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Real Estate is Doomed – Part 3: In Substance Foreclosure
Ramsey Su: There is good news. Part 3 is the last of the “Real Estate is Doomed” series … and it is short.
“In substance foreclosure (ISF)” is a technical FASB accounting term. I first learned about this term during the S&L era in pertinence to income property loans. Once upon a time, S&Ls were holding thousands of loans that were still current, but operating with negative cash flow. As an example, if an apartment building is collecting $1 million in gross rent, has $300,000 in expenses and a debt service of $800,000, the loan is technically an “in substance foreclosure” (ISF). The theory being that even if the loan is current, the borrower will run out of funds sooner or later unless his cash flow condition recovers.
An S&L executive told me that it was the change of reserve requirements that brought down the S&L industry, kind of like the straw that broke the camel’s back. What happened was that when the crisis hit, all S&Ls were required to identify all loans on their books that were ISFs and, if I remember correctly, reserve 8% as a loan loss provision.
During the sub-prime era, though it was obvious to many that the bubble was unsustainable, it was not clear what would trigger the bursting of the bubble. As it turned out, it was Lehman Brothers. It could have just as easily have been Merrill Lynch, or Countrywide, or some new regulation.
Lehman’s bankruptcy – a major trigger event of the financial crisis – via pepperdine.edu – click to enlarge.
For some strange reason, the market (and Bernanke) was surprised by how these sub-prime loans could actually create such big losses. I remember chatting with a CalPERS official at the time. He related the story about how CalPERS was under the impression their asset allocation model would limit their exposure to just the real estate portion of the massive fund. As it turned out, while it was true that only a manageable percentage of the funds was invested in real estate, other parts of the funds were investing in builders, lenders and other real estate related instruments.
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Source: http://marketdailynews.com/2015/03/09/real-estate-is-doomed-part-3-in-substance-foreclosure/
