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Financial Distress 101: What
Happens When Good
Investments Go Bad



Kevin Fisher, Paul Hastings
Josh Myerberg, Morgan Stanley
22 April 2008
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Financial Distress 101: What
Happens When Good
Investments Go Bad              Table of Contents

                               Section 1   Executive Summary

                               Section 2   Introduction to Distress

                               Section 3   What Happens in Default

                               Section 4   Conclusion
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Financial Distress 101: What
Happens When Good
Investments Go Bad




                               Section 1

                               Executive Summary
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Financial Distress 101: What   Executive Summary
Happens When Good
Investments Go Bad             Executive Summary

                               • The market environment has significantly deteriorated over the past year, triggered in large part
                                 by the subprime crisis, decline in the residential housing sector and an increase in the overall
                                 risk premium (and declining availability of credit)
                                Economy
                                • Overall economic environment remains challenging according to leading economic indicators
                                  – Unemployment rate has increased to 5.0%, up from its cyclical trough of 4.4% (a move of
                                    such magnitude has predicted a recession in 10 out of 10 cases in the postwar period with no
                                    false positives and no false negatives, per Goldman Sachs)
                                  – 4Q07 GDP growth of 0.6%
                                Credit Markets
                                • All credit markets have been disrupted, with real estate markets hardest hit
                                  – CMBS spreads have gapped out with AAA and BBB- spreads currently trading at 346bps
                                    and 1,571bps, respectively (versus 84bps and 207bps one year ago)1
                                  – CMBS issuance has effectively shut down, with few transactions priced in 2008 thus far
                                What Could this Mean for Real Estate Owners?
                                • Higher borrowing costs
                                • Declining fundamentals
                                • Falling asset prices


                                       Notes
                                       1. Source: Morgan Stanley Fixed Income Research Securitized Products / US CMBS for the week ended April 16, 2008                                                                       1
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  Financial Distress 101: What    Executive Summary
  Happens When Good
  Investments Go Bad              Economic Headwinds Leading to Recession

• Economic growth has fallen      Current U.S. Economic Headwinds                                    U.S. Real GDP Growth
  below average during 2007                                                                          %
  driven in part by the housing
  correction and the financial    • Consumer-led downturn                                             5     4.5        4.2       4.5                                                                                              Forecast
                                                                                                                                            3.7                                                 3.9
  markets turmoil                  – Continuing and intensifying weakness in                          4
                                                                                                                                                                                                         3.2      3.3

• Current challenges likely to       the homebuilding sector                                          3                                                                               2.5                                 2.2              2.2
  persist through 2008
                                   – Negative consumer psychology                                     2                                                                     1.6
                                                                                                                                                                                                                                  1.1
                                                                                                                                                          0.8
                                     surrounding housing markets                                      1

                                                                                                      0
                                   – More restrictive lending environment




                                                                                                              1997

                                                                                                                        1998

                                                                                                                                  1999

                                                                                                                                                2000

                                                                                                                                                              2001

                                                                                                                                                                            2002

                                                                                                                                                                                      2003

                                                                                                                                                                                                2004

                                                                                                                                                                                                         2005

                                                                                                                                                                                                                  2006

                                                                                                                                                                                                                          2007

                                                                                                                                                                                                                                  2008E

                                                                                                                                                                                                                                           2009E
                                   – Decelerating retail sales
                                                                                                                Annual Growth                                                Historic Average, 1990 to Present

                                                                                                   Source      Morgan Stanley forecast as of 10 March 2008

                                  • Ongoing challenges likely to depress
                                    growth in 2008                                                   U.S. Average Monthly Job Formation
                                                                                                     Jobs (000‟s)
                                   – Housing market expected to remain
                                     challenging through 2008 and possibly                             400
                                                                                                                     280                                                                                                          Forecast
                                                                                                       300                     250 264
                                     through 2009                                                                                                  162                                           172
                                                                                                                                                                                                          212
                                                                                                                                                                                                                  175
                                                                                                       200                                                                                                                                 140
                                   – Weakening labor market
                                                                                                                                                                                                                           95
                                                                                                       100
                                                                                                                                                                                         9                                         10
                                   – Retail sales growth likely to moderate                               0

