428 Jon Winick, CEO | Clark Street Capital
How to buy real estate collateralized loans
I have been receiving Jon's newsletter for years and when I saw a topical article on the Evergrande unravelling, I thought to invite him on the show despite being wary that our conversation might become dated very quickly - something I like to avoid, preferring always to produce 'evergreen' content.
But our conversation turned to my favorite of all topics: loan sales on real estate collateralized assets. Jon is one of the country's foremost authorities and has been involved in trading loans for and with banks since the global financial crisis of 2008-2010. This is an exceptional episode to learn, not just about a new asset class, distressed loan sales, but about the downside of what happens when real estate investing goes wrong.
What You're Going to Learn
- The Failure of Evergrande and Impact on US Economy
- A hundred billion dollars in Real Estate losses
- Why banks sell Non-Performing Loans
- Difference between a Non performing loan and underperforming loan
- Economic growth can still occur with distressed debt situations
- What you should know when buying a distressed loan
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The Failure of Evergrande and Impact on US Economy
Adam Gower: So to what extent could a failure of Evergrande and I've actually not heard the name spoken. I only ever read news, so I'm not sure how it's pronounced. But Evergrand, Evergrande... What are the implications of a failure of this company or another company similar in size on the US economy?
Jon Winick: It really depends on what type of failure. So, you take the 2008 financial crisis and the Lehman Brothers failure would be the worst kind of failure. And the Wachovia failure would be like the best kind of failure. So a lot.
Adam Gower: Make the distinction. Make the distinction between them. Why was Lehman bad and Wachovia good?
Jon Winick: First off. Lehman Brothers was thrown into bankruptcy court, which is a very chaotic way to resolve. Also a very expensive way to resolve something.
Adam Gower: Hmm.
Jon Winick: And, I think it caused a serious contagion and really caused a ripple effect, whereas Wachovia was basically resolved through the FDIC. The depositors didn't lose any money. Wells Fargo assumed the assets, and it was an orderly liquidation. So, first things first. You know, all failures are not good. But there is both an orderly failure and a disorderly failure.
Adam Gower: Ok.
Jon Winick: So, the Chinese government is talking tough that they're not going to bail them out. Well, sure. I mean, it depends on what you define a bailout. I mean, just because you prevent a systematic Lehman Brothers type scenario doesn't mean you bailed out Evergrande. I mean, I doubt that the Chinese government is going to bail out the stockholders or bondholders, but, I suspect they will do some sort of orderly liquidation where they sort of minimize the destructiveness of a big failure.
Adam Gower: Mm.
Jon Winick: You know, could this cause problems? Sure. I mean, I guess the other question is, is this a bad apple or are there other bad apples out there?
Adam Gower: Right.
Jon Winick: And, I suspect they're not the only one. I just - I've seen enough evidence that the Chinese government and the way it treats its banks. They have very high levels of NPLs. Nobody seems to resolve anything.
Adam Gower: Non-performing loans. Just to tell that one guy in the audience that doesn't know what an NPL is. Yeah.
Jon Winick: Correct. So. You know, it's so hard to predict because this is such a unique situation. But, you know, short answer: it's not good.
$100 billion dollars in Real Estate losses
Adam Gower: If there is underlying chaos in the Chinese real estate market, the economy, how could that impact the US real estate economy?
Jon Winick: Sure. Well, I mean, I think everything is more and more correlated pretty much since the collapse of long-term capital. All these things seem to be somewhat correlated. So, OK, let's just play this out. Evergrande collapses. The bondholders, the stockholders take huge losses. There's these various real estate projects which are now sort of worthless and chaotic. So, you know, a bunch of consumers and and businesses take losses. It could bankrupt their suppliers. So yes, I mean, it certainly would be felt. Now, it certainly could mean that the Chinese real estate market takes a big hit and people deploy their money - take their money out of China and put it in the U.S.
Adam Gower: Ok.
Jon Winick: So there could be like a quality aspect of this, which would minimize the damage. But, you know, if if we're talking $100 billion dollars in losses, that's not just - that's felt by a lot of folks. It's not just the Chinese government taking the losses, ultimately. They may step in but, you know, you got all those bondholders, all those stockholders. I mean, that's why you have these people showing up at these town, you know, buildings, town centers and protesting and so on. So yeah, it's it's a potentially nasty situation.
Why banks sell Non-Performing Loans
Adam Gower: What is the motivation for a bank to sell them - these non-performing, underperforming loans?
