Title: L:MSRMSRE West AdminULI Market Distress PresentationULI Market Distress Presentation v8'pptA2XP15 AP
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Financial Distress 101 What Happens When Good
Investments Go Bad
Kevin Fisher, Paul Hastings Josh Myerberg, Morgan
Stanley
22 April 2008
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Financial Distress 101 What Happens When Good
Investments Go Bad
Table of Contents
Section 1
Executive Summary
Section 2
Introduction to Distress
Section 3
What Happens in Default
Section 4
Conclusion
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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 1
Executive Summary
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Executive Summary
Financial Distress 101 What Happens When Good
Investments Go Bad
Executive Summary
- The market environment has significantly
deteriorated over the past year, triggered in
large part by the subprime crisis, decline in the
residential housing sector and an increase in the
overall risk premium (and declining availability
of credit) - Economy
- Overall economic environment remains challenging
according to leading economic indicators - Unemployment rate has increased to 5.0, up from
its cyclical trough of 4.4 (a move of such
magnitude has predicted a recession in 10 out of
10 cases in the postwar period with no false
positives and no false negatives, per Goldman
Sachs) - 4Q07 GDP growth of 0.6
- Credit Markets
- All credit markets have been disrupted, with real
estate markets hardest hit - CMBS spreads have gapped out with AAA and BBB-
spreads currently trading at 346bps and 1,571bps,
respectively (versus 84bps and 207bps one year
ago)1 - CMBS issuance has effectively shut down, with few
transactions priced in 2008 thus far - What Could this Mean for Real Estate Owners?
- Higher borrowing costs
- Declining fundamentals
- Falling asset prices
1
- Notes
- Source Morgan Stanley Fixed Income Research
Securitized Products / US CMBS for the week ended
April 16, 2008
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Executive Summary
Financial Distress 101 What Happens When Good
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Economic Headwinds Leading to Recession
- Economic growth has fallen below average during
2007 driven in part by the housing correction and
the financial markets turmoil - Current challenges likely to persist through 2008
Current U.S. Economic Headwinds
- Consumer-led downturn
- Continuing and intensifying weakness in the
homebuilding sector - Negative consumer psychology surrounding housing
markets - More restrictive lending environment
- Decelerating retail sales
- Ongoing challenges likely to depress growth in
2008 - Housing market expected to remain challenging
through 2008 and possibly through 2009 - Weakening labor market
- Retail sales growth likely to moderate further
due to negative wealth effect from housing - Signs emerging of spillover into corporate sector
Forecast
Source Morgan Stanley forecast as of 10 March
2008
Forecast
Source Morgan Stanley forecast as of 10 March
2008
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Executive Summary
Financial Distress 101 What Happens When Good
Investments Go Bad
Tailwinds Limit Downturn
- A bearish case is made throughout this
presentation. However, there are several
important positive catalysts for the economy - Principal tailwinds
- Continuing global growth
- Weak dollar
- Strong export growth
- Strong business investment
- Rising consumer incomes
- Risk of much sharper slowdown if housing issues
not contained and global growth slows
Current U.S. Economic Strengths
- We believe the downturn may be modest and brief
in duration - Excesses to be unwound are modest
- Housing recession already part-way over
- Corporate environment has been lean hiring and
capital expenditure increases have been modest - Government acting quickly and strongly to spur
growth - The Fed has cut rates and engaged in other
actions to relieve stress in the financial
markets - Congress passed a 165Bn economic stimulus bill
- Weak dollar providing some support to the economy
- Export growth remains healthy, import growth has
slowed - U.S. is a more attractive investment destination
given the weak dollar, notwithstanding the
current cyclical downturn
Forecast
Source Morgan Stanley forecast as of 10 March
2008
Forecast
Source Morgan Stanley as of 10 March 2008
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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 2
Introduction to Distress
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 1 Rising Interest Rates
Financial Impact
- Examples
- Commercial Market
- Refinance of existing mortgages
- Housing Market
- Re-set of Adjustable Rate Mortgages
Base Assumptions
Asset Value 100
EQUITY 20
Net Operating Income (NOI)
7.0
Less Debt Service (80 x 5 interest rate)