                                     further due to negative “wealth effect”                          (100)
                                                                                                                                                                (147)
                                                                                                                                                                              (44)

                                                                                                      (200)
                                     from housing


                                                                                                                     1997
                                                                                                                               1998
                                                                                                                                         1999

                                                                                                                                                       2000
                                                                                                                                                                     2001

                                                                                                                                                                               2002
                                                                                                                                                                                         2003
                                                                                                                                                                                                  2004

                                                                                                                                                                                                           2005
                                                                                                                                                                                                                   2006

                                                                                                                                                                                                                           2007
                                                                                                                                                                                                                                   2008E
                                                                                                                                                                                                                                           2009E
                                   – Signs emerging of spillover into
                                                                                                               Annual Avg.                                                   Historic Average, 1990 to Present
                                     corporate sector
                                                                                                   Source      Morgan Stanley forecast as of 10 March 2008




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  Financial Distress 101: What    Executive Summary
  Happens When Good
  Investments Go Bad              Tailwinds Limit Downturn

• A bearish case is made          Current U.S. Economic Strengths                                        Fed Funds Rate Target
  throughout this presentation.                                                                          %
  However, there are several
                                  • We believe the downturn may be modest and                             6
  important positive catalysts                                                                                                                                                     Forecast
  for the economy                   brief in duration                                                     5

• Principal tailwinds             • Excesses to be unwound are modest                                     4

  – Continuing global growth       – Housing recession already part-way over                              3

  – Weak dollar                    – Corporate environment has been lean; hiring                          2

  – Strong export growth             and capital expenditure increases have been                          1
                                     modest
  – Strong business                                                                                       0
    investment                    • Government acting quickly and strongly to spur                            2004           2005            2006                 2007           2008           2009

  – Rising consumer incomes         growth                                                             Source     Morgan Stanley forecast as of 10 March 2008


• Risk of much sharper             – The Fed has cut rates and engaged in other
  slowdown if housing issues         actions to relieve stress in the financial                          U.S. Exports Growth
  not contained and global           markets                                                             %

  growth slows
                                   – Congress passed a $165Bn+ economic                                   16.0                                                                                        Forecast
                                                                                                                    11.9
                                     stimulus bill                                                        12.0                             8.7                            9.7
                                                                                                                                                                                        8.4    8.0
                                                                                                                                                                                 6.9                  6.9     6.5
                                                                                                           8.0
                                  • Weak dollar providing some support to the                                                2.4
                                                                                                                                    4.3
                                                                                                           4.0
                                    economy                                                                                                                        1.3
                                                                                                           0.0
                                   – Export growth remains healthy, import                                (4.0)                                           (2.3)

                                     growth has slowed                                                    (8.0)                                   (5.4)




                                                                                                                      1997
                                                                                                                             1998

                                                                                                                                    1999
                                                                                                                                           2000
                                                                                                                                                   2001

                                                                                                                                                           2002
                                                                                                                                                                   2003
                                                                                                                                                                          2004

                                                                                                                                                                                 2005
                                                                                                                                                                                        2006

                                                                                                                                                                                               2007

                                                                                                                                                                                                      2008E
                                                                                                                                                                                                              2009E
                                   – U.S. is a more attractive investment
                                     destination given the weak dollar,                                         Annual Growth                             Historic Average, 1990 to Present
                                     notwithstanding the current cyclical downturn                     Source     Morgan Stanley as of 10 March 2008




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Financial Distress 101: What
Happens When Good
Investments Go Bad




                               Section 2

                               Introduction to Distress
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  Financial Distress 101: What   Introduction to Distress
  Happens When Good
  Investments Go Bad             Distress Scenario 1: Rising Interest Rates
                                 Financial Impact



