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

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


1
L\MSR\MSRE West Admin\ULI - Market Distress
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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)
4
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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
Investments Go Bad
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
Investments Go Bad
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
Financial Distress 101 What Happens When Good
Investments Go Bad
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
Investments Go Bad
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
Investments Go Bad
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
Investments Go Bad
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
Financial Distress 101 What Happens When Good
Investments Go Bad
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
Investments Go Bad
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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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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