When it comes to dealing with commercial property, understanding the timing of liquidation in relationship to a loan’s maturity and the time of default is important on several levels. Knowing the data allows banks to make better loan pricing and loan workout decisions. For example, loss severity is greater for loans with 75% loan-to-value (LTV) than with 100% LTV. This is counterintuitive but can be accounted for by understanding that bankers move faster to liquidate properties that have higher LTVs. Loss severity increases the longer it takes to liquidate a property or business. Carrying cost hurt. In this post, we explore the data of some 11,000 loans in the Trepp database and extract what bankers need to know to better manage defaults and how to make that hard decision on when to move into liquidation.
Why Liquidation Timing Matters
Most banks have no established framework or guidance on liquidation timing. When it comes to recovery expectations, many bankers are also influenced by the optics of managing earnings and the reputational risk around potential losses that can also change the outcome. This is a mistake as loss-timing is a strong predictor of expected losses. In addition, most bankers take don’t take into account the time between default and liquidation into the loss model. Making an estimate on time of liquidity can translate into bankers becoming more accurate in predicting loss severity. These intervening months or years can materially help or hurt the recovery value and loss severity.
Using LTV and DSCR: Credit metrics such as loan-to-value (LTV) and the debt service coverage ratio (DSCR) are still the best predictors of loss levels, but it is LTV and DSCR at the time of liquidation, not the time of default, origination or last credit review that makes a difference. Loan losses follow a normal, or bell-shaped distribution and are predictable as a result. In fact, 50% of losses occur plus or minus within 15% of the medians below according to Trepp and JP Morgan data. While most bankers intuitively know this, few have a formal process around making sure these factors get updated, recorded and re-analyzed to better estimate future losses.
Maturity Defaults: The other factor that has been learned during the downturn that banks can incorporate into their credit model is the timing of liquidations. Most banks assume a loan goes bad during the life of the loan. The reality is that in 60% of the loans defaults occur either at maturity or after. Borrowers often struggle but find a way to make payments on a distressed property up until a balloon payment is coming due. The borrower hopes that a successful refinance can be achieved, but when options don’t avail themselves, they are forced to stop payment resulting in a payment default just before maturity. This occurred in 75% of the loans that we reviewed that went into default at or after maturity. The remaining 25% of the defaults occurred at maturity or after and had a drawn out liquidation period either as a result of the borrower or the bank. In almost all of these cases, losses were greater than compared to the previous group where the bank knew of the stress, and the bank was able to move into liquidation quickly (within three months).
Life of Loan Defaults: Those loans that didn’t go into default just prior or at maturity made up 40% of the defaults. These loans went into default way in advance of maturity. Years four and five of a seven or ten-year loan is the area that had the largest amount of defaults. The common characteristic of loans that go into default in advance of maturity is that the bank and borrower felt less pressure to move into liquidation. These loans almost always took longer to move into foreclosure and liquidation. In fact, the average time to liquidation was 12 months. Here again, a longer time to liquidation rarely worked in the bank’s favor.
Putting It Into Action
The takeaways here revolve around getting banks a better understanding of when losses occur. Banks should build in more liquidations at maturity and increase the severity of losses on loans that have extended periods of liquidation. Further to this point, banks should strive to reduce liquidation time whenever possible. While the trend is usually for property values to continue to deteriorate, the largest driver is the cost of carrying combined with higher legal fees. Limiting the time between default and liquidation works for the bank.
Submitted by Chris Nichols on October 24, 2016