(4.0)
DEBT 80
Levered Profit (Loss)
3.0
Effects of Distress
Interest Rates Increase to 10
Net Operating Income
7.0
Less Debt Service (80 x 10)
(8.0)
Levered Profit (Loss)
(1.0)
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 1 Rising Interest Rates
Evidence In the Market
- Credit spreads have widened substantially in the
last year - Borrowers having trouble refinancing at rates
that are covered by operations - In the broader economy, credit markets are
significantly wider then historical levels (1) - 10Y swap spread 61 bps current vs 40 bps
historic average - Baa corp spread 310 bps vs 240 bps
- Junk bond yield spread 850 bps vs 620 bps
- Housing market is facing 1.2 trillion of ARMs
re-setting in the next 5 years
2,500
2,100
1,571
1,071
871
346
Source Morgan Stanley Fixed Income Research
Securitized Products / US CMBS
Source Deutsche Bank / Loan Performance, UBS
- Notes
- Source Merrill Lynch on 03/20/08
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 2 Falling NOI
Financial Impact
- Examples
- Commercial Market
- Orange County office market
- Retail market / retailer bankruptcies
- Housing Market
- Falling wages
Base Assumptions
Asset Value 100
EQUITY 20
Net Operating Income
7.0
Less Debt Service (80 x 5)
(4.0)
DEBT 80
Levered Profit (Loss)
3.0
Effects of Distress
NOI Drops by 50
Net Operating Income (7.0 x 50)
3.5
Less Debt Service (80 x 5)
(4.0)
Levered Profit (Loss)
(0.5)
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Introduction to Distress
Financial Distress 101 What Happens When Good
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Distress Scenario 2 Falling NOI
Evidence In the Market
- Though real estate fundamentals seem to be
holding up generally, selected property types /
geographic areas are projected to decline - Orange County has suffered a 600 bps increase in
vacancy during the last year primarily due to
tenant bankruptcies / downsizing from sub-prime
mortgage lenders (New Century, Ameriquest)1 - Retailers could be put under pressure if consumer
economy continues to lag - Sharper Image bankruptcy and rumors from Linens
N Things could foreshadow additional tenant
softness - Retail vacancies are on the upswing
- In the residential sector, individual incomes
could decline as unemployment rises
Sources PPR, Reis, TWR, Morgan Stanley
calculations
Source Current Population Survey, Moodys
Economy.com, Morgan Stanley
- Notes
- Availability rate source CBRE
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Distress Scenario 3 Declining Values
Financial Impact
- Examples
- Commercial Market
- Refinance at lower basis
- Sale values that require incremental cash
investments - Housing Market
- Home price declines / short sales
Asset Value at Closing 100
Base Assumptions
Asset Value Declines 30
EQUITY 20
DEBT 80
DEBT 80
Effects of Distress
New Asset Value 70
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Introduction to Distress
Financial Distress 101 What Happens When Good
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Distress Scenario 3 Declining Values
Evidence In the Market
- Declining values effect owner returns but cause
distress when assets are worth less then the
debt, particularly when a refinance is imminent - Primarily a concern for short-term debt from
assets bought at peak pricing (i.e., Macklowe) - 5, 7 or 10-year debt maturities potentially at
risk but values have increased - Landlords facing a decision about whether to
support a project that requires more capital when
values have declined may also push properties in
default prior to a refinance - Through March 2008, home prices have declined 11
nationally year-over-year1 - If homeowners need to refinance or decide to sell
because of job displacement / relocation, home
may be in pushed into default
Source Morgan Stanley and NCREIF
Average 5.0
Source Standard Poor's, Fiserv Inc. and Macro
Markets LLC
- Notes
- Source Case-Schiller
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Introduction to Distress
Financial Distress 101 What Happens When Good
Investments Go Bad
Other Examples of Distress
- Distress scenarios can also occur in less obvious
situations - Technical Defaults
- Tripping loan covenants that may / may not be an
economic default but are used by banks to protect
their interests if the borrowers business begins
to deteriorate - Example net worth covenants for homebuilders or
banks while asset values decline - Development Projects
- Projects that have high operating leverage and
require substantial fixed costs before a
liquidity event - Example condo projects
- In all of these cases, the property owner has an
incentive to walk away - from the property, but this is not as easy as it
sounds
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Financial Distress 101 What Happens When Good
Investments Go Bad
Section 3
What Happens in Default
