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…
Substitution was only permitted within the REMIC tax regime if the loan provisions granted it as of right to the borrower, and the lender had no discretion. Consequently we tied ourselves into knots trying to create provisions that looked like, and passed muster as, borrower entitlements, but, in effect, gave the lender some control over whether a substitution indeed could occur. For sponsors who did not focus on, and address, substitution in the original loan documents, “optionality remorse” would be unrequited, as substitution could not be added to the loan documents after closing. If it wasn’t baked into the deal at the front end, you couldn’t change the recipe.
Now come the September 2009 REMIC amendments, designed to provide more flexibility for modifying loans in existing pools. While it’s pretty clear to me that the drafters of the REMIC modification amendments did not have substitution in mind, these amendments now make collateral substitutions possible after the fact.
This is huge. Borrowers who otherwise had to torque their business plans around the reality of a long-term, fixed-rate financial structure now can see a way out. Under the September 2009 amendments (discussed here, here (pdf) and here (pdf)), a substitution of collateral by itself does not violate the REMIC rules, provided that the new real property collateral has a fair market value equal to, or greater than, the released real property collateral.
Now, no PSA will specifically empower a servicer to exercise its discretion to approve a substitution, since it was not a possibility when these PSAs were written. So a servicer is going to have to make a conclusion that substitution is fundamentally consistent with the servicing standard. Some PSAs may contain language which suggest that this type of transaction cannot be approved, but one hopes servicers will take a common sense view to get to a result demonstrably in the best interest of the bond holders.
When a borrower comes to a servicer and proposes the substitution of a materially better piece of collateral, it seems to me the servicing standard would be best served by approving it. Probably the proposed new collateral will have to be materially better than the old for the transaction to make any sense at all, but where better and more valuable collateral can replace weaker, the servicer ought to strive to conclude that substitution should be allowed. I think that, in general, they’ll get there.
See, I can write about good news once in a while.
This post is not written as tax advice and cannot be used to avoid tax penalties or to promote any transaction.
By Rick Jones.