Examples
Commercial Market
• Refinance of existing                                     Base Assumptions
  mortgages
                                  Asset Value: $100
                                                             Net Operating Income (NOI)                                                                                      $7.0
                                      EQUITY: $20
Housing Market                                               Less: Debt Service ($80 x 5% interest rate)                                                                 ($4.0)
• Re-set of Adjustable Rate
  Mortgages
                                                                 Levered Profit (Loss)                                                                                       $3.0




                                                            Effects of Distress
                                        DEBT: $80
                                                             Interest Rates Increase to 10%

                                                             Net Operating Income                                                                                            $7.0

                                                             Less: Debt Service ($80 x 10%)                                                                              ($8.0)


                                                                 Levered Profit (Loss)                                                                                   ($1.0)



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  Financial Distress 101: What      Introduction to Distress
  Happens When Good
  Investments Go Bad                Distress Scenario 1: Rising Interest Rates
                                    Evidence In the Market



• Credit spreads have widened       CMBS Spreads
  substantially in the last year    Basis Points

  – Borrowers having trouble         3,000
    refinancing at rates that
                                     2,500                                                                                                                                                                                           2,500
    are covered by operations
                                     2,000                                                                                                                                                                                            2,100
• In the broader economy,
                                     1,500                                                                                                                                                                                           1,571
  credit markets are                                                                                                                                                                                                                 1,071
  significantly wider then           1,000
                                                                                                                                                                                                                                     871
  historical levels (1)                500                                                                                                                                                                                           346

  – 10Y swap spread: +61 bps                0
                                            Jun-98                     Jan-00                 Aug-01                      Apr-03                         Nov-04                           Jul-06                         Apr-08
    current vs +40 bps historic
                                            AAA                  AA                   A              BBB                   BB                     B
    average
  – Baa corp spread: +310 bps      Source   Morgan Stanley Fixed Income Research Securitized Products / US CMBS


    vs +240 bps
  – Junk bond yield spread:         ARM Re-Set Schedule
                                    $Bn
    +850 bps vs +620 bps
• Housing market is facing           350           325
                                                                                                    300
  $1.2 trillion of ARMs re-          300
  setting in the next 5 years        250                                                220
                                                                      200
                                     200                                                                              175
                                     150
                                     100
                                                                                                                                           45
                                      50                                                                                                                       30                  23                   25                  15
                                        0
                                                  2008               2009             2010         2011              2012                2013                2014                 2015                2016                2017

                                   Source   Deutsche Bank / Loan Performance, UBS




                                                     Notes
                                                     1. Source: Merrill Lynch on 03/20/08                                                                                                                                                5
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  Financial Distress 101: What   Introduction to Distress
  Happens When Good
  Investments Go Bad             Distress Scenario 2: Falling NOI
                                 Financial Impact



Examples
Commercial Market
• Orange County office market                               Base Assumptions
                                  Asset Value: $100
• Retail market / retailer
  bankruptcies
                                                             Net Operating Income                                                                                            $7.0
                                      EQUITY: $20
Housing Market                                               Less: Debt Service ($80 x 5%)                                                                               ($4.0)
• Falling wages
                                                                 Levered Profit (Loss)                                                                                       $3.0




                                                            Effects of Distress
                                        DEBT: $80
                                                             NOI Drops by 50%

                                                             Net Operating Income ($7.0 x 50%)                                                                               $3.5

                                                             Less: Debt Service ($80 x 5%)                                                                               ($4.0)


                                                                 Levered Profit (Loss)                                                                                   ($0.5)



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  Financial Distress 101: What     Introduction to Distress
  Happens When Good
  Investments Go Bad               Distress Scenario 2: Falling NOI
                                   Evidence In the Market



