOI
Evidence In the Market

• Though real estate fundamentals seem to be
  holding up generally, selected property types /
  geographic areas are projected to decline
• Orange County has suffered a 600 bps increase in
  vacancy during the last year primarily due to
  tenant bankruptcies / downsizing from sub-prime
  mortgage lenders (New Century, Ameriquest)1
• Retailers could be put under pressure if consumer
  economy continues to lag
• Sharper Image bankruptcy and rumors from Linens
  N Things could foreshadow additional tenant
  softness
• Retail vacancies are on the upswing
• In the residential sector, individual incomes
  could decline as unemployment rises

Sources PPR, Reis, TWR, Morgan Stanley
calculations
Source Current Population Survey, Moodys
Economy.com, Morgan Stanley

• Notes
• Availability rate source CBRE

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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 3 Declining Values
Financial Impact

• Examples
• Commercial Market
• Refinance at lower basis
• Sale values that require incremental cash
  investments
• Housing Market
• Home price declines / short sales

Asset Value at Closing 100
Base Assumptions
Asset Value Declines 30
EQUITY 20
DEBT 80
DEBT 80
Effects of Distress
New Asset Value 70
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 3 Declining Values
Evidence In the Market

• Declining values effect owner returns but cause
  distress when assets are worth less then the
  debt, particularly when a refinance is imminent
• Primarily a concern for short-term debt from
  assets bought at peak pricing (i.e., Macklowe)
• 5, 7 or 10-year debt maturities potentially at
  risk but values have increased
• Landlords facing a decision about whether to
  support a project that requires more capital when
  values have declined may also push properties in
  default prior to a refinance
• Through March 2008, home prices have declined 11
  nationally year-over-year1
• If homeowners need to refinance or decide to sell
  because of job displacement / relocation, home
  may be in pushed into default

Source Morgan Stanley and NCREIF
Average 5.0
Source Standard Poor's, Fiserv Inc. and Macro
Markets LLC

• Notes
• Source Case-Schiller

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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Other Examples of Distress

• Distress scenarios can also occur in less obvious
  situations
• Technical Defaults
• Tripping loan covenants that may / may not be an
  economic default but are used by banks to protect
  their interests if the borrowers business begins
  to deteriorate
• Example net worth covenants for homebuilders or
  banks while asset values decline
• Development Projects
• Projects that have high operating leverage and
  require substantial fixed costs before a
  liquidity event
• Example condo projects
• In all of these cases, the property owner has an
  incentive to walk away
• from the property, but this is not as easy as it
  sounds

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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 3
What Happens in Default
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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Signs of the Real Estate Loan in Distress

• Monetary defaults
• Covenant defaults
• Real estate taxes delinquent
• Property or business operating at a deficit
• Capital improvement needs
• Investors unwilling to make capital contributions
• Subordinate liens, judgments
• Review of financial reports change in financial
  circumstances, cash flow

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Initial Review

• Review legal documents
• Structure
• Completeness
• Defects
• Perfection
• Evaluate how loan has been administered
• Course of conduct
• Representations
• Memos, e-mails in file Smoking Guns
• Understanding lenders goals and capabilities
• Benefits of modification (short term, long term)
• First loss is smallest loss
• Lenders capacity to own, manage or liquidate
• ORE portfolio
• Bank regulatory issues
• Evaluate long term market conditions
• Explore asset sale prospects

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Initial Review (contd)

• Understanding borrowers goals and capabilities
• Replacement franchisor, operator, tenant
• Management skills
• Reputation honesty
• Capital infusion from borrower or equity source
• Guarantors commitment to transaction or business
• Guarantors financial condition
• Understanding the relevant market
• Value of collateral and borrowers business
• Marketability of collateral
• Business market trends
• Leasehold market trends
• Debt marketplace
• Borrowers refinance or sales prospect

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Initial Review (contd)

• Understanding the collateral (realty and
  personalty)
• Condition
• Deferred maintenance
• Environmental considerations
• Appraisals (access to conduct)
• Evaluate project finances
• Potential for commingling or diversion of cash
  flow
• Leases
• Competing creditors

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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings
Strategies, Techniques and Objectives

• Pre-Workout Agreement/Standstill Agreement
• Preserves status quo
• Sets ground rules for discussions
• Either party can terminate discussions at any
  time
• Protects lender against waiver, oral modification
  arguments
• No oral agreements can be made
• Lenders goal obtain borrowers acknowledgement
  of debt and waiver of defenses
• Loan documents in force
• Without prejudice to rights and remedies

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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings (contd)
Strategies, Techniques and Objectives

