Simultaneous Distress of Residential Developers and Their Secured Lenders: An Analysis of Bankruptcy and Bank Regulation

Abstract

With falling home prices and home foreclosures currently acknowledged as a severe problem in the U.S., more attention needs to be paid to the contributing phenomenon of residential developers undergoing liquidation, which has left behind a trail of partially-completed or abandoned properties. In order to understand this phenomenon, we analyzed 222 residential developers that filed Chapter 11 bankruptcy petitions between November 2007 and December 2008. We find that only a very small proportion of these developers, as compared to previous similar large studies, confirmed a reorganization plan. Most of the cases were dismissed or converted to Chapter 7, culminating in foreclosure or liquidation sales. In the sample, 72.5% of the cases showed at least one instance where a secured lender sought lift-stay motions to pursue foreclosure. Among such cases, orders granting the lift-stay motions were granted 92.2% of the time. Investigating this liquidation preference, we develop explanations based on nuances in the creditor banks' lending functions, risk management and regulatory environment that have not been explored in the prior literature on bankruptcy. We posit that, during a severe recession, banks may prefer liquidation of the developers over reorganization because of a capital shortfall and procyclical regulatory pressure to reduce portfolio concentrations, particularly in real estate lending. This would be inconsistent with theories that secured lenders will choose economically optimal outcomes within a bankruptcy case, as they may choose outcomes that are sub-optimal within a bankruptcy so as to maximize an exogenous urgent need for capital and regulatory compliance. Pursuing this hypothesis, we find that 45.4% of the secured lenders in our sample which are driving low confirmation rates are themselves failed or undercapitalized financial institutions. Furthermore, based on multivariate regression modeling, we find that the effect of a bank’s financial distress on the probability that it will file a lift-stay motion is economically large and statistically significant, after controlling for firm size, capital structure, housing market prices and region. Together, this is strong evidence that the standard theory of creditor behavior in bankruptcy is incomplete without consideration of the economic cycle or banking regulation.