Prisoner’s Dilemma: a paradox in decision analysis in which two parties acting in their own best interest pursue a course of action that does not result in the ideal outcome. The typical prisoner’s dilemma is set up in such a way that both parties choose to protect themselves at the expense of the other participant. As a result of following a purely logical thought process to help oneself, both participants find themselves in a worse state than if they had cooperated with each other in the decision-making process.
Fortunately for borrowers with multiple loan problems, privacy laws prevent lenders from discussing their borrower’s loans or financial condition with third parties, including other creditors. Yes, limited exceptions to this rule exist but not in the case we are discussing here. As a practical matter, creditors do not typically conspire against borrowers because in distressed situations, everyone knows the debtor has only a limited amount of assets, so the creditors are essentially adverse and don’t trust one another any more than they trust the debtor.
This particular client faced a difficult employment situation and multiple loan problems, and we had been engaged to assist his attorney. The borrower’s employer was downsizing, and he was laid off from the sales force. Through freelancing he was able to make about 40% of his prior salary. His decline in income made it difficult for him to continue making payments on two ill-advised real estate investments. And unfortunately for him, the lender on vacant land in a failed vacation resort project, Z Bank, also held the mortgage on his home. We were able to actually use this problem to our advantage in one respect.
The lender on the other real estate investment in which he was involved, a tract of land in South Carolina, was a large regional bank, Bank B. He had been making the payments, but we knew it was good money after bad. The Client simply had to stop making payments because he could no longer afford it. The value of the land was 20% of the outstanding loan balance.
Two months after we advised the client to stop paying, Bank B finally made contact, and we spent an additional four months going through a very frustrating process of explaining and substantiating the client’s lack of liquidity, other loan problems, lawsuits, severe income decline, and other personal issues. We seemed to be getting nowhere.
But after six months, two things happened. We received a short sale offer for only slightly less than Bank B’s appraised value (the land had been on the market for 2.5 years with no offers at any price). Bank B wanted a consent judgment against our client for the remaining outstanding balance on the loan in exchange for approving the short sale, which was a deal killer. However, a day or two later the court set a hearing date in the lawsuit Z Bank had filed against the client. The court would consider Z Bank’s motion for summary judgment in 5 weeks.
We quickly explained to Bank B that the short sale had to occur before the hearing because the court was sure to grant Z Bank’s motion for summary judgment. Z Bank would then have a judgment for many times Bank B’s loan (and many times the client’s net worth). If Z Bank put a judgment lien on the South Carolina property before the sale, it would be impossible to sell the property to the buyer or anyone else. Bank B would have to foreclose to extinguish the judgment lien, which in South Carolina means judicial foreclosure, which meant months of delay and expense even if the borrower didn’t contest the foreclosure, which we regretted to inform Bank B he surely would.
Therefore, we proposed that the client would go through with the short sale, but only if Bank B forgave the entire deficiency. We argued that any recovery on that judgment would be more than offset by their expenses, and their judgment would be a fraction of the judgment Z Bank was sure to obtain.
Meanwhile, we contacted Z Bank and advised them that Bank B required a consent judgment to approve a short sale of its collateral and that the parties (the buyer and seller) set a closing date before the summary judgment would be final, such that Bank B could put its judgment lien on the property mortgaged to Z Bank and prevent its sale absent a foreclosure, which we happened to know Z Bank did not want to do because no properties in the area had sold in years.
We were offering 80% of Z Bank’s appraised value, sourced from a family member willing to loan the client the funds. We suggested to Z Bank’s asset manager that they take the offer quickly (before the family member came to her senses). If accepted, Z Bank would take a 70% loss on this loan, but we argued that the property was actually worth about half what the appraisal said, so Z Bank would actually obtain a better recovery by accepting our proposal.
Thus the two banks have a prisoner’s dilemma: if they both take the settlements, they both get cash and resolve their loan. But if Z Bank takes a settlement and Bank B doesn’t, Bank B can then put a lien on what other assets the man owned, which were encumbered by loans but had considerable equity, and get a far better recovery. On the other hand, if Bank B takes a settlement and Z Bank doesn’t settle, Z Bank will have a lien on the equity in the other properties and get a far better recovery. And neither creditor knows what the other creditor will do!
We wanted both to settle, but if only one settled, we would consider it a successful, though temporary, result. We could negotiate with the one remaining bank and reach a settlement. What kept us awake at night was if both banks refused to settle. The client would be crestfallen and might be persuaded into his lawyer’s advice to file for personal bankruptcy in advance of the summary judgment hearing.
Although sometimes that’s a good idea, in this case the client had liquid assets that would be protected somewhat from a judgment creditor but definitely on the table in bankruptcy. We saw taking our chances negotiating on the judgment as the less-bad course of action.
We expected the potential payoff would focus the creditors on the reality of the situation—the borrower has a contract on the property and the buyer (for Bank B) and the family member (for Z Bank) have proof of funds. Resolution is no longer abstraction discussed in weekly meetings.
Thankfully, Bank B agreed to the deal. The bank swept away the usual approval process, which usually takes months, and in 5 weeks the short sale closed, and Bank B forgave the entire deficiency.
That Bank B was a financially healthy super-regional bank made it easier for them to forgive the deficiency, and we had provided mountains of information explaining the borrower’s financial situation and showing that the appraised value was not realistic.
Meanwhile, Z Bank rejected our offer initially and demanded a deficiency judgment as well. But with some cajoling, a few concessions, and a payment plan on an additional part of the deficiency, we reached a settlement. Usually these negotiations would take a couple of months to negotiate, paper up, and close, but this one moved quickly because we presented the consent judgment for Bank B as a done deal—that the property was under contract for short sale and that the borrower would execute a consent judgment at closing.
Nobody at Z Bank asked the right question, which was whether the client had agreed to the consent judgment on the deficiency. We didn’t have to tell Z Bank that giving Bank B a consent judgment was a deal-killer. But if Z Bank asked that specific question, we would have to admit that we were still negotiating the issue and retreated to saying that he would do it only if Z Bank didn’t take the deal. Then things would’ve gotten testy.
Furthermore, nobody at Z Bank ever asked us why in the world our client would agree to give Bank B the consent judgment for the entire deficiency. They did not put themselves in the borrower’s shoes.
This case involved more than a few sleepless nights given what was at stake, but in the end we were fairly confident that each would act in its own self-interest, which was to confess, i.e., settle.
Article Image courtesy of Jeff Prieb.