Jon Winick: Well, I think it's - there's a lot of reasons. Let's sort of go through them. One, they can take - the capital treatment on defaulted loans is now higher than what it was pre Dodd/Frank and pre Basel. So-
Adam Gower: What does that mean? Just explain that.
Jon Winick: I that banks have to hold more capital for a defaulted loan. And, that ultimately means they can't - they have less lending ability. So -.
Adam Gower: Plus, if they get to a certain percentage of non-performing loans, they can actually fail.
Jon Winick: Correct. I mean, if - and that's a combination of realized losses, perceived losses, and in some cases, there are runs on deposits from time to time. But yeah, I mean, sure, I mean, it's - it could be a lot of punishment. You know, the regulatory scrutiny of having high levels of NPLs, the hassle factor, there's the deployment of resources, the reputational issue. It's often falsely stated that, you know, that there are reputational issues in selling loans. It's actually quite the opposite. The banks who sell loans have better reputations than those who don't.
Difference between a Non performing loan and underperforming loan
Adam Gower: Just define for me, if you would briefly, the difference between an NPL - non-performing loan, and an underperforming loan, from a bank's perspective.
Jon Winick: Yeah, I mean, I'll just use the FDIC definition. So the FDIC says, OK, if it's less than 60 days, it's still performing. If it's 60 to 90, it's sub-performing. If it's over 90, it's non-performing. I mean, 90 days is kind of the industry standard of when something is considered non-performing.
Adam Gower: And what's important about that is that a sub-performing loan can be made performing, but a non-performing loan can never go back.
Jon Winick: Well, it could certainly become re-performing. I mean, I don't want to get into a whole rabbit hole with TDRs and so on, but... You know, there's a path of no return when you get to NPL status.
Adam Gower: Right.
Jon Winick: It's hard to be a good borrower again with the bank when you've had a 90 day delinquency.
Economic growth can still occur with distressed debt situations
Adam Gower: Do you wake up every morning looking at the news, hoping for another financial crisis?
Jon Winick: No, I mean, I think that - I mean, there are other factors, right? There's the performing loan sale market, for one thing.
Adam Gower: Ok.
Jon Winick: The financial crisis is not so good for that. There's your own, sort of, personal investing, right? And certainly my portfolio would take a pretty big hit. That would be somewhat unpleasant. But I mean, I think, you know, there's a subtle and classy way to go about doing it. Look, the opportunistic, distressed debt community is an unsung hero in a lot of situations. I mean, talk to any bankruptcy judge and say, how important is his stalking horse bidders or vulture bidders? And they'll all say, without them, without these people showing up, they want to get paid for it. There'd be nothing for us to do. So, you know, they play a very vital role and I believe that the process of failure - working that failure out, rejuvenation, is so critical to economic growth. And I think what we've done in the past year and a half is - we won't let any restaurant fail. Even though every restaurant that fails is replaced by another restaurant.
So, I think there are real costs to missing the important cleanup phase of any recession or any problem. And, you look back the past year and a half, name a big company that failed. Can't name one. Except a few energy companies. But even the companies that went bankrupt, like Hertz, you know, fully recovered, paid all their bondholders back at par. You know, it's just - there are costs to that.
And you know, you hear a lot about AMC because of all the investors who are bidding up their stock, well, wouldn't AMC be in a better shape if Regal Cinemas didn't exist anymore or some of the smaller regional chains? Some of them did probably close. But, we are doing something that's never been done before. We're having a severe recession and keeping everyone alive, and I think there are real costs to that.
So, you know, I don't look at taking advantage of an opportunity as being a bad thing. I actually think it's the opposite.
What you should know when buying a distressed loan
Adam Gower: What is the most important thing, someone interested in investing in distressed bank debt, collateralized by real estate, should keep in mind? Somebody wants to buy a distressed loan from you, an individual investor, what should they be keeping in mind?
Jon Winick: I think that they have to be prepared for all the possible scenarios. You know, they have to be prepared to maybe own the real estate. And I think there are certain asset classes like, for example, a church, a nursing home where you may never want to take possession of the collateral for various reasons. You need to understand your way around the legal process. Ok, this loan goes to default. Was does it costly to foreclose? How long is that going to take? Is this in a judicial state? Is it in Texas? Like, how long is that going to take? So, I think it's - you have to understand the underlying collateral value and really, all the possible outcomes that can come out and you need to be realistic in those outcomes.
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