Question

You are a commercial loan borrower deciding whether or not to threaten to strategically default on the lender and you have the following information: • This is a non-recourse loan • The current loan balance = $15,500,000 • The foreclosure (deadweight burden) costs to the lender to the lender in foreclosure occurs = $3 million • Current market value is uncertain, but there are 2 possibilities:

1. Scenario I: $18 million

2. Scenario II: $16 million

Part A. For each scenario (I and II) calculate the cost/benefit to the lender if you decide to default and the cost/benefit to you (the borrower) if you decide not to default. Then explain why or why not you have decided to default. YOU MUST SHOW ALL CALCULATIONS TO RECEIVE FULL CREDIT!

Part B. Revisit scenario II, now you (the borrower) try to negotiate the loan balance down to $13.5 million and threaten to default if the lender does not do so. How much will you lose/gain if the lender decides not to negotiate and lets you default? YOU MUST SHOW ALL CALCULATIONS TO RECEIVE FULL CREDIT!

Part C. Revisit scenario II again, now you are the lender. What is your financial gain/ loss if you refuse to negotiate and the borrower defaults? What is your financial gain or loss if you negotiate with the borrower and reduce the loan balance to $13.5 million? Explain whether or not you should negotiate? YOU MUST SHOW ALL CALCULATIONS TO RECEIVE FULL CREDIT!

Answer 1

The outstanding loan balance is $15.5 million and underying asset values are either 18 million (Scenario I) or 16 million (Scenario II) .

Lender's cost / benefit in case of default :

Scenario I : 18 - 15.5 -3 = - 0.5 million

Scenario II : 16 - 15.5 -3 = -2.5 million

Borrower's cost / benefit for not defaulting:

Scenario I : 18 - 15.5 = 2.5 million

Scenario II : 16 - 15.5 -3 = 0.5 million

Given that in either scenario, the value is more than the current loan outstanding, it would be better not to default. This is purely based upon the current values and does not consider the impact on credit score of the company , ability to access the lenders again nor does it consider any judicial injunctions as a result of strategic default.

Part B. If the loan is re-negotiated to $13.5 million then the gain is $ 2 million but if the lender decides not to renegotiate then the loss in case of default is equal to current value minus the loan amount which is going to 0.5 million. As a borrower, one would have to let go of this value, to default on the loan.

Part C : As a starting under Scenario II, basis the current value and foreclosure costs the net value for the lender is -2.5 million. Now if the lender decides to bring down the loan value to 13.5 million, its net value will still remain same = 16 - 13.5 - 3 - 2 (immediate write off loss) = -2.5 million

Since in either case the financial valaue remains unchanged for the lender, it should not negotiate with the borrower since it can send negative signal to the other borrowers