CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

The conference kicks off on Wednesday with a series of panels discussing distressed debt issues and opportunities for 2013. First up is a panel titled “Market Trends and 2013 Opportunities,” moderated by TriMont’s John D’Amico. The panelists will include David Harrison of PNC Real Estate/Midland Loan Servicers, Gregg Chiota of Garrison Investment Group, Shari Linnick of Trepp, Bliss Morris of First Financial Network and Brian Olasov of McKenna, Long and Aldridge.

The discussions continue throughout the day on Wednesday and include panels such as “Creative Workout Structures” (hosted by Joe Sarcinella of Thompson and Knight) and “New Capital, Bridge and Rescue Lending and Equity” (hosted by Greta Guggenheim of Ladder Capital Finance LLC).

Next up, the balance sheet lenders will take center stage as Dechert’s own Rick Jones moderates a panel on balance sheet lender viewpoints. The panelists will be David Bouton of Citigroup Global Markets, Mike Moran of Allstate Investments, Elizabeth Fitzpatrick of Bank of America, Brian Furlong of NYLIM, Ivan Lehon of Ernst & Young LLP and Greg Null of Carlton Fields. This all-star group will discuss opportunities in the distressed debt market for portfolio lenders as well as hurdles portfolio lenders face in the distressed debt market.

Next up, the mezzanine lenders get a word in edgewise during the “Tranche Warfare” panel moderated by Bill O’Connor of Thompson & Knight. And it wouldn’t be a distressed debt conference if the special servicers didn’t get a say – day one of the conference closes out with “Special Servicer’s Roles in CMBS Secondary Markets” in a panel hosted by Kevin Donahue of C-III Capital Partners. Panelists include Jim Callahan of Pentalpha Capital Group, Bill Landis of Raith Capital Partners, Lea Overby of Nomura Securities International, Isaac Pesin of LNR Partners LLC and Tom Ruffing of CT Investment Management Co., LLC. The panel will discuss structural changes in CMBS 2.0/3.0 as well recent trends and current challenges of special servicing in the debt markets and is sure to be riveting.

Day two starts bright and early with a panel on exit strategies (moderated by Jan Sternin of Berkadia) and continues with “Enforcement of Foreclosure Rights” (moderated by Craig Welin of Frandzel Robins Bloom & Csato). The conference closes out by lunchtime on Thursday with back-to-back panels on the perspective of the B piece buyer, moderated by Nelson Hioe of Raith Capital Partners, and of owners and operators, respectively. Wrapping up at 12:30 on Thursday will give everyone an opportunity to network with old and new friends, and possibly sneak over to the Garden for day three of the Big East Tournament.

Dechert will continue to blog throughout the conference, and we look forward to seeing many of you there. Welcome to New York.

By: Krystyna Blakeslee and David Pildis
 

The regulations prescribed under the risk retention requirement shall (B) require a securitizer to retain (i) not less than 5 percent of the credit risk for any asset (I) that is not a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer, and …(E) with respect to a commercial mortgage, … (ii) retention of the first-loss position by a third-party purchaser that specifically negotiates for the purchase of such first loss position, holds adequate financial resources to back losses, provides due diligence on all individual assets in the pool before the issuance of the asset-backed securities, and meets the same standards for risk retention as … the securitizer. (Dodd-Frank Section 941)

After having vigorously and stubbornly embraced premium capture, having to walk it back in the face of compelling objections from the regulated community (structurally, it would have entirely ended securitization as a viable business) the agencies have, as a consolation prize, embraced a new version as the 5% retention rule. Under this provision, the B buyer, in order meet the risk retention obligation of the issuer, would have to buy 5% by value of the underlying assets, and hold that position for five years.

As those in the securitization world know, the current architecture of the business is that a B buyer buys roughly the bottom 5% of the face amount of the certificates at a significant discount to par or face to reflect the risk of owning the bottom of the capital stack. Broadly, this is the non-investment grade portion of the capital stack. It is also free to sell or hypothecate that position at any time. If compelled to buy 5% by value, it will virtually double the size of the B piece and significantly torque the business model. Bottom line: does the B buyer buy investment grade bonds at the yields that such bonds would attract in the open market, therefore, radically reducing the value of the investment to the B buyer, or does the B buyer buy the entire position up through the investment grade bonds at the same yield at which it buys the non-investment grade, thereby, significantly increasing the cost to the issuer? One side of the trade or the other is going to get gored by this regulatory change. Free market outcomes will be frustrated. Consequently, as the business is torqued to meet regulatory goals, securitization will get less efficient, the cost of capital to the end user will go up and the availability of capital will diminish. That’s what we call unintended consequences.

Well, that’s the headline bad news. But we’re not here today to rehash all the arguments that the rule is intellectually fraudulent and horribly ill-designed to serve its intended purposes of improving the function of the capital markets. Water over the dam. Today, let’s focus on all the second tier questions such a rule, when drafted, needs to address.

Imagine an exposure draft (or, worse, a final or interim final rule) comes out tomorrow (and it might come out tomorrow). What will it say? We don’t know and the tea leaves have been few and far between on this. Here are some of the things that really need to be addressed to make this Rule operational:

• Who will qualify as a B piece buyer? Will there be criteria for minimum net worth, minimum liquidity, capabilities, track record, etc.? Must it be a QIB? A QIL? Or something new?
• Can the position be levered? The statute says that if the Issuer holds the 5% horizontal strip, it cannot lever the position with non-recourse debt. What will be the rule as to the B piece market? The realities of the business model are that yield needs to be quite high to pay for the assumed risk of holding first loss paper. Will there be no more non-recourse lever? Is recourse to an entity that just owns the bonds OK? Must there be a guarantor or sort of net worth liquidity or AUM requirements applicable to it?
• What happens when appraisal reduction eliminates the B piece buyer control (as it does under CMBS 2.0 deal structures)? Must the B buyer continue to hold yet have no control? It would certainly make no sense to anyone entering the B piece business. Does this even carry out the Congressional intent?
• How about when realized losses eat the B piece away? Is the vehicle still in compliance? Must a new B piece holder be designated and agree to hold its bonds in accordance with the obligations of the original B buyer? That seems absurd, not to mention hard to implement and would certainly be the end of liquidity in junior investment grade bonds.
•  What happens when the B buyer breaches its covenant regarding leverage, assignment, hypothecation or the like? Remember the retention obligations attached to the issuer, or in some cases the originator. The B buyer undertook its retention obligations under the pooling and servicing agreement. Who gets to enforce it? What happens if the enforcement effort fails? How about during the period in which the enforcement effort continues? We know that litigation of complex commercial matters in the U.S. courts is not a quick or easy process. Remember that if the issuer fails its B piece obligation it faces civil penalties including three tiers of fines. (Dodd-Frank Section 929P)
• What happens if the B piece buyer becomes insolvent and its assets are transferred by operation of law? Same issue?

