May 12, 2010

A "Calculated" Default For The Cannery At Del Monte Square

Playing the strategic default card, in March Vornado Realty Trust stopped making payments on the $18 million mortgage which helped finance its purchase of San Francisco's landmark Cannery at Del Monte Square for $33.5 million in 2007.

"Vornado wants to keep the property, [a person familiar with the matter] said. But, like many owners of distressed property, the company has defaulted as a strategy to restructure the debt...“It was a calculated move,” the person said."

Cannery Loan Is in Default [WSJ]

First Published: May 12, 2010 2:15 PM

Comments from "Plugged In" Readers

Vornado wants to keep the property, [a person familiar with the matter] said. But, like many owners of distressed property, the company has defaulted as a strategy to restructure the debt...“It was a calculated move,” the person said."

Why is this acceptable, but replace Vornado/company with Homeowner and it's a moral hazard?

Posted by: marko1332 at May 12, 2010 2:48 PM

^^
I think the answer is some version of "If I owe the bank $180,000 and don't pay ... it's my problem. If I owe the bank $18 million and don't pay ... it's the bank's problem."

Posted by: sanfrantim at May 12, 2010 3:02 PM

This will go down on their permanent record.

Posted by: steve at May 12, 2010 3:10 PM

marko1332 wrote:

Why is this acceptable, but replace Vornado/company with Homeowner and it's a moral hazard?

I'm sure that I don't agree with it at all, but over at The Atlantic magazine, Megan McArdle tried to explain the difference between the two this way, after introducing the topic by way of rehashing the story of a Palmdale teacher and her husband who strategically defaulted on a no-down-payment loan when they found out they were underwater by over $230,000, then used the money they were no longer paying towards a mortgage on a new rental property and new furniture:

…why shouldn't they just walk away, the way a corporation would? Well, for one thing, companies don't always behave like this, and those who get a reputation for stiffing their suppliers run into trouble. But for another, because society doesn't really work on such clean logic. The reason we can have easy bankruptcy and a pretty robust credit market (usually) is that most people act like debts are obligations which should always be paid off if possible. I'm not saying you should live on Kraft dinner and water for twenty years to slave at an impossible mountain of debt. But I think before you walk away from three different mortgages, you should explore life options that do not include $1,800 worth of new furniture.

Like I said, I don't quite buy it, but there are people out there who try and draw a distinction between corporate behavior and personal behavior.

Posted by: Brahma (incensed renter) at May 12, 2010 3:53 PM

The quote from Megan McCardle is complete gibberish and has no connection to reality. Do you think that a REIT is worried about it's reputation with "suppliers"? Of course "companies don't always behave like this" when it comes to "suppliers" or other obligations...because usually the borrower's other assets are exposed to the claim they are walking away from. With real estate, unless there is a guaranty from a solvent entity or some other kind of credit enhancement, it's almost always non-recourse and the borrower/owner has an option not to pay and simply to give the building back. Real estate investors have always known this as have their lenders; it wasn't until the last two years or so that the typical homeowner even knew it was possible to "walk away."

Megan McCardle may have landed herself a writing gig as a "business and economics" writer at a "prestige" magazine, but I'd guess that she couldn't run a hot dog stand.

Posted by: Uncle Festus at May 12, 2010 4:43 PM

Birds do it.
Bees do it.
Even REITs do it.
Let's do it.
Let's default.


Only remember to always call it, please, strategic.

Posted by: Salarywoman at May 12, 2010 5:03 PM

I see walking away as a contractual and legal right for companies and individuals alike. If one is able to make the business decision to walk away, why shouldn't the other? The argument is actually stronger for individuals, because two corporate parties are likely to be sophisticated contractors, whereas a highly sophisticated bank imposed lending terms on a comparatively-unsophisticated residential real estate buyer.

That said, seriously, ignore anything Megan McArdle says, as Uncle Festus advises. She generally fails to think critically, and I find all kinds of holes in her arguments all the time. A lot of her posts tend to be more ideological than anything else. For someone who claims to be an "economics" writer, she knows very little about economics.

