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 Paul Andrews and Aaron Tam of UHY Advisors FLVS Inc.'s restructuring and turnaround practice group comment on private equity acquisitions and the mortgage crisis in The Daily Deal.The subprime mortgage debacle was caused by many factors--frankly, too many to discuss in this article. One of the most significant root causes, however, was the abundance of inexpensive available cash early through mid-decade. In the subprime markets, low interest rates drove the demand to do more deals. The supply of good-credit borrowers buying houses in the ordinary course likely did not significantly change. In the mortgage markets this imbalance meant a combination of lowering underwriting standards and increasing the number of higher-risk subprime loans that were made.
Similarly, a significant amount of private equity was looking for a home--presumably with a commensurate and appropriate increase in returns for investors on their instruments--in the early 2000s. This was especially true as investing in the stock market became less desirable as a result of less attractive returns. The Dow Jones Industrial Average increased at an annual rate of over 20% during the two-year period ending December 1999 and then declined about 7% in each of the subsequent two years. In addition, securitization of both mortgage and corporate loans substantially increased as investors were drawn to these diversification vehicles with higher returns backed by assets --homes and corporations--increasing in value.
The similarities regarding the two situations are fairly apparent: low interest rates and plenty of available cash fueled accelerated lending practices used to purchase over-valued assets. Will we see another (or acceleration of the current) tidal wave of financial institution issues (see Bear, Stearns & Co.) from this series of events as is occurring with subprime residential real estate lending? The similarities are significant: Cheap Money: The prime lending rate, which is used for most home equity loans, dropped 5.5% from mid-2000 to mid-2003. LIBOR, established by BBA in England and used for most asset-backed corporate loans, correlates highly to the prime lending rate. These rates fell to 40-year lows in early October of 2001 and resided at their mid-2003 lows for a full year. This precipitous drop is consistent with the record declines that occurred during the recessions of the mid 1970s and early 1990s. Low Underwriting Standards: Along with the declining rates, banks got creative with their mortgage lending products. There was an increase in the use of ARMs, interest only, home equity loans, and loans based on stated income. A recent study of stated income loans indicated that approximately 90% applications where the borrower's income was overstated--nearly 60% of which were overstated by at least 50%. In the corporate world there was an increase in negative amortizing, second and third lien, and no covenant or "covenant light" loans. Underlying due-diligence fundamentals were dismissed. Record Lending: The record low rates and weak underwriting standards created incentives to lend. Real estate loan generation more than doubled from 2000 to 2005. LBO volume increased from $24B in 2001 to a record $320B in 2006. The highly liquid securitization market helped drive this trend as both mortgage and corporate lenders could quickly sell the paper, which was prized for its diversification properties, higher returns, and "minimal" downside asset value risk. Underlying valuation fundamentals were dismissed. Over-Valued Assets: In both situations, the owners of the underlying assets--homeowners and private equity firms--anticipated that the consistently increasing value of the assets they purchased was a long-term trend and would continue during their ownership horizons. The lenders were willing to use these valuations since comparable transactions were so prevalent. Housing prices increased by at least 6% annually for each year between 2001 and 2006, with many markets enjoying consistent double-digit growth. LBO purchase multiples rose from 6.3x in 2001 to 10.4x for the first half of 2007. Asset owners and their lenders thought rising prices were the norm. In the mortgage lending market, the subsequent rise in interest rates--the prime rate rose 4.25% between mid-2004 and mid-2006--eventually led to residential real estate delinquencies rising to record levels. Once this became a consistent trend among the high-risk homeowners, the underwriting standards tightened and the securitized loan market dried up. Financial institutions that were heavily invested in residential mortgage loans--especially those to sub-prime borrowers --started to face liquidity issues. After the underwriting standards tightened and the securitized loan market dried up for mortgage lending, the same thing happened in the corporate loan market. In late summer 2007, the music stopped. The reason financial institutions that are heavily invested in corporate loans have not had (public) issues is due to the differences of the two markets: Transaction size: Since the average house has significantly less market value than the average corporation, the loan size is correspondingly lower. Therefore, a mortgage delinquency will have a smaller impact on the liquidity of the lending institution than a corporate loan payment default. However, the effort required to work through the outstanding issues and/or liquidate the underlying asset in the mortgage example is not materially different and is certainly proportionately higher and more difficult. This is why lenders are willing to bundle bad mortgage loans and dump them at distressed prices. With a higher transaction size, corporate loans justify individual attention. Workout expertise: Many delinquent mortgage borrowers were first-time homebuyers and certainly had little to no experience dealing with large debts to major financial institutions. Corporate boards and senior management tend to be much