CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

The Miami Heat’s home playoff games are not going to be the only events drawing attention to sunny Miami next week as IMN hosts its annual REO-to-Rental Forum in Miami. As we have previously discussed numerous times (here, here and here, and OnPoint Updates here and here), the REO-to-Rental asset class has become quite a hot topic and this conference is sure to provide invaluable insight into current trends in the market, as well as where market participants see this class of assets going over the near- and far-term.

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The FDIC's new rules (promulgated per the requirements of the Dodd-Frank Act) for calculating deposit insurance assessments for insured depository institutions, including "large institutions" and "highly complex institutions," are set to become effective on April Fool's Day, 2013. No kidding. As institutions of this type are active investors in CLOs, particularly the “AAA”-rated tranche of CLOs, there has been significant consternation among market participants on the immediate and long-term effect of such new rules.

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While we’re on the topic of Dodd-Frank rules and regs that could have a significant impact on the securitization market, the SEC recently reported the findings of a study it conducted regarding assigned credit ratings for structured finance products – a report required under Section 939F of the Dodd-Frank Act that will subsequently lead to new rulemaking.

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Arguably the largest gathering of capital markets professionals in the world, ASF 2013 had over 5,300 registrants as of Monday morning according to Tom Deutsch, Executive Director, American Securitization Forum. Vegas is bustling and it's always a pleasure to conveniently be out of town when there's messy weather back east.

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Last Thursday, the U.S. Commodity Futures Trading Commission (“CFTC”) responded to ASF’s and SIFMA’s requests for relief from the new CFTC rules which implemented certain Dodd-Frank amendments that brought swaps within the purview of the CFTC.  The new rules, which took effect on October 12, 2012, threatened to regulate many securitization vehicles as commodity pools even though these vehicles typically only use swaps for hedging or risk management purposes.  The crux of the issue, and possibly the unintended consequence of the new CFTC rules, is that, without relief, sponsors and advisors (such as depositors, trustees, collateral managers and servicers) would be subject to CFTC registration and regulation as commodity pool operators and/or commodity trading advisors. 

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Last week, the Federal Housing Finance Agency (“FHFA”) has joined the chorus of opponents, expressing “significant concerns about the use of eminent domain to revise existing financial contracts”.  We at CrunchedCredit have recently covered the eminent domain proposals being considered by Chicago and San Bernardino County.
 

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What if LIBOR is disrupted? Something new to worry about, as if Europe’s slow motion financial train wreck, the U.S. elections, the fiscal cliff, the slowing U.S. economy, Mid-east tensions and uncertainty about the Asian economy aren’t enough. We now have a broken LIBOR to entertain us too!

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Sometimes a bank just has to sell assets. For many banks confronting capital shortfalls, this is one of those times. Last week, we wrote generally about the "Investing in Distressed Bank Assets Conference" in London. Great conference. Marquee headline: EU Banks Will Sell Risky Assets. Time for a deeper dive into issues confronted by the sellers. 

So, if you want to sell a big pile of assets (steaming or otherwise), what do you do? You can certainly hire one of the well-known brokers (er, I mean loan sale advisors) in the market and tell them to have their way with you. They will do some level of loan file organization; produce some type of tape; produce a book (pretty pictures); and set up a war room. They will run a public auction process. They will jawbone the bidders.  Do they do a really good job? Read on. Is this the only option? No.

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Recently, the Wall Street Journal highlighted the arrival of “bad loan securities.” If this is a trend, and I both hope and think it is, we clearly have to get a better deal name for these than “Insert Bank Name”, Bad Loan Securities 2012-1. Securitization of less than ideal conduit product has been with us since the birth of securitization, but reached its apogee in the RTC series, for non-performing loans, in the early to mid 1990s. That transaction architecture is being revived, and it’s about time. Both Fitch and DBRS have published criteria, or at least guidance and the other agencies are beavering away, busy working with bankers to come up with workable ratings technology.

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While wrapping your holiday presents, don’t forget about another regulatory gift that springs to life as of the new year: Rule 193 and the accompanying joys of Items 1111(a)(7) and 1111(a)(8) of Reg AB. The final rules for Dodd-Frank’s Section 945 – which we at CrunchedCredit.com have addressed before - are almost a year old and their effects are coming to a public transaction near you by requiring “issuers” (1) to perform (or have a third party perform) a due diligence review of a deal’s underlying assets with the aim of reasonably assuring that disclosure included in the related offering documents is materially accurate and (2) to disclose in offering documents the nature of the review, any findings or conclusions of the review and any details regarding assets that deviate from the disclosed underwriting criteria. And this is a gift that keeps on giving.

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Not only is football back, but so is Reg AB II. Just as enduring as our love of tailgating and touchdowns is our love of transparency in the capital markets. On the heels of yet another Reg AB comment deadline (see re-proposed rule here (pdf)) now is a good time to check the score. Dechert continues to participate in committee (and subcommittee) discussions with industry specialists and we were happy to serve as nose tackle for the drafting of CREFC’s response/comment letter (see CREFC comment letter here (pdf)). So where do we stand with shelf registration eligibility requirements now that Dodd-Frank and its related regulations have addressed some of the issues included in the second round of Regulation AB from April 2010 (i.e., Reg AB II)?