What do we do with deals with only investment grade bonds? Shouldn’t there be another exception, maybe based on Section 943 of Dodd-Frank dealing with high quality representations and warranties or the qualified commercial loans or qualified commercial real estate ("CRE") loans (§__.18 to §__.20 of the proposed rules) that might alleviate the need of a B piece in deals tranched only to investment grade? Wouldn’t it be silly to create a B piece in that case just to meet the requirements of the statute? When one thinks of the underlying policy purpose of the statute, a low leverage deal without a B piece should meet it. The proposed rules contain the concepts of qualified commercial loans and qualified CRE loans which could easily fix this. The qualified loan in the proposed rules was insanely narrow and industry research indicated that virtually no loans ever originated for securitization would have met it. The chatter is that it will be designed to be unavailable, forcing issuers to some other form of risk retention. It’s silly when prescriptive rules conflict with sensible policy descriptions and this seems to be the case here. 

Finally, in just the musings of a paranoid lawyer, it’s been two and a half years since Dodd-Frank and these regulations were supposed to be effective two years after implementation which, I suspect, Congress thought would happen tout suite after publication of Dodd-Frank. Now, if the regulations come out in final or interim final form (which, the regulatory types tell me, an interim final rule will begin the two year tolling on effectiveness), the industry will have almost five years since Dodd-Frank. Might some regulatory agency try to shorten that time by adopting this Rule or the substance of this Rule in another context where there would be no two year transition rule? It seems to me the temptation is there and we need to be diligent for any hint that such a bad surprise is being cooked up. OK. So I’m paranoid. But in this political environment I worry about ill-thought through regulations that have more to do with the ideology than the practical delivery of the risk mediation the rules were designed to provide.

By: Rick Jones

We began writing about liquidating trusts well over a year ago. We were delighted to have played an important role in bringing the Rialto transaction to the marketplace. This transaction has many innovative features and was structured to address a range of complex legal and tax related problems that are incident to the pooling of sub-performing and non-performing loans. For a general discussion of tax implications of pooling these sorts of battered assets, see this previous post. 

At about the same time that Rialto came to the market, another deal we worked on - the A10 Securitization 2012-1 - closed. This was an offering backed by a pool of bridge or unstabilized loans. Some of the loans included in this transaction had future funding components. The structure was a melding of traditional CMBS and CLO technologies which balanced the sponsor’s need to manage and nurture bridge product while providing investors with substantial credit enhancement, downsize structural protection and certainty.

Both these transactions are fascinating in their own respects and each had a relatively long gestation as innovation takes both considerable time and effort. But what is most interesting about these two, and a handful of other recent transactions including such things as the L-Star Securitization from 2011 and a number of other bespoke private transactions, is that innovation in the real estate capital markets is alive and well.

The late unpleasantness (as the Civil War is still today described in parts of the South) taught tough lessons about fundamental underwriting and deal structure. Along with the “Lessons of the Fall”, now canonized as received wisdom, such as “no income, no doc” resi underwriting is an oxymoron, B notes will not continue to pay a coupon during a severe market downdraft and never get involved in a land war in Asia, came an enervating anxiety about structure and change, a conviction that keep it simple stupid needed to be the touchstone of our industry for many years to come. 

Really hard lessons tend to be overlearnt and that happened here. Innovation, sophisticated engineering and change are not the enemy. They are central to what we do and mid-wife capital formation. We need to embrace our ability to innovate and adapt.

There are lots of good ideas out there and the industry must continue to be open to them. A10 and Rialto are all about using capital market solutions to provide financing for asset accumulators. CMBS and its analogs are easily adapted to a leverage and not a sale technology. Whether it is par product or a non-performing pool, the capital markets can offer nifty solutions. Innovation married to the basics of credit blocking and tackling, conservative underwriting and robust structures is simply a good thing. 

Look, there may not be adequate capital in the banking sector to meet the needs of the users of capital. That niche is where we play. Do some of these leverage structures look a bit like the late lamented CRE CDOs? Maybe it looks more like a securitized repo or securities contract. Maybe there will be elements of covered bonds and synthetics. There are answers here!

So let’s get over our post-traumatic stress syndrome, stop trying to fight the last war and embrace innovation! As we’ve said before in this Blog, the market knows how to underwrite commercial real estate mortgages and knows how to underwrite managers. Putting those two together to provide accumulation leverage technology for high-quality whole loans or, in fact, non- and sub-performing whole loans, in the rights hands, is doable, so let’s do.

By: Rick Jones

As you can see, I’m pretty good at questions. The trouble is that, when you run a business, you’ve got to come up with some answers. As I’ve said to my colleagues around here, we need to have a view. Not taking a view is taking a view and no matter how daunting the prognostication game can be, you gotta do it.

So, with that said, this is what I think.

·         No deep recession for the United States (if there is, ignore everything below).

·         The job situation will continue to steadily improve, but the new normal of structural unemployment will be 6-7%, not 4-5%. The new normal of full employment notwithstanding, this will lead to continued firming of the demand for commercial real estate space.

·         Private deleveraging will continue, housing will finally make a bottom, and CRE markets will modestly expand.

·         Here in the U.S., we won’t fix the debt problem anytime soon. I hope Keynes was right about aggregate demand and government spending, but I doubt it.