Posted by: sfrenegade at May 12, 2010 5:08 PM

Salarywoman wrote:

Only remember to always call it, please, strategic.

Well, of course it's strategic if you can afford to make the payments, but think that the loan is for so much more money than the market value of the property that you decide to stop making payments. Both the Wall Street Journal story and the largely similar story in the San Francisco Business Times mention this:

In a May 4 filing with the Securities and Exchange Commission, Vornado requested that the mortgage loan on a California retail property with a principal balance of $17.5 million be placed with a special servicer.
“We have not made debt service payments since March and are in default. We are in negotiations with the special servicer; there can be no assurance as to the timing and ultimate resolution of these negotiations,” the filing stated.

So if the filing was correct and they had a balance of $17.5M on an original mortgage amount of $18M which they took out in 2007, that means they only managed to make half a million dollars worth of payments in about three years. They must be broke, right?
Let's take a look at the First Quarter 2010 Financial Results:

Net income attributable to common shareholders for the quarter ended March 31, 2010 was $200.3 million, or $1.09 per diluted share, compared to $125.8 million, or $0.80 per diluted share, for the quarter ended March 31, 2009.

Vornado Realty Trust (New York Stock Exchange: VNO) today closed at $83.22, up 1.64%, although that probably means nothing.

Posted by: Brahma (incensed renter) at May 12, 2010 6:50 PM

Aren't all defaults strategic?

Posted by: Kathleen at May 13, 2010 8:04 AM

No, not all defaults are strategic, if that was a sincere question. If you're bankrupt, which Vornado Realty Trust certainly is not, or going out of business or broke, then if you default at that point it's not strategic.

Posted by: Brahma (incensed renter) at May 13, 2010 8:08 AM

Why is this acceptable, but replace Vornado/company with Homeowner and it's a moral hazard?

because they're hypocrites.

just like this:
Food Stamps are Welfare. $700 Billion TARP program isn't.

Midwest manufacturers losing their jobs is "improved productivity and efficiency" but Wall Streeters losing their jobs is "systemic risk".

Farmers who make a mistake are "dumb", Wall Streeters who make mistakes are "sophisticated" and "talent"

The trick is to not let yourself get caught in their semantics.
===

the more practical answer:
because the banks never expected the Homeowners to understand that they have a RIGHT under the contract to walk away leaving the bank with the asset, and then act on it. The banks were foolishly lending against the future income stream of the borrower instead of against the asset itself.

this is why they changed the bankruptcy laws a few years ago, to try to beef up their claim on the plebe's future income streams.

we get crash II if homeowners en masse realize what is and isn't in the contract, and act accordingly. The "green shoots" recover only works if people remain debt slaves to the banks (propping up bank balance sheets)

Posted by: ex SF-er at May 13, 2010 8:30 AM

I think the morality play, as incentive to accept debt slavery, is nothing but a joke at this point.

The banks didn't let morals stop them from issuing toxic sub-prime, negative amortization loans to all your neighbors, causing wild swings to your property value, no matter how responsible you have been...

Posted by: J at May 13, 2010 8:30 AM

ex SF-er is exactly right when comparing situations like Vornado's to some homeowners. Vornado's contracts with its lenders plainly allowed it to "walk away" with no further recourse by the lenders. That is not so clearly the case with homeowners.

Many states do not allow an owner to "walk away" at all. If you do, you can end up with a deficiency judgment for the difference between the REO price and the loan balance(s). Then you get your wages garnished, liens placed on other property, etc. for many years. Bankruptcy is no longer an out if you have an income, and a lousy out for those who have little income. In California, it is clear that you can "walk away" from a loan used to purchase the place (you still get a big credit hit, and until about a month ago a big state tax bill). However, it is much murkier where refis and seconds are involved, which, I would guess, describes the majority of those who are underwater as these were so common during the bubble. Oddly, the calculus to be undertaken in arriving at this decision was much simpler in Vornado's case then in that of a typical distressed homeowner.