more sophisticated in these matters than individual homeowners. Major financial institutions typically have entire departments that focus on nothing but these workout situations. In addition, if either party does not have the requisite experience, there are various professional advisory organizations readily available with experts in every industry and situation. Sophistication on both sides maximizes options. Due to these differences, the impact from corporate loan defaults will likely be diminished in comparison to the mortgage lending issues. This does not imply that financial institutions are free from the liquidity risks relating to poorly constructed corporate loans. According to a recent Standard & Poor's report, corporate default rates are expected to increase based on changes in the credit-pricing environment and a slowing of the economy. Although default rates remain below historical average, they "are on the upward leg of an ascent that will gain momentum in the second half of 2008 and likely continue into 2009. A material risk remains that defaults could be significantly more pronounced and severe beyond the one-year forecast horizon." Corporate lending has much in common with the current mortgage crisis. While we will see corporate loan portfolios quickly liquidated for institutional reasons, in general, it is more efficient to pay attention to the portfolio's problem loans. It's not that there won't be issues--it is just that financial institutions will work through the issues this time around, with a lot of help from professionals. Paul Andrews is a managing director and Aaron Tam, Ph.D. is a principal with UHY Advisors FLVS Inc.'s restructuring and turnaround practice group. CategoriesComments Deal Video
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HOUSING’S DEATH SPIRAL MUST BE STOPPED, AND THERE IS A WAY
By Marc Berger
The news is bad and will only get worse. Mortgage delinquencies and home foreclosures reached record levels the first quarter of this year, with California and Florida leading the way, according to the National Association of Mortgage Bankers. The number of new foreclosures and the number of homes in foreclosure reached a 29-year high.
I’ve seen this type of housing crisis before during the recession of the early 1990s, and we all agree, it’s not a pretty sight. But this is worse. Much worse. What makes foreclosures this time so devastating is that they continue to invade the housing market for all homeowners, not just those who have purchased or refinanced a home during the past several years. Each time a flood of foreclosures hit the market, it depresses housing values in areas where the foreclosures are occurring.
The economic reverberations for individual urban areas across the U.S. are enormous. Tax receipts are expected to fall by $6.6 billion in selected states, according to a report by Global Insight, which points out that nearly 130 cities around the nation will face sluggish growth; 65 major metro areas will see their economic activity diminish by a third. Job loss in these impacted areas could reach 525,000.
Based on new foreclosure projections by the Center for Responsible Lending, it is estimated that one in 33 current U.S. homeowners will be in foreclosure, many in the next two years. Among the states hardest hit are Nevada, where one in 11 homeowners could soon be in foreclosure; California, with one in 20; Florida, with one in 26, and Georgia, with one in 27. The destructive force of these massive foreclosures could create what I see as areas of economic “pocket depressions.â€
There is a solution, and it’s one the federal government has implemented once before with significant positive results, and that was the Resolution Trust Corporation. The RTC was a U.S. Government-owned asset management company mandated to liquidate assets (primarily real estate-related assets, including mortgage loans) that had been assets of savings and loan associations (S&Ls) declared insolvent by the Office of Thrift Supervision as a consequence of the savings and loan crisis of the 1980s.
It’s time for the Feds to give serious consideration to Resolution Trust Corporation II, or what I have dubbed the Housing Recovery Corporation (“HRCâ€). If they did it in the late 1980s, they can, and must, do it again. As I envision it, the HRC will be a quasi-public entity that will establish Housing Recovery Zones (“HRZâ€) in the hardest hit geographic areas such as the Inland Empire and other urban areas that are suffering most from foreclosures. It’s comparable to the federal government declaring disaster relief areas such as the Gulf States after Katrina. The difference is, this could be a much bigger disaster across the entire country.
Here’s how it works. Once a HRZ is in place, the Housing Recovery Corporation would purchase the debt of distressed, owner-occupied homes from the debt holder at a discount. The HRC would then restructure the debt into a two-part mortgage. The new 1st TD would be a market-rate, performing mortgage that the HRC could sell into the secondary market, and the 2nd TD would be an interest-free, self-amortizing loan based on a contractual agreement with the homeowner and held by the HRC.
It’s a win-win. The homeowners have an economic incentive to stay in their homes; the property values of surrounding properties are not as impacted by foreclosures; the banks and other lenders would have a secondary market for their non-performing mortgages; state and local governments are relieved of the pain of seeing residents kicked out of their houses and rental units (a lot of rentals are homes now in foreclosure with renters standing in the doorway); and the housing market – and ultimately the economy -- are not being pummeled by the tidal wave of foreclosures.
(Berger is a principal XRoads Solutions Group with offices in New York City and Santa Ana, CA. He has extensive experience working with homebuilding and real estate entities, and heads XRoads' newly established Homebuilding Practice.)