S.E.C. Real Estate Observer

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When a bank loan goes 30 days delinquent in payments or past the due date, it becomes a scheduled item with the auditors. They may or may not require any reserves be put aside for loan losses. As default status continues, the loan will be written down based on borrower financial strength, appraisal, strength of the bank, etc. After 90 days delinquent, it will be put on non-accrual, meaning the bank cannot book accruing interest to income. At this time, a loan loss reserve will be established or increased. Loans can be put on the watch list or scheduled items for other reasons; lack of current financial numbers on the borrower or business, old appraisal, or appraisal showing no equity.

Sub-performing loans become non-performing after 90 days of no payments, and normally, this is where foreclosure starts. After foreclosure, the bank may get a new appraisal and set up an additional loan loss reserve (probably around 20%). Each year, the bank holds REO will require another appraisal and another 20% write off. This write off is charged to loan loss reserves and is an expense of the bank and a charge against bank capital. After 5 years, they have written the asset to “0.” However, once they sell it, they can credit operating revenues for anything they sell the REO in excess of its then current book value. In our 5-year example above, their book was written to -0-. Book value is a very valuable number for you to know. A bank can sell at book and not take any more losses. That does not mean they will, but they can.

Example. Investor buys $1M piece of development land and borrows $700,000 interest only, against the $1M appraised value. Market deteriorates and client struggles. Over time, the bank writes the loan down to $500,000. The borrower is still trying, and is making monthly interest payments. Borrower and bank agree to a loan modification extending the due date 2 years and lowering the interest rate to 3%.

Questions:

1) How much does the borrower owe?

2) How much loss has the bank incurred to date?

3) How much capital was written off?

4) What can the bank sell the loan for today without any additional recognized loss?

5) If the borrower offered to buy his loan for $600,000, what impact does it have on the bank?

Answers: $700,000; $200,000; $200,000; $500,000; $100,000 profit and increased capital.

In the 3rd part of this series, we will look at some ways to work with banks, and formulas that will allow the bank to preserve their capital and still market their non-performing assets. In the meantime, remember to share the love with your local banker.