• Background considerations
• Identify all necessary parties, sources of
  funding, credit enhancements (L/C issuers,
  guarantors, mezzanine lenders)
• Identify, negotiate and resolve all material
  business points early to avoid borrowers
  disguised delay tactics
• Engagement of financial consultants or turnaround
  specialists
• Beware oral modification or waiver during
  negotiations
• Prepare and execute detailed term sheet (subject
  to credit approval)
• Issue a loan commitment, if appropriate
• Need a formal instrument of modification
• Need for requisite corporate or partnership
  authority
• Ratification of loan documents, guaranties
• Obtain subordination agreements (or discharge of
  liens)
• Title insurance payment of taxes
• Always be aware of intercreditor issues

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What Happens in Default
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Loan Restructurings (contd)
Strategies, Techniques and Objectives

• To avoid
• Unrealistic optimism about borrower, borrowers
  business, the property or the market place
• Needlessly complex strategies or restructure
  models
• Strategies that ignore essential parties
• Strategies or models where lender has all
  downside and borrower has all upside (and vice
  versa)

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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings (contd)
Strategies, Techniques and Objectives

• Opportunity for enhancements
• Concessions or contributions from other
  lenders/creditors
• Concessions or contributions from franchisor
• Additional collateral (shares of stock,
  partnership interests, business assets, reserve
  accounts)
• Beware pledge of assets by non-obligors
  (consideration, fraudulent conveyance issues)
• New or additional guaranties increasing scope
  of guaranteed obligations
• Cure legal or document deficiencies
• Obtain additional loan covenants or monitoring
  rights
• Control of project revenue cash collateral
  Cash Management Agreement  Lock Box/Control
  Agreement
• Obtain waiver and release of defenses and
  counterclaims
• Ratification of indebtedness
• Formal extension of matured obligations
• Preserve or improve underlying collateral
  (capital expenditures)

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Alternative Restructure Models
One Lender and Multi-Lender Transactions

• For multi-creditor transactions
• Awareness of concessions, contributions and
  business requirementsby other creditors
• Relationships among creditors priority
• Lien subordination/Intercreditor Agreement
• Structural subordination
• Deferral notes and debt forgiveness
• Beware tortious interference with contract
• Guaranty coverage/collateral coverage

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions

• Possible scenario 1 reinstatement of loan cure
  short term default
• Justification for default
• Amend terms or covenants/back in compliance
• Possible scenario 2 Discounted Repayment
  Agreement as an exitstrategy
• Tied to market conditions, lenders business
  objectives, target market
• Example 10mm debt accept 9mm in six months
  or 8mm immediately
• In non-recourse loan, discount needs to give
  borrower incentive to pay the discount possible
  equity recapture by borrower
• In recourse loan discount in exchange for
  release of note and guaranty
• Never release note or guaranty until payment or
  consensual asset liquidation has occurred

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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions

• Possible scenario 3 short term forbearance
  agreement
• Six months to cure identified business problem
  suspension or reduction of debt service payments
• Waiver of covenant defaults
• Waiver of defenses, acknowledgement of debt,
  release of claims
• Possible scenario 4 longer forbearance (i.e.,
  one to two years) tied to
• Shortening maturity
• Economic concessions
• Discounted repayment built into restructure
• Additional collateral included in forbearance
  agreement
• Increasing number of guarantors or scope of
  guaranty
• Accrual of default rate or interest shortfall,
  with waiver upon performance

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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions

• Possible scenario 5 Substantive Loan Restructure
• Restructure loan to conform to market (lower
  interest rates, change or eliminate amortization,
  less burdensome financial covenants)
• Reduce interest rate or principal debt if
  borrower infuses cash, stabilizes business,
  brings in beneficial business partner or adds
  collateral
• Principal debt repayment plan with contractual
  incentives (e.g., 10mm loan  restructure at
  9mm pay down 2mm forgive 1 mm)
• Tax issues
• Cancellation of indebtedness income
• Intercreditor arrangements
• Possible scenario 6 additional
  collateral/guaranties
• As consideration for business concessions by
  lender
• Additional collateral and/or guaranties protect
  lender against downside, further business erosion
  and insolvency
• Expansion of existing limited guaranties
  guaranty of tranches of debt

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions

• Springing guaranties recourse events
• Interference by borrower or guarantor with legal
  remedies
• Diversion of cash flow
• Non-payment of real estate taxes
• Fraud
• Mismanagement
• Environmental liability
• Bankruptcy (by or against)
• Material alteration of collateral
• Lenders strategy use workout to fix loan,
  collateral and perfectiondefects
• Offer concessions/forbearance in effort to fix
  collateral or perfection defects (illustrations
  internal audit discloses financing statements
  never filed)
• Obtain acknowledgement of debt/waiver of defenses
• Obtain remedies certainty, finality,
  predictability finishes the process

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What Happens in Default
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions

