CrunchedCredit : Capital Markets Finance and Real Estate Attorneys

To be clear, this is a financing tool, not a sales tool. Depending, of course, on the depths of ugliness in the pool, this is 35-55% leverage with a sponsor holding the risk piece. Nonetheless, it is peerless, durationally matched leverage that is terrifically useful for buyers of the distressed debt inventory. As the holders of non- and underperforming debt have increasingly fessed up to their marks, we’re now at a point where these transactions can be done without creating massive capital charge problems for the banks and other financial institutions holding this paper.

These structures are designed to allow an active, dynamic manager to liquidate a portfolio of loans, hence: liquidating trusts. The manager anticipates selling and resolving all of these loans and reducing them to cash in a finite and relatively short period of time. The ratings models work off individual business plans for each loan, taking into account current period income, liquidation proceeds and haircutting the bankers’ views both on the level of achievable proceeds and the time required to resolve the assets. 

But these are not easy deals and we haven’t found the magic bullet to make them easy. First, these are management intensive transactions that are dependent upon the investors’ confidence in the quality and performance capabilities of the manager. Second, the quality of data available on seasoned non- or under-performing loans tends to be a bit dodgy, and that impacts the quality of disclosure and the difficulty of delivering high quality information to manager and investor. Finally, and most frustrating, is what needs to be done to achieve tax transparency. The assets typically can’t be subjected to a REMIC election because they’re not performing. For reasons, which for the life of me I cannot fathom, our Internal Revenue Code punishes pools of mortgage loans with corporate level taxation. Why are mortgages treated as the bad boys of the financial neighborhood such that they need to be rousted by the tax cop when they gather together on the street corner? The Code doesn’t pick on other asset classes in the same way. It’s inexplicable.

When mortgage loans are pooled, the so-called taxable mortgage pool rules (TMP) apply and these rules make it nigh unto impossible, in many cases, to issue more than one time-tranched class of debt. Therefore, these vehicles tend to be somewhat inefficient with only one class of equity and one class of debt. Seriously better pricing could be obtained if the debt could be both credit- and time-tranched like in most other structured finance products. Now there are ways around these problems, but none of these fixes work terribly well. So, for instance, if the loans are really bad, so that a large enough portion can be treated effectively as equity interests in the underlying collateral rather than as mortgage loans for tax purposes, you may be OK. If somehow you can be sure the loans will all be liquidated in 3 years, you may be OK. If the vehicle can be structured as a Qualified REIT Subsidiary (although watch out for dealer income that is bad REIT income in a liquidation strategy), or if the structure is entirely offshore, the TMP problems can be avoided. Each of these fixes, though, has, shall we say, material negative externalities which limit their use.

With all that said, this structure is very useful in the right situation. It’s going to be used, and it’s going to be used extensively in 2012. It is a way to move assets that one party does not want, or cannot hold, into the hands of those who want the exposure. It’s a way to tidy up the balance sheets for financial institutions, create market velocity, move risk to investors who want it and set the table for more capital creation.

Now that’s a good news story.

By: Rick Jones

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. 

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.

For our part, we’ve received numerous inquiries lately from clients interested in acquiring or aggregating portfolios of these loans. The traditional methods of financing such a portfolio, such as warehouse financing or traditional CMBS securitization, are either not attractive (from a cost perspective) or simply not achievable in the market. One structure we like is the liquidating trust. If you are old enough to have enjoyed the early 1990’s, you might recall liquidating trusts. This structure became very popular in the wake of the savings and loan crisis (in the interest of full disclosure, your author was in high school back then, and has had to search the internet and rummage through dusty old files to learn more about these structures).

Let me use this opportunity to “cue the deer” and briefly describe a typical early 90’s liquidating trust structure utilized by the Resolution Trust Corporation (which was created by the US. government to manage the disposal of real estate assets held by failed financial institutions). A pool of defaulted commercial mortgage loans and REO was established. The acquisition vehicle funded the acquisition of the loans by the issuance of securities. The deals were usually structured with senior tranches of investment-grade securities sold to the public and with a subordinate equity piece retained by the issuer or sponsor. A servicer coordinated the collection of monthly payments, if any, and managed the sale or liquidation of the loans or REO held by the trust. Debt service (on the merely damaged loans), REO income and liquidation proceeds were used to pay interest and principal on the issued securities. Since these proceeds were variable, a liquidity reserve was established to help fund interest payments on the issued securities.

With a bit of tweaking and a refreshing dose of modern technology and practice, a liquidating trust can provide an answer for banks looking to offload the billions in bad loans and REO still gumming up the works. Indeed, the idea seems to have gained enough critical mass to draw the attention of the rating agencies, who are showing increased interest in these types of structures. DBRS has advocated the use of liquidating trusts as a viable option for disposing of sub- and non- performing loans, arguing that these structures are a practical alternative given the expectation of foreclosure on the mortgage assets of the trust, and finding that some liquidating trust transactions performed considerably better than expectations. DBRS recently requested comments to its proposed ratings methodology for liquidating trust structures. We understand the other rating agencies are in the process of developing ratings criteria as well.

Again, the lending re-start begun in 2010 and continuing in ’11 is a great sign, but the echoes of the bubble years can still be heard – liquidating trusts might be the vehicle to finally clean up the books.

By: Stewart McQueen and Krystyna Blakeslee