• Though real estate               National Retail Vacancy Rates                                                                         Orange County, CA Office Vacancy Rate
  fundamentals seem to be          %                                                                                                     %
  holding up generally,             12                                                                                                    18
  selected property types /
  geographic areas are              11
                                                                                                                                          15
  projected to decline              10
  – Orange County has                   9                                                                                                 12
    suffered a 600 bps
    increase in vacancy during          8
                                                                                                                                            9
    the last year primarily due         7
    to tenant bankruptcies /                1997    1999      2001      2003      2005     2007   2009       2011                           6
    downsizing from sub-prime               Vacancy Rate                                                                                        1996                    2000                    2004                    2008
    mortgage lenders (New
                                  Sources PPR, Reis, TWR, Morgan Stanley calculations
    Century, Ameriquest)1
• Retailers could be put under
  pressure if consumer             Residential Market Could be Impacted by Rising Unemployment
                                   %
  economy continues to lag
  – Sharper Image bankruptcy        7
    and rumors from Linens „N                                                                                                    6.0
                                    6                                                                            5.8
    Things could foreshadow                                                                                                                      5.5
                                                                                                                                                                                                                 5.3
                                                                                                                                                                                                                                 5.5
    additional tenant softness                4.9                                                                                                                5.1
                                    5                                                             4.7                                                                            4.6             4.6
                                                            4.5
  – Retail vacancies are on the                                           4.2
                                                                                         4.0
    upswing                         4

• In the residential sector,        3
  individual incomes could                   1997          1998          1999           2000      2001         2002            2003             2004           2005            2006            2007           2008E           2009E
  decline as unemployment                   Unemployment %                                         Historic Average, 1990 to Present
  rises
                                  Source    Current Population Survey, Moody’s Economy.com, Morgan Stanley




                                                    Notes
                                                    1. Availability rate source: CBRE                                                                                                                                                      7
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  Financial Distress 101: What   Introduction to Distress
  Happens When Good
  Investments Go Bad             Distress Scenario 3: Declining Values
                                 Financial Impact



Examples
Commercial Market
                                 Asset Value at
• Refinance at lower basis                                                                     Base Assumptions
                                 Closing: $100
• Sale values that require
  incremental cash
  investments                                                                                     Net Operating Income                                                            $7.0
                                  EQUITY: $20
                                                                                                  Cap Rate                                                                       7.0%
Housing Market
• Home price declines / short                               DEBT: $80
  sales                                                                                                Implied Asset Value                                                       $100




                                                            New Asset                           Effects of Distress
                                    DEBT: $80
                                                            Value: $70
                                                                                                  Cap Rates Increase from 7% to 10%

                                                                                                  Net Operating Income                                                            $7.0

                                                                                                  Cap Rate                                                                    10.0%


                                                                                                       Implied Asset Value                                                     $70.0



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  Financial Distress 101: What      Introduction to Distress
  Happens When Good
  Investments Go Bad                Distress Scenario 3: Declining Values
                                    Evidence In the Market



• Declining values effect owner     Projected U.S. CMBS Issuance and Office Building Capital Appreciation
  returns but cause distress        $Bn                                                                                                                                                     Index Price (1997 = 100%)
  when assets are worth less
  then the debt, particularly        250                                                                                                                                                        230                          150%
                                                                                                                                                                                203
  when a refinance is imminent       200                                                                                                                                                                                     140%
                                                                                                                                                                169
  – Primarily a concern for
                                     150                                                                                                                                                                                     130%
    short-term debt from
    assets bought at “peak”          100                                                                                        78
                                                                                                                                                93
                                                                                                                                                                                                                             120%
                                                                74                                 68                                                                                                            70
    pricing (i.e., Macklowe)                                                   57
                                                                                           47                   52
                                      50          37                                                                                                                                                                         110%
  – 5, 7 or 10-year debt
    maturities potentially at          0                                                                                                                                                                                     100%
    risk but values have                        1997          1998          1999         2000      2001       2002            2003            2004             2005            2006            2007           2008E
    increased                      Source   Morgan Stanley and NCREIF

