Not all loan defaults are the same. In this section, we’re going to talk about different types of defaults. Many people think, incorrectly, that a default is triggered by non-payment of a loan. Loans can go into default because of issues relating to the loan terms or maturity dates. In this lesson, we’ll dig into this further.
In this section, we will discuss the different types of loan defaults. These are known as Term Defaults. Now, there are two types of term defaults. The first are monetary defaults. Many defaults occur because of non-payment of principal or interest – this is pretty straightforward. These are more serious defaults that trigger a foreclosure. Then the second type of term default is a non-monetary default. Technical defaults can occur for many reasons, such as failing to seek appropriate lender approvals on key decisions, or failing to provide information in a timely manner. Now, there is a joke in the industry that every borrower or sponsor is in default day one, as the covenants are written in such a way that the bank can call the loan due at their whim. Although this is the exception rather not the norm, banks will always become nervous when markets falter and valuations fall.
The second type of loan default is the Maturity Default. Some loans enter default because they cannot be repaid at maturity. Many times, these loans possess the cash flow to pay the lender costs during the term of the loan, but the property cash flow cannot support new debt that is needed to repay the existing debt at maturity. Here is a real life example: During the credit boom of the early to late 2000s, up until around 2007, banks and lenders were getting aggressive with their terms and underwriting. So aggressive, in fact, that it wasn’t uncommon for a lender – usually a conduit lender – to underwrite a loan off of the pro forma income assumptions. Now, fast forward to ten years later, where lending has tightened and most of those values never hit their pro forma projections. They are, essentially, underwater. The lender will need to take a hit, or the sponsor may file bankruptcy – as many lenders in this environment won’t underwrite a loan at a made up number for a valuation, simply to cover the existing debt structure on the loan. This is no different than a home being underwater, in which it has a loan amount exceeding its value. A mortgage lender is going to underwrite a new loan based only on its value today – not its value during heyday.
Now we’re talking about the senior lender, the first trust deed, or the mortgage here. Senior lenders have the most control and are in the best position; however, their defaults are the most serious. The senior lender will typically seek a foreclosure or a note sale quickly, and they will typically avoid real-estate owned (REO) property. In the event of a default, the senior lender drives the work-out process, which consists of the following:
- This can appear in the form of a Forbearance Agreement, where the lender and borrower make an agreement acknowledging a default, and where they establish modified terms under which both parties agree to keep working together. (The terms are dependent upon what caused the default in the first place.)
- Another workout may come in the form of a Loan Restructure. This is when the borrower and the lender agree on new repayment terms which typically include interest and term and – in some cases – principal, by which the borrower will repay the loan.
- In residential, you’ve probably have heard of a Deed in Lieu of Foreclosure. This occurs in commercial when the borrower returns the deed to the lender and typically gets something in return, such as management/consulting contracts, cash, the release of principal or personal guarantees, and so forth.
Diving deeper into the distressed funnel now, foreclosure is driven by the senior lender, and foreclosure occurs when the lender provides the courts with a notice of default. This legal action sets that specific state’s foreclosure proceedings into motion, whereby the lender exercises these rights under the deed of trust and seeks to become the owner of the property. If you’re qualifying an opportunity, you always want to know whether anything “legal” has been filed. You may not receive this information up front, but it is critical to understand what your options are so that you can properly structure the deal. And, finally, we have bankruptcy. Bankruptcy is the last-gasp option for the borrower to retain ownership of the property.
In a default situation, the mezzanine lender relies heavily on the intercreditor agreement. In cases where the mezzanine lender has the right to assume the senior loan, they typically do so. If the mezzanine lender does have that right, then they must pay off the first trust to exercise complete control. Let’s take a closer look at these unique situations:
- The first trust is in default, but the mezzanine loan is not in default. In this case, the mezzanine lender moves to protect the loan’s interest. In most cases, a default of the first trust is an automatic default of the mezzanine loan. The mezzanine lender has two options here. The first is to foreclose on the partnership interest and assume the first-trust loan, and the second is to foreclose on the partnership interest and pay off the first-trust loan – thus gaining ownership of the property.
- The first trust is not in default, but the mezzanine loan is in default. In this case, a default of the mezzanine loan is typically not an automatic default of the first-trust loan. The mezzanine lender has few options other than to foreclose on the mezzanine loan and own the asset. If the intercreditor agreement allows, the mezzanine lender is forced to pay off the senior loan.
In a default or bankruptcy situation, the authority or rights of the equity investor are governed by the partnership operating agreement. Limited partners have little to no say in the plan or the resolution. Thus, they are the most at risk. General partners typically control the asset in times of default; however, the original general partner can sometimes be replaced (providing there is language to do so in the operating agreement) by a third-party or limited partner – if the original general partner is not performing and the property suffers a loss or a loan default.
All defaults typically allow time for the borrower to fix or cure the problem; this time is known as a cure period. Equity investors need to understand their rights and remedies in the event of a project default. In a default situation, lenders, creditors, and equity partners look to the character of the sponsor. In these situations, character, reputation, and behavior are important. Sponsors who take a cooperative approach to help fix the problem stand a better chance of being treated well by the lenders. Conversely, sponsors who take a combative approach risk an all-out fight with the lenders.
In difficult times, lenders are looking for problem-solvers. The actions of the borrower are differentiated by how much equity they are perceived to have remaining in the asset, as well as by the degree of leniency the lender shows in restructuring the loan to allow the borrower to recapture this equity. Let’s take a closer look at each of these different situations.
As we have learned, the senior loans are secured by first trust deeds, so the senior lenders have first priority in preference of repayment. If the loan goes “bad,” the remedy is to foreclose on the collateral. Given that the LTV is usually less than 75%, the senior loan holders will likely be paid-in-full after the sale of the collateral.
Mezzanine lenders are known as the junior participants. Most mezzanine loans are typically collateralized by an Assignment of Partnership Interests. This means that if there is a default on the mezzanine loan, the mezzanine lender can step into the shoes of the General Partner or managing member.
In terms of repayment, the mezzanine debt is paid after the first trust debt is repaid and before the equity is repaid. In the case of a default, the mezzanine lenders would pay off the first trust loan and become the senior lenders. They would assume the first trust loan and keep the senior loan in place.
Most equity investors provide loans which are unsecured. They rely on the Partnership Agreement to determine their rights and benefits. In a default situation, if we’re talking about have a preferred equity transaction, remedies run to the General Partner and not to the property. The typical remedy involves dilution of the General Partner’s economic interests and/or their ability to manage or control the property.
Special servicers are often appointed by the loan originator or the primary servicer when a loan enters a default. Special servicers work for the asset, but their interests are not always aligned. It is important for the investor to know whether a special servicer owns the B Note or not. If they do, they will be willing to work with you to maximize the value. If they do not, they will seek the quickest resolution. A special servicer may be a contract worker who was selected to work on the loan, or they may be the B Note buyer who has an established relationship with the investor at the time of the loan origination.