It is axiomatic in American business bankruptcy practice that though they may disagree strenuously on the particulars, all parties to a Chapter 11 case are interested in the same basic goal: maximization of the debtor’s asset values.

Or are they?

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NYU Professor Sarah Woo has recently published an empirically-based analysis of this assumed common goal, and the results of that analysis are striking.  As she describes her own research (presented in an article titled “Regulatory Bankruptcy: How Bank Regulation Causes Firesales“):

This Article demonstrates empirically that this assumption is inaccurate: the actions of banks in bankruptcy proceedings are not necessarily driven by value maximization. The findings in this Article have groundbreaking implications for bankruptcy policy which focuses on the debtor and overlooks exogenous creditor-specific factors. Where banks, which extend the bulk of the outstanding credit in the United States, are driven by financial regulatory policy to over-liquidation of their own borrowers, these actions lead to fire sales which potentially amplifyliquidity shocks and systemic risk.

Ms. Woo’s working hypothesis is that changes in the banking sector over the past decade, including increased consolidation and increased leverage, eventually pushed banks to pursue higher portfolio returns.  As a result, many banks over-concentrated their portfolios in commercial real estate – a strategy which worked well during frothier times, but which proved disatrous in the aftermath of 2008’s economic collapse.

In the aftermath of the banking crisis, over-concentration by banks drew significant regulatory scrutiny – and, ultimately, significant new regulation designed to pressure banks to reduce their concentration risk.  According to Professor Woo:

As with many episodes of financial instability which can be traced to misguided attempts to use regulatory power, pervasive regulatory pressure with capital adequacy as a centerpiece affected bank behavior in bankruptcy, interfering with investment expectations and diminishing asset values. In the case of IndyMac Bank, the bank shed more than a billion dollars of construction and development loans in the first six months of 2008 under regulatory pressure, partly through liquidations in bankruptcy. The actions of bank regulators thus had unintended but dire consequences of rendering the standard assumption of value maximization in bankruptcy policy obsolete by creating a different set of incentives dependent on the bank creditor’s own health. The phenomenon of regulatory bankruptcy thus demands a comprehensive reevaluation of current bankruptcy policy which has not kept up with these developments in the banking industry.

Professor Woo’s work is important, not only for the specific question of how and why banks behave the way they do in bankruptcy, but also as an example of how industry dynamics can mold and shape the bankruptcy process – and further, how empirical data can be marshalled for the benefit of informed legislative change and judicial decision-making.

“There’s a cement slab on Ridge Lane, topped with a few pipes, an electrical box and a porta-john.  Nearby, an empty house, a large sign in the driveway declaring ‘inventory home.’  Around the corner, a few muddy lots, rimmed with construction fences … ‘If [the developer] is gone,’ [Kathy] Koss [a resident in the neighborhood] said, ‘what is going to happen to these houses?’”

This quote from a story in March 15’s Charlotte Observer opens an extensive and intriguing study assembled by Sarah P. Woo, entitled “A Blighted Land: An Empirical Study of Residential Developer Bankruptcies in the United States – 2007-2008.”  Woo is an independent risk management consultant and doctoral scholar at Stanford University with prior experience as a research manager at Moody’s KMV London and a background in corporate finance at White & Case LLP.  She offers a simple premise as the basis for her 194-page work, which also serves as her dissertation:

Until the housing sector is stabilized, there will simply be no recovery in America.  And as financially distressed residential developers and home builders are forced into liquidation or foreclosure, the unfinished projects they leave behind affect not only the immediate community, but area housing prices as well.

Woo is not alone in her assessment of the persistent weakness of the US residential housing sector.  A Deutsche Bank study released in early August and briefly summarized in a CNN-Money article last Wednesday indicates that home prices may fall another 14% before hitting a bottom, leaving as many as 48% of mortgage holders “underwater” by 2011.

Ouch.

Among Woo’s findings on developers who have filed Chapter 11 cases over the last 2 years:

- Only 5.3% were able to successfully reorganize.  In fact, the majority of cases were actually dismissed or converted to Chapter 7 – leaving real estate to be foreclosed or liquidated in forced sales.

- 72% of the cases sampled involved at least one request by a secured lender to lift the stay for purposes of foreclosure.  In such instances, relief was granted approximately 90% of the time.  However, foreclosure may not always have been the best outcome for the bank.  According to Ms. Woo, “[i]n one case, the bank which repossessed the property not only had trouble with the remaining development process but also found itself in a position where it could not necessarily sell the property as a going concern . . . .  In [another] case, the bank which repossessed the property was seized by regulators 2 months later for being insufficiently capitalized, raising the issue of the extent to which a bank’s own financial problems might have contributed to its preference for liquidation during bankruptcy proceedings.”

- Where properties were disposed of through “363 sales,” Woo “uncovered a pattern of winning credit bids where secured lenders acquired the properties . . . at low prices.”

- Access to DIP financing appears to have been severely impaired for developers (as it has been for many Chapter 11 debtors this cycle, regardless of industry).  Even where DIP financing has been available, such financing often occurred in cases where the debtor was ultimately liquidated or packaged for sale (again, a common scenario this cycle regardless of the debtor’s industry).

Is the near-certain prospect of liquidation or sale facing struggling residential home developers a good one for the sector?

On the one hand, Woo’s study appears to suggest that the control available to lenders through mechanisms such as DIP financing and stay relief litigation, employed by highly regulated and troubled US banks desperate to raise capital by seizing and liquidating collateral, puts housing developers who might reorganize in Chapter 11 on a very slippery slope with little prospect of survival.  On the other, it suggests that the industry may be ridding itself of weak performers very quickly, leaving only the strongest to survive as the residential housing sector struggles back to prior levels.

Where real estate development and the residential housing sector are concerned, is the shortest way up . . . straight down?