Insurers brace themselves for oncoming 'bullets.' (intermediate-term loans) (Special Report: Quarterly Real Estate) (Industry Overview)

Stricter capital requirements could add to their woes

Life insurance companies could face big losses from their Los Angeles area real estate holdings in the next year or two as intermediate-term "bullet" loans come due and stricter regulatory capital requirements take effect, industry analysts said.

How insurers cope with their L.A. real estate woes could further devastate commercial property values throughout the county, analysts said, if insurers go the route of financial institutions that have sold foreclosed real estate at below-market prices to get it off their balance sheets.

David Ash, former director of First Boston Corp.'s real estate operations in Los Angeles, said ascertaining the value of Los Angeles area real estate and real estate loans held by insurance companies is very difficult because most studies simply report a national number and don't break the numbers down geographically.

But insurers' real estate woes are not limited to Los Angeles County. Similar scenarios are playing out throughout the country.

Insurance companies' real estate problems stem from several causes, according to Stan Ross, managing partner of accounting firm Kenneth Leventhal & Co., and Dennis Yeskey, a consulting principal at the firm.

During the 1980s, insurers competed with banks to provide short-term or "bullet" loans, typically with terms of five to seven years. Those intermediate-term loans were designed to bridge the gap between short-term construction loans and permanent financing. They're called bullet loans because they require the borrower to pay interest only for the term of the loan, followed by one large "bullet" payment at the end.

Combined with billions of dollars in bullet loans scheduled to come due this year and next, insurers face new regulations adopted in December by the National Association of Insurance Commissioners. Those new regulations require insurance companies to meet stricter standards for capital -- a reserve held against losses -- much as regulators have forced banks and savings and loans to maintain stricter capital standards.

According to Goldman Sachs & Co., domestic life insurance companies already hold $15.5 billion in foreclosed U.S. real estate in their portfolios, with an additional $18.2 billion in delinquent loans facing possible foreclosure.

In February, Hartford, Conn.-based Travelers Corp. announced it would post a $589 million loss related to its decision to sell $2 billion in foreclosed holdings, and other insurers are expected to follow suit.

The insurers, most of them publicly held, must also contend with shareholders pressing for improved balance sheets and higher earnings, plus the need to clean up balance sheets to maintain high marks from credit-rating agencies.

Richard Klein, a partner in Leventhal's investment advisory department, said there is no question that the bullet loans and new regulations will have a substantial impact in Los Angeles.

Klein said the insurance companies bought some buildings outright or in joint ventures, but the majority of their total investment in real estate is in loans, and loans are where the problems lie.

One of the big question for insurance companies, he said, is how to handle the problem loans.

"Do you foreclose? Do you manage the property? Do you restructure the debt? If so, how? These are all the same issues that the banks and S&Ls have already had to tackle," Klein said. "Banks, because of lowering interest rates and some anticipation of the problem, have been able to deal with it fairly successfully."

Ash added that many insurers are already renegotiating their bullet loans. Many of these are actually performing loans on which the borrowers are making payments, he said, but their loan-to-value ratios now are much higher because of the decline in property values. According to Ross, insurers generally are unwilling to lend more than 75 percent of a property's value.

Insurance companies are considering a host of alternatives for dealing with bullet loans on Los Angeles area properties and the real estate they have foreclosed on, known as "real estate owned," or REO, said Klein. Among the alternatives are restructuring loans, selling pools of loans and forming real estate investment trusts to buy assets.

"How the insurance companies deal with the bullet loans is going to be interesting. If they refinance them, with the property markets being so decimated in Los Angeles and around the country, it's a much harder underwriting process to try to get a loan renewed. But they may have no choice because there aren't many other lenders who would want to take on the loans," Klein said.

Selling loans would get them off the insurers' books, thereby improving their balance sheets. Or, by bundling the loans and securitizing them through the formation of real estate investment trusts, insurance companies could reduce their exposure by retaining part ownership of the REITs while at the same time bringing in capital from other investors. Yeskey said Leventhal is already working on at least a dozen REITs for insurance company clients.

Deciding which route to choose will depend on complicated analyses that insurance companies must conduct, and Klein said many of Leventhal's clients are already conducting such analyses.

"You need to know cash flows generated by the properties, likelihood of foreclosure, value of the assets and other considerations before making a decision. Without exception, every insurance company that has any investment in real estate at all should be looking at alternatives and anticipating how to deal with problems," Klein said.

Klein said the current concerns underscore how real estate has come full circle from what it represented for insurers in the 1980s.

"In the past, REO wasn't always something negative. It was positive because the insurance companies at one time made a lot of money from their REO. But today it is generally viewed as the result of a bad loan that has been foreclosed on," he said.