Corus Bankshares, Inc., incorporated in Minnesota in 1958, is a bank holding company registered under the Bank Holding Company Act of 1956. Corus, through its wholly-owned banking subsidiary, Corus Bank, N.A. (the “Bank”), is primarily focused on commercial real estate lending and deposit gathering. The third, and smaller, business of the Bank is servicing the check cashing industry.
Corus is suffering from the extraordinary effects of what may ultimately be the worst economic downturn since the Great Depression. The effects of the current environment are being felt across many industries, with financial services and residential real estate being particularly hard hit. The effects of the downturn have been particularly severe during the last 90 to 180 days of 2008 and have continued into the first part of 2009. Corus, with a portfolio consisting primarily of condominium construction loans, many in the hard hit areas of Arizona, Nevada, south Florida and southern California, has seen a rapid and precipitous decline in the value of the collateral securing its loan portfolio.
As a result of the deepening problems related to our loan portfolio and our current financial condition, the Company announced in February 2009 that, in coordination with, and at the request of, both the Federal Reserve Bank of Chicago (the “FRB”) and the Office of the Comptroller of the Currency (the “OCC”), the Company and the Bank, respectively, have entered into a Written Agreement (the “Agreement”) with the FRB and a Consent Order (the “Order”) with the OCC. The Agreement and the Order (collectively, the “Regulatory Agreements”) contain a list of strict requirements materially affecting the Company’s and the Bank’s capital, financial condition and operations. In particular, the Regulatory Agreements contain capital directives that require Corus and the Bank to develop capital plans, and the Order requires the Bank to achieve and maintain minimum regulatory capital levels in excess of the statutory minimums to be classified as well-capitalized, and require the Bank to develop a liquidity risk management and contingency funding plan, in connection with which the Bank will be subject to limitations on the maximum interest rates the Bank can pay on deposit accounts. Under the Regulatory Agreements, the Company and the Bank each is prohibited from paying any dividends without, among other things, prior FRB or OCC approval, respectively, and the Bank is restricted from engaging in any new business activities, or resuming its commercial lending originations.
Because Corus’ loan portfolio is concentrated in loans secured by condominium construction loans, Corus is impacted more than most banks by a weak housing market. The continued weakening of the housing market and the general economy has contributed to increased levels of nonperforming assets, charge-offs, and credit loss reserves. As a result, Corus reported a net loss of $456.5 million for the year ended December 31, 2008, compared to net income of $106.2 million for the year ended December 31, 2007. To the extent that the current conditions in the housing market and the general economy continue or worsen, the level of problem assets and losses is likely to increase, which could result in the Bank being placed into conservatorship or receivership, or force the Company to liquidate or reorganize.
In summary, at this point in the housing cycle, we are experiencing significant loan quality issues. The impact of the current financial crisis in the U.S. and abroad is having far-reaching consequences and it is difficult to say at this point when the economy will begin to recover. As a result, we cannot assure you that we will be able to resume profitable operations in the near future, or at all.
Commercial Real Estate Lending
Principal Products and Services
In the first half of 2008, we originated $1.2 billion of new loans. Approximately half of the loans were for the construction of office buildings, largely in the Washington, DC metropolitan area. We did not originate any new loans in the second half of 2008 and have no new commercial real estate loans in process as of December 31, 2008. Due to the uncertain condition of the commercial real estate market, the uncertain pace of future loan payoffs and loan paydowns, the growth in our problem loans, and our desire to bolster our capital ratios, management has decided that this is not the right time to originate new loans. In addition, we are prohibited, under the Order, from resuming commercial real estate lending and from offering new products or services without the prior approval of the OCC. We are unable to predict when, and to what extent, we will begin to originate new commercial real estate loans. The Company is focused on managing its existing loan portfolio in an effort to conserve capital and minimize losses
During 2009, the Company began to offer, on a limited basis, residential loans to potential buyers who were interested in purchasing condominium units for properties that are either owned by Corus or are secured by Corus loans. To date, the Company has closed on five loans and received applications for an additional 14 loans. While the Company does not expect that residential loans will become a material part of its business, the Company hopes that offering these loans will provide some, albeit limited, support for its commercial real estate portfolio.