• Deed in Lieu consensual turnover or liquidation
  of assets
• Business decision to take back or market the
  collateral
• Predictability
• Speed
• Deed or consensual liquidation faster than
  court remedies
• Note need foreclosure to eliminate subordinate
  liens on real estate
• Lenders sale of the distressed loan to a third
  party
• Speed, certainty, finality, elimination of
  further risk of loss
• Target market considerations
• The third party purchaser bargains for long term
  upside value
• Public relations, lender liability considerations
• Ready marketplace purchasers of distressed debt
• Loan to Own strategy

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What Happens in Default
Financial Distress 101 What Happens When Good
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Creditor Remedies and Enforcement Actions

• California has unique rules regarding real
  property collateral remedies
• Judicial foreclosure
• Non-judicial foreclosure
• One Action Rule
• Mixed Collateral Rules
• Blend of rules in UCC and other California
  statutes
• Potential impact on
• Ability to pursue deficiency
• Redemption rights of borrower
• Ability to pursue guarantors
• Ability to foreclose on collateral
• Mezzanine loans
• Structural subordination
• Can become owner by foreclosure
• Must then deal with senior lender
• Creditors should be extremely cautious when
  exercising remedies

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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Creditor Remedies and Enforcement Actions (contd)

• Bankruptcy
• Automatic stay stops creditor remedies
• Breathing room to attempt reorganization
• Single asset real estate
• Single commercial project with no other
  business/assets
• 90 days to propose plan or resume monthly
  interest payments
• Otherwise automatic stay lifted
• Not a panacea the project still needs to work

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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 4
Conclusion
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Conclusion
Financial Distress 101 What Happens When Good
Investments Go Bad
Externalities
Sustainability

• While distress has a significant economic impact
  on both the lender and
• borrower, bad projects can have much broader
  implications
• Sustainability
• Local impact swimming pools rotting in
  Sacramento
• National impact degradation of land for
  unnecessary projects
• Exurban sprawl is especially costly. Low-density
  residential communities developed at the fringes
  of metropolitan areas are often far from places
  of employment, as well as from civic, commercial
  and recreational destinations. Consequently, such
  development results in more road congestion, more
  carbon emissions and adverse climate change. The
  public services and the infrastructure needed to
  support low-density fringe development are
  unavoidably inefficient, both functionally and
  financially. The Washington Post (April 12,
  2008)
• Global impact natural resources such as steel /
  timber / petroleum products used to build houses

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Conclusion
Financial Distress 101 What Happens When Good
Investments Go Bad
Externalities
Infrastructure

• Infrastructure
• Strain on infrastructure from unnecessary sprawl
• There is a silver lining. Slowing growth in
  Southern California signals that the overheated
  market is in fact over and that the long,
  difficult process of correction, in which prices
  return to sustainable levels, is under way. If
  local officials are smart, they'll take advantage
  of sprawl's apparent stall to plan more carefully
  for future growth. In planning terms, think of
  this as a strategic pause, a moment to
  concentrate on water supply, traffic, school
  construction, infrastructure -- all of which tend
  to be brushed aside in the press of expansion but
  which need and deserve the long look that this
  moment may allow. LA Times (March 24, 2008)
• Decay of communities that provides services that
  cannot be supported by local tax base from a
  half-developed MPC or struggling in-fill
  locations
• The Worchester, MA housing inspector team is a
  kind of frontline scout platoon in the city's
  ongoing battle against urban decay, a fight that
  got much tougher during the last year, as the
  mortgage meltdown sent foreclosure rates soaring
  in Worcester and across the countryRecent
  legal action is part of the city's strategy to
  get mortgage companies and banksto take
  responsibility for the upkeep of houses that end
  up in their portfolios through foreclosure.
  Worcester Telegram Gazette (April 13, 2008)

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L\MSR\MSRE West Admin\ULI - Market Distress
Presentation\ULI - Market Distress Presentation
v8.ppt\A2XP\15 APR 2008\643 AM\39
Conclusion
Financial Distress 101 What Happens When Good
Investments Go Bad
Externalities
Workforce Housing

• Workforce Housing
• Lower home prices have resulted in increased
  affordability but capital remains scarce for new
  projects
• Affordable housing is the latest victim of the
  credit crunch that is reverberating through
  financial markets. Projects are being canceled
  because some of the nation's largest financial
  companies, including Fannie Mae, Freddie Mac and
  Bank of America, have scaled back their
  participation in the federal government's largest
  and most prolific affordable housing tax-credit
  program, designed to boost construction of
  below-market-rent apartments. Wall Street
  Journal (March 12, 2008)
• Irresponsible product programming exaggerates
  impact
• Responsible phasing and growth plans along with
  thoughtful/ holistic
• analysis on the front-end of a project can often
  prevent many of
• these externalities

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