My last commentary, Playing with Broken Toys in Coronavirus Land, touched on the notion that sometimes following rules can guarantee a bad outcome.  I’ll leave more important musings about ethics and morality aside here (I still don’t have a clue about what Kant was nattering on about) and focus on the more mundane question of whether one should do what a contract says when the contract conflicts with the exercise of good judgment.

This is a discussion about proscription versus principle.  To cut to the chase, it’s about the CMBS industry’s flirtation with the commission of ritual suicide in response to the COVID-19 virus.

Examples abound about this kind of thing and perhaps a quick trip through the annals of truly dumb, blind and stupid rule following is instructive.  How about The Charge of the Light Brigade?  Hey, chaps, we’re waving sabers about on horseback and there are a bunch of cannons up ahead pointed at us.  Anyone see a problem?  Or there’s the French army’s willingness to fight in blue and red uniforms and refusal to use machine guns at the outset of World War I, because that’s what the manual of war said to do.  I’m not sure if lemmings actually jump off cliffs, but you get the idea.

Closer to home, just look at what the Financial Accounting Standards Board has done to financial accounting.  I used to think that accountants were supposed to make it easier for investors, managers and the like to understand the performance of a business enterprise, but if that was ever the case, we’ve certainly lost our way.  Financial statements have become telephone book exercises in obscurity.

The Financial Accounting Standards Board (FASB) has turned our accounting rules into a classic example of overly prescriptive rules evidencing an almost actual hostility to the exercise of judgment.  I clearly remember an exchange with a very frustrated FASB staff member years ago when I was banging on about how the Generally Accepted Accounting Principles (GAAP) made no sense on issues of true sale.  That occasioned a lecture that GAAP was not about clear communication, but it was all about preserving the internal coherence of a rule-based system, and the fact that only the denizens of the academic accounting world understand how those rules work was simply not the point.  As an example, I will give you as much time as you like to try to explain to me why I can get sale treatment selling a junior note and retaining the senior, but can’t if the transaction is done through a participation.  I’m not making this up.  That’s what the rule says.

Or how about the risk retention rules?  When the risk retention rules were created back in 2014-2016, there was no single-family rental (SFR) industry to speak of and therefore the rulemaking didn’t contemplate it.  Whether SFR was a “commercial” transaction or a “residential” one was important, because the risk retention rules went into effect at different times for commercial and residential mortgages, and there were a number of very specific of structural features in the rule as to each.  I remember talking to a convocation of the regulatory consiglieri at Treasury back in 2015 and asking that question.  The answer was that it was not “residential” real estate (blindingly obvious to me).  But after considerable thought, the agencies concluded that neither did it fit the definition of “commercial multifamily,” because commercial multifamily requires more than 5 units on a property on a parcel of real estate.  We asked, “What’s the difference between five units under one roof, and five units under five roofs?”  The answer?  “That’s not what the rule says.”

A handful of words on paper, thoughtlessly written without the foresight reserved for the Gods mattered more than the underlying purpose of the rule.

Now, of course, some rules indeed make sense: don’t kiss a rattlesnake, don’t take your bicycle on the interstate, don’t get into a land war in Southeast Asia, etc.  But it’s a fallacy to think that because some rules make sense, all rules do.  More broadly, one could argue persuasively that the more detailed, prescriptive and comprehensive the rule, the less sense it’s likely to make, and the higher the likelihood that it will lead to unintended and often unpleasant consequences.

The trouble with complex and detailed rules, of course, was captured by (or attributed to) Yogi Berra: “Predictions are hard, particularly about the future.”  Rulemaking is all about peering into the future, informed by the past and attempting to create detailed guidance from what one does when confronted by something that hasn’t yet happened.  Consequently, implicitly, if not explicitly, rulemaking assumes that we can know what’s going to happen, and when those things happen, what choices are available and what choices should be made.  We should approach all rulemaking with considerable humility, but rarely do.

All rules should be subject to a good judgment override, an ejection seat, a bolt hole, an escape hatch for when rule-following will lead to disaster.

Apparently, we’re just enamored of rules.  Is that the DNA speaking, or do we just have too many damn lawyers?  Maybe both.  We marinate in this culture of “don’t trust your instincts” and “always have a clear cut rule-based answer,” and notwithstanding considerable evidence, it’s often a bad idea, but we keep doing more of the same.

Once again, it’s probably the lawyers’ fault.

And now we are about to make just this mistake in considering the role of forbearance in the COVID-19 emergency.

Because of our enthrallment with the rules, we, as an industry, are on the precipice of delivering what could be a near fatal blow to the commercial real estate capital markets industry.  We’re about to actually and affirmatively feed a narrative that will certainly develop sometime soon that Wall Street, commercial lenders and bankers and all those traditional denizens of the nefarious financial system took full advantage of the national COVID-19 emergency to rape and pillage Main Street and destroy commercial enterprises throughout the country.

We’re going to do it because many market participants say our documents say we have to.

All structured finance documentation—the plumbing, as it were—provides detailed guidance about when a commercial loan is performing and when it is not.  It provides detailed guidance for what to do when a loan is not performing.

But no one thought of COVID-19 when the plumbing was installed.

