Reading the Lender: The Psychology of the Workout Game

Borrowers hire us to restructure commercial real estate loans, and that often requires the lender to accept a discount. Booking a loss, even when it is the lender’s best available outcome, isn’t something that comes easily. Asking politely or going over an asset manager’s head is not the path to have an institution accept reality. The borrower must show why the discount serves the lender better than the alternative, and why doubling down on a failed borrower won’t hurt the asset manager’s reputation.

Game theory is the study of decisions in which the result depends on what the other party decides. In a workout, the lender decides whether to modify or foreclose based on what it expects from the borrower, and the borrower’s proposal only works if it reads the lender correctly.

During the “game”, waiting impacts the two sides differently. The borrower’s equity is a call option on the property struck at the loan balance. It is worth nothing while the asset trades below the debt, and it captures every dollar of recovery above it, so a few more quarters can take the borrower from a wiped-out position to a viable one.

A discount does the same thing in the other direction, because lowering the debt moves the option back into the money. The lender’s payoff is capped at par plus interest however far the asset recovers, and its cost of funds accrues every month the loan is outstanding. The borrower is long an option that gains value with time; the lender is short the same option and paying to stay in it.

Economics alone isn’t enough. In one component of Game Theory, called the Ultimatum Game, say one player holds $100 and proposes a split, and if the second player rejects it, neither gets anything. A purely rational second player would accept even $10, because that’s more than $0. In practice, people reject offers they consider unfair and give up their own share to deny the other side its $90 (Güth, Schmittberger and Schwarze, 1982). Lenders work the same way. A bad borrower under a modification can be politically damaging to the asset manager and the firm, and some resolutions make the lender look bad for having made the loan to begin with.

Commercial real estate measures success by closed deals. In a workout, every decision impacts the next one, and the consequences may appear several moves later. What follows is the simplest form. One lender, one borrower, one property, and no court.

Leverage

Borrowers often reach out to us after a notice of default, and then ask whether we know the lender. We typically do, but that’s the wrong question. In a workout, the door is open because you’re the borrower, but the goal is the right number and that takes more than a relationship.

When a lender decides how to resolve a distressed loan, it compares the cost of a proposed modification with the expected recovery from foreclosure and liquidation. John Nash modeled that comparison in 1950 (The Bargaining Problem). The side with the better alternative wins, and in a workout the lender almost always has better optionality. A workout has no FOMO on the lender’s side. The lender doesn’t want the modification, it wants its money, and foreclosure is one way to get at least some of it. It can reject proposals and force the borrower to negotiate against itself. The borrower’s leverage, in some cases, may simply be the lender’s reluctance to take back a cash-draining asset. Don’t rely on that.

The lender’s fallback counts only when it pays more than the deal. Binmore, Shaked, and Sutton showed in 1989 that a threat to walk is credible “only when dealing himself out gives the bargainer a bigger payoff than dealing himself in” (An Outside Option Experiment). The borrower cannot remove the foreclosure ace, but it can prove that enforcement isn’t as attractive as the lender assumes. Foreclosure may leave the lender with operating deficits, deferred repairs, leasing risk, and a timetable controlled by the market. Lenders are not operators.

Showing that a takeover is expensive is not enough. We compare current performance with the original underwriting, separating market-driven problems, which help the borrower, from execution problems, which the plan must address directly. If the borrower distributed cash while systems deteriorated, the lender will charge a credibility premium, known in the industry as schmuck insurance. The borrower has an outside option too. Sometimes the right move is to walk.

Reply to Influence

A lender that seems unwilling to “negotiate in good faith” can test even a seasoned investor, but the anger is usually unfounded. The counterparty has the economic equivalent of a loaded gun, and no obligation to act in good faith beyond what the documents require.

Game theory calls the rational reply a Best Response, the choice that produces the best result given the other player’s move. If the other driver is already rolling through the four-way stop, braking is the best response even when you have the right of way. Some lender asset managers speak sharply, respond slowly, and still demand speed and cooperation. Calling counsel at that point is a potential legal case where only the attorneys make money, and what looks like intransigence is usually an asset manager still figuring out the asset. And a good call with an asset manager is not approval. The deal must survive each level of decision-making.

What the Lender Believes

Lenders do not make instant decisions. No matter the distress, they have to learn the asset, the borrower, and the situation, all while pursuing collection and enforcement. The lender models two recoveries, foreclosure versus leaving the borrower in control, and it cannot know whether vacancy reflects the market, the asset, or the operator. If it decides the borrower caused the distress, it may view foreclosure as the better recovery even when the real problem is the floor plate. The borrower, therefore, must manage the evidence that shapes the lender’s view.

The lender forms those beliefs through a Repeated Game. Diligence, negotiation, closing, and post-closing performance each produce evidence about how the borrower will behave in the next phase, including the next loan. If a routine question produces delay and repeated follow-up during negotiations, the lender expects the same after modification. A lack of preparation may be the cause, but to the lender it looks like an unwillingness or inability to cooperate.

That is why operations are part of the negotiation. A property-management failure is a borrower failure that confirms the lender’s worst assumptions. We manage the lender communication so it receives prompt, accurate answers with backup, keep operating expenses flowing while cash is trapped, and keep the lender involved in major repairs so they are pre-approved and funded. The riskier it looks to leave the borrower in control, the more attractive foreclosure becomes.

