The Latest Installment

Dear Dealburt: On February10 you answered a question from "Dealless", whose business was depressed to the point that Dealless despaired of any successful outcome. Among other things, you urged trying to look at one’s situation with "artistic imagination," as you called it, as authors, composers, poets, sculptors, painters and actors do, to "see or experience something from a selected viewpoint." In that way, you said, Dealless might be able to find a way through or around the barriers that seemed to be impenetrable.

I’ve been trying this, because my business, too, is seriously struggling, but I seem only to see the same problems and impossibilities every time I go through the exercise. I haven’t had a breakthrough yet. I don’t want to complain, but it makes me angry. What else can I try?—Crabby in a Dark Dungeon

Dear Dungeness: I don’t know whether this is the case with you, but sometimes a person will try to see his or her business situation for a fresh viewpoint, but fail to do so from the perspective of a different person—such as "a complex character in a quality movie, book or play," as I recommended on February 10. What I’m saying is that for this exercise to work, you have to get out of yourself and your habitual ways of thinking.

When my teenaged sons played the "Dungeons and Dragons" game, they began each game by "rolling up a character", who would have to play the game according to the destiny which was established for the character when the dice were rolled at the beginning. Without realizing they are doing that, many people "roll up a character" which they think defines everything about themselves. As they begin a business, they think that who they are and what they can accomplish are predestined by the "givens": their abilities and interests.

I think they are wrong; their abilities and interests are their starting point, not their boundary. In your business, as in life, you are not stuck with who you have been, or by a roll of the dice at the beginning. You have the opportunity to build upon your interests and abilities, rather than be confined by them.

So, here’s my take-away advice: Try to determine what abilities and interests you would have to have, to make your business a success. Then decide to develop them. If it helps, think of a real or fictional person who has the abilities and interests you need, and begin to act and think as that person would. Act the part, until you become the part.—Dealburt

Dear Dr. Dealburt: No one else has been able to find a cure for the chronic pain I endure, because of the debt on my commercial properties, and because of the tax cost of doing anything about that debt. I’m not alone with this problem, as the LoopNews story on March 2 [cited below] reports under the headline, "Owners Who Negotiate Debt Reductions Could Face Tax Hits".

It’s difficult enough to get my lenders to agree to write down my debts, but then, as the story says, I’d face an ordinary-income tax to the extent that the debt forgiven exceeds my basis in the properties. And, for those of my properties in states such as New York, I’d face a heavy transfer tax—or the bank would—in the event of a deed-in-lieu or foreclosure. I’ve asked around locally, and I asked around on Wall Street. Where can I find relief? — Hurt on the Street

Dear Hurt: For my patients with this problem, I recommend fast-acting Exdebtrin as a workout solution for debt, without adverse tax consequences. Exdebtrin’s secret formula contains WWW, or "Workout Without Writedown", which, amazingly enough, enables you to pay your debt in full—so there’s no relief of debt to be taxed—and to replace it with new, reduced debt financing that you can afford. It’s a refinancing method which involves no transfer of title to the property, so the transfer-tax problem goes away, too.

For the bank, Exdebtrin provides a legal high: reduced risk, increased capital, increased income, increased liquidity, fully performing returns, and no writedown.

Call me for a prescription. More cartoon doctors recommend Exdebtrin than any other remedy for under-water commercial debts and the related tax on relief of debt or transfer.

Aside: I think you should talk with your state legislator about changing the transfer tax so that it wouldn’t apply in deed-in-lieu or foreclosure situations. It is both silly and unreasonable to apply the transfer tax in those situations.—Dr. Dealburt

The LoopNews story:

www.loopnet.com/xnet/mainsite/news/news.aspx?DocID=12911&sourcecode=1lntd009

Dear Dealburt: "Lending Falls at Epic Pace," the lead story in The Wall Street Journal says today, in the "sharpest decline in lending since 1942". The story cites factors such as (1) pressure on banks from their regulators to be more prudent in their lending, (2) banks’ reduced willingness to lend, (3) banks’ fear of lending, (4) banks’ decisions to reduce the size of their loan portfolios, (5) lack of demand, or weak demand, for loans, (6) a shortage of credit-worthy borrowers, and (7) "the looming problem of troubled commercial-real-estate loans". All of the experts seem to be flummoxed by this situation. I’m a substantial investor in state-chartered banks in three states, and I serve on the boards of directors for several banks. Like everyone else, though, I feel helpless to do much about the problem, other than to try to wait it out. Is there anything pro-active that can be done, not only for my banks but also for the sake of the economy as a whole?—Bank Director, seeking direction

Dear B.D.: Pardon me for the length of my response here, and for my boldness in saying this, but the reason why the experts are flummoxed by this situation is that they are looking at it through the wrong lens. If we don’t start looking at it through the right lens, the United States may suffer through a "lost decade" much as Japan did.