• Landlords facing a decision
  about whether to support a        National Home Price Trends
  project that requires more        Annual Growth %
  capital when values have
  declined may also push              20%
                                                                                                                                                                                              14.6% 14.7%
  properties in default prior to      15%
                                                                                                                                                      9.8%                10.6% 10.7%
  a refinance                         10%     7.6%                                                                                7.1% 8.2%                     7.7%
                                                       5.8%
                                                                                                                        4.5%                                                                                     Average 5.0%
• Through March 2008, home             5%                                                 1.6% 2.6% 2.1% 2.1%
                                                                         0.1% 0.1%                                                                                                                                 0.2%
  prices have declined 11%             0%
  nationally year-over-year1                                   -1.0%
                                      -5%
  – If homeowners need to            -10%
                                                                                                                                                                                                                             -8.9%
    refinance or decide to sell
                                     -15%
    because of job                             1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
    displacement / relocation,
                                   Source   Standard & Poor's, Fiserv Inc. and Macro Markets LLC
    home may be in pushed
    into default
                                                    Notes
                                                    1. Source: Case-Schiller                                                                                                                                                          9
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Financial Distress 101: What   Introduction to Distress
Happens When Good
Investments Go Bad             Other Examples of Distress

                               Distress scenarios can also occur in less obvious situations:
                               • Technical Defaults
                                 – Tripping loan covenants that may / may not be an economic default but
                                   are used by banks to protect their interests if the borrower’s business
                                   begins to deteriorate
                                 – Example – net worth covenants for homebuilders or banks while asset
                                   values decline
                               • Development Projects
                                 – Projects that have high operating leverage and require substantial fixed
                                   costs before a liquidity event
                                 – Example – condo projects


                               In all of these cases, the property owner has an incentive to walk away
                               from the property, but this is not as easy as it sounds…




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Financial Distress 101: What
Happens When Good
Investments Go Bad




                               Section 3

                               What Happens in Default
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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Signs of the Real Estate Loan in Distress

                               • Monetary defaults
                               • Covenant defaults
                               • Real estate taxes delinquent
                               • Property or business operating at a deficit
                               • Capital improvement needs
                               • Investors unwilling to make capital contributions
                               • Subordinate liens, judgments
                               • Review of financial reports – change in financial circumstances, cash flow




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Initial Review

                               • Review legal documents
                                 – Structure
                                 – Completeness
                                 – Defects
                                 – Perfection
                               • Evaluate how loan has been administered
                                 – Course of conduct
                                 – Representations
                                 – Memos, e-mails in file – “Smoking Guns”
                               • Understanding lender’s goals and capabilities
                                 – Benefits of modification (short term, long term)
                                 – “First loss is smallest loss”
                                 – Lender’s capacity to own, manage or liquidate
                                    – “ORE” portfolio
                                    – Bank regulatory issues
                                 – Evaluate long term market conditions
                                 – Explore asset sale prospects
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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Initial Review (cont’d)

                               • Understanding borrower’s goals and capabilities
                                 – Replacement franchisor, operator, tenant
                                 – Management skills
                                 – Reputation – honesty
                                 – Capital infusion – from borrower or equity source
                                 – Guarantors’ commitment to transaction or business
                                 – Guarantors’ financial condition
                               • Understanding the relevant market
                                 – Value of collateral and borrower’s business
                                 – Marketability of collateral
                                 – Business market trends
                                 – Leasehold market trends
                                 – Debt marketplace
                                 – Borrower’s refinance or sales prospect




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Initial Review (cont’d)

                               • Understanding the collateral (realty and personalty)
                                 – Condition
                                 – Deferred maintenance
                                 – Environmental considerations
                                 – Appraisals (access to conduct)
                                 – Evaluate project finances
                                 – Potential for commingling or diversion of cash flow
                                 – Leases
                                 – Competing creditors