·         EU banks will sell U.S. and EU assets

·         U.S. banks will sell assets in a less panicky way – portfolios will be balanced

·         The EU crisis will have its own “trading range”. The EU will not collapse, no one will leave, but it will not get healthy, either. No European economic growth for the foreseeable future, or until they finally learn high taxation, protectionism and a massive regulatory apparatus is not a recipe for growth.

·         EU countries will not let national champion banks fail, period.

·         There will be a global tightening of credit and U.S. banks will have a material competitive advantage, if our own regulators don’t do more stupid things.

·         Kicking the can down the road on bad loans is getting closer to its final denouement. More loans will get resolved, loan sales, real restructurings and rescue capital trades will accelerate

·         Structured finance will be used broadly to facilitate disintermediation. Liquidating trusts, seasoned low leverage CMBS, and CRE CDOs will all be broadly used.

·         There will be a CMBS business. Modestly better than 2011. What’s broken will trend toward being fixed – bid/ask spreads will come in. Rating agency models will migrate to levels at which capital formation can occur, and the gap between the CMBS bid and the portfolio bid will come in as the portfolio bid will simply be insufficient to deliver all the capital required by a modestly growing CRE sector.

·         Further, regulatory action will continue to be characterized by unintended consequences being markedly more costly than the value of the intended good. This will continue to threaten the recovery and all of the good stuff above.

·         The election matters, hugely. If the market concludes that Mr. Obama will remain in the White House and the Democrats may get more seats in the House and Senate, much of the good news above is materially trumped.

·         Macro/global tail risks are at an all time high. Really bad stuff could completely shuffle the deck.

So what does all this mean for planning? We will see increased transactional activity in the CRE and structured finance space. Our clients are likely to be busy. There will be a premium on ingenuity, and innovation and scale will be rewarded.

So, here’s my plan: Go all in.  We’ll grow. We’ll invest in innovation and deliver scale. When the risk/reward traffic lights are flashing green and the downside risks, while pretty catastrophic, still look tailish, it’s an easy call.

I’m looking forward to 2012; I think.

Even though Dodd-Frank got one of our Golden Turkey Awards, issuers doing public deals must heed these new rules. Some things are clear: Rule 193 only applies to registered deals after December 31, 2011 and does not extend to Rule 144A and private placements, and the rule does not detail the nature or type of the required due diligence reviews or the content of required disclosure.

One might ask: to what extent will issuers (or other securitizers) be subject to additional legal exposure? In CMBS land, we already do detailed loan-level disclosure subject to 10b-5 materiality standards. All securitizers already have detailed underwriting policies and procedures and mortgage loan sellers and sponsors understand the value of internal due diligence standards, so does this new rule really bring with it any new headaches? You bet. Here’s a few:

(1) Scope - the rule requires compliance by “issuers” but it remains unclear whether the goal of the regulators was to include other deal parties like sponsors, depositors or loan sellers within the scope of the new rule. Could the authors, having used the word “issuers,” intended to limit the scope to issuers? Unlikely, according to industry chatter so far; instead, the expectation is that the rule will apply to parties beyond the issuer, including sponsors and depositors. So loan sellers and their counsel must deal with this – at least for now.

(2) Experts - the rule permits the hiring of a third party to conduct the due diligence review but it also requires that the third party consent to being an expert for ’33 Act purposes if the issuer (or other securitizer) “attributes” the review to that third party. What if you hire and rely on your accountants to comfort diligence data? And what if your lawyers review loan documents? If you think that accountants and lawyers will sign up for expert liability under the ’33 Act, I’ve got a bridge for sale. So just steer clear of “attributing” the review to third parties, right? Not so fast: there is some unclear commentary and related discussions among deal parties, questioning exactly what types of third-party back-up reviews may require expert consent even if the securitizer does not fully attribute the review to the third party. This one is also playing out as we blog.

(3) Hot Potato (or Risk Allocation) – How the foregoing scope and expert considerations get fleshed out impacts how lawyers and deal parties will allocate risk including by way of drafting and backing up offering document disclosure, negotiating indemnification agreements and providing 10b-5/159/Reg AB negative assurance letters and opinions. 

Wait, there’s more holiday spirit included in the hang-em-high stocking stuffing provisions of Item 1111(a)(8) of Reg AB. A securitizer is required not only to disclose specific asset deviations with respect to underwriting criteria but they must also disclose the identity of the entity responsible for determining that an asset should be included in a deal pool notwithstanding its deviations. Never mind the Reg AB II certifications that we recently discussed here - anybody eager to sign up for these due diligence determinations? We blogged about this last year when the rule was first published and what we thought then remains true. Rule 193 is likely to expand issuer liability and legal concern while producing little in the way of better disclosure. Just what we need right now.

Seasons greetings! And more to come.

By: Devin Swaney

The seminar consisted of a panel of industry specialists representing issuer, investor and legal perspectives: Paul Vanderslice, Managing Director, Citigroup; our own Rick Jones, Partner, Dechert LLP; Tom Doherty, Executive Director, JP Morgan; Ken Cohen, Managing Director, UBS Investment Bank; Brian Furlong, Managing Director, New York Life; and Bruce Martin, Research Analyst, Fidelity. 

The group considered investor motivations related to the public/private distinction, including whether the appetite of some investors in registered securities is driven by limitations on the amount of private paper that they can soak up or driven by a particular desire to diligence the additional information that is available in a private context.  In addition, the panel emphasized the industry’s (thus far unsuccessful) effort to demonstrate to regulators that the CMBS space, in comparison to other asset classes, has traditionally provided voluminous (and adequate) disclosure with respect to underlying assets and deal structure, whether in a public or private context.  So maybe the line in the CMBS sand is not so bright when it comes to a) disclosure -  because public and private books are not that different; and b) investor satisfaction - because some investors just want and can handle more information, while others have limited capabilities to buy private deals. 

With respect to CMBS 2.0, the panel noted some trends across the board for public and private deals: among other things, the inclusion of (1) mortgage loan seller representations and warranties and related exceptions, (2) enhanced (e.g., Reg AB-compliant) asset-specific and party-specific information, (3) investor Q&A forums and (4) the role of the operating trust advisor (which we at CrunchedCredit.com have previously discussed). 