During the past few years, prior to management’s decision to stop originating new commercial real estate loans, the Company’s lending focused almost entirely on condominium projects, although as noted above, the Company began to diversify its lending during the first half of 2008. This activity breaks down into two broad categories — construction of new projects, and conversion of existing apartments into condominiums. Corus also originated condominium inventory loans which are loans secured by the unsold units of completed condominium construction or conversion projects. Condominium loans represent the largest portion of Corus’ commercial real estate loans at approximately 75% of total commercial real estate loan commitments as of December 31, 2008.
Over 90% of Corus’ loans are non-recourse, meaning that the loan is secured by the real estate, generally without further benefit of payment guarantees from borrowers. The most significant exception is with respect to completion guarantees. Under a completion guarantee, the guarantor agrees to pay the costs necessary to complete the project in the event project costs exceed the original budget. These guarantees do not protect the Bank from decreases in collateral value but they do help ensure that the Bank’s exposure in a project is not higher than originally expected.
We believe that the business of commercial real estate lending is highly cyclical. Because our business model is based on a concentration in loans secured by condominium construction and conversion loans, Corus is impacted more than most banks by a weak housing market, and our earnings in 2008 reflected the severe deterioration in the residential housing market. Since we hold all of the loans that we make from the date of origination to final payoff, we are directly affected by any downturn in the housing market.
Due to continued weakness in the residential for-sale housing market, an increasing number of borrowers are requesting extensions and other amendments to their loans. Corus underwrites such requests carefully. Although such requests may sometimes be viewed as an opportunity to keep profitable loans on our books, an increasing number of such loans are problematic and are categorized as such.
An increasing number of problem loans involve foreclosure litigation. We foreclosed or otherwise took ownership of assets securing nine loans in 2008. Subsequent to December 31, 2008, the Company has foreclosed or is in the process of foreclosing on 18 loans as discussed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Loan Portfolio — Other Real Estate Owned (“OREO”).”
Corus generally has several options with regard to properties acquired via foreclosure. First, Corus could sell the property as a whole to a bulk purchaser. While this may be the quickest resolution, the pricing may be such that this is not a very desirable option. Second, Corus could complete the project, to the extent necessary, and internally manage the process of selling the units individually in the market. Finally, depending on the property and the market it’s located in, Corus may opt to rent individual units until such time as property values recover and a bulk sale is more attractive. Importantly, each property is unique and management will decide on the best strategy for dealing with other real estate owned properties on a case-by-case basis. For a more detailed discussion, please see “Management’s Discussion and Analysis of Financial Condition and Results of Operations— Loan Portfolio— Other Real Estate Owned (“OREO”).”
Generally, Corus requires all the equity and mezzanine sources of funds to be infused into the project to pay for approved project budget costs before Corus begins funding its commitment. As a result, the projects have no interim cash flow and consistent with market practice, Corus’ construction loans almost always have interest reserves. An interest reserve allows a certain portion of a borrower’s interest cost to be “capitalized” into the loan balance over the life of the loan. It is Corus’ practice to set the size of interest reserves such that borrowers will be required to make out-of-pocket interest payments to support slow-to-stabilize or weak loans.
Condominium construction loans carry with them substantial unfunded commitments. As of December 31, 2008, Corus had approximately $1.2 billion of unfunded condominium construction commitments. We focus heavily on total loan commitments and, to a lesser extent, on outstanding balances. We try to maintain liquidity and capital at levels appropriate not only for the funded balances, but also for the unfunded commitments, being cognizant of the fact that loan repayments may not be sufficient to meet all funding requirements pursuant to existing loan agreements.
As discussed above, market risk is the risk that the value of the property will decline such that the proceeds from sales, or from a refinance in the case of apartments or offices, will potentially be inadequate to pay off Corus’ loan. Market risk differs somewhat for each category of loans, as discussed below.
Condominium Construction Loans
When assessing market risk for condominium construction loans, Corus considers both the estimated aggregate sell-out price of the property assuming it was currently complete and ready for sale, and the pace at which the individual units could be sold (absorption) based on current market conditions, as well as the interplay between the two factors.
Presales are one factor that management looks to in an effort to address market risk. While varying from state to state, projects securing our loans often involve presales. Presales can provide insight into the extent of consumer interest in a project as well as provide a measure of value at the time of the loan’s origination. Corus analyzes this information carefully in light of the varying laws and practices in different markets. In addition, due to the deteriorating conditions in the housing market and the overall economy, presales have become less reliable in predicting the success of a project, as an increasing number of consumers have been rescinding presales.