Posted by: A.T. at May 13, 2010 8:45 AM

we get crash II if homeowners en masse realize what is and isn't in the contract, and act accordingly.
I'm pretty sure its coming; strategic default just went mainstream thanks to this 60 Minutes piece last weekend. Even the 10 percenters are walking: And because Deaner, like many Americans, only made a 10 percent down payment on his home, "taking a hike" is a lot easier.

Posted by: EBGuy at May 13, 2010 10:31 AM

I am in the process of strategically defaulting right now.

The value of my condo is down approx $250K (if it sells) and I don't think it will come back to what I paid for it for 7-10 years. I feel 100% fine about walking away.

It's a simple business decision and I am not in breach of my contract. Just because the business contract doesn't work in the banks favor...doesn't make me feel bad.

The very smart bankers knew the risks when they lent me the funds. They also knew that all purchase money in CA is non-recourse.

If the bank is willing to play by those rules. Then why should I feel bad doing the same?

In this case, the bank and I just both made bad business decisions lending and buying when we did. Now both of us are suffering. I lose my down payment and the years of interest only mortgage payments (when it would have been MUCH cheaper to rent) and they lose by being stuck with a condo that's worth less than the note.

I'm guessing my bank's ability to recover will be much greater than mine. I can't apply for TARP funds.

Moral hazard?? No way. Good business decision, absolutely.

Posted by: Strategic_defaulter at May 13, 2010 12:51 PM

@sd:

Your bank didn't care whether you paid it back or not. They would sell the loan to a investment bank for a large profit and then service the loan, also for a large profit. They could care less if you ever pay.

The investor who bought the loan was likely some pension fund operator who also didn't much care whether you pay it back. They bought it with a promise of earning ridiculous interest rates demanded by their pensioners. The pensioners were greedy and demanded 8% in a 4% world. Your mortgage is how the pension manager delivered 8% in a 4% world. He got a huge bonus. He's gone. He doesn't care if you pay it back.

The investment banker who sold it to the investor made a huge profit. He doesn't care if you pay it back.

The investors insured it with AIG. If you don't pay it back, AIG will. They don't care if you pay it back.

AIG got a bunch of money from TARP. If you pay it back, they use your money and if you don't pay it back they use the government's money. They don't care if you pay it back.

The government collects that money from the taxpayers and if they need more, they print it or tax it. They don't care if you pay it back.

The elected officials helped out their friends at the banks. If the public gets mad and doesn't reelect them, the banks will hire them. They don't care if you pay it back.

The taxpayers consider that money already gone. They aren't expecting you to pay it back. If you do, one billionth of one cent goes back to each of us. One billionth of one cent just doesn't matter to any of us, so we don't care if you pay it back.

No one appears to really care if you pay it back.

So why would you pay it back?

Posted by: tipster at May 13, 2010 2:17 PM

^^^ Re "Moral hazard?? No way. Good business decision, absolutely."

You are not taking into account the externalities of your decision, which will likely impact your neighbors (in the form of another REO in their community that further depresses their home values), your fellow citizens (in the form of their tax dollars going to bail out the bank you screwed), future home buyers (in the form of higher interest rates into the future as mortage lenders price in this risk), etc.

If a way could be devised whereby these externality costs are paid by you and not by the rest of us, I would have no objection at all. But the way the system works currently, you aren't just screwing your bank, you're screwing all of us as we wind up paying for your real estate bet gone bad.

I agree that the bank is not blameless, but neither are you.

Posted by: Mark D. at May 13, 2010 2:18 PM

ex SF-er wrote:

we get crash II if homeowners en masse realize what is and isn't in the contract, and act accordingly. The "green shoots" recovery only works if people remain debt slaves to the banks (propping up bank balance sheets)

I wish this would happen because it would make an SFH cheaper for me, but I don't think it will. The reason is that there's nothing forcing banks, that I've seen at least, to put a home on the market within a certain amount of time after a foreclosure.

