Deleveraging America's Real Estate

Monday, May 4, 2009 - 00:00

Editor: Would each of you tell us about your background and practice area?

Berkman: I have been a commercial real estate and transactional attorney for more than 40 years in the Stamford, Connecticut office. My sub-specialty is commercial leasing. I have never represented lenders, only borrowers.

Tancredi: I am co-head of the Bankruptcy and Creditors' Rights Practice Group, which represents, in effect, every sector of the economy that is in restructuring or liquidation mode at this time, as well as the Distressed Assets Practice Group, which focuses on a multi-disciplinary approach to strategic asset acquisitions. We often represent either institutional lenders or strategic acquirers. I have also been fortunate enough to learn the other side of the trade, representing closely held or public companies that are in restructuring proceedings. I have practiced in these areas for about 30 years.

Editor: What effect do you anticipate the FASB ruling regarding a change in mark-to-market rules for bank balance sheets will have on the way banks treat troubled mortgage loans?

Tancredi: Initially, the ruling may bump the stock market higher as there is some renewed hope about the recovery of banks. Ultimately, I think that the plan was calculated to create liquidity by getting the toxic assets off the banks' balance sheets. The Wall Street Journal pointed out that Ireland and other countries around the world, having similar concerns, are now about to embark on a process to set the rules for valuing assets.

Editor: Do you expect Secretary Geithner's P-PIP program for ridding banks and other institutions of toxic securities to be the panacea that the government would like to see occur?

Tancredi: Everyone is holding his breath for a panacea, but I don't think there is one. The Secretary's effort is meant to rebuild confidence in business fundamentals, which should be a major shot in the arm in terms of building confidence. My view, shared by some economists, is that while these measures are headed in the right direction, until GM files for bankruptcy and we see how GM will emerge, we are not quite at the bottom.

Editor: Do you see a conflict between the change in the mark-to-market rule and the P-PIP program in the sense that at the time the P-PIP program was announced the mark-to-market ruling had not come down, which will have the effect of inflating the value of some bad bank assets?

Tancredi: I see the contradiction but I also understand that you need different rules for different times. If the rules are too rigid, we are going to create only self-fulfilling negative prophecies. There is expediency, if you will, in creating some inconsistencies.

The Obama administration is trying many different approaches simultaneously. Along with the way these approaches are being refined, like a giant chemistry experiment, they will all be titrated. In the history of economies, there has never been a clear answer as to how you fix a problem of this magnitude.

Editor: Jerry, what tools can be used by a secured creditor to best assure that his collateral is protected from a weak debtor?

Berkman: When I think of tools, I think of reserves. A mortgagee can impose reserve requirements - reserves for interest for some period of time and also reserves for brokerage commissions and tenant improvements. One of the problems that landlords are beginning to face in this weak economy is the difficulty in bringing in new tenants. For example, if there are reserves as part of the mortgage loan for brokerage commissions and tenant improvements, which the landlord can draw upon in order to bring new tenants to the building, thus increasing the value of the lender's security, this becomes a wonderful tool.

Tancredi: There is compelling simplicity in that proposition - saving for a rainy day. Projects should be underwritten on the basis of fundamentals, such as management and built-in reserves, rather than perceived market values. Those fundamentals were paramount in history, and we are probably going to come back full circle to such fundamentals again.

Editor: What about requiring that more loans be written based upon 70 to 75 percent valuations as opposed to the 95 to 100 percent?

Tancredi: The reserve requirement of a 70 percent loan to value ratio - a reasonable margin of safety - recognizes that there are inevitable ups and downs in most of our markets. Projects that we thought had equity last year appraisers are now writing down by 20 to 30 percent today.

Berkman: The 95 percent, 100 or 100 plus percent loan to value ratio, was an aberration. It was inevitable that we would be coming back to something more realistic.

Editor: What is the status of a letter of credit supplied by a tenant who is about to go into bankruptcy? Is the letter of credit outside the bankrupt estate?

Berkman: The letter of credit has not held up for landlords quite as well as they might have hoped. The letter of credit is an independent obligation of a bank. Landlords in the past have relied very heavily on the fact that it is an independent obligation. While this is true, recently the bankruptcy courts and federal appellate courts have tended to apply the same rules to letters of credit as have been applied to cash security deposits. For example, if the landlord is fortunate enough to have received a letter of credit in an amount in excess of the statutorily allowed damages in bankruptcy, it will not be permitted to keep the excess proceeds but will be required to put them back into the creditors' pool of funds. So landlords are not getting quite the benefit from letters of credit that they hoped. There is a recent decision ( In re Stonebridge Technologies, 430 F. 3rd 260 (5th Cir. 2005) ) from a federal court of appeals that goes the other way with a finding that the landlord could keep those excess proceeds from the letter of credit. Because the fact pattern in that case is pretty narrow, it is not one that will be common going forward; hence, I don't think that landlords can take much solace from that decision. I think that a landlord has to assume that the letter of credit proceeds will be treated similarly to a cash security deposit.

Tancredi: Jerry is focusing on the capping of a landlord's claim in bankruptcy. Letters of credit still do have some utility in terms of not being subject to the automatic stay in bankruptcy, unless there is some prerequisite to give the debtor notice before drawing on the letter of credit, which is seldom the case.