There is still plenty to talk about with respect to Reg AB II, but some issues are now being dealt with elsewhere. Risk retention was addressed by March 2011’s Dodd-Frank rules and on-going ’34 Act reporting by ABS issuers was addressed by Dodd-Frank’s Section 942(a) and Rule 15Ga-1. Both of those issues have been removed from the scope of Reg AB II. The previous discussion concerning confirmation of reps and warranties has evolved, as detailed below, into a discussion about the role of a credit risk manager and procedures related to repurchase dispute resolution. At least one thing that is still clear: credit ratings are to be eliminated from the shelf eligibility test.

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My team and I have spent the better part of the past eight weeks dealing with Irish loans and other portfolios of…stuff. While the conduit market was imploding, pipelines were being aggressively repriced and loan production was shifting into a very low gear, there has been a full scale feeding frenzy for portfolios of seasoned loans. While new loan originations were being dragged through the knot hole of torturous and ultimately paralytic analysis, millions of dollars were spent in high speed car chases for billions of dollars of seasoned loans in awkward, brief and brutal auctions.

Cognitive dissonance anyone? These are alternate universes. In the Ordinary Course Loan Origination Universe, every proposal suffers the death of a thousand cuts: “OK, maybe it’s a pretty good loan but I need to really understand what happens if the anchor tenant leaves, the president of the management company gets arrested and an asteroid hits Ohio. What exactly happens in the cash flow?”  In the Alternate "Bid ‘Em Up Universe", crappy reps, document defects and weird deal features? Fine! Win the bid!
 

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I just can’t schedule enough time in my day to worry about all the things that seem to demand to be worried about. As I write, this week the Dow closed 630+ down one day and bounced 600 points the next. Yikes.  Between that, the debt ceiling and downgrades, Dodd-Frank, the interminable drumbeat of hostility towards Wall Street and business coming out of the White House, the mess in Europe, the falling dollar, insanely low interest rates, high unemployment, the fact that somehow corporate America seems to still be earning bucket loads of money, and, in general the discomfiting disconnect between our still positive every day deal world and the angst, anxiety and drumbeat of awful news in the macro market, what should we think?  It makes my hair hurt.

But, drawing on my deep and boundless reserve of existential anxiety, I’ve now found a few free moments to worry about the SEC’s new re-proposal on shelf eligibility for asset-backed securities. This missive was released (pdf) on July 26, 2011, and comments are due by October 4, 2011. 

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A new kid showed up on the CMBS block in 2010: the operating trust advisor, sometimes also referred to as, among other things, the senior trust advisor (the “OTA”). During the great recession and credit interregnum, investors dreamt of an independent third party who would represent the interests of investment-grade investors to protect them from the conflicted and potentially nefarious behavior of special servicers who were considered by some to be in bed with the B-piece buyer and to facilitate an improved flow of information on a real-time basis. Someone who would somehow be there for bondholders when pools began to wobble. When the New York Fed was rooting around for a structure for TALF that would not only execute well but would also provide a learning opportunity for the market, they listened to the IG bondholders, and the OTA was born.

For the regulatory community and some elements of the investor community, it was love at first sight. But by late 2010, some thought that the OTA was going the way of the Edsel. A one-hit wonder. Then, in April 2011, the regulators embraced the OTA in their proposed risk retention rules. And now the OTA may be here to stay. Perhaps bowing to the inevitable, most recent 2011 CMBS conduit deals (and some single asset deals) have utilized some form of an OTA. 

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Greetings. What ever happened to those REMIC rules regarding property releases that we blogged and wrote about in 2009 (pdf) and 2010 (pdf)? The REMIC rules were revised in September 2009 to add flexibility to facilitate certain types of servicing transactions. However, under the new rules, if a property release occurs, the loan had to be retested to determine whether it continued to be principally secured by real estate (e.g., secured by no more than 125% loan-to-real property value ratio).

Quite a price for a bit more flexibility! This caused enormous consternation as it was promulgated during a massive cyclical downturn in real estate values which resulted in many properties not being able to pass the new “principally secured” test if a release occurred. And many loans contemplated such a release. In a bold recognition of reality, something not entirely common in regulatory circles, the IRS issued Revenue Procedure 2010-30 (pdf) establishing a safe harbor for certain “grandfathered transactions” and “qualified paydown” transactions. Under the Rev Proc, a loan would not lose its status as a REMIC “qualified mortgage” even if the “new” loan-to-real estate value ratio was in excess of 125% (i.e., if the loan was less than 80% secured by real property) so long as the loan was “grandfathered,” meaning that it was closed on or before December 6, 2010 (and not amended after that date).

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On May 5, SIFMA hosted a Spotlight Series: Risk Retention and Qualified Residential Mortgages.  It was immediately apparent that unintended consequences of the proposed risk retention rules (pdf) abound.