And of course there's nothing forcing a bank to foreclose in a certain amount of time after the borrower stops making payments and the loan becomes non-performing. Everybody that reads socketsite has probably heard about or had some friend, neighbor or acquaintance who has stayed in their home, rent free, for a year or more after ceasing mortgage payments.

If the bank has sufficient capitalization and assets, there's nothing that says they can't keep a home off the market indefinitely. And since bank officers know that flooding the market with homes is a great way to depress prices, they are almost guaranteed not to do so, no?

Posted by: Brahma (incensed renter) at May 13, 2010 2:21 PM

Maybe if it goes to sale for half the debt it will be purchased on the courthouse steps?? Just an idea

Posted by: inclinejj at May 13, 2010 2:37 PM

Maybe if it goes to sale for half the debt it will be purchased on the courthouse steps?? Just an idea

Posted by: inclinejj at May 13, 2010 2:37 PM

"If a way could be devised whereby these externality costs are paid by you and not by the rest of us, I would have no objection at all. But the way the system works currently, you aren't just screwing your bank, you're screwing all of us as we wind up paying for your real estate bet gone bad."

We are talking about a mortgage contract between two parties. If the items you suggested are all externalities of ending the mortgage contract, you're suggesting that we should have much much much more regulation and taxation for *entering* into a mortgage, not for leaving one.

Some of the externalities you cited are not even true externalities resulting from the borrower. Why is an REO that different from a neighbor who has never mowed his lawn? The drop in value is a consequence of the bank failing to adequately monitor and maintain the property.

Furthermore, the bailouts don't have to occur, and nothing the individual homeowner did necessitates a bailout. It was many homeowners in the aggregate combined with terrible lending practices combined with bad lawmaking that resulted in the bailout, not an individual.

Higher rates may result because the bank never properly priced in the risk in the first place. That's the bank's screw-up.

The banks and the security holders deserve to take a haircut for bad lending practices. That our government decided to bail out the idiots doesn't mean that it's a proper externality. In fact, almost all the factors you pointed to are the bank's responsibility.

Posted by: sfrenegade at May 13, 2010 2:46 PM

The the externalities of my decision which will likely impact your neighbors:

1)"....another REO in their community that further depresses their home values" - I'd argue the price we are listing my condo at is reflective of market value, regardless of whether it's an REO or not. Supply and demand sets price. If you are blaming one person for effecting supply and demand, I completely reject that.

2)...in the form of their tax dollars going to bail out the bank you screwed" - I've already paid my portion of taxes (and more so when I was earning enough to support my mortgage). So I've contributed my share to the problem and the solution.

3. "future home buyers (in the form of higher interest rates into the future as mortage lenders price in this risk), etc." - I'd have to go with a previous poster who stated the lenders didn't price the risk appropriately to begin with...and that's what got us into this mess. Rates will go higher as they price accordingly now....

You can shame me all you want, but all prudent business decisions are made this way. I am cutting my losses now instead of bleeding to death.


Posted by: Strategic_defaulter at May 13, 2010 3:13 PM

Re sfrenegade's post at 2:46:

I agree that we should have much more regulation and taxation for entering a mortgage, and I think it's a fairly uncontroversial point that many of the mortgage products of the past decade have turned toxic and shouldn't have been allowed.

An externality is defined as "an effect of a purchase or use decision by one set of parties on others who did not have a choice and whose interests were not taken into account."

An REA isn't different from a neighbor who doesn't maintain his/her lawn - both depress property values and create externalities for the larger community.

Regarding "nothing the individual homeowner did necessitates a bailout. It was many homeowners in the aggregate combined with terrible lending practices combined with bad lawmaking that resulted in the bailout, not an individual." This is akin to saying that smog comes from all those **other** cars on the freeway, and not my car, which after all only puts out a tiny amount of smog which wouldn't be a problem at all if it weren't for all those other cars out there.

I said earlier that the bank isn't blameless, but neither is the strategic defaulter, whose real estate bet has gone bad and who is now going to externalize the costs of that bad bet.