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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Signs of the Real Estate Loan in Distress
- Monetary defaults
- Covenant defaults
- Real estate taxes delinquent
- Property or business operating at a deficit
- Capital improvement needs
- Investors unwilling to make capital contributions
- Subordinate liens, judgments
- Review of financial reports change in financial
circumstances, cash flow
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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Initial Review
- Review legal documents
- Structure
- Completeness
- Defects
- Perfection
- Evaluate how loan has been administered
- Course of conduct
- Representations
- Memos, e-mails in file Smoking Guns
- Understanding lenders goals and capabilities
- Benefits of modification (short term, long term)
- First loss is smallest loss
- Lenders capacity to own, manage or liquidate
- ORE portfolio
- Bank regulatory issues
- Evaluate long term market conditions
- Explore asset sale prospects
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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Initial Review (contd)
- Understanding borrowers goals and capabilities
- Replacement franchisor, operator, tenant
- Management skills
- Reputation honesty
- Capital infusion from borrower or equity source
- Guarantors commitment to transaction or business
- Guarantors financial condition
- Understanding the relevant market
- Value of collateral and borrowers business
- Marketability of collateral
- Business market trends
- Leasehold market trends
- Debt marketplace
- Borrowers refinance or sales prospect
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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Initial Review (contd)
- Understanding the collateral (realty and
personalty) - Condition
- Deferred maintenance
- Environmental considerations
- Appraisals (access to conduct)
- Evaluate project finances
- Potential for commingling or diversion of cash
flow - Leases
- Competing creditors
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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings
Strategies, Techniques and Objectives
- Pre-Workout Agreement/Standstill Agreement
- Preserves status quo
- Sets ground rules for discussions
- Either party can terminate discussions at any
time - Protects lender against waiver, oral modification
arguments - No oral agreements can be made
- Lenders goal obtain borrowers acknowledgement
of debt and waiver of defenses - Loan documents in force
- Without prejudice to rights and remedies
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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings (contd)
Strategies, Techniques and Objectives
- Background considerations
- Identify all necessary parties, sources of
funding, credit enhancements (L/C issuers,
guarantors, mezzanine lenders) - Identify, negotiate and resolve all material
business points early to avoid borrowers
disguised delay tactics - Engagement of financial consultants or turnaround
specialists - Beware oral modification or waiver during
negotiations - Prepare and execute detailed term sheet (subject
to credit approval) - Issue a loan commitment, if appropriate
- Need a formal instrument of modification
- Need for requisite corporate or partnership
authority - Ratification of loan documents, guaranties
- Obtain subordination agreements (or discharge of
liens) - Title insurance payment of taxes
- Always be aware of intercreditor issues
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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings (contd)
Strategies, Techniques and Objectives
- To avoid
- Unrealistic optimism about borrower, borrowers
business, the property or the market place - Needlessly complex strategies or restructure
models - Strategies that ignore essential parties
- Strategies or models where lender has all
downside and borrower has all upside (and vice
versa)
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What Happens in Default
Financial Distress 101 What Happens When Good
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Loan Restructurings (contd)
Strategies, Techniques and Objectives
- Opportunity for enhancements
- Concessions or contributions from other
lenders/creditors - Concessions or contributions from franchisor
- Additional collateral (shares of stock,
partnership interests, business assets, reserve
accounts) - Beware pledge of assets by non-obligors
(consideration, fraudulent conveyance issues) - New or additional guaranties increasing scope
of guaranteed obligations - Cure legal or document deficiencies
- Obtain additional loan covenants or monitoring
rights - Control of project revenue cash collateral
Cash Management Agreement Lock Box/Control
Agreement - Obtain waiver and release of defenses and
counterclaims - Ratification of indebtedness