The panelists acknowledged that the regulators had a very tough mandate, and that the rules are way more complicated than anticipated.  It was estimated that approximately 60% of the proposed rule will make its way to the final rule, and that while feelings of annoyance with respect to the drafting of the proposed rule may linger, it is up to the securitization market participants to help the regulators provide us with a clear, workable final rule.

Under the proposed rule, calculation of the amount of required risk retention would be based on a percentage of the par value of the ABS interests in an issuing entity.  The discussion began with a couple questions some of us have already been asking …

What do regulators mean by “par value”?  What is an “ABS interest”?

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Last Thursday evening, Dechert partners in our Finance and Real Estate Group and Bankruptcy, Business Restructuring and Reorganization Group hosted a cocktail party for our clients at our New York office.  The main item on the agenda for the evening was simply to take the opportunity to learn more about what's on the minds of our clients and to discuss the outlook for the remainder of 2011.  Also on the agenda for the night - wine, sushi, taking in the view of the Empire State Building and catching up on the latest activity in the Major Leagues.

With well over 100 people in attendance, we had the chance to hear from a wide variety of clients in commercial and residential loan origination, mortgage servicing and securitization (CMBS, RMBS, ABS and CLOs).  Across the board, I would say the mood was upbeat and optimistic.  Lending is ramping up.  Term sheets are being drafted.  Bankers are talking more about securitization as a viable take out strategy.

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Earlier this month, the New York Supreme Court issued a decision upholding the enforceability of a springing recourse guaranty given in connection with a commercial real estate loan that provided for a full "blow-up" upon voluntary bankruptcy. [Author's Note: the decision can still be appealed: New Yorkers tend to call their trial court the "Supreme Court", their supreme court the "Court of Appeals", their front steps the "Stoop" and their minor league team the "Mets".] Most of our readers are, at this point, intimately familiar with the "bad boy" guaranty and the leverage it provides a lender once the loan hits the fan. Conversely, our readers are also keenly aware of the degree to which sponsors were able to erode the scope of recourse carve outs and isolate liability in poorly capitalized shell entities during the go-go years. The most famous example, of course, being GGP’s ability to run an end-around the bad boy guaranty by filing borrowers and gurantors alike into bankruptcy in 2009 – leaving the holders of $ billions of CMBS paper without practical recourse.

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A few weeks ago, I wrote that it was manifest destiny that the CRE CDO would return to the commercial real estate space.  A lot of people took the time to tell me that I was delusional, at best. I thought I would take a moment to return to the topic and try to establish my bona fides as something other than a knave, a fool, or a foolish knave.

Let’s start with the question of need.  Do we really need this?  Portfolio lenders in need of yield and securitization lenders in need of warehouse capacity are in a day-in, day-out search for leverage. The problem, of course, is that almost all leverage available in the commercial market tends to be short term, creating a durational mismatch against the underlying financial assets.  That situation is bad.  That mismatch killed a lot of players last time.  The CRE CDO addresses this problem with durationally matched financing.  It is also blessedly bereft of the repo mark-to-market.

So that’s the need. It’s real.

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Near the epicenter of the late unpleasantness was that wonder of complex engineering, the CRE CDO. It has been blamed for near everything that went wrong or was wrong in the commercial real estate space. It probably is responsible for the winters of 2010 and 2011.

The CRE CDO, as it was initially designed, was an on-balance sheet term financing facility which was designed to be free of the vicissitudes of traditional bank warehousing restrictions and, of course, the dread mark to market of the repo market. The transactions were often dynamic and had substantial term, often up to 7 years. Whole loans (as well as other stuff) which met the elaborate and complex (more on this later) eligibility criteria could be financed on a rolling basis with the proceeds from the disposition of assets reinvested for a substantial portion of the term. CRE CDO paper was customarily rated. The average cost of funds was substantially lower than what could be obtained on a straight bank facility. 

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Although there is renewed optimism for a vibrant CRE lending market in 2011 (or at least a significantly better market than the prior 3 years), many lenders and servicers continue to face challenges in dealing with delinquent or defaulted commercial mortgage and mezzanine loans (whether held on balance-sheet or securitized). The volume of these “scratch and dent” assets are expected to increase this year and are responsible for continued misfortune by masking positive returns and causing realized losses. Despite this misfortune and the associated headaches, there is appetite in the industry to acquire or aggregate large portfolios of these loans on the cheap, and make a buck or two in the process of restructuring the loans or exercising remedies.

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Leading with the good news, the commercial mortgage finance market is back and growing at a brisk pace.  From a few standalones in the fourth quarter of 2009, we’ve gotten to a remarkable place.  Even during the first half of 2010, while lenders were hesitantly starting to lend, precious few lenders actually had real balance sheet availability for securitization.  That changed.  We’re back!  

Almost as soon as these markets began to function again, complaints about the quality of the loans began to bubble up.  OK, LTVs remain modest and, broadly, we’re not  underwriting pro forma income, but structural rigor and simplicity did not long endure.  Give me a break.  The joke has always been that our business had a seven year cycle and five year memories so that once in every cycle we’d recapitulate the errors of the last.  But five months?