Unsurprisingly, the group could not avoid discussions of risk retention and premium recapture - hot topics that CrunchedCredit.com has also addressed before.  Additionally, the presentation provided timely regulatory updates, including life with (1) Rule 17g-5 (i.e., no talking to, and instead posting of materials for, the rating agencies), (2) Rule 17g-7 (i.e., comparing a deal’s reps to rating agency benchmarks), (3) Rule 15Ga-1 (i.e., reporting and disclosing repurchase demands) and (4) Rule 193 (i.e., requiring issuers to know their assets).

More generally, the panel expressed a common industry sentiment regarding the many regulatory efforts currently on the table:  just make the rules and we will figure it out from there.

If you missed this after-work episode and the related installment of updates, the instant replay is available here on CREFC’s website.  And one thing you can count on is that there is plenty more to come!

By Devin Swaney. 

Indeed, the theme for the affair - On the Road Again - was apt and matched the overarching zeitgeist present in the lobby of the Waldorf. With perhaps $50b in insurance company lending and $40b in expected CMBS issuance expected by year's end, the industry is back to work in earnest. While eager issuers looked to a return of larger deals, cautious investors expressed some concern of perceived weakening in underwriting standards. Participants discussed the impact of this past spring's roll-out of CREFC's CMBS 2.0 market standards - a comprehensive initiative to provide consensus on Annex A, a standardized framework for loan underwriting principals, an expanded investor reporting package, a model set of CMBS representations and warranties and an efficient, workable model for dispute resolution when the reps go bad. (One particularly frequent topic of discussion was when (and if) issuers would widely adopt the form reps and warrants).

As could be expected, continuing regulatory developments commanded significant attention. Forefront on the minds of the industry, of course, are risk retention, rating agency reform, the status of covered bond legislation and what can be done with the GSE’s. Conversations on Premium Recapture divided investors and issuers – while issuers view the concept as a doomsday device with existential consequences for the CMBS market, investors take the view that it represents an effective risk-retention tool that has precedent in other structured-finance spheres (auto, credit card, etc.). All could agree, however, that the concept, as laid out in the NPR, requires significant refinement.

Day two continued with discussions of the return of a market for floating rate deals as fixed rate competition heats up. As I tweeted, more than a few participants discussed the re-invention of the CRE CDO as a viable financing model (yes, someone will find a way to get a CRE CDO done, and no, it will not be called a “CDO”). We at Crunchedcredit.com concluded the business end of the Conference with dinner and cocktails with close to 200 of our friends and clients at Quality Meats. The food was good and the room was full – very full – a physical manifestation of a market back at work. We were overjoyed with the size of the turnout and the opportunity to rub shoulders (literally) with so many of those we work with throughout the year.

By: Matt Clark

The Rev Proc also provided exemption for a “qualified paydown.” This is a release where the loan’s balance is reduced by a “qualified amount.” A qualified amount, for these purposes, includes an amount equal to (i) the net proceeds of an arm’s length sale of the release parcel to an unrelated person, (ii) the fair market value of the release parcel at the time of the release or (iii) an amount such that the loan-to-value ratio of the loan (as determined by the lender according to an acceptable REMIC valuation) does not increase as a result of the release.

So what does all that mean for a securitizer or mortgage loan seller conveying loans into a deal these days? Essentially, if loans are grandfathered, it’s business as usual. But what about loans originated or modified after December 6, 2010 with release mechanics? Obviously, as the market reflates, more loans going into new securitizations were closed after that magic date. Then we have two options. First, make sure that the loan documents are drafted at origination to be in compliance with the Rev Proc or find and modify any existing loan documents to make them compliant before putting them into a deal. As mortgage loan originator/seller or its counsel, ya just got to focus. Is there a release provision that may blow up the REMIC? What to do if you’ve found a loan originated or modified after December 6, 2010 with non-compliant provisions? Fix it or throw it out.

The servicer’s job has been made easier on this conundrum by CMBS 2.0 practice. CMBS 2.0 documents now generally contain a rep confirming that no releases are allowed in the loan documents other than in compliance with applicable REMIC provisions. This gives an out to a servicer who might otherwise be caught between the proverbial rock and hard place of a contractual obligation to permit a release and its obligation to prevent any REMIC violation. If the servicer discovers a non-compliant release mechanic, the loan can then be put back to the mortgage loan originator/seller for breach of rep. A solution for the servicer. Cold comfort for the originator/seller.

As you contemplate this nifty additional trap for the unwary, remember this release restriction applies to outparcels even if underwritten at no material value, and it applies to partial releases resulting from casualty or condemnation (whether voluntary or involuntary) and releases under a cross-collateralized structure or a multi-property portfolio structure.

Within the tsunami of regulatory change that our industry is confronting, these REMIC changes were a one-day wonder and have since gotten little attention outside servicer land. But this is important, particularly for the originator/seller. At the end of the day, you’re going to give a clean rep that the loan documents comply. A non-compliant release restriction is easy to miss. The price of screwing up is high. Save at least one worry bead for Rev Proc 2010-30.

By Devin Swaney.

Having closed on the acquisition of several A/B structures in past months, I’m wondering if, as our recovery continues, it could be time for a form A/B Colender? The basic architecture of the A/B Colender is already largely understood and could be effectively reduced to a widely-accepted formula. The waterfall, absent any deal-specific fee sharing arrangement, is pretty standard (pre-triggering event, Servicer fees, A interest, B interest and pro-rata fees; post-triggering event, Servicer, A interest, A principal, A costs and then to the B). Cure rights and purchase options could be standardized without necessarily limiting a B Note holder’s ability to negotiate changes from deal-to-deal. (That said, I’ve never quite understood how a B Note holder cures a non-monetary event of default, and in the past few years I think the A would be more than happy to accept a par pay-out on a defaulted loan regardless of whether the requirements of the Colender had been fulfilled). Limitations on transfers of interests in the B Note (more than 49% only to a Qualified Transferee) and the rights of the B Note holder to pledge or finance its interest are, again, largely standard across deals.

