Problems for Secondary Lenders?

I received a call today asking whether a local company in Louisville should be worried that its secondary lender on its real estate filed a lawsuit to foreclosure due to default. In some ways an odd question, but perhaps not. Imagine this, Company X owns real property worth $750,000 at the time of financing. First Bank holds a mortgage for $500,000 and Second Bank holds a mortgage for $225,000. If both banks have properly recorded their mortgages, all would seem to be in order. But, in a declining real estate market, we could imagine the property now being worth about 20% less (here, just $600,000). First Bank is still secured, but Second Bank is now undersecured. If Company X stops paying Second Bank, but is in good standing with First Bank, then what are Second Bank's options? Foreclosing on the real estate might ordinarily be a good call, but what happens in a declining market if the real estate has to be sold at auction?

Second Bank seems now to be undersecured. If real estate values have fallen dramatically, Second Bank could be in even worse shape. Its options? Perhaps Second Bank might try to renegotiate the terms of the mortgage to get Company X back on track. Alternatively, the loan might be sold to First Bank at a deep discount if First Bank is interested. If Second Bank obtained any guarantys from the owners of Company X when it issued the loan, that might help . . . if the individuals have enough assets to cover the loan. Forcing Company X into bankruptcy also might not work out so well if there are not sufficient assets to pay the creditors.

In the end, should Company X be worried about any lawsuit by Second Bank? It is a tough market out there. Secondary lenders on real estate may as a group be finding themselves with less bargaining power than in the past. If Company X is not worried about the situation about Second Bank it could be that good corporate news is around the corner that will allow them to pay the lender. In this market, though, Company X might know that Second Bank has rights, but little to enforce them against.

— JSM