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BANKS GET REAL ABOUT REAL ESTATE LOSSES
In June, 1991, First Chicago Corp.'s top officers devoted their annual management retreat in Kohler, Wis., to the bank's troubled real estate loans. They considered the alternatives. Maybe it was best to bite the bullet: simply write off the loans and dump them. Or create a separate "bad bank" to handle the dirty work. Or perhaps hold on and ride out the real estate recession. Says W.G. Jurgensen, the chief financial officer: "We all recognized that real estate assets were the single most negative influence on our earnings."
For over a year, the bank rode it out. But the real estate recession has turned into a depression -- with no turnaround in sight. So on Sept. 14, First Chicago put up for sale $ 2.1 billion in troubled real estate properties and loans, after writing down their value by 46%. Many other banks are mulling the same choice. Two days later, Fleet Financial Group of Boston announced its escape plan. Wells Fargo & Co., Citicorp, and others may follow. "First Chicago is just the first news to hit the ticker," says Jon A. Fosheim, a principal at real estate research firm Green Street Advisors. "The fundamentals are in place for all the big institutions to own up to the diminished value of their real estate holdings."
The big question is whether this spate of fire sales will further depress prices and thus add to the glut of foreclosed properties and empty office buildings. There is already $66 billion in bad real estate loans on bank balance sheets nationwide, and traditional buyers, such as pension funds, insurance companies, and banks, are on the sidelines. The upshot for banks could well be that their loan portfolios will be worth even less.
Certainly, some foreign institutions, rich families, a covey of "vulture" funds, investment banks, and real estate investment trusts (REITs) are picking up some of the merchandise. But the combined power of newer buyers doesn't come near the demand that was once generated by the major U.S. institutions. And some of this buying interest has already been siphoned off by Resolution Trust Corp., which still has $35 billion of property and loans left to peddle.
That leaves the banks with a delicate balancing act: how to move real estate loans in a buyer's market while offsetting the damage to their balance sheets. The problem is that big write-offs can hurt already fragile banks unless they find some way to replenish their capital. Big write-offs drag down capital ratios at a time when the Federal Deposit Insurance Corp. is pushing for higher capital standards.
First Chicago dealt with this problem with a mixture of stock sales and accounting gimmickry. The bank will offset a $625 million write-off in the third quarter with a $300 million gain, by marking up the value of its venture-capital portfolio to its market value. And to bolster its capital further, it hopes to sell $300 million of preferred stock before yearend, in addition to the $292 million in common it sold in June. "This strategy requires the courage and the resources to absorb a big hit. Not everybody can do it," says Hugh F. Kelly, director of economic research at Landauer Associates Inc., a consulting firm. It also assumes that First Chicago will be able to get 54~ on the dollar, or more than $1 billion for its bad loans and foreclosed properties, which is far from assured.
But it was First Chicago's best alternative. The widely heralded "bad bank" strategy, which pawns off troubled loans into a separate new bank, can be cumbersome and costly. A good example is Mellon Bank Corp., an early pioneer of the strategy. In 1988, it set up Grant Street National Bank, to which it sold $500 million of bad real estate loans. To do so, it had to mark down the loans to about 41~ on the dollar, float $500 million in debt, and raise $175 million from a private investor. Grant Street then put those marked-down loans on the block.
WHO PAYS? Grant Street has unloaded all but $5 million of them, but not without unpleasant consequences. Mellon and Grant Street have been sued by several former borrowers whose loans ended up in Grant Street's portfolio. The banks are appealing a $29 million judgment to one Colorado developer. If Mellon doesn't win on appeal, it could be liable for any award of more than $10 million. Says William B. Eagleson, chief executive of Grant Street: "We concluded it was better to move this stuff out."
First Chicago did not pursue another option favored by some banks: the auction block. It's easy to see why. On Aug. 13, Jones Lang Wootten USA, an arm of the big British development company, tried to auction off $500 million in commercial real estate, much of it foreclosed bank property. Even though bidders from the U.S., Europe, and the Pacific Rim crowded the Century Plaza Hotel in Los Angeles, barely half the properties sold, and those fetched less than half their original value. Several buildings sold for less than their published minimum prices. Says Nick Buss, director of investment research at Real Estate Research Corp. in Chicago: "Now, the market is moving to a point where illiquidity is totally in effect."
While First Chicago sells one loan at a time, some banks are quietly packaging and dumping loans in batches of $100 million -- and up. On Sept. 18, Shawmut National Corp. entertained offers for a parcel of loans with a face value of about $100 million. The bidding from institutional investors: 55~ to 60~ on the dollar. Fleet Financial, which plans to sell $500 million of bad assets in bulk parcels, may do even worse. James H. Hance Jr., chief financial officer of NationsBank Corp. in Charlotte, N. C., wouldn't be surprised. "Few banks have gone this route, because they've been unwilling to sell at the market value" -- often only half as much as the original loan, says Hance. He will sell three pools of loans and assets before yearend for $600 million, for 50~ to 60~ on the dollar.
`GRAVE DANCER.' Banks, whatever their strategy, are busily scouting for buyers. Some major investors are shopping, such as the Bass brothers of Texas and the Pritzkers of Chicago. Barry S. Sternlicht, president of Starwood Capital Partners of Chicago, raised $62 million early this year from rich families to buy $250 million worth of real estate loans and buildings from banks. "There are opportunities in the market for entrepreneurial capital that can move quickly," Sternlicht says.
"Vultures" are circling, too. Samuel Zell, nicknamed "the grave dancer," has seen some of his own investments go sour lately. But he's packing a $450 million investment fund raised by Merrill Lynch & Co. "The supply-and-demand imbalance is going to be in favor of the buy side for quite a while," says Richard B. Saltzman, Merrill's head of real estate.
Landauer's Kelly agrees. "There is still a capital shortage for this industry," he says. Ronald Greenspan, director of restructuring services at Price Waterhouse, recently met in Tokyo with 50 banks, trading companies, insurers, and other potential investors, all of which had previously invested in U.S. real estate. Only one was interested in making new purchases. "If 80% to 90% of them could just pick up their chips and go home, they would," Greenspan says.
And while some U.S. pension funds would like to buy, most are wary. Many bought into real estate investment pools launched by such firms as JMB Realty, Copley Real Estate Advisors, J.P. Morgan, and Trust Company of the West only to be burned by write-downs on their investments. "Are we going to invest any more in real estate?" asks William R. Schwartz, executive secretary of the Missouri Local Government Employees' Retirement System. "With the write-downs we've had over the last couple of years, probably not."
Nearly anything, however, can be sold if the price is right. Michael Herzberg, chief executive of Ferguson Partners in Chicago, says: "I don't think there's a lack of capital. The issue is pricing." Herzberg is obviously right. And that means the only direction commercial real estate prices have to go, at least for a while, is down.BANKS HAVE A LOT OF REAL ESTATE ASSETS TO SELL
Real estate Foreclosed
Millions of dollars
BANKAMERICA $19,234 $1,540
CITICORP 18,204 4,315
WELLS FARGO 12,572 627
NATIONSBANK 10,556 766
CHEMICAL BANKING 8,941 1,497
CHASE MANHATTAN 8,329 1,003
FIRST UNION 6,300 340
SUNTRUST 5,246 244
FLEET FINANCIAL 4,725 514
FIRST INTERSTATE 4,829 320
*Includes residential and commercial real estate
DATA: KEEFE, BRUYETTE & WOODS INC.
David Greising in Chicago, with Geoffrey Smith in Boston and bureau reports