Regardless of how confident management is about what a project might be worth today, or how quickly it might sell out, future economic events, such as the market turmoil that we are currently experiencing, can render those estimates inaccurate. In order to help mitigate the risk of loss, during the origination process Corus limits senior loan exposure on condominium projects to be between approximately 55% and 65% of the estimated aggregate sell-out price of the units at the time of the loan origination. This provides some cushion against market deterioration. Presales, as discussed above, are also relevant as a source of repayment.
Office loans accounted for approximately half of the new loans that we originated during the first half of 2008. As of December 31, 2008 office loans amounted to $659 million, or 11%, of total commercial real estate commitments. When originating office loans, Corus considers many of the same factors discussed above with respect to condominium loans, although the “absorption” relates to the potential for the office space to be leased, as opposed to unit sale potential for condominium projects.
Corus’ office loans do not typically involve pre-leasing to a single tenant or group of tenants. Therefore, Corus must look to other factors, such as leases of similar properties in the area, in order to determine the projected income stream of the property (which consists of factors including the lease price, the percentage of space occupied, and the operating costs of the building). Corus will receive payment on the loan once the project has become stabilized and the owner is able to either sell the property or refinance the property, and use the proceeds to repay the loan. The income stream is an important factor in the owner’s ability to sell or refinance the property, and as a result Corus analyzes the potential income stream carefully.
Corus originated office construction loans with significant equity and mezzanine loan components to the capital structure (typically a 60-65% loan to cost). The budget for an office construction project includes a significant amount for tenant improvements and leasing commissions that are to be paid in the future once leases are signed. If the market deteriorates and the project does not lease at all, the ratio of the Corus loan to total cost would be 5% to 10% lower than if the building were fully leased because of the unfunded loan amount for tenant improvements and leasing commissions.
Rental Apartment Loans
As of December 31, 2008 rental apartment loans amounted to $603 million, or 11%, of total commercial real estate commitments. As discussed in Note 5 of the consolidated financial statements, many of Corus’ condominium loans have been reclassified as rental apartment loans because the owner was unable to sell the condominium units and as a result has decided to offer the units as rentals. As with office loans, no pre-leasing is involved, and the projected income stream of the property is an important factor in determining whether the loan will ultimately be repaid. Unlike office loans, however, the entire project will be substantially completed, and the loan will generally be fully drawn, before the builder attempts to lease the properties.
Condominium Conversion Loans
As of December 31, 2008 conversion loans amounted to only $175 million, or 3%, of total commercial real estate commitments. Because Corus has stopped originating new loans and does not plan to originate new loans for the foreseeable future, conversion loans will continue to be a small part of the Company’s loan portfolio.
Conversion loans typically are used to finance the conversion of existing apartments into condominiums. In some cases, conversion projects include such extensive renovation that management believes the loan is more appropriately categorized as a construction loan. In those cases, management will classify the loan as such.
Conversion loans have different risk characteristics when compared to construction loans. Every project and every loan is different and caution should be used in applying absolutes to the risks associated with any loan. Conversion loans can be safer than construction loans since conversion projects can be brought to market much more quickly, making the length of time they are subject to market risk shorter. Of course, this comparison is to construction loans without presales; presales can change the amount of market risk we undertake. Conversion loans can be riskier than construction loans since the buildings are often not as well located and, as a result, potentially less attractive assets in the face of a market downturn.
The market risk discussion above with respect to condominium loans is as applicable to conversion loans as it is to construction loans. Corus has historically underwritten conversion loans at loan-to-sellout ratios comparable to construction loans. In addition, management routinely includes terms in loan agreements requiring that certain sale thresholds be met in order to avoid an event of default. These covenants help ensure that in the case where sales are slower than expected, Corus can engage in negotiations with the sponsor to amend the terms of the loan sooner rather than later, hopefully while the sponsor still feels relatively optimistic about the project. These amendments might include a further equity investment by the sponsor to pay down the principal balance of the loan, stricter milestones for future sales thresholds that if not met also result in paydowns of the principal balance of the loan and/or principal repayment guarantees from the sponsor.
With respect to conversion loans, Corus attempts to avoid situations where a local municipality has discretionary authority to deny the right to convert an apartment project into condominiums. If local municipality approval is required, Corus would require the approval prior to closing. Finally, similar to construction loans, Corus focuses during the underwriting process on capital structure. This is an attempt to try to ensure that there is a party with enough money at risk, subordinate to Corus, to continue to support the project in a downturn.