Another issue that landlords have not focused on is if damages have accrued, they can very clearly draw on the letter of credit. One concern affecting landlords who consider drawing on a letter of credit in the bankruptcy process is that wrongful draws are just as dangerous as getting tied up in a lender liability claim. Landlords have to be mindful that they need mature, clear, damage claims to do a rightful draw.

Editor: Why are creditors today reluctant to foreclose on some properties?

Tancredi: There are mixed motivations. One of the motivations affecting banks is to wait for some kind of TARP assistance to take out bad loans. In addition, there has been a reluctance on the part of some institutions to take the hit in terms of affecting the bank's capitalization. Lastly, there is a tendency for banks to wait for more liquidity in the market. Today there are not many buyers for troubled assets.

Berkman: Lenders historically have not wanted to be owners and for that reason have almost always been reluctant to foreclose. It seems that lenders have less capacity and fewer workout people than in the past. The independent work-out groups who were such a powerful force in the late '80s and the early '90s have virtually disappeared.

Editor: Why is a prepackaged bankruptcy preferable in many instances to a non- structured bankruptcy?

Tancredi: Most insolvency practitioners will tell you that the transaction cost associated with a formal bankruptcy or insolvency is significant. Because there are multi-party disputes, the transaction costs often involve a debtor having to pay the costs associated with counsel and other professionals representing both the secured lenders, and the unsecured creditors. A bankruptcy process that is not controlled can run for several months, or for a public company can go several years. Time is money and strategic control is absolutely essential to emerging in one piece in a cost effective way. Pre-packaged plans truncate the timeline, truncate the contest, truncate sometimes the roles that some of the second or third tier constituents might have in delaying the process. There is an absolutely compelling strategy on which a pre-packaged or partially pre-packaged bankruptcy plan is premised - it effectively says "I dare you to stand in front of an express train."

Berkman: In a real estate related bankruptcy we know that the 2005 amendments to the bankruptcy code substantially reduced the period of time that tenants have to make a decision whether to assume or reject a lease. Wouldn't that be another reason why it would be preferable to get those decisions made before any bankruptcy filing so that they are not under such great pressure in terms of time?

Tancredi: Aside from cost, it is things such as the period for assuming and rejecting leases; the single asset real estate provisions, which provide a much shorter period of time for reorganization; a real estate bankruptcy requiring almost immediate payment on debt service and truncation of exclusivity that suggest that doing as much out of bankruptcy as possible is the only feasible way to use the bankruptcy process to emerge today. Editor: In the instance of a lease expiration occurring while a tenant is in bankruptcy, what is the best solution for a landlord who wishes to take control of the property?

Berkman: If taking control of the property involves removing the tenant whose lease has expired, the bankruptcy courts will recognize such an expiration as grounds for removal. It is prudent for a landlord to get a release from the automatic stay in bankruptcy before removing the tenant through the state courts if the landlord believes it to be in his interest. In this economy a landlord might be better advised to take control of the property by renegotiating the lease terms with the existing tenant if the landlord perceives that the tenant is going to come out of bankruptcy in decent financial condition.

Editor: In the case of non-monetary defaults by tenants, how lenient are you seeing lenders (including institutions) in waiving defaults in today's world?

Tancredi: Landlords are less likely to pull plugs based on non-monetary defaults. Likewise, lenders, aside from being concerned about lender liability with a non-monetary default, are more cautious about whether or not the business can be saved or restored.

Editor: What impact has the present market crisis had on real estate portfolios in general?

Tancredi: Generally, the market dynamic is forcing all constituencies to think creatively. We may see bifurcated mortgages, not unlike the kinds of structures that General Motors is talking about. Some mortgages may be converted to equity pieces. In the cases of properties that are woefully underwater or those in markets that are not likely to turn around anytime soon, a combination of the lack of equity that exists in these properties, the transaction costs associated with an effort to reorganize, and the real tough provisions of the bankruptcy code (particularly SAR or single asset real estate provisions) will drive that class of debtor to deed over the property to the lender rather than go through foreclosure.

Editor: What has become of the proposal that bankruptcy judges be given the right to reset the terms of a mortgage?

Tancredi: On the business side, the bankruptcy courts have always had the ability to reset rates on mortgages or to rewrite certain non-monetary covenants. The consumer mortgage area is troublesome. Generally, consumer bankruptcy practitioners believe that the tools do not exist under the current provisions of chapter 7 and chapter 13 to reset rates and bifurcate mortgages. Congress is very active right now in considering such provisions, such as a roll back to many of the pre-2005 bankruptcy code provisions. Even a faction of the landlord lobby is recognizing that in getting what they wanted in 2005, they were given almost too much power. The 2005 amendments to the Bankruptcy Code created a situation in which big debtors like Circuit City, rather than going to talk to all of the creditors, decided to liquidate.

Editor: I think that many are saying today that irrespective of all the legislation that is being written on the books that this market will take care of itself overtime - that markets have a way of rectifying themselves.

Tancredi: Yes and the rectification that is going on is called deleveraging, a very painful exercise. It hurts people in their homes and their jobs and their futures.

Please email the interviewees at jberkman@daypitney.com or jjtancredi@daypitney.com with questions about this interview.