I think the two areas where some disagreement could arise would be the servicing transfer mechanic (from interim to PSA) and Controlling Holder control rights. Generally, the loan is administered by a servicer acting on behalf of the A Note - initially, pursuant to an interim servicing agreement; post securitization, pursuant to the PSA. The transition mechanic between interim and PSA can vary from deal-to-deal. Sometimes, the B note holder will have a chance to review and comment on the PSA, sometimes the parties will agree to a form of PSA (something much easier in the days when issuers had form PSA’s to attach), and sometimes, the Colender will limit changes to certain material terms or definitions (control appraisal events, for instance). With CREFC spearheading an effort to produce a form PSA (presumably containing market-standard provisions that adequately protect the holders of non-pooled components), at least some of the heartburn felt by issuers (“I can’t have the B Note holder holding me up!”) and B note holders ("I’m not getting jammed with a terrible PSA!") could be averted.

Controlling Holder control rights are probably among the most negotiated portions of these agreements - the list of consent and consultation rights ranging widely from deal-to-deal. In practice, however, it's not always clear that a long litany of controlling holder rights beyond the basics (i.e. rights that put the Controlling Holder at the nexus of a proposed workout) are necessarily that helpful when things hit the fan. And, of course, these rights could easily be negotiated on a deal-by-deal basis – why not start from a form? In addition, a form would allow for a more streamlined control appraisal mechanism (including standard rights for additional appraisals and threshold collateral) – especially if a form PSA should gain traction.

Like a lot of us, my experience with Colenders during the Crunched Credit era often followed a similar pattern - debt syndicated on co-lending arrangements that anticipated - no, needed - the A to be securitized; the servicing arrangements outside of the predicted PSA left vague, ill-defined (or, in some cases, just broken). And then the music died. (This is all more than somewhat understandable - few clients found it worthwhile to commission robust, fully-textured interim servicing agreements to administer freshly-minted mortgage loans during the months between origination and securitization. It's just that loose interim servicing arrangements and co-lenders dependent on a future PSA only work until they don't).

To be clear – I’m not suggesting each deal could be spit out on a standard form or that there isn’t significant value in thoughtful, zealous negotiation between parties on these points (I mean, I’ve spent the better part of my career having these conversations). But as CMBS 2.0 loans continue to be originated and sold, a model Colender could contribute to a more efficient market with reduced transaction costs.

By: Matt Clark

The discussion began with a summary of where we stand. Pace for domestic CMBS issuance is around $40b in 2011. Obviously, a small fraction of 2004 – 07, but still a big jump from 2010 (let's let '09 alone). Nine US deals have priced so far this year that I’m aware of, and the pipeline is equally encouraging, with reports of six more deals slated for May and June. It's important to note that this activity is occurring at a time of relatively significant uncertainty - no one is quite sure what the landscape will look like when the regulators finally declare victory (especially as it regards risk retention (see also here), and we're still waiting to see how 2.0 best practices will work their way into deals (for instance, whether issuers will adopt the form reps developed by CREFC). Meanwhile, the life companies, as a group, seem to have been the most obvious beneficiaries of the (heretofore) sluggish recovery of CMBS lending – they will essentially match CMBS lending this year and are similarly in-line with bank portfolio lending.

The presentation asked the panel to discuss their approach to a series of hypothetical properties – the stabilized, suburban office complex, the un-stabilized downtown office tower, the grocery-anchored retail development, the urban boutique hotel - and to explain their strategies for hitting the bid. The similarities among the panelists analysis was striking as each walked through their concerns on the underlying fundamentals (location, tenant mix, sponsorship, recourse). The major differences? Surprisingly (or maybe not surprisingly) not nearly as pronounced. At this point in the cycle, the Life Co's and Banks are competing (more or less) for the same deals as the CMBS lenders (albeit, it seems these days, the Life Co's are winning). There was some concern expressed that this may drive CMBS lenders to lowering underwriting standards. I’m less cynical on this point – from what I can tell, CMBS lenders - for these past four years cast as the Azazel of all that is poor underwriting - are looking at the same fundamentals as everyone else.

After the event, I joined some colleagues for dinner with clients … clients that were delayed a full hour at the office. More green shoots, I suppose. It will be a really good sign when industry "After-Work" seminars don't get rolling until at least 8:30.

By Matthew Clark.

Still, the bad boy guaranty (together with amendments to the Bankruptcy Code rendering single-asset bankruptcies less attractive to borrowers) did, in fact, work to reduce the number of bankruptcy filings during this most recent downturn and provided lenders with a measure of dry powder when seated at the negotiating table. A warm-body guarantor is often thought of as the gold-standard of behavior modification – no one wants to explain to their children how their college fund was paid over to a CMBS trust. Of course, a high-net worth entity can be equally as effective – so long as its assets extend beyond the subject real estate. Lenders’ confidence should be bolstered by the recent Empire State decision, which is in line with the majority of legal precedent on this issue:

● Blue Hills Office Park LLC v. J.P. Morgan Chase Bank  - Massachusetts court applies plain language of guaranty to uphold claim arising from misapplication of settlement proceeds;

● CSFB 2001-C-4 Princeton Park Corporate Center, LLC v. SB Rental I, LLC – New Jersey court rejects argument that recourse guaranty constituted an unenforceable liquidated damages provision;

● GCCFC 2006-GG7 Westheimer Mall, LLC v. Edward H. Okun - New York court finds guarantor liable for full amount of the loan after voluntary bankruptcy petition; and

● Diamond Point Plaza L.P. v. Wells Fargo Bank, N.A. – Maryland court holds guarantor responsible for full amount of loan after misapplication of rents and failure to maintain SPE status.

Recent vintage loans are, generally, including expanded carve-outs that are supported by stronger credit (indeed, the CREFC model representations and warranties include a specific representation on the presence of a recourse guaranty). Moreover, there has been a significant push by 2.0 issuers and rating agencies to require foreclosing mezzanine lenders to provide a substitute guaranty from credit-worthy entities - in some cases, that meet objective asset and shareholder equity thresholds - as a condition precedent to foreclosure (whether or not the existing guarantor is released).

Alternatively, sophisticated borrowers – themselves weary from the battles of the past half-decade – are now insisting that mortgage loan guaranties burn-off after they’ve been removed from control as a result of mezz foreclosure. Telling the kiddies that the tuition is gone because your mezz lender filed the property into bankruptcy is a different conversation altogether.