- Formal extension of matured obligations
- Preserve or improve underlying collateral
(capital expenditures)
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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models
One Lender and Multi-Lender Transactions
- For multi-creditor transactions
- Awareness of concessions, contributions and
business requirementsby other creditors - Relationships among creditors priority
- Lien subordination/Intercreditor Agreement
- Structural subordination
- Deferral notes and debt forgiveness
- Beware tortious interference with contract
- Guaranty coverage/collateral coverage
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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions
- Possible scenario 1 reinstatement of loan cure
short term default - Justification for default
- Amend terms or covenants/back in compliance
- Possible scenario 2 Discounted Repayment
Agreement as an exitstrategy - Tied to market conditions, lenders business
objectives, target market - Example 10mm debt accept 9mm in six months
or 8mm immediately - In non-recourse loan, discount needs to give
borrower incentive to pay the discount possible
equity recapture by borrower - In recourse loan discount in exchange for
release of note and guaranty - Never release note or guaranty until payment or
consensual asset liquidation has occurred
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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions
- Possible scenario 3 short term forbearance
agreement - Six months to cure identified business problem
suspension or reduction of debt service payments - Waiver of covenant defaults
- Waiver of defenses, acknowledgement of debt,
release of claims - Possible scenario 4 longer forbearance (i.e.,
one to two years) tied to - Shortening maturity
- Economic concessions
- Discounted repayment built into restructure
- Additional collateral included in forbearance
agreement - Increasing number of guarantors or scope of
guaranty - Accrual of default rate or interest shortfall,
with waiver upon performance
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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions
- Possible scenario 5 Substantive Loan Restructure
- Restructure loan to conform to market (lower
interest rates, change or eliminate amortization,
less burdensome financial covenants) - Reduce interest rate or principal debt if
borrower infuses cash, stabilizes business,
brings in beneficial business partner or adds
collateral - Principal debt repayment plan with contractual
incentives (e.g., 10mm loan restructure at
9mm pay down 2mm forgive 1 mm) - Tax issues
- Cancellation of indebtedness income
- Intercreditor arrangements
- Possible scenario 6 additional
collateral/guaranties - As consideration for business concessions by
lender - Additional collateral and/or guaranties protect
lender against downside, further business erosion
and insolvency - Expansion of existing limited guaranties
guaranty of tranches of debt
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What Happens in Default
Financial Distress 101 What Happens When Good
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions
- Springing guaranties recourse events
- Interference by borrower or guarantor with legal
remedies - Diversion of cash flow
- Non-payment of real estate taxes
- Fraud
- Mismanagement
- Environmental liability
- Bankruptcy (by or against)
- Material alteration of collateral
- Lenders strategy use workout to fix loan,
collateral and perfectiondefects - Offer concessions/forbearance in effort to fix
collateral or perfection defects (illustrations
internal audit discloses financing statements
never filed) - Obtain acknowledgement of debt/waiver of defenses
- Obtain remedies certainty, finality,
predictability finishes the process
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What Happens in Default
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Alternative Restructure Models (contd)
One Lender and Multi-Lender Transactions
- Deed in Lieu consensual turnover or liquidation
of assets - Business decision to take back or market the
collateral - Predictability
- Speed
- Deed or consensual liquidation faster than
court remedies - Note need foreclosure to eliminate subordinate
liens on real estate - Lenders sale of the distressed loan to a third
party - Speed, certainty, finality, elimination of
further risk of loss - Target market considerations
- The third party purchaser bargains for long term
upside value - Public relations, lender liability considerations
- Ready marketplace purchasers of distressed debt
- Loan to Own strategy
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What Happens in Default
Financial Distress 101 What Happens When Good
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Creditor Remedies and Enforcement Actions
