It’s The Law
By Rachana D. Oza
Thorough Due Diligence Is Key
To Buying and Selling Loans
LOAN DISPOSITIONS HAVE BECOME A GROWING
trend in this down cycle. While higher-quality debt is actively traded in the open market, slowly but surely, lower-quality
debt is also being bought and sold. Sales of leveraged
loans, however, have become increasingly challenging.
Within the past year, leveraged loans put up for sale have
increased over 20%, and are currently up to $197 billion.
It clearly benefits selling lenders to get bad debt off their
books. A less obvious advantage is an increase in stock
value. In July 2008, CIT Group sold almost $10 billion of
its mortgage loans and, as a result, its shares rose 29.7%.
Some sales do not cause such dramatic increases, but still
keep lenders ahead of their competition. When Citigroup
Inc. announced in the spring that it was selling a chunk of
its leveraged buyout loans, its stock rose marginally, but on
By the end of November, corporate leveraged
loans were trading at 65 cents on the dollar,
despite being fully secured by assets.
a day on which comparable lenders’ stocks fell.
JPMorgan Chase has begun calling paper suffering
from the credit crunch “legacy” loans, which made up
$18.3 billion of the firm’s total lending commitments at the
end of March 2008. With parts of the market functioning
at the old norm, the goal has been to get these loans off
the books. JPMorgan sold $2 billion of this debt between
March and July 2008, but at a 30% markdown. By midsummer, JPMorgan’s average leveraged loan was trading
at 80 cents on the dollar, compared to 85 cents just three
months earlier.
With lenders so eager to get these loans off the
books, why bother buying them? There are actually several advantages for the buying lender. Most obvious, the
loans are being purchased substantially below their face
value. In February 2007, leveraged loans were trading at
an average of 100.11 cents on the dollar, but by March
2008, the number was down to 87 cents. By the end of
November, corporate leveraged loans were trading at 65
cents on the dollar, despite being fully secured by assets.
As a result, a non-performing loan will not hit the buying
lender quite as hard simply because the buying lender’s ini-
tial investment was not as great as that of the seller. On the
optimistic side, a performing loan will keep cash coming in.
Non-performing loans also lead to foreclosure opportunities in which the buying lender can seize the asset used as
collateral for the loan.
From a legal standpoint, counsel for the buying lender
has the critical task of performing thorough due diligence.
One place to begin is looking to the due diligence performed by the selling lender. There are several aspects of
the loan that must be dissected and analyzed.
First and foremost is a clear understanding of exactly
what secures the loan in question. Is it property or membership interest in an entity? If it is a property, it is important
to know what percent of the building is leased and by
whom. If the building is partially or mostly vacant and the
borrower is dependent on the revenue from rental income
to repay the loan, this is valuable information about the
likelihood of default. Keep in mind that any liens on the
building—water, sewer or mechanic’s liens, etc.—will be
transferred along with the building in a foreclosure.
Another essential aspect of the loan is how and when
the buying lender is to be repaid. If there are multiple levels
of priority and the buyer is subordinate to other lenders,
under what circumstances can it foreclose? Depending on
the collateral and any higher-priority loans, it’s possible that
the buyer may not even benefit from a foreclosure action.
Even if the loan is first priority and a foreclosure action is
within easy reach, a crucial, and often overlooked, consideration is whether the buying lender can handle the asset.
If it is a hotel, can it operate the hotel? If it’s not in the business of whatever is securing its investment, this is the time
to come up with an exit strategy.
The market for buying and selling loans is peaking. With
sellers eager to get debt off their books and buyers looking
to get loans at a discount, it is vital for buying lenders to
retain counsel who are experienced in analyzing the past,
present and future of the loan being transferred. ◆
The views expressed in this article are those of the
author and not REAL ESTATE FORUM.
Rachana D. Oza is a Washington, DC-based associate with
the law firm of Greenberg Traurig. She may be contacted at
ozar@gtlaw.com.
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