Why should home buyers care about conflict between lenders and other institutional stakeholders in a home builder’s bankruptcy? Because it affects the issue of whether the builder would end up in liquidation and foreclosure or reorganize and fund the completion of unfinished homes.

Conflict in Foreclosure Sale

An interesting piece on conflict between institutional stakeholders appeared in Bloomberg this morning – see Wilbur Ross Defies Bruce Rose in Battle Over Housing Villains. Carrington Capital, a hedge fund, accused American Home Mortgage Servicing of putting its interests ahead of those of bondholders. It is in American Home’s interest to quickly unload foreclosed properties, while Carrington stands to gain from delayed foreclosure sales.

Conflict in Builder Bankruptcy

There is an analogous (albeit inexact) scenario playing out in the field of bankrupt home builders. An example is seen in Randall Martin Homes (for which the Dobson and Higley communities filed for bankruptcy last year).
In both cases, the banks, being senior secured lenders (being 1st in line in terms of recovering on the builder’s debt), moved for relief from stay, in order to pursue foreclosure of the distressed real estate. On the other hand, the hedge fund, Mountain Funding, which held a second lien, attempted to provide post-petition financing and supported the builder’s bankruptcy restructuring efforts.

In the midst of proceedings, Randall Martin Homes filed a Disclosure Statement and Reorganization Plan proposing to restructure the banks’ secured claims such that it would bear interest at no greater than 6.5% per annum, amortized over 20 years and paid over 7 years. It also proposed to restructure its claim with Mountain Funding. In exchange for the hedge fund providing post-petition financing, it would receive all new equity interests in Randall Martin Homes.

It is not hard to understand the incentives driving this scenario. Based on appraisal values proffered at the time, the banks might recover around 70% if they foreclosed and sold the real estate. The hedge fund might end up with little, save for an unsecured claim against the shareholders of the builder who have guaranteed its debt.

What the hedge fund held was an instrument similar to a call option, with the strike price being the value of the bank’s outstanding debt amount (or the amount at which it was willing to compromise, taking into account deteriorating market conditions). One of the key drivers of option value is asset volatility. A restructuring effort by the builder is likely to represent a measure increasing volatility. After all, one may consider it a gamble – to bet on a rising housing market whereby the builder can continue operations and sell off homes at a price level higher than that of foreclosure sales.

Unfortunately, this play was resolved in favor of the banks. The court granted the motions for relief from stay. I am an advocate of reorganization over liquidation, but this case smacks of irony - it is the hedge funds which are trying to push for reorganization in an attempt to protect their self-interest. But not before the banks have made some colorful, strong remarks in court filings - attached below for readers with the same sense of ironic humor.

The benefit to Mountain Funding from the Plan is obvious – it allows Mountain Funding to speculate on an increase in the value of Debtor’s property in exchange for a de minimis payment to unsecured creditors and a commitment to pay FNBA at artificially low rates over a commercially unreasonable time while it waits for the real estate market to recover. Although Mountain Funding stands to benefit greatly, the proposed Plan provides no apparent benefit to Debtor. Upon information and belief, the only reason for Debtor’s blatant give-away to Mountain Funding is Mountain Funding’s threat to enforce its guaranty against Bury. Armed with that threat, Mountain Funding has turned Debtor into a puppet attached to a set of strings that only Mountain Funding controls.