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Here’s a nifty trick.  Back in the days of CMBS 1.0, certain types of large loans included complex mechanics to permit the sponsor to substitute collateral without triggering a prepayment of the loan or a partial release.  These provisions, while perhaps not common, were sometimes found in deals with a lot of homogeneous collateral such as shopping centers, healthcare facilities, retail outlets, etc.  Substitution was a terrific bit of flexibility for a sponsor looking at locking up money on a long-term basis, but seeking to maximize optionality in its business.

But substitution was hard...

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I am on a Halloween kick right now – it’s the elections. I hear Zombies are popular this year.  Zombies indeed.  Do you ever think this could be a deeply sophisticated and sly commentary on our GSEs?  How droll.  They are scary.  How about that for a segue.

The private securitization market for residential mortgages is still dead (like Generalissimo Franco) and the GSEs, attached to a fire hose of taxpayer money, continue to fuel 90% of the United States housing market.  But they are insolvent. What apparently worked so brilliantly for twenty-five years is breathtakingly broken.  Call me silly, but I don’t think we’ve got a sustainable model here.  The good news is that no one else seems to think we have a sustainable model either.  There was a symposium at the Federal Reserve last week on the future of housing finance.  I don’t think a lot of progress was made.  I was passingly concerned to see that almost all of the talking heads were academics.  That demographic may be really good at some things; my guess is not so much at rebirthing a functional housing finance market. It struck me as more can kicking.  When in doubt, talk.  Wonk-filled symposiums give birth to papers, not markets.

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Last week the FDIC approved its final Safe Harbor Rule regarding securitization. That something that sounds so good could be so bad leaves you thinking: can’t we catch a break in trying to repair this damaged economy? To set the stage a bit, the FDIC has a suite of powers, while acting as conservator or receiver of an insured depository institution (“IDI”), to affirm or repudiate contracts and claim or recover property of the IDI. When a failing IDI securitizes financial assets, these powers allow the FDIC to undo the transaction and re-acquire those assets. The possibility that a securitization would be undone by the FDIC is an existential problem for any proposed securitization. But never fear. So long as a transaction meets all the conditions for sale accounting under GAAP, the transaction is proof against the exercise of those powers. Even better, there is a Safe Harbor! Sounds simple, right?

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The final day of ABS East in Miami closed on Tuesday late afternoon and we’re back home with no suntans.

Those of us who didn’t overdo it on Monday evening (we won’t mention names) started Day 3 at a panel discussion titled “Lessons from the Financial Crisis: Required Steps for Rebuilding the Investor Base and Future Sources of Liquidity.”

Talking about RMBS, the consensus is that the economics just aren’t working for issuers, let alone the other impediments to getting deals done these days. Current interest rates on jumbo mortgage loans are too low. Over the next six months, however, at least one panelist thinks spreads will come in and the dearth of alternative investment grade securities that are attractive to investors will help the RMBS sector.

One panelist said that too much leverage cracked the world economy and if institutions become so highly levered again, it will happen again. Insofar as regulations are concerned, many of us agree with him that it is irresponsibility that needs to be regulated.
 

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Dechert attorneys kicked off ABS East by hosting a Day 1 cocktail party at the Fontainebleau that was well attended by our friends and clients.

Day 2 of ABS East is underway. The Monday opening panel-- Restoring Confidence and Rebuilding the Industry: The Role of Securitization-- drew a pretty full house.

The general consensus is that the regulatory bodies are in the way and will cause delay in the recovery of the securitization market. I won't go so far as to claim it wasn't broke and didn't need some fixing, but it's clear the fixing to come is going to take a while. Without definitive rules, potential issuers can not evaluate the cost to enter the market. If we had a more targeted response to our problems from Congress and the regulators we could avoid this delay.

On the resi front, clearly the GSEs have crowded out private issuance, which has been facilitated by Congress and the Fed. Whereas commercial real estate found a natural bottom, the feeling is that resi never did. And, as one panelist put it, "distressed loans continue to pose a lingering cloud preventing meaningful recovery." The question was posed as to why there was nothing much after Redwood in the resi space. Again, the GSEs are dominating that space. Conforming loan limits have never been higher and it's increasingly more difficult to even qualify for a jumbo loan under current underwriting criteria. With CMBS, it's possible to get a reasonable number of loans. RMBS requires many more loans and there's competition for the best loans.

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We’re looking forward to ABS East October 3-5. More than 2,200 attendees are expected to gather at the Fontainebleau Miami Beach to discuss current topics in securitization.  Hot topics this year include Lessons from the Financial Crisis, Restoring Confidence and Rebuilding the Industry, the Role of Securitization in Revitalizing the Economy, Assessing the Changing Face and Needs of ABS Investors, the Role of the GSEs, and U.S. Regulatory Developments.  Dechert attorneys Patrick Dolan, Mac Dorris, Ralph Mazzeo, John Timperio, Cindy Williams, Joe Beach and Laurie Nelson will be in attendance to participate and meet with our friends and clients.