By Matthew Clark
 

Nonetheless, the model reps are very instructive as to those issues that are weighing mostly heavily on the minds of CMBS investors as they look to allocate risk in CMBS 2.0 structures. And – while certainly not an investors’ wish-list by any means – the model reps do, in some ways, represent significant risk-shifting on many issues – particularly as it relates to underwriting practices. A game changer? Maybe, maybe not – but it will be interesting to see how investors (B-piece buyers in particular) use this set of reps and warrants to lever increased reps and warrants on a going-forward basis.

I’m in the process of comparing the model reps to the deals that have populated the 2.0 market thus far and will be preparing a more detailed review of the final rep package once it’s released. The following, however, is an (unscientific) preview of the features contained in the CREFC model that could been seen as new additions to traditional CMBS loan seller reps:

• Representations that the origination, due diligence and underwriting performed by the loan seller materially complied with its internal origination, due diligence, underwriting procedures, guidelines and standards for similar loans, as well as a representation that interim servicing was conducted in accordance with industry standards;
   
• Representation that the loan seller obtained a certified rent roll and operating history within 180 days of the date of origination of the loan;

• Representation that the loan seller obtained an organizational chart reflecting all equity owners of 10% or more of the equity in the property, as well as representations regarding know-your-client processes and credit-checks;

• Significantly expanded representations regarding lease estoppels for retail, office and industrial properties, including requirements that lease estoppels be requested of all commercial tenants and requirements that estoppels be received from tenants representing 65% of in-place rental within 90 days of the origination of the loan;

• Expanded representations regarding site visits, including representations that the property was inspected within 4 months of origination and 12 months of securitization, and that an engineering report was obtained within 12 months of securitization;

• New reps for hotel properties, including representations regarding the enforceability of franchise comfort letters;

• Substantial revision and clarification to common MLPA insurance reps that reflect the input from several CMBS-industry insurance consultants;

• Increased scrutiny of originator due-diligence with respect to the adequacy of licenses and permits required to operate the property; and

• Representation requiring recourse liability to guarantors that are natural persons or entities that have assets independent of equity in the property.

Many of the reps obviously represent a significant departure from the reps and warrants we were accustomed to, and, inevitably, many could become susceptible to litigation abuse. But in light of what was being pushed by investor groups last summer, it’s clearly a heavily-negotiated product. Perhaps perfectly so – a set of reps and warrants that makes everyone unhappy.

After the seminar, we had dinner with a client (from one of the larger CMBS investors) in TriBeCa – the place where if you don’t call De Niro “Bobby” they’ll know you’re from Boston. Over appetizers, I asked him whether, after having attended the seminar, he’d push to stretch issuers on reps going forward. But as Jimmy Conway would say, “never rat on your friends and keep your mouth shut” .

By Matt Clark.

CREFC President Lisa Pendergast opened with a warming message to attendees highlighting the great work CREFC and its members have done during the past 12 months, making special note of the commencement, in earnest, of the "healing process" of our industry that is now in full effect.

The important work that CREFC's members do for our industry should be noted. DC is a particularly appropriate venue for this year's conference. The work CREFC has accomplished on behalf of the mortgage industry in Congress - specifically as it relates to Dodd-Frank - has been critical. Moreover, the work of the CREFC Task Forces (literally hundreds of industry participants motivated solely by a desire to shape CMBS 2.0) has made amazing progress in developing best practices for Loan Underwriting, Representations and Warranties, PSA's and Annex-A’s.

The conference now underway, we will certainly be posting more as the conference develops.
 

By: Matt Clark

Certainly a sort of Gresham’s Law is at work here: aggressive underwriting drives out conservative underwriting.  There’s a shocker.  But the pace of change has caught most market participants, and certainly me, by surprise.  I thought we’d muddle along with relatively low LTV structures on essentially problem-free real estate assets for the better part of a year before starting to see what we’re already seeing.

On reflection, however, what’s happened shouldn’t be a surprise.  The genie does not go back into the bottle.  Technology does not get unlearned (Dark Ages aside arguendo).  We’ve developed sophisticated financial engineering, a set of structures and documentation to work around innumerable issues presented by “challenged” properties.  That technology is not going away.

So the originator agreed to alter the spread based on subsequent performance?  No problem!!  One, prepare an A/B.  Two, shove the variability into the retained B.  Three, size and price accordingly.  So the borrower needs to take a property out of a multi property loan?  Voila!  Bake in a substitution mechanic (and more easily now given REMIC reform).

Moreover, we need lots of mezz and we need B notes.  That just is.  The rigor of LTV, combined with a still very benign interest rate environment means that LTV caps mortgage loan size, leaving plenty of revenue to service a high yield coupon.  Welcome mezz and B Notes to close the gap between CMBS 2.0 (or is that more like 1.01?) and the borrowers' hunger for proceeds.

Loan performance is measured through the dual metrics of the incidence of default and the severity of loss.  Complexity and structure tend to go to the severity.  As long as LTVs remain modest and underwriting remains anchored to in-place cash flows, who really cares about pesky structural complexity?  The loan won’t go bad, right?  Ya just gotta believe to play.  Let’s face it, complexity is fun.

By Rick Jones.

We need to get on with it.  There are already lots of good ideas in circulation.  We’re not going to get any smarter.  We do not need more symposia. Official leadership just needs to get out of the “I’ll think about this some day” box and into the “do today” box.  When your pants are on fire, stop worrying about the tailoring!

A few things seem obvious to me.  First, there will be a private securitization market again.  That market, when not crushed by a giant securitizer with zero cost of funds and no need to make a profit, will re-flate.  Simply and syllogistically, the need for credit will be met by supply.

Second, the government is going to continue to fill the role of guarantor of last resort.  Okay, some countries, many with much larger governmental sectors than ours, seem to have done pretty well without a government role in housing, but that train has left the station.  There’s a notion that government needs to remain a final bastion of defense against the next housing apocalypse.  That is received wisdom and will be part of Housing Finance 2.0.

Third, we have two great organizations full of bright and hard-working people who can and should be part of the solution.