1. Start at the wrong beginning point, and you get little more than stalling for time.

To begin to see the problem through the right lens, imagine that some not-very-bright politician had proposed, in 2008, to impose a federal tax of, say, 50% of the value of real estate, both residential and commercial. Such a proposal would have been greeted with both ridicule and horror, because, as about everyone would have agreed, such a tax would have been terribly destructive for the nation’s economy.

Well, apart from the fact that the government didn’t collect tax money from it, that imaginary proposal might as well have been implemented, because the value of real estate has declined nearly everywhere (50% in many cases, more or less in others, but you get the point). The result is similar to what would have resulted, if the government had taxed that value away. If the government had done so, everyone would now be saying, "Quick, let’s repeal that tax, to get rid of that burden." As it is, though, the experts are not proposing to deal with the problem quickly, but instead to drag it out indefinitely, and to deal with it around the edges without really resolving much.

2. This is primarily a pricing problem, not a contract problem.

If when banks were making loans in 2007 they had known that real estate values would soon drop precipitously, would they have made those loans at those amounts? No.

If the borrowers had known that real estate values would soon drop precipitously, would they have wanted to borrow as much? No.

But now that it has happened, everyone—banks, regulators, borrowers, advisers, politicians—views the problem as if banks and borrowers had known what would happen to real estate values. The banker thinks, "John Doe borrowed $20 million for that shopping-center loan and still owes us the whole amount, regardless of the fact that the shopping center is now worth $10 million. John Doe’s mistake about the value doesn’t excuse him from his obligation. The fact that the bank was wrong in its estimation of future value has nothing to do with it."

To see the economic effect of that, imagine the debt-service cost were a property tax instead of debt service. Does anyone think John Doe should continue to pay property taxes as if the shopping center were still worth $20 million? No, but about everyone thinks he should continue to pay for his loan as if the property were still worth $20 million—because "that’s the deal he made."

3. Re-align incentives, to achieve a quick and complete re-pricing of loans.

As long as we continue to think that way, these excessively priced loans will continue to burden the economy. Instead, those loans need to be re-priced, and quickly, so that investing, hiring, lending and borrowing can begin again.

Think of it this way: Nothing happens that doesn’t happen on, or in connection with, real estate. As long as real estate is bearing the economic equivalent of an oppressive tax at a 30% or 40% rate or whatever, recovery will be delayed and substantially weakened.

So, instead of what we have now, with bankers (and their regulators!) resisting and postponing the restructuring of loans and only dealing with the problem in fits, starts, and tiny pieces, we need to have a way for banks to be able to—and to want to—take the lead in a rapid and complete re-pricing of loans.

4. Wouldn’t re-pricing the loans just pass the losses on real estate to the banks?

It need not do so. What the banks need is a recapitalization structure that enables them effectively to turn those losses into additional capital for the banks: capital that can be marketed by the banks to increase their income at the same time the problem of over-priced loans is corrected, and not just dragged out.

The banks are uniquely in a position to be able to turn real estate losses into capital. Creation and implementation of the structure for doing so is where thinking legally and contractually comes into play.

Recapitulation, and recapitalization

All of the factors cited in today’s story in The Wall Street Journal can be addressed, if we will begin to understand that the root of the matter is a mis-pricing problem, not a legal one; that it is urgent that the mis-pricing be addressed on a broad scale, because we can’t sustain the largest lending decline since 1942 and expect to skate along as if nothing had happened; and that the need for thinking contractually and legally is in creating a mechanism for turning real estate losses into capital and in creating incentives to implement that mechanism quickly—as a private-sector activity.