Tuesday morning, October 5, Dechert partner John Timperio will participate in the “Required Steps for Rebuilding the Investor Base and Future Sources of Liquidity” panel.  Tickets are going like hotcakes for this “don’t miss” Tuesday morning opener.

Stay tuned as we will be blogging live from Miami.

By Ralph Mazzeo and Laurie Nelson.

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Last week, the Supreme Court of the State of New York handed down a decision in the battle between CWCapital, representing the senior mortgage debt as special servicer, and Pershing’s andWinthrop’s joint venture, who recently bought the mezz debt in this transaction at a deep discount.  Everyone knows what’s going on here.  The mezz debt was bought as a lever to attempt to get control of the property through, or in the shadow of, bankruptcy.  A successful workout would, by definition, compromise the senior debt.  To prevent that, CW sought injunctive relief to prevent the foreclosure of the mezz debt and they got it.  Unless this is reversed, it’s game over for the mezz because the foreclosure of the mortgage debt is coming up very soon. 

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The gestation of CMBS 2.0 continues apace. A slow pace. The bulk of the deals look an awful lot like CMBS 1.0, but at least one, the Goldman/Citi deal, seemed to come right out of the playbook of the activist investment grade ad hoc committee that has been fulminating for fundamental change in the structure of CMBS. The Goldman/Citi deal saw a B buyer without customary rights to terminate the special servicer, bondholder voting mechanics to remove the special servicer, a consulting ombudsman for the investment grade classes, and constrained special servicer compensation. To say the least, the industry’s notion of what CMBS 2.0 ought to look like has not gelled and will probably continue to see innovation and tinkering for some time to come. Certainly, the industry has yet to absorb whatever risk retention FinReg will bring us as well as possible changes in the structure of representations and warranties and perhaps something to reflect enhanced underwriting.

The talk on the street is that the investment grade buyers responded very well to the Goldman/Citi structure. At the end of the day the structure will follow the money.

So it’s a good time to pause for a minute on the rush to the new structure. Is the new structure, so adamantly pursued by segments of the investment grade marketplace, really an unalloyed good?

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As a follow up to my earlier post, we just issued this article (pdf) about the IRS’ recent Revenue Procedure (pdf) regarding the REMIC rules. The problems inherent in last September’s REMIC Regulations have been well-covered in this blog. In short, the IRS surprised the industry by requiring a mortgage loan to pass an 80% value-to-loan test as a condition to any lien release (the same test required upon initial contribution to the REMIC). While the existing REMIC Rules could have been read to only expressly permit releases of property in connection with a qualifying defeasance, the pervasive view among issuers and their counsel for years was that certain releases (outparcels, condemnation, and partial releases upon pay-down, to name a few) were permissible so long as the release was at the option of the borrower and was subject only to certain objective criteria.

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I know I return to this theme a lot in this column, but the Unintended Consequences Watch needs to be manned day and night. Today let’s talk about 17g-5. This esoteric sounding SEC rule is intended to diminish the perceived failings of the rating agency culture which has been fingered as one of the principal causes of the “Late Unpleasantness”. The notion was that the rating agencies, hired by the issuers, were mired in conflicts of interest and there were few, if any, structural safeguards to protect investors from bad ratings.

17g-5 provides that rating agencies must require a party retaining the agency to rate an asset backed security (including CMBS) to establish and maintain a password-protected website for all other rating agencies. The website must contain all information provided to the rating agency in connection with the rating. This pertains whether information is provided in writing or orally and to information provided by the issuer or by anyone on behalf of the issuer. The information must be loaded into the website simultaneous with its delivery to the retained rating agency. This was purported to provide a structural counterpoint to the pressure for continuously lower levels by issuer procured ratings.

This has some superficial appeal. To the extent that investors were concerned about conflicts of interest, unsolicited ratings seems an antidote to these perceived concerns. Indeed, on first blush, it’s hard to see an argument that unsolicited ratings are bad.

But on first blush I thought the financial crisis that began about three years ago last month, would be over by Thanksgiving. The story of 17g-5 is yet another reminder that financial systems are much more complex than rule makers perceive them and wish them to be. Welcome back, yet again, to the wonderful world of unintended consequences.

In this case, what has flowed from the desire to do good by providing multiple opinions of value to the investors is a system which is likely to degrade the quality of information and analysis available to investors.

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The commercial banks have largely paid it off, GM has paid it off, and even AIG says it will soon pay off the government’s emergency investment to save the Western world as we know it. As to the GSEs: not so much. We’ve got about $150 billion invested in these entities and no end in sight. In fact, as far as I can tell, there’s yet no plan in sight to ultimately come to an end in sight. Clearly, there are hard political questions about these enterprises which the political class have seen fit to dodge or kick down the road. Should they be private businesses? Conduits for subsidized housing? Both? We now know that both is the wrong answer, or at least not a very good answer. Someone said the GSEs are critical because the private markets have abandoned housing. But how can private markets compete with enterprises that have no need to make a profit, and whose debt is backstopped by the full faith and credit of the United States of America. Who’s going to compete in that market place? Moreover, you’d hope Washington is aware that many other advanced Western economies seem to do quite well without such quasi-public vehicles (not to mention without tax deductibility of mortgage payments, but that’s another story).

