With the recent financial crisis it is needless to say that many banks have invested in bad real estate and our looking for a way out. Below is a simple guide for some advice on the topic.

For simplicity: We start by imagining 4 banks that have loans in 4 developer projects crisscrossed.

• Bank A, B, C and D. Each have loaned each property 2½ mio. \$ (That is each bank has 10 mio. \$ in problems).
• Properties Red, Yellow, Green and Blue. In each of them the loan/book value is 1 1/3 and loan of 10 mio. \$. But each bank does not have seniority in all of the properties.

Lets imagine for arguments sake that seniority in each property is as follows:

• Red house: Bank A,B,C and D. Where in the event of foreclosure sale Bank A is covered first, then Bank B, etc.
• Yellow house: Bank B,C,D and A.
• Green house: Bank C,D,A and B.
• Blue house: Bank D, A, B and C.

The general security the banks have is on average loan/book value = 1!
Let’s suppose you are Bank A. Then you take all impairments in Yellow house – recognising the money is lost. When the developers don’t service their loan – of course they don’t.

Then You move to foreclose in Yellow house – and do certainly NOT service the loans of the other banks.
If you are tough enough then when the similar situation develops in the other houses you do as follows:

• Red house – you tell the other banks, that if THEY don’t service your loan, then you move to foreclose – one or more of the other banks will pay you.
• Green house – you tell Bank B that you will take your chances at foreclosure sale and bid out banks C, D and your own share. So any service on the loans will rest squarely on Bank B.
• Blue house – you tell the other banks that you do intend to bid half book value, so you are covered.

What will happen depends:

• Yellow house will be sold at ¾ of book value bought by Bank D. Bank A looses the money.
• Red house will not foreclose – yet – as Bank D pays service.
• Green house will be bought by Bank A at ¾ of book value.
• Blue house might be bought by Bank A or B at either ½ or ¾ of book value.

The general result will be that only one house will foreclose the one Bank A has impaired.
After this round of “chicken” the situation is:

• Red house Banks A, B, C and D.
• Yellow house Bank D
• Green house Bank C, D, A and B
• Blue house Bank D, A, B and C

Now loan to book value varies considerably
Bank A = 2/3, Bank B = 1, Bank C = 8/9 and D = 9/8.’

This goes some way to explain commonly observed phenomenon:
1)    Banks are scared of one bank breaking the solidarity. Before the auction the bank were equal in misery, but after the first auction their books look widely different:
Bank D has been forced to deteriorate its position, where Bank A – taking the loss – has improved its situation markedly.
The critical bank is D: Will it step up and take the loss or not?
If bank D don’t bid in, then the property will go to C which will be largely indifferent, as the profit from the advantageous buy not quite outweighs the problem of being saddled with the property.
2)    The situation is highly unstable as this simplistic model shows.  It moves from a situation in balance – very uneasy, but balanced – to an undetermined situation dependent on a player, that is largely indifferent and one that will deteriorate its position markedly.
That is probably why governments generally step in with rescue missions. The first bank to take loss will improve their situation markedly.
As anyone that tries and audit the calculation will experience, you tend to lose focus and get confused.
3)    We’ve said “book value”, but that is not quite right, for in reality all the banks have manipulated their valuation of property with a wildly optimistic view of the future. An evaluation that can only be justified – just – if there is no turnover in investment property.
So ANY foreclosure sale will force the entire banking sector to readjust their book value.
4)    The real danger is if one of the banks have a home rental agency that will profit from lower market price. That is why it is destabilising if f.i. pension funds buy distressed banks. The pension fund is interested in low real estate prices because they want to keep their apartment blocks full and earn a profit from the rent – so if they can buy real estate cheaply a banking loss in their bank might be worthwhile.
That is why “supermarket banks” is a disaster in progress: Pension savers and banks have opposite interests in critical situations: Banks will try and smear off losses on pension funds and pension funds profit from bank losses.