Posted by: Mark D. at May 13, 2010 3:27 PM

But every penny Strategic_defaulter (legally) chooses not to pay the lender is going somewhere else -- either to buy other goods and services or as savings/investments. It's a zero-sum game. Who's to say that he's not a net contributor to the overall financial and social well-being by diverting his finite resources to these other areas?

Posted by: A.T. at May 13, 2010 3:37 PM

"Regarding "nothing the individual homeowner did necessitates a bailout. It was many homeowners in the aggregate combined with terrible lending practices combined with bad lawmaking that resulted in the bailout, not an individual." This is akin to saying that smog comes from all those **other** cars on the freeway, and not my car, which after all only puts out a tiny amount of smog which wouldn't be a problem at all if it weren't for all those other cars out there."

That's a TERRIBLE analogy. The buyer has nothing to do with the securitization of the loan. That's all on the bank. The buyer only entered into a single contract, and then the bank aggregated it with other loans.

Sorry, all of the items you mentioned are things the *bank* did, not the buyer. The bank has a responsibility to make sure the property is maintained and the bank sold the loan. You are confused about what externalities are.

In any case, externalities are rarely used as the only justification, but I'm just pointing out massive flaws in your analysis.

Posted by: sfrenegade at May 13, 2010 3:40 PM

An externality is defined as "an effect of a purchase or use decision by one set of parties on others who did not have a choice and whose interests were not taken into account."

I assume you're also including in your definition items like Prop 13, permitting restrictions, ZIRP, bailouts, first-time-buyer credits, FHA loans, liar's loans, MBS market structure, etc, etc?

Anyway, it seems you're worried that strategic defaulters are going to damage the gains in property value that incumbents received during the run-up. But the defaulters are simply playing the same game that led to the run-up to begin with. Damage to a bubble is not something I'm going to lose sleep over.

Posted by: acoustician at May 13, 2010 3:48 PM

Regarding: "Sorry, all of the items you mentioned are things the *bank* did, not the buyer." You seem to have forgotten that it's the buyer who is breaching the contract by deciding not to pay back the loan. The specific act giving rise to externalities is the decision by the defaulter to breach.

In contract law, this is similar to a theory of efficient breach - "the view that a party should be allowed to breach a contract and pay damages, if doing so would be more economically efficient than performing under the contract." The problem as I see it is that the breaching party doesn't pay all the costs of his breach - he only loses the condo and can externalize the other costs of his breach onto others.

Posted by: Mark D. at May 13, 2010 4:01 PM

Mark D:

Your hypothesis is entertaining, and, in a reasonable world, would be worthy of consideration.

However, it is clear that essentially all externalities except the absolute grossest and most obvious in our society are routinely ignored for any corporation, or any rich person. BP is making money hand over fist while causing dozens of small oil spills, which they do not clean up, over the last five years. Businesses routinely violate anti-polluting acts, make enormous amounts of money for their higher-up employees and backers, and then go out of business, leaving taxpayers to finance the cleanup (or leaving messes that don't get cleaned up at all.) The people running banks, mortgage brokers, and so forth have essentially nuked our economy, and they are being rewarded for it beyond all dreams of avarice.

So what you're saying is, we need to hold mortgage owners to a much higher standard than we hold anyone else in this nation to, because... for some reason, they're more morally culpable for their externalities than anyone else is.

If we were talking about polluters who were destroying some irreparable part of nature as an externality, something that could never be replaced, then I would agree with you. But we're just talking about a little money, and the people with the problem are, in the main, THE PEOPLE WHO CAN STILL AFFORD HOUSES. Gee, should I feel sorry for them? Or for my friend's parents, who have been out of work for eighteen months?

In short: holding individuals with underwater mortgages to a higher ethical standard than we hold anyone else ever? Fuck that.

Posted by: Fred Fnord at May 13, 2010 4:24 PM

The problem as I see it is that the breaching party doesn't pay all the costs of his breach - he only loses the condo and can externalize the other costs of his breach onto others.

How nice it would be, if purchasers were the only ones socializing their losses!

Posted by: acoustician at May 13, 2010 4:48 PM

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