And yes, lest you wonder, I have a plan.—Dealburt

Dear Dealburt: I’m not given to envy, and I’m not at all troubled by others’ financial success. Indeed, I get paid more than most people do. Something just doesn’t seem right, however, when some financial wizards get paid as much as a small country’s national income. On the other hand, the idea of another 1,000-page piece of legislation in which the government tries to fine tune everything is repugnant to me. Please tell me that there’s a simpler answer, one that will allow for entrepreneurial freedom, provide incentives for growth, and return some sanity to executive compensation.—Pale in comparison

Dear Sarah: I think you will be pleased to learn that this is one of those "one-fell-swoop" situations. Some things really do have a simple answer, and this is one of them.

Begin with this question: Why is it that companies sometimes pay such inordinate compensation, whether as salaries or bonuses? Of course, part of the answer is that they want to attract and retain the most capable people: the ones who can bring in the really big bucks. Another part of the answer, though, is that salaries and bonuses are tax-deductible for the business, but dividends aren’t. So, companies have a substantial incentive (at the corporate marginal rate in the U.S., 35%) to pay money deductibly to their employees rather than to pay it non-deductibly to their shareholders.

A very simple amendment to the tax code, to make dividends fully deductible by the business, would create a very strong incentive to pay excess money to their shareholders. Businesses could still pay whatever amount is needed to attract and retain the most capable people, but those businesses would also have competitive pressure to attract and retain shareholders, who could go elsewhere to invest, where dividends aren’t so stingy. This competitive pressure would further empower investors in their efforts to get their boards of directors to moderate compensation levels for the most highly paid employees.

Dividend-paying stocks would immediately be revalued upward, and the "wealth effect" would make investors more ready to spend money as consumers.

Yet another efficiency would result: Most of the hoops through which people jump to try to avoid or escape the double-taxation problem (tax at the business level, then another tax at the personal level) would become unnecessary.

If we would make this one change, we would see an explosion of economic activity, growth and well-being. That would even grow the government’s tax revenues, pail in and pail out.—Dealburt

P.S. If you agree, let others know.

Dear Dealburt: What I’m seeing out there is a mixed bag, but the largest group seems to be developers who have performing notes on centers that are severely upside-down. So while at first blush these are not problem centers, per se, they are certainly problematic for the developers. They cannot sell, or refi, or install any add-value, if that existed. And they have tenants who are just itching to take advantage of any slip up, or any co-tenancy clause, in an effort to renegotiate their leases. These centers are destined to go backward, so if they are performing today, it is highly likely they’ll become non-performing in years to come.

It would seem to me that your Workout Without Writedown (WWW) program would be a godsend for this type of scenario, assuming I understand the premise.

Example: A 200,000 sf power center developed with the assumed value of $30 million, gets finished, leased, and is covering its debt. However, the current value is now around half. Your program could give the developer a chance to regain a positive position, with a new note that would again give him some leverage with the tenants and other lenders or investors. The bank, under your system, would get paid off using some offsetting method that in fact puts them in a profit situation over a longer period. With a currently performing note, however, what is the bank’s incentive, beyond explaining to them the inevitability of the developer’s regressing position?—Bob

Dear Bob: President Calvin Coolidge said, "Four-fifths of all our troubles would disappear, if only we would sit down and keep still." There is wisdom in that, as to possible problems, but it’s foolishness to do nothing about a loan one knows is going bad. It seems to be a human tendency to worry needlessly about things that won’t happen, while putting off as long as possible the hard work of solving a real problem. (Did someone mention Social Security’s unfunded liability?)

These are benefits WWW brings to the bank, and these are therefore incentives for the bank to address the matter now: (1) reduced risk; (2) increased capital, both immediately and later; (3) increased income; (4) increased liquidity; (5) fully performing returns (important for regulatory compliance); (6) no writedown to capital; (7) matched maturities for funds sources and funds uses; (8) no foreclosure risk; (9) no property-management cost or risk; (10) no above-market cost of funds; (11) re-balanced and cleaned loan and investment portfolio, going beyond the one loan in question; (12) no lurking day of reckoning; and (13) good relations with customers and regulators.

The way to maximize the incentive for the bank is to help the bank to see the whole scope of what WWW has to offer: for the problems in the bank’s loan portfolio, and not just this one loan to this one developer. As the late Sen. Everett Dirksen said, "A billion here and a billion there, and pretty soon you’re talking about real money." — Dealburt