- California has unique rules regarding real
property collateral remedies - Judicial foreclosure
- Non-judicial foreclosure
- One Action Rule
- Mixed Collateral Rules
- Blend of rules in UCC and other California
statutes - Potential impact on
- Ability to pursue deficiency
- Redemption rights of borrower
- Ability to pursue guarantors
- Ability to foreclose on collateral
- Mezzanine loans
- Structural subordination
- Can become owner by foreclosure
- Must then deal with senior lender
- Creditors should be extremely cautious when
exercising remedies
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What Happens in Default
Financial Distress 101 What Happens When Good
Investments Go Bad
Creditor Remedies and Enforcement Actions (contd)
- Bankruptcy
- Automatic stay stops creditor remedies
- Breathing room to attempt reorganization
- Single asset real estate
- Single commercial project with no other
business/assets - 90 days to propose plan or resume monthly
interest payments - Otherwise automatic stay lifted
- Not a panacea the project still needs to work
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Financial Distress 101 What Happens When Good
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Section 4
Conclusion
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Conclusion
Financial Distress 101 What Happens When Good
Investments Go Bad
Externalities
Sustainability
- While distress has a significant economic impact
on both the lender and - borrower, bad projects can have much broader
implications - Sustainability
- Local impact swimming pools rotting in
Sacramento - National impact degradation of land for
unnecessary projects - Exurban sprawl is especially costly. Low-density
residential communities developed at the fringes
of metropolitan areas are often far from places
of employment, as well as from civic, commercial
and recreational destinations. Consequently, such
development results in more road congestion, more
carbon emissions and adverse climate change. The
public services and the infrastructure needed to
support low-density fringe development are
unavoidably inefficient, both functionally and
financially. The Washington Post (April 12,
2008) - Global impact natural resources such as steel /
timber / petroleum products used to build houses
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Conclusion
Financial Distress 101 What Happens When Good
Investments Go Bad
Externalities
Infrastructure
- Infrastructure
- Strain on infrastructure from unnecessary sprawl
- There is a silver lining. Slowing growth in
Southern California signals that the overheated
market is in fact over and that the long,
difficult process of correction, in which prices
return to sustainable levels, is under way. If
local officials are smart, they'll take advantage
of sprawl's apparent stall to plan more carefully
for future growth. In planning terms, think of
this as a strategic pause, a moment to
concentrate on water supply, traffic, school
construction, infrastructure -- all of which tend
to be brushed aside in the press of expansion but
which need and deserve the long look that this
moment may allow. LA Times (March 24, 2008) - Decay of communities that provides services that
cannot be supported by local tax base from a
half-developed MPC or struggling in-fill
locations - The Worchester, MA housing inspector team is a
kind of frontline scout platoon in the city's
ongoing battle against urban decay, a fight that
got much tougher during the last year, as the
mortgage meltdown sent foreclosure rates soaring
in Worcester and across the countryRecent
legal action is part of the city's strategy to
get mortgage companies and banksto take
responsibility for the upkeep of houses that end
up in their portfolios through foreclosure.
Worcester Telegram Gazette (April 13, 2008)
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Conclusion
Financial Distress 101 What Happens When Good
Investments Go Bad
Externalities
Workforce Housing
- Workforce Housing
- Lower home prices have resulted in increased
affordability but capital remains scarce for new
projects - Affordable housing is the latest victim of the
credit crunch that is reverberating through
financial markets. Projects are being canceled
because some of the nation's largest financial
companies, including Fannie Mae, Freddie Mac and
Bank of America, have scaled back their
participation in the federal government's largest
and most prolific affordable housing tax-credit
program, designed to boost construction of
below-market-rent apartments. Wall Street
Journal (March 12, 2008) - Irresponsible product programming exaggerates
impact - Responsible phasing and growth plans along with
thoughtful/ holistic - analysis on the front-end of a project can often
prevent many of - these externalities
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