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.
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