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Loan Restructurings
                               Strategies, Techniques and Objectives




                               • Pre-Workout Agreement/Standstill Agreement
                                 – Preserves status quo
                                 – Sets ground rules for discussions
                                 – Either party can terminate discussions at any time
                                 – Protects lender against waiver, oral modification arguments
                                 – No oral agreements can be made
                                 – Lender’s goal: obtain borrower’s acknowledgement of debt and waiver of
                                   defenses
                                 – Loan documents in force
                                 – Without prejudice to rights and remedies




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Loan Restructurings (cont’d)
                               Strategies, Techniques and Objectives




                               • Background considerations
                                 – Identify all necessary parties, sources of funding, credit enhancements
                                   (L/C issuers, guarantors, mezzanine lenders)
                                 – Identify, negotiate and resolve all material business points early to avoid
                                   borrower’s disguised delay tactics
                                 – Engagement of financial consultants or turnaround specialists
                                 – Beware oral modification or waiver during negotiations
                                 – Prepare and execute detailed term sheet (subject to credit approval)
                                 – Issue a loan commitment, if appropriate
                                 – Need a formal instrument of modification
                                 – Need for requisite corporate or partnership authority
                                 – Ratification of loan documents, guaranties
                                 – Obtain subordination agreements (or discharge of liens)
                                 – Title insurance – payment of taxes
                                 – Always be aware of intercreditor issues



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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Loan Restructurings (cont’d)
                               Strategies, Techniques and Objectives




                               • To avoid:
                                 – Unrealistic optimism about borrower, borrower’s business, the property or
                                   the market place
                                 – Needlessly complex strategies or restructure models
                                 – Strategies that ignore essential parties
                                 – Strategies or models where lender has all downside and borrower has all
                                   upside (and vice versa)




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Loan Restructurings (cont’d)
                               Strategies, Techniques and Objectives




                               • Opportunity for enhancements
                                 – Concessions or contributions from other lenders/creditors
                                 – Concessions or contributions from franchisor
                                 – Additional collateral (shares of stock, partnership interests, business
                                   assets, reserve accounts)
                                 – Beware pledge of assets by non-obligors (consideration, fraudulent
                                   conveyance issues)
                                 – New or additional guaranties – increasing scope of guaranteed obligations
                                 – Cure legal or document deficiencies
                                 – Obtain additional loan covenants or monitoring rights
                                 – Control of project revenue – cash collateral – Cash Management
                                   Agreement – Lock Box/Control Agreement
                                 – Obtain waiver and release of defenses and counterclaims
                                 – Ratification of indebtedness
                                 – Formal extension of matured obligations
                                 – Preserve or improve underlying collateral (capital expenditures)


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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Alternative Restructure Models
                               One Lender and Multi-Lender Transactions




                               • For multi-creditor transactions
                                 – Awareness of concessions, contributions and business requirements
                                   by other creditors
                                 – Relationships among creditors – priority
                                    – Lien subordination/Intercreditor Agreement
                                    – Structural subordination
                                 – Deferral notes and debt forgiveness
                                 – Beware: tortious interference with contract
                                 – Guaranty coverage/collateral coverage




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Alternative Restructure Models (cont’d)
                               One Lender and Multi-Lender Transactions




                               • Possible scenario 1: reinstatement of loan – cure short term default
                                 – Justification for default
                                 – Amend terms or covenants/back in compliance
                               • Possible scenario 2: Discounted Repayment Agreement – as an exit
                                 strategy
                                 – Tied to market conditions, lender’s business objectives, target market
                                 – Example – $10mm debt – accept $9mm in six months or $8mm
                                   immediately
                                 – In non-recourse loan, discount needs to give borrower incentive to pay the
                                   discount – possible equity recapture by borrower
                                 – In recourse loan – discount in exchange for release of note and guaranty
                                 – Never release note or guaranty until payment or consensual asset
                                   liquidation has occurred