Commitments

A promise is only as good as the promiser’s motivation to keep it when the time comes. Thomas Schelling showed that “a party can strengthen its position by overtly worsening its own options,” because the other side can rely on a commitment once breach no longer pays.

This is where borrowers go wrong all the time. The lender asks for tough pre-negotiation language or consent to a receiver, and borrowers with a decisive posture take a hard line without understanding the request. The lender is asking for a commitment with teeth. If a defense is viable, preserving it may help for leverage. If it is not, trade it for stipulations the lender values. Where the documents already give the lender a receiver after default, consenting costs the borrower little, and the lender reads the consent as a credible commitment to act in good faith.

An operating shortfall creates an Assurance Game, where each side funds only if the other does. The lender can let payables pile up, foreclose, and leave the vendors behind. The borrower cannot, because it needs those vendors. If the lender agrees to fund part of the shortfall when the borrower covers part, it has made a visible commitment of its own, even if only to keep its options open. The borrower can reject a bad claim on Monday and professionally deliver complete backup on Tuesday. The lender may still reject the proposal, but it won’t question whether the borrower will honor an agreement it would sign.

Design the First Move Last

Backward induction starts with the last decision and works back, assuming each party acts in its own interest at every later step. At CASE, we use it to stress-test an offer before recommending it. The lender’s final choices are to modify, foreclose, or sell the note, and its term sheet is limited to what committee approved, so the borrower’s first proposal must fall within that range. Behind it sits the lender’s decision to negotiate, dual-track, or seek a receiver, which turns on how the borrower handled diligence, consents, and the property during default. The borrower acts first, but that first move is the last one designed.

Dual-tracking raises the borrower’s cost of waiting, and in Rubinstein’s 1982 model the party that can wait longer gets the larger share (Perfect Equilibrium in a Bargaining Model). But the pressure runs both ways. Foreclosure costs the lender legal fees, receiver fees, protective advances, and whatever value the property loses under placeholder management, and once it forecloses it loses every other option. That gives the borrower one last window. A borrower that kept the property operating, within its means, and then presents a credible proposal may give the lender a good reason to stop the clock. A borrower that spent the period stalling is a time waster.

Hold-Ups

Once the cabinets are gutted, a contractor can demand more money to finish. A modification creates the same exposure between term sheet and closing. Take a hypothetical $40 million loan with a nonbinding term sheet for a three-year extension, a $2 million paydown, and a $1 million leasing reserve. The borrower pays the lender’s fees, calls investor capital, lets a refinance quote expire, and signs a tenant LOI. Then the lender’s draft arrives with every reserve release in its sole discretion and cash-management provisions the term sheet never mentioned. Each change can be defended as ordinary lender protection, but packed together they mean the reserve may never reach the tenant and the property’s cash may never reach the borrower.

A lender holding up a borrower doesn’t automatically signal bad intent. Its counsel often creates the hold-up unasked, and the asset manager defers on points called legal even when they move the economics. The borrower’s alternatives have narrowed, so a threat to walk from a deal that still makes sense may not be credible. We negotiate the expected terms before any hold-up occurs and call investor capital ahead of the closing date, because a missed closing can trigger a quick foreclosure.

War of Attrition

Some lenders, especially CMBS, do not wait for a default. A performing borrower may find its cash trapped and its sponsor put on notice over positions the documents only tenuously support. The borrower’s remedy is weak. Modern documents waive damages and jury trials and limit lender liability, and in CMBS the trust indemnifies the servicer, so the cost of a dispute is paid from certificate holders’ recoveries. A borrower expecting litigation to pressure the servicer is misreading the power dynamics.

John Maynard Smith described the War of Attrition in 1974 as a contest in which victory goes to the contestant willing to remain longer (The Theory of Games and the Evolution of Animal Conflicts). A lender that believes the borrower cannot fund a fight will keep pressing until the borrower sues for peace. And even if the borrower proves there was no default, the lender may look for another one, because modern documents do not fit most borrowers’ operations and we’ve seen loans in default from the day they closed. So, before contesting the lender’s position, we audit the borrower’s compliance so its flank is covered when the lender turns.

Borrowers posture wrong in two ways. Some stay accommodating far too long. Others answer aggression with aggression and give the lender the dispute it is prepared to fight, while damaging the good-faith record they will need when that same lender must approve a consent. From the first exchanges, we show that we read the documents as closely as lender’s counsel, that the borrower can remain in the contest, and that neither fact changes our tone.

A workout is decided long before the term sheet. By the time the credit committee votes, the asset manager has formed a view of the borrower from the diligence responses, the consents, the vendor payments, and the tone of every exchange, and the committee judges the proposal against that view, even when the numbers support it. The borrower’s one durable advantage is its knowledge of the property, and that advantage shrinks as the lender’s diligence catches up. Borrowers should call us before the notice of default, at the point where the financials show a decline that isn’t reversing and the borrower has to decide whether to put in new capital. New money either buys time for a plan the lender can underwrite or disappears into the shortfall, and with the analysis done early, the borrower can weigh the injection against a workout or a consensual exit while both are still available.

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