Don’t Be Fooled by Lack of Bankruptcies

The Miami Herald
June 30, 2008

Here in South Florida it is painfully apparent that the real estate sector is under siege. Indeed, as a bankruptcy lawyer for the past 35 years, I cannot recall anything of the magnitude that we are presently witnessing. Yet, local real estate development-related bankruptcies have been few and far between and those that have been filed are really not very instructive about the situation we find ourselves in. The Puig Development Group bankruptcy cases are but the fallout of the latest Ponzi scheme. Levitt & Sons is a programmatic liquidation. TOUSA is just a lawsuit in disguise.

So where's the tsunami of real estate bankruptcies everyone has been talking about? In my view, the bankruptcy cases that have not materialized speak volumes, and what they instruct indicate is that bankruptcy may not be so prevalent in this particular cycle.

First, developer balance sheets are meaningfully different today. When money was abundant, lenders---particularly hedge funds and private equity groups---devised all sorts of new vehicles for putting money to work: first and second lien loans, B-strips, mezzanine loans, and on and on. The proliferation of lending vehicles has served not just to lard up balance sheets but to create more seats at the proverbial bargaining table, more lenders to make happy and reduced prospects for equity holders.

Second, property values continue to decline and we really have no idea where all this will bottom out. Wherever the bottom may be, it likely will be an abyss for property owners. With little or ever-declining margins of equity, developers have nothing with which to fend off creditors or reorganize around in bankruptcy.

Third, despite previous enthusiasm in the capital markets, lenders have clearly become less willing to lend money into bankruptcies. Worse yet, many lenders are unwilling to take any chance of ending up with their collateral, and they are selling their positions for pennies on the dollar to opportunistic buyers who would be happy to take the collateral and sit with it until values rebound. Indeed, the prospects of getting loans from new sources in bankruptcy have also declined as those sources are waiting for distress sale opportunities. Bankruptcy hardly ever works without fresh money.

Fourth, the Bankruptcy Code was amended not too long ago to limit the time for single developers to fish or cut bait. If a single asset developer cannot put forth a plan for reorganization with reasonable prospects for confirmation or start paying its lender within 90 days of filing bankruptcy, the party is over.

Last, many lenders cleverly required so-called "bad boy guarantees," which provide that if a developer files bankruptcy its principal will be held liable for all indebtedness to the lender, but if it does not file bankruptcy the principal walks. Need I say more?

Getting the picture? Too many lenders at the trough; dwindling property values; no cash to use; too little time under bankruptcy law; and, financial retribution for filing bankruptcy. I believe that if we do see a spike in real estate bankruptcies it will be attributable to pre-packaged plans, most often to facilitate bankruptcy sales of distressed real estate assets. But, take no false sense of comfort from that as we are still bleeding red ink and things are likely never going to be the same as before we started this remarkable descent into the belly of the beast.

This article is reprinted with permission from the Miami Herald.

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