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As I discussed in my prior blog post, and this article, last September’s REMIC regulations left servicers, lenders and borrowers in a quandary over the effect the new “principally secured by real estate test” would have on troubled multi-property loans with release features. The new rules, in some cases, could have resulted in adverse tax consequences to REMIC containing loans with underlying real estate collateral that had fallen below a 125% ltv. Yesterday, the IRS announced Revenue Procedure 2010-30 which, at first read, provides some relief. The new Rev Proc elucidates the circumstances under which certain modifications will be deemed not to fail the principally-secured test. Specifically, loan modifications that relate either to a “grandfathered qualified mortgage” (generally, a modification effected pursuant to the terms of loan documents executed prior to December 6, 2010) or a “qualified pay-down transaction” (generally, a release of a lien in exchange for a principal pay-down of a qualifying amount) won't result in the IRS asserting a REMIC challenge. Apparently, someone at Treasury recognized the conundrum the new rules created in lien-release scenarios – more information and analysis on the new rules will be forthcoming.
 

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Issuers, investors, rating agencies and other industry participants continue to wrestle with the fundamental changes that will come to define CMBS 2.0. Among the (many) issues raised in the "Best Practices" guidelines issued by CREFC during June’s get-together was a proposal for market-wide, programmatic change to the package of representations and warranties given by securitization issuers. Specifically, investors are calling for the formulation of a market standard list of reps and warrants, and for a standard procedure for receiving any deviations on a deal-by-deal basis. One would hope this would sate the appetite of the investing community – a community ravenous after being starved of ground lease exceptions and knowledge qualifiers during the lean years.

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If there’s a worry bead left to worry, hold it in reserve for Basel III. Basel III (its informal name – it’s actually a patch job on the never really fully implemented Basel II) is the most recent effort by the Basel Committee on Banking Supervision to fix the worldwide financial system. I am far from a master of the nuances of this enormous regulatory undertaking, but I know enough to be worried. As a friend and colleague said, “if the only right answer on Jeopardy to ‘What is Basel?’ were ‘a delightful walled medieval city,’ we might be better off.”

Basel II was never fully implemented, certainly not in the United States. While Basel II generally resulted in a significant relaxation of capital requirements for most lending activities, (that worked well, right), it stipulated that many types of commercial real estate loans warranted uniquely higher capital changes.  These loans, called High Volatility Commercial Real Estate or HVCRE, include acquisition and development loans, construction loans and loans to sectors deemed by the applicable regulators to have higher risks of default and greater loss expectancy.  As Basel II was never implemented here, these CRE rules never really bit.
 

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Goldman and Citi are about to launch a moderate size new CMBS conduit deal. This would follow on the heels of JP Morgan’s more or less successful offering in June. Comparing these two deals is going to be a huge “tell” about CMBS 2.0. If market chatter is right, the Goldman/Citi deal will have many of the bells and whistles at the core of the investment grade buyer’s proposed “Best Practices” wish list regarding CMBS 2.0. Let’s assume for a minute that, indeed, the deal includes a bunch of their “alignment” features, such as some form of “skin in the game”, an independent special servicer not subject to being kicked out and replaced by any B buyer, an operating advisor representing the interest of the investment grade buyer, a bond registrar so that bondholders can more effectively exercise voting rights, enhanced data available to all bond buyers or prospective buyers, a robust web-based disclosure add-on, enhanced representations and warranties, and more data about rent roll on the underlying properties. If so, we’ll have set the table to resolve some of the most contentious issues in CMBS 2.0.

In other words, it will be put up or shut up time for the investment grade buyers. If such a deal is deemed to have traded materially inside JP (adjusted for collateral quality, subordination levels and the like), that will be pretty good evidence that investors are really prepared to pay up for these innovations and that should inform the shape of the new market. If the market senses that these new deal features (many of which have a material price to the deal) do not attract noteworthy better spreads, then the great debate over CMBS 2.0 may be over, and 2.0 will probably continue to look a lot like CMBS we’ve known and loved.

Oh, there will be some enhancements to 2.0 whether or not bond buyers swoon over the new structure. Underwriting will be better (for a while), reimbursement of accrued but unpaid interest will be subordinate to the return of principal, we’ll tweak disclosure, and yes, with FinReg in the books, we’ll now have to deal with some form of skin in the game. Otherwise, 2.0 will equal 1.0. That’s the market for you. Just like in TV land, if the consumer, having said they will only watch Masterpiece Theater, really watches Gilligan’s Island, then we’ll get a steady diet of Gilligan’s Island.
 