So let’s stop kicking this can down the road.  The outlines of the solution are apparent.  Freddie and Fannie need to be re-launched using some variant of a good bank/bad bank structure.  A private tranche of guaranty capital must be developed with some ultimate governmental backstop bought and paid for.  Paying a premium for a federal backstop, at least on some type of mortgages, will even-out the playing field and open the tap for private money and conventional securitization.  We need that.  Otherwise, housing will continue to be starved for capital and, simultaneously, suffering as a political football.  I personally think some sort of co-op structure, such as can be found today in the federal home loan bank system, seems appealing.

The problem is, of course, politics.  The GSEs have been a third rail. Fixing them will take courage. Within a week, the election will be over and perhaps we’ll get down to business.  The Treasury, the GSEs and the business community should be able to sit down and sort this out.  Fundamentally, it's not that hard. And it’s hugely important.

By Rick Jones.

We’ve beaten to death the nexus of conflict between a B buyer with termination rights and a special servicer intent on doing its bidding. Done. Agreed. What we got in return may be a special servicer that is incredibly hard to replace and is perhaps insensitive to bondholder concerns. In the Goldman/Citi deal, seventy-five percent of the bondholders must vote to replace the special servicer. Seventy-five percent! While the deal created the infrastructure for a voluntary bondholder register, it is unclear whether it will work at all. My bet is it doesn’t. My bet is bondholder removal initiatives will make hen’s teeth seem common.

So we have a special servicer for life and a fairly toothless B buyer who will have substantially less tools at hand to hold the special servicers’ feet to the fire. Is that a reasonable price to avoid the conflict? For those around in the early days of the business, we saw a full and robust debate over whether the B buyer at the bottom of the capital stack with the unfettered right to remove the special servicer was good or bad and the conclusion was that it was good. To borrow from Mr. Churchill, it was the worst possible system for enforcing the rights of various bondholders as a collective whole, except for all of the others.

And then you have an ombudsman. An ombudsman is essentially limited to cajoling and jawboning. Will that really improve the performance of the servicer? I doubt it. Will it create more transactional friction in the system that is already not exactly a paradigm of German engineering? For sure. Will it generate emails and correspondence which will potentially be grist for the mill of aggrieved borrowers who don’t like any particular decision of the special servicer and are looking to attack it? Certainly. Will this really move the ball forward? I think the question is on the table.

Finally, at least finally for purposes of this brief piece, special servicing compensation has been suppressed. Competition is certainly a wonderful thing and it can generate efficiency and enhance performance. On the other hand, if you pay peanuts sometimes you get monkeys. Is there enough compensation here to motivate the special servicer throughout the term of this long term relationship? Is the compensation competitive enough here to attract a replacement in the event the bondholders somehow get to the point they wish to remove the special servicer. I don’t know the answer, but I think the debate on these issues have been short of full and robust.

Standby. I don’t think we’re at the end of the experimentation that will ultimately stabilize into a CMBS 2.0 – no one should jump to conclusions in these early days.

By Rick Jones

What exactly will be included in the CMBS 2.0 rep package is being debated by market constituents. One overriding issue being driven by the investor community is the inclusion of some derivation of representations regarding underwriting practices. Investors will push hard for reps that underwriting procedures were generally in-line with “market standards”, or that the underwriting of a loan complied with the originator’s own best practices. We could also see a push for issuers to stand behind their underwriting on a more granular level – including representations regarding the issuer’s receipt and review of current rents rolls and historical operating statements. These representations will be the source of stress for issuers; good underwriting – always more of an art than a science – is difficult to shoehorn into a clear representative statement.

Will the model reps catch on? Perhaps not – as highlighted in this blog, deals are getting done in advance of any widespread agreement on rep and warranty expansion. And practically, while CMBS 1.0 reps and warrants were never quite “fixed”, there was a pervasive understanding of the universe of statements given from deal-to-deal. I also might suggest that the real effects of any deterioration of reps during the boom years (if there really was any) have been overplayed – in the vast majority of circumstances, the contributing causes of widespread loan failures would not have been resolved by greater representation or disclosure, no matter how robust.

However, if a new rep package is widely adopted, lenders will need to be very careful to ensure that their form loan documents include the appropriate provisions in order to stand behind the reps they will be expected to deliver.

And that’s just for commercial real estate.  Our duly elected representatives have tied themselves into knots trying to square an ideological commitment to risk retention with the dawning realization that a private residential securitization market may be critically needed and is on life support and may not tolerate any risk retention.  This broad rush to regulate will almost inevitably result in an overly intrusive and complex set of rules, burdening an already weakened capital formation process far in excess of the benefits conferred.

The second bit of good news may be that the effective dates of these rules have been pushed out into the dim recesses of the middling long term.  Courtesy of Senator Crapo and others, the Fed, FDIC, SEC, and Office of Thrift Supervision (why in the world is the Office of Thrift Supervision still involved? It’s done, isn’t it?) have been, first, directed to study all of this, particularly its impact in light of FAS 166 and 167, before beginning to develop regulations.  So, if my math is right, the study is going to take at least 90 days (with luck a little longer) to complete, then Congress is supposed to react and presumably give further direction to the Regulators.  That’s got to take some real time, right?  Then the rules have to be crafted, which almost certainly will take a very substantial amount of time.  Finally, the effective date for CMBS is 2 years after that.  In a world where we see more game changing news in a week than we used to see in a year, three plus years to implementation sounds a lot like forever.  A lot can happen before forever.  A lot can change.

More on this later, but let me spend a moment on the proprietary trading ban.  A couple of weeks ago, I got myself into a lather worrying that the prohibition on proprietary trading, as written in the framework Senate bill, banned securitization.  The bill said that a depository institution (and affiliates) could not buy or acquire a financial asset with the intention of selling it.  Okay, I’m paraphrasing a bit there, but that’s the gist.  Lo and behold, the final bill contains a specific carveout for securitization.  It’s buried in 13(g) Rules of Construction and it’s worth quoting in its entirety: 

"Nothing in this Section shall be construed to limit or restrict the ability of a banking entity or non-bank financial company supervised by the Board to sell or securitize loans in a manner otherwise permitted by law."  

