As we have discussed in several previous StreetWise columns, thedistressed asset pipeline, which has been clogged for nearly twoyears, is beginning to loosen up. Lenders and special servicers arefaced with thousands of distressed assets on their balance sheetsand in their portfolios, yet until recently, only a small number ofthese assets have made their way to the market.

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Everything that has happened from a regulatory perspective hasprovided these entities with the ability to avoid having to makedecisions relative to these distressed assets. These regulatorychanges have included changes in the FASB market-to-marketaccounting rules, modifications to REMIC guidelines and bankregulators letting banks hold notes on their books at par eventhough they know the collateral is worth substantially less.

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The Federal Reserve's highly accommodative monetary policy isallowing for the recapitalization of the banking industry which isrelieving pressure on lenders to deal with distressed assetsquickly.

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Additionally, the foreclosure process can be particularly long,cumbersome and complicated (particularly in states other than Texasand Georgia). Many holders of distressed assets are choosing tosell notes rather than wait for the foreclosure process to becompleted which would allow them to sell the assets rather than thepaper.

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Note sales can take two forms. The first is simply a financialtransaction in which a bank or special servicer will pool manydisparate loans with disparate collateral spread throughout astate, region or the entire country. These loans will typically besold to what we call a "financial engineer" which will look at eachloan, determine where it is in the foreclosure process, what can bedone to enhance the note's value and how to maximize the value ofthe individual loans for resale. These buyers are simply buying ona percentage-of-par basis and are looking to make a profit on theslicing and dicing of these pools.

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The other approach to note sales is to simply sell a singlenote, collateralized by a property or a portfolio of properties.The typical buyer here will be a real estate investor who is buyingthe paper to get to the title of the property and own the assets ona long-term basis. These buyers typically pay much more for thenote than a financial engineer will because they don't have tobuild a profit into the process of administrating the foreclosureprocess. This is the type of note sale transaction that MasseyKnakal has focused on in our Special Assets Group.

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If we look at the distressed assets that we have sold recentlyand are currently working on, 78 percent of them have been notesales as opposed to REO ("Real Estate Owned" is a typicalterm used by lenders for properties they take title to after aforeclosure) sales. We expect this percentage to decline astime goes on and the foreclosure process is allowed to finish. Ourlarge percentage of note sales versus REO sales is not surprisingwhen consideration is given to the percentage of recovery sellersare achieving on note sales relative to collateral value.

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Collateral value is the key measuring stick by which wedetermine how effective a note sale recovery can be. I am oftencalled by investors who claim that they want to buy distressednotes, however as soon as they tell me that they wish to buy paperat 50 cents on the dollar, meaning 50 percent of par value, Iimmediately know that they are not serious note buyers and let themknow that they will be unsuccessful in this endeavor. .

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The reason I say this is because if the collateral value is only40 percent of par, they will be overpaying at 50 percent and willlose money. If, however, the collateral is worth 90 percent of par,and they are only offering 50 percent, they are not going to beable to buy anything as savvy investors will certainly outbid them.Therefore, we see that par value is really irrelevant relative towhat a recovery will be.

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A much more important indicator is collateral value or what theasset is worth if the deed were to be delivered. When we areretained by an institution to sell a note, the first thing we do iscalculate the value of the collateral. This amount is thendiscounted by a percentage which is derived based upon taking theentire scenario into consideration. The variables include how faralong the institution is in the foreclosure process, whether theborrower is being cooperative and the quality of thedocumentation.

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Clearly, if a foreclosure process is nearing its conclusion, itis a very different situation than if the foreclosure process hasnot even begun but the note is in default. Similarly, if a borroweris cooperative, it adds value to the recovery. We have donetransactions in which the borrower had a completely adversarialrelationship with the lender, such that we could not even gainaccess to the property. In cases like that, we may not even beaware of the the tenancy in the property. In a scenario like that,the discount for the note would be much more significant than ifthe borrower is cooperative and we have a sense of how the realestate is performing.

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Additionally, it is important to do significant due diligence onthe quality of the documentation that exists. All documents must bereviewed including the note, the mortgage and the intercreditoragreements (to the extent that there is subordinate debt on theproperty). A summary of all interaction between the borrower andthe lender can also be helpful.

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When marketing a note, we move down two parallel pathssimultaneously in that we must not only perform due diligence onthe real estate asset, we must perform due diligence on thedocumentation to fully understand what exactly it is we areselling. This takes tremendous amount of time and effort but isimportant to make sure that all participants in the transactionfully understand what they are stepping into.

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Another factor which greatly affects the recovery on a note saleis the extent to which the seller of the note is prepared to makerepresentations. Some lenders have very complete files and arewilling to make substantial representations about what they haveand what they have done. Here , recovery is enhanced.

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There are, however, some lenders that will only represent thatthey own the note and have authorization to sell the note. Theywill not make any representations beyond this. I am often asked bya lender or a special servicer if a note can be sold under thosecircumstances. My answer is always that everything can be sold andeverything has a price; it is only a question of what the highestprice will be. Understandably, the more definitive therepresentations a lender is willing to make, the higher the finalprice and, therefore, the recovery.

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Note sales have been dominating the distressed asset marketrecently and are becoming more and more popular. This isparticularly true as distressed asset holders attempt to takeadvantage of the supply / demand imbalance that I often refer to inthis column which provides the seller the ability to achievepricing higher than what current economic fundamentals woulddictate. There is significantly more demand than there is supplywhich is resulting in dozens of investors competing for eachavailability.

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Under these circumstances, there is no wonder why distressedasset holders are eagerly entering the note sale market.

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Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered thesale of over 1,050 properties in his career having an aggregatemarket value in excess of $6.2 billion.

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