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Back from vacation … The sheer joy of re-engagement cannot be captured in words.  But, can there be a better way of restarting than perusing FinReg?  Being the parochial structured finance lawyer that I am, I start with Subtitle D with the Potemkin village-like name of  "Improvements to the Asset Backed Securitization Process" and Section 13, which is the Proprietary Trading or so-called Volcker Rule provisions.  I’ve got some thoughts.

Let's start with the improvements to the securitization process.  The good news, as I’m sure everyone knows by now, is that some sensible asset class-specific provisions for commercial mortgages were included in the risk retention language.  More flexibility in sorting out what alignment of interests ought to look like.  Included was the notion that a B piece buyer could meet the retention requirement as could really good reps or underwriting.

The bad news is, just as in almost every other corner of this massive regulatory exercise in political self-indulgence, all the tough and important issues have been kicked down the road to the “Regulators”.  The scope of that delegation is breathtaking.  The regulators have been invited to sort out what is and what is not risk retention (vertical strip, horizontal strip, L strip), what is the “credit risk” for which 5% must be retained, what are good hedges and bad, what is the minimum hold period for risk, what is high quality underwriting, and what appropriate risk management practices of securitizers ought to be.  Wow!  They can do all that?  We won’t have to think at all.

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Dechert has assembled a team to cover the latest legislative and regulatory developments affecting the CMBS, RMBS, and ABS markets. Each Dechert Securitization Update provides timely information on these developments. For a discussion of several recent legislative and regulatory developments that will shape the future of the securitization markets, please see the latest Securitization Update Dechert has prepared. This Securitization Update includes a discussion of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC's proposal to amend Regulation AB, the FDIC's proposed changes to the "safe harbor" rule, and the SEC's new rating agency rules. To be added to our regular Securitization Update mailing list, please follow this link, fill out all required fields, and check the box entitled "Real Estate and Structured Finance", along with any other subject areas that might be of interest.

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We’ve been promised that the House and Senate financial reform bills will be reconciled in a highly transparent and thoughtful way and be wrapped up and ready for the President’s signature by Independence Day.

I’m trying to be upbeat about this.  There are, after all, substantial benefits to be obtained from certainty, and once this is done, we’ll at least have rules.  We may not like them, but at least we’ll have rules. (OK, the final Bill will probably include dozens of referrals to the regulatory community to make the actual rules, but nothing’s perfect.).  God only knows what to expect when our duly elected representatives, awash in populist outrage and with the clock ticking loudly down to election day, try their hands at making sense of these two ridiculously complicated 1,400 page bills.  Barney Frank will manage the reconciliation process.  Imagine, he has now been imbued with the hopes of the financial services community for a sensical and balanced Bill.  Man bites dog.  You can’t make this stuff up. 

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This article was published by Matthew T. Clark and Stewart McQueen.

The 2010 CREFC Annual Convention has begun in earnest.  Day 1 began for many attendees with a meeting of the Securities and Loan Investors Forum.  This meeting included a lengthy discussion of the Fair Value Purchase Option and a perceived conflict of interest existing when the special servicer holds the securitization's B Piece.  A short break was followed by a lunchtime address from Congressman Scott Garrett (R - NJ), who was vocal in his critique of the current drafts of Financial Reform Legislation that is presently the subject of Congressional reconciliation. We just left the Servicers Forum, which was led by Forum Chair Daniel Bober from Wells Fargo. The Forum is currently working to identify the lessons learned from the past 36 months and to suggest industry-wide changes as we re-imagine CMBS 2.0.  The panel discussed common document deficiencies, issues relating to decision making authority under pooling and servicing agreements and investor frustration.  Next on the agenda is the Opening General Session on CRE Fundamentals, including an overview of the current state of the CRE market and a look toward the second half of 2010.

Depicted in the photo are Dechert attorneys/ bloggers Matthew T. Clark (left) and Stewart McQueen (right) with Larry Kligman from Ventras Capital Advisors LLC

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We’re looking forward to the 2010 June Convention of the Commercial Real Estate Finance Council (formerly the Commercial Mortgage Securities Association) next week at the Waldorf-Astoria in New York City.  From June 14th to 16th, over 700 lenders, borrowers, investors, fund managers, servicers, attorneys, and other industry participants will gather to discuss current topics in commercial real estate finance.  This year’s hot topics will include sourcing new capital, the ongoing role of government agencies and their effect on the marketplace, the re-emergence of securitization (CMBS 2.0) and whole loan markets and on-going opportunities for distressed-asset investment.  Thirteen Dechert FRE attorneys will be in attendance to participate, learn, and meet with our friends and clients.  We will be posting live updates on CrunchedCredit from the event.

Featured blogger Rick Jones will chair the CRE Finance Council PAC Advisory Committee meeting at 9:30am on Monday, June 14th. The PAC Advisory Committee is an essential part of the CRE Finance Council’s mission to promote the ongoing strength, liquidity and viability of the commercial real estate finance markets. Stay tuned for highlights from this and other forums!
 

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I can’t stand it. We now have skin in the game provisions proposed by the SEC, the FDIC, the House of Representatives and the United States Senate. 