So here’s what’s going to happen unless we are very, very careful.  Innumerable borrowers won’t make payments required by the loan documents in May—and perhaps the months to follow—because their buildings are shut, their tenants have gone, people won’t shop and residents won’t have the money to make rent payments.  Our documents generally stipulate that non-payment is a default.  Full stop.

If a loan is in default, control of the loan moves to the special servicer.  When that happens, the servicing fees associated with managing that newly “defaulted” loan balloon exponentially and the servicer becomes entitled to a resolution fee once the loan is sold, foreclosed or returned to performing status.  That fee, in many cases, is as much as 100 bps.  Other servicing-related fees may be imposed in connection with the active servicing of that loan.  All those charges will ultimately be laid at the door of the borrower, and if the borrower can’t pay, at the feet of the bondholders.  You will not find in any of our documents the word forbear or provisions that explicitly discuss forbearance in the time of a national emergency.  Why? Obviously, because we didn’t think of it, and not thinking of important things that haven’t yet happened is why rules need a judgment override.

Should we default loans because of COVID-19 related disruption?  Should we begin the special servicing rumba?  Do we really want to default loans in the middle of a world-girding medical emergency where perhaps hundreds of thousands of people will die?

Do you really want to feed the meme that our industry has used the emergency to take advantage of the little guy, that Wall Street has yet again turned on Main Street?  Our industry is, of course, not full of people with a predilection to piracy.  No one is celebrating COVID-19 as an opportunity to savage the little guy.  But that’s not the point.  That’s what people will think.

Now, I know all the arguments we will make.  Not all the borrowers are good folks, not all the borrowers are little guys; there are lots of people out there in real estate land taking advantage of us poor lenders.  But that’s not going to be the narrative.  If you were around for the Great Recession, you understand where this is going.  What will happen then?  Senior members of the financial industry will be marched into the halls of Congress to testify (okay, mostly to be yelled at). Our institutions will become subject to the type of punitive investigations we learned can proceed largely untethered from actual lawbreaking following the Great Recession.  Fines and penalties with follow, people will be fired and fined, stigmatized and vilified.  Lending businesses will fail.  As a final indignity at the end, this will ultimately lead to a new assortment of intrusive, ill-conceived rules and regulations that will be destructive of capital formation and destructive of our businesses.  Rinse and repeat.

While not all of this can be avoided—the meme of Wall Street vs. Main Street is in our collective DNA, and will follow the “Second Great Recession” as night follows day—damage can be ameliorated right now by associating the commercial real estate capital markets with the solution and not the problem.  What’s that mean?  It’s time to forbear for a brief period of time from the exercise of remedies.

Let me be a bit specific here.  If the loan was performing before COVID-19, if its failure to perform is rationally connected to COVID-19, if the forbearance is short-term and the borrower is prepared to agree to repay the missed payments over a reasonably short period of time, we should broadly offer forbearance.  Will we make bad deals with scoundrels by doing so?  Yes.  Price of admission to heaven.  But in the face of a global emergency, this is what needs to get done.   This is good judgment and that needs to be more important than the punctilio of the contract.  “I was just following orders” is not going to save us.

Many will say, including me, that a short-term forbearance, whether it be three months or six, is not going to fix the problems of many of our loans.  When the tide goes out, there will be a lot of transactions stranded with the inability to pay debt service, or indeed, even operating expenses, and those loans will and should at that point be transferred to special servicing and resolved.

What I’m suggesting is that a short-term forbearance, be it three months or six, will largely inoculate us from the all too easy assertion that the financial community took advantage of the crisis for its own pecuniary benefit.  So let’s not jump off the cliff like the lemmings.  Let’s not follow our GPS past the “bridge is out” sign.  (Have you noticed that we’re all fixated on that GPS like a cat with a shiny thing? I swear to God, that when I’m driving around and my GPS is on, my brain is off and vice-versa.)

While I know master and special servicers are worried about liability, particularly in the conduit space where CMBS 2.0 PSAs make it easier for an investor to sue a deal party than before, I don’t really see that happening in scale.  We can help ourselves a lot while we do the right thing.  The industry will embrace the notion that granting forbearance under these circumstances is consistent with the servicing standard, and not doing so is not.  It’s the override, stupid.  Obeying the servicing standard is an imperative, an overarching obligation of the servicers not to be confounded by the several-hundred-page lawyer-written dribble that we call a “pooling and servicing agreement.”  Mr. Servicer, what would you do with your own loans?  We can see across the broader portfolio lending community the answer, and that is to forbear for the moment.  Deal with the problems later on.  That is what we should be doing and I think that’s a perfectly good defense.

Moreover, by the time anyone gets around to thinking about strategic litigation, forbearances will be granted, and loans will have either returned to performing status or will legitimately be in the hands of special servicers because they cannot be restored.  This will be a blip in the life of the loan and we will move on.

So it’s time to embrace good judgment, to recognize the limit of rulemaking, to recognize the vulnerabilities of our contracts and to elevate our commitment to the servicing standard over ill-conceived prescriptive wording.

Parking the brain in neutral and following the GPS over the cliff is not a strategy.  We’re in a crisis.  “I was just following orders” won’t cut it.  It’s time for everyone in our industry to do the right thing.