A nugget of good news, indeed.  I almost cried.

So, what’s it all mean?  Just that the regulations contemplated by these four Sections of the Bill may give us a tome to rival the Internal Revenue Code.  But that won’t happen for a couple of years, and, as I said, a lot can happen in that time.  Does this stop the SEC or the FDIC from pushing forward with their own skin in the game rules?  One might think that the provisions requiring a study to be completed by the applicable regulatory agencies before rule-making commences, a directive to all applicable agencies to coordinate rule-making and a two year effective date might strongly argue for a deferral of the current rule-making process (and note the current comment period for the FDIC version expired July 1, and for the SEC, it expires in early August).  Such a deferral would be consistent with the spirit of the Act.  We should strongly argue that current rule-making efforts be suspended.

It’s important for the industry to remain engaged on this and on all the major regulatory initiatives that will flow from FinReg.  We need to continue a robust educational effort with the regulatory constituencies about how our business can be improved in an efficient manner that doesn’t impair capital formation.  Get ready for a long slog.  We need to get this right.  Otherwise, we’re looking at a choking fog of incredibly complex regulations that will make only the lawyers happy.  Hey, what am I saying?  Is that so bad?

Mixed bag on sentiment.  Here’s my day two:

• More of my friends are off gmail and have real email addresses at banks.  A very good sign.
• Congressman Scott Garrett of New Jersey’s fifth did not cheer us up.  He sees Fin Reg reconciliation (he sits on the joint committee) going nowhere good.  The populist Wall Street bashers are in full throttle.  Senator Blanche Lincoln, the middling lefty incumbent Senator’s near-death experience at the hands of the truly far left means we may be going to a bad place on proprietary trading.
• Our fundamentals panel saw cap rates coming in and happy days again by 2012.  But also acknowledged 2010 cap compression didn’t make a whole lot of sense, except as a response to too many dollars chasing any yield.  I wasn’t left feeling comfy about recovery.  Employment growth anyone?
• Our keynote speaker, the noted economist Mark Zandi of Moody’s Analytics, told us that if a whole bunch of really positive and thoroughly unlikely events occur, we could get this languid, desultory excuse for a recovery to a successful conclusion in three years.  I was close to irrational exuberance.
• We had a series of meetings of investors, servicers and issuers which proved, if proof was needed, that we ain’t figured out what CMBS 2.0 ought to look like yet.  In one corner, the Investor’s Forum which, Moses-like, brought down from the Mount a Best Practices missive.  In the other, JPM, with a reportedly fully subscribed deal in the market with just a nod to said Best Practices.  We do not need a Colonel Gaddafi and Ronald Reagan “line of death” moment here.  No one wins here if the investors get rolled and keep buying but are horribly disaffected.  No one wins if Best Practices brings issuance to a grinding halt because of cost and other deal features that kill the golden goose.  I’m reminded that, in Canada, where they make the Amtrak Acela, the train is called the PIG because it was finally made so heavy by US safety standards it cannot meet its design specifications of speed. So we end up with a marginally useful, world’s slowest fast train.  Perfect.

Finally, everyone is fibbing again.  Deals done, terms given, workouts embraced, bonds sold or bought.  This is terrific news and the best leading indicator of a repairing market.  We've been so depressed these past few years, we had neither energy nor incentive to spin.  Energy and optimism (irrational in part) are back.  Bring on the spin!

So, we’re partying – and why not?  Just don’t think The Decameron.
 

There are lots of good ideas floating around (ok, some really bad ones as well). The servicing community, the investor community and the Street have all weighed in, but there doesn’t seem to be much energy around making real, industry-wide, best practice fixes. We’ve seen four deals that, more or less, constitute CMBS 2.0 with a range of new features. But, on balance, a fair minded observer would have to conclude it’s all a tepid response to the existential failures of the current industry model. 

Why not embrace best practices to address those things which seem ripe for a fix?   Things such as acknowledged problems in the waterfall of reimbursing accrued interest ahead of principal recovery, the exclusion of appraisal reduction from the control class change mechanic, the variability in servicing standard, the absence of clarity about the discount rate for valuing specially serviced loans. Let’s also look at data, at transparency and surveillance. 

Why not (gasp!) try to standardize, at least, some of the PSAs. Many of the key components could practically be standardized without enormous brain damage. So underwriters want to brand their product with a particular form of PSA, fine, but there is no reason why we ought, for example, to have multiple definitions of the servicing standard. There’s no reason why we can’t find key provisions in roughly the same places across program PSAs.

Finally, can’t we stop for a moment and make the disclosure documents and PSAs more readable, more narratively clear and understandable?  These documents have grown up like coral reefs from original precedent. Genetic drift has not, broadly, been productive. We have a chance to prune the wild things back into something more coherent, shorter and more understandable. It would be good for the market for CMBS 2.0 relaunch and for liquidity. 

The counterpoint, of course, is that investors really won’t pony up for better documents, better disclosure, more data, etc. Someone will do all the best practice things championed by the various IG constituencies and see no premium. Maybe that’s the case but it’s still no reason not to fix what’s broken. At the end of the day, the fixes will still have a positive difference in the new cycle. OK. If I was a bettin’ man, I’d bet we’d not do these things, but we should.

It’s also extraordinary to see how much uncertainty there is in the actual mechanics of these, admittedly, highly complex instruments when tested in the crucible of a real live downturn. We are all going to learn a lot about how these financial machines work, and CMBS 2.0 should be better for that learning. In the meantime, if you own a bond or an interest in a financial asset, synthetically or directly, boy, it’s time sit down and read that PSA from cover to cover. OK, I know that is a mind-deadening experience, but remember that you don’t own a tangible asset here, something you can take home and lock in the front yard. You own a bundle of contractual rights which are no more or less than the sum of the words in that 300 page, single spaced Pooling and Servicing Agreement. If you’re not sure what ASERs is or how WODRA actually works, or what a special servicer can and cannot do, how cash actually flows through the waterfall or what a CCR is or can do, what happens to appraisal reduction and actual realized losses, then it is actually time to sit down and read one of these damn things.