On CNN the other day, Congressman Barney Frank said that the most important part of the House Financial Reform bill was skin in the game in securitization. Okay, I know we’re probably stuck with it and the world will not end. Capital formation will be modestly depressed and the geniuses on the Street will work overtime to mitigate the impact of all that excess capital sloshing around. But it pains me to give up the fight. Skin in the game is certainly an attractive slogan and, superficially, it makes a great deal of sense. But no one has really looked at the data.  The worst performing sector in the fixed income world was, without doubt, loans to developers, builders and the like. All of this lending activity was on book or, in the skin in the game parlance; the lenders had nothing but skin in the game.

Hello! Lehman failed. Bear failed. Merrill failed (more or less). The GSEs don’t even bear thinking about.   All of this carnage happened not because the institutions were brilliantly successful in laying off bad credit to dumb investors, but because they had skin in the game. In the CMBS sector, mortgage loan originators generally sold 100% of the risk of the loans they originated, and the sector is experiencing losses generally consistent or somewhat better than the performance of commercial real estate taken as a whole. Again, explain to me how skin in the game is going to fix this?

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CMBS 2.0 is coming, we hope (and pray). But boy, it’s taking its good time about it. Putting aside what our friends in Washington may or may not do to the structure of securitization, it’s remarkable to me how shy we in the industry (and its trade organizations) seem to be about putting a stake in the ground as to what CMBS 2.0 should look like. 

With CMBS 1.0, we built the airplane while flying it, so it's hardly shocking that when tested, some things failed the stress test. On the other hand, we also did a great deal of fundamental work on an industry-wide basis in the early days, to make CMBS work. We created the IRP, the data dictionary and the like. Shouldn’t we do at least that much again?

Now that we’ve had a chance to observe the problems of CMBS 1.0 in the crucible of a wrenching recession, we seem mildly disinclined to take any dramatic action to address structural problems on an industry wide basis.

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The Wall Street Journal and Bloomberg, among other outlets, reported last week that the Royal Bank of Scotland Group Plc is in the process of placing a multi-borrower securitization – the first such issuance to come to market since June 2008. Of course, RBS is facing several hurdles as it trailblazes once-familiar territory. The offering, variously reported to be between $300 and $500 million, would represent a significant tool for other banks in determining pricing for future multi-borrower deals. The offering will also serve as a measuring stick for investor demand in the post-TALF world.

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Note to File:

If you thought about it, when we take something as complicated as a pooling and servicing agreement and then modify it to do a work around changes to GAAP, it’s not going to be pretty. And it’s not. Welcome to the fair value auction. In a CMBS securitization, when a loan defaults, you’d figure the servicer would either work it out, foreclose it or sell it. That’s what we did until 2001 when the accountants concluded that, if the servicer had the ability to try to sell a mortgage loan, the trust would no longer be a qualified special purpose entity or a Q, and the securitization not a true sale. If it’s not a true sale, the mortgages stay on the issuer’s balance sheet and the transaction simply fails to work.

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I’m just about to do another CRE Finance Council (formerly CMSA) PSA after work tutorial. A couple of observations. As a lawyer who packed the sausage casings, it is startling to see how much uncertainty and, in fact, misinformation exists about how a PSA actually works in the community of people who buy and sell bonds and other financial assets. Perhaps not surprising, because who reads these things, except the lawyers who draft them and a few anal B piece buyers, who really need a life? 

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The changes to the REMIC rules (PDF) were intended, at least in part, to ease restrictions on servicers of securitized mortgage loans. However, while expanding the scope of permitted modifications, the new REMIC regulations also impose a requirement that the modified loan be re-tested to ensure the mortgage loan continues to be principally secured by real estate. This generally makes sense REMICs are intended to hold mortgage loans, and this new requirement presumably prevents a servicer from modifying the mortgage loan so as to be secured by other assets, such as credit-card receivables, cash or other non-real estate collateral.

The problem, however, is that the new regulations also require mortgage loans to be re-tested any time real property collateral is released (even if the release is explicitly contemplated by the loan documents). On troubled multi-property loans (with an LTV of less than 80%), this re-testing requirement potentially puts servicers between a rock and a hard place, forcing them to choose between entering into a prohibited modification (resulting in the imposition of potentially severe tax penalties) and incurring liability to borrower (and potentially, junior lenders) for failing to meet the obligations of the loan documents.

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As if we didn’t have enough trouble already, we’re now caught in the political cross-fire between Sheila Bair at the FDIC and the rest of the regulatory apparatchnik of the capital markets. We all commented last week on the FDIC’s Advanced Notice of Proposed Rulemaking (“ANPR”) on the new safe harbor for bank securitization. It seems little more about turf than mission, the FDIC proposed to lard its safe harbor with a number of substantive restrictions on what a securitization transaction would look like, including “skin in the game”, limits on the number of tranches of securitized debt, seasoning requirements on the underlying financial assets and compensation restrictions for the people in the bank responsible for the securitization.

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