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Alternative Restructure Models (cont’d)
                               One Lender and Multi-Lender Transactions




                               • Possible scenario 3: short term forbearance agreement
                                 – Six months to cure identified business problem – suspension or reduction
                                   of debt service payments
                                 – Waiver of covenant defaults
                                 – Waiver of defenses, acknowledgement of debt, release of claims
                               • Possible scenario 4: longer forbearance (i.e., one to two years) tied to
                                 – Shortening maturity
                                 – Economic concessions
                                 – Discounted repayment built into restructure
                                 – Additional collateral included in forbearance agreement
                                 – Increasing number of guarantors or scope of guaranty
                                 – Accrual of default rate or interest shortfall, with waiver upon performance




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Alternative Restructure Models (cont’d)
                               One Lender and Multi-Lender Transactions




                               • Possible scenario 5: Substantive Loan Restructure
                                 – Restructure loan to conform to market (lower interest rates, change or
                                   eliminate amortization, less burdensome financial covenants)
                                 – Reduce interest rate or principal debt if borrower infuses cash, stabilizes
                                   business, brings in beneficial business partner or adds collateral
                                 – Principal debt repayment plan with contractual incentives (e.g., $10mm
                                   loan – restructure at $9mm; pay down $2mm; forgive $1 mm)
                                    – Tax issues
                                    – Cancellation of indebtedness income
                                 – Intercreditor arrangements
                               • Possible scenario 6: additional collateral/guaranties
                                 – As consideration for business concessions by lender
                                 – Additional collateral and/or guaranties protect lender against downside,
                                   further business erosion and insolvency
                                 – Expansion of existing limited guaranties; guaranty of tranches of debt




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Alternative Restructure Models (cont’d)
                               One Lender and Multi-Lender Transactions




                               • Springing guaranties – recourse events
                                 – Interference by borrower or guarantor with legal remedies
                                 – Diversion of cash flow
                                 – Non-payment of real estate taxes
                                 – Fraud
                                 – Mismanagement
                                 – Environmental liability
                                 – Bankruptcy (“by or against”)
                                 – Material alteration of collateral
                               • Lender’s strategy – use workout to fix loan, collateral and perfection
                                 defects
                                 – Offer concessions/forbearance in effort to fix collateral or perfection
                                   defects (illustrations – internal audit discloses financing statements never
                                   filed)
                                 – Obtain acknowledgement of debt/waiver of defenses
                                 – Obtain remedies – certainty, finality, predictability – finishes the process


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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Alternative Restructure Models (cont’d)
                               One Lender and Multi-Lender Transactions




                               • Deed in Lieu – consensual turnover or liquidation of assets
                                 – Business decision to take back or market the collateral
                                 – Predictability
                                 – Speed
                                 – Deed or consensual liquidation – faster than court remedies
                                 – Note: need foreclosure to eliminate subordinate liens on real estate
                               • Lender’s sale of the distressed loan to a third party
                                 – Speed, certainty, finality, elimination of further risk of loss
                                 – Target market considerations
                                 – The third party purchaser bargains for long term upside value
                                 – Public relations, lender liability considerations
                                 – Ready marketplace – purchasers of distressed debt
                                    – “Loan to Own” strategy




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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Creditor Remedies and Enforcement Actions


                               • California has unique rules regarding real property collateral remedies
                                 – Judicial foreclosure
                                 – Non-judicial foreclosure
                                 – “One Action Rule”
                                 – “Mixed Collateral Rules”
                                 – Blend of rules in UCC and other California statutes
                               • Potential impact on:
                                 – Ability to pursue deficiency
                                 – Redemption rights of borrower
                                 – Ability to pursue guarantors
                                 – Ability to foreclose on collateral
                               • Mezzanine loans:
                                 – Structural subordination
                                 – Can become owner by foreclosure
                                 – Must then deal with senior lender
                               • Creditors should be extremely cautious when exercising remedies

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Financial Distress 101: What   What Happens in Default
Happens When Good
Investments Go Bad             Creditor Remedies and Enforcement Actions (cont’d)


                               • Bankruptcy
                                 – Automatic stay – stops creditor remedies
                                 – “Breathing room” to attempt reorganization
                                 – “Single asset real estate”
                                    – Single commercial project with no other business/assets
                                    – 90 days to propose plan or resume monthly interest payments
                                    – Otherwise automatic stay lifted
                                 – Not a panacea – the project still needs to work




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Financial Distress 101: What
Happens When Good
Investments Go Bad




                               Section 4

                               Conclusion
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Financial Distress 101: What   Conclusion
Happens When Good
Investments Go Bad             Externalities
                               Sustainability




                               While distress has a significant economic impact on both the lender and
                               borrower, bad projects can have much broader implications…
                               • Sustainability
                                   – Local impact – swimming pools rotting in Sacramento
                                   – National impact – degradation of land for unnecessary projects
                                       – “Exurban sprawl is especially costly. Low-density residential communities
                                         developed at the fringes of metropolitan areas are often far from places of
                                         employment, as well as from civic, commercial and recreational destinations.
                                         Consequently, such development results in more road congestion, more carbon
                                         emissions and adverse climate change. The public services and the
                                         infrastructure needed to support low-density fringe development are
                                         unavoidably inefficient, both functionally and financially.” – The Washington
                                         Post (April 12, 2008)
                                   – Global impact – natural resources such as steel / timber / petroleum
                                     products used to build houses




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Financial Distress 101: What   Conclusion
Happens When Good
Investments Go Bad             Externalities
                               Infrastructure




                               • Infrastructure
                                   – Strain on infrastructure from unnecessary sprawl:
                                        – “There is a silver lining. Slowing growth in Southern California signals that the
                                          overheated market is in fact over and that the long, difficult process of
                                          correction, in which prices return to sustainable levels, is under way. If local
                                          officials are smart, they'll take advantage of sprawl's apparent stall to plan more
                                          carefully for future growth. In planning terms, think of this as a strategic pause,
                                          a moment to concentrate on water supply, traffic, school construction,
                                          infrastructure -- all of which tend to be brushed aside in the press of expansion
                                          but which need and deserve the long look that this moment may allow.” – LA
                                          Times (March 24, 2008)
                                   – Decay of communities that provides services that cannot be supported by
                                     local tax base from a half-developed MPC or struggling in-fill locations
                                        – “The [Worchester, MA housing inspector team] is a kind of frontline scout
                                          platoon in the city's ongoing battle against urban decay, a fight that got much
                                          tougher during the last year, as the mortgage meltdown sent foreclosure rates
                                          soaring in Worcester and across the country…[Recent] legal action is part of
                                          the city's strategy to get mortgage companies and banks…to take responsibility
                                          for the upkeep of houses that end up in their portfolios through foreclosure.” –
                                          Worcester Telegram & Gazette (April 13, 2008)


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Financial Distress 101: What   Conclusion
Happens When Good
Investments Go Bad             Externalities
                               Workforce Housing




                               • Workforce Housing
                                  – Lower home prices have resulted in increased affordability but capital
                                    remains scarce for new projects:
                                      – “Affordable housing is the latest victim of the credit crunch that is reverberating
                                        through financial markets. Projects are being canceled because some of the
                                        nation's largest financial companies, including Fannie Mae, Freddie Mac and
                                        Bank of America, have scaled back their participation in the federal
                                        government's largest and most prolific affordable housing tax-credit program,
                                        designed to boost construction of below-market-rent apartments.” – Wall Street
                                        Journal (March 12, 2008)
                                  – Irresponsible product programming exaggerates impact




                                  Responsible phasing and growth plans along with thoughtful/ holistic
                                  analysis on the front-end of a project can often prevent many of
                                  these externalities




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