One of the pleasures of life is re-encountering old friends, catching up on what’s happened while your lives have gone their separate ways, reminiscing about the good old days and reconnecting. It comes back so fast, it’s like you never were apart.
Me and the Liquidating Trust had just such an experience the other day.
I think I met the Liquidating Trust for the first time in 2010. It had friends other than me, not that I’m jealous. I first heard about the Liquidating Trust when it became besties with the Resolution Trust Company in the early 1990s and moved an enormous amount of dodgy S&L assets into better homes. Frankly I ignored it, didn’t return its phone calls and otherwise gave it the cold shoulder for over a decade. Then the Great Recession arrived and changed everything, and all of a sudden, I needed a friend.
The Liquidating Trust and I became close in the years between 2010 and 2013. Having slumbered for the better part of a decade, the Liquidating Trust was again robust and virile and enormously attractive to the vast set of investors who yearned for yield and the barbarous who picked over the dead and wounded on the battlefields of commercial real estate finance following the Great Recession in search of likely candidates.
The Liquidating Trust provided liquidity where there was otherwise little available and facilitated the transfer of unloved assets from the unloving to new investors. More proof, if any was needed, that there are no bad assets, just bad pricing.
I am so fortunate to have re-encountered my old friend the Liquidating Trust here in the early summer of 2020 because I think we are going to get to become close friends again.
Of course no one knows the course of the pandemic, its attendant flash recession nor the path of our recovery (there will be a recovery, won’t there? Right?), but it’s almost certain when the pandemic tide finally goes out, it will leave hundreds if not thousands of commercial real estate assets and their concomitant leverage not… hale. If the path of the pandemic is longer and the recovery is less robust, or we experience the dreaded double dip, there will be more broken toys out there, but either way, broken toys there will be.
So I thought it might be useful to reacquaint all of you, my readers, with the Liquidating Trust.
First, what is it? The Liquidating Trust is an actively managed securitization vehicle providing leverage against non-performing loans (NPLs), sub-performing (SPLs), REO assets and even some unsecured loans. The trust manager’s main job, indeed its only job, is to manage these assets to cash. The amount of leverage provided by these vehicles was not breathtaking, as you might expect and will be clearly dependent upon the quality of the assets (or lack thereof) in the pool. Leverage in the mid-30s to mid-50s on a bond OPB to acquisition cost basis was common (the original outstanding principal balance of these assets at this point is largely irrelevant).
If all that sounds awful, in the lee of The Great Recession, leverage was in short supply and this leverage afforded to managers who had the capability to take on distressed assets was important.
The key structural innovation behind the Liquidating Trust was the development of business plans for each asset. These business plans described how each asset would be managed to its ultimate resolution. The business plans contained detailed models projecting the on-the-run and terminal cash flows of the assets and projected both the timing and the cost attendant to resolution of the assets. The modeling assumptions behind these business plans were set forth in great detail in the offering documents for investors to peruse and consider.
These structures were often rated and while the capital structures were relatively simple for tax and other reasons, they did, in the day, generate some investment grade securities. All deals were offered in the 144A or private marketplace. The offering circulars, which were robust for the time, describe in detail the business plans and modeling assumptions and otherwise were typical in format for a 144A offering. The risk factors could be funny. How many ways can you say that all this is dross. There were always loads of exceptions to the reps.
DBRS and Moody’s rated these and perhaps some of the other ratings agencies did as well (remember this was the dawn of the electronic age and I’ve seemed to have misplaced a lot of precedents from that time). The agencies developed criteria for haircutting the modeling assumptions of the bankers. Haircuts were hardly surprising as rating agencies are not paid to have the sunny disposition and optimistic mien of the bankers. The haircuts reduced the expected returns, increased the expected costs and extended the expected timelines for resolution. DBRS alone, if memory serves, actually published criteria for Liquidating Trusts in the fall of 2010. Expect these criteria to be dusted off and updated soon.
The tax structure of these transactions was complex and often drove the design. These deals couldn’t be structured as REMICs, because they were not full of performing loans. You can REMIC a non-performing loan (largely), but the REMIC can’t foreclose on that loan’s real property collateral. If the issuer is structured as a qualified REIT subsidiary, in addition to foreclosure issues, there is concern over dealer income as the structure is indeed set up to sell and liquidate the assets. It’s possible to avoid the taxable mortgage pool consequence for these transactions entirely by having only one maturity of the debt classes and so no classes of time tranched securities (which is often very inefficient), if enough of the loans are really bad and not considered mortgages in the first instance or if a high level of comfort can be achieved that all the assets will be disposed of and the vehicle collapsed within 3 years. All doable, but you’ll spend a lot of quality time with your tax lawyers.
The basic chassis of these transactions was a lot like a CRE CLO. An indenture, one or more purchase agreements, servicing agreements, asset management agreements, custodial agreements and the other contractual infrastructure of a typical CRE CLO would complete the document suite.
The parties? Also the customary suspects: a custodian, an indenture trustee, an owner trustee (if a grantor trust), a seller or sellers of the loan, an issuer (and oddly often many, many, many issuers reflecting that the assets were often owned in segregated SPVs for liability purposes). There would be a sponsor (a role that will now be increasingly important because of the risk retention rules, which were not in play when these transactions last saw the light of day), depositor or transferor, a master and primary servicer, often in these transactions called a Cash Management Servicer, and of course an Asset Manager (which was a bit like a Collateral Manager and a Special Servicer all rolled into one). The sellers provide reps, albeit not as robust as in a performing transaction and which were often limited by seller’s knowledge as the loans were often acquired in open market transactions, and reflected the dodgy birthing process of many of these loans that were never actually intended for securitization. As mentioned above, an astonishing number of rep exceptions were generally part of the deal.
These are actively managed transactions. In some significant measure, investing in the securities of these transactions is a bet on the quality of the manager and the manager’s ability to execute the business plans developed for each of the underlying assets. These deals were designed to go quick and the average life might be a little more than a year and so it’s all about the asset manager’s plan. In a typical transaction, the collateral manager might first divide the assets into buckets and build plans around the buckets and then include variations for things such as where the properties were located, what the foreclosure regime was in those jurisdictions and whether the underlying loans had bankruptcy protection. In these transactions, one might see the following categories of the loans:
- Preforming par payoff assets
- Modifying and extending assets
- Discounted payoff assets
- Deed in lieu assets
- Foreclosure assets
- REO assets
- Note sale assets
- Hold assists (meaning no recovery is expected).
In these transactions, both the Cash Management Servicer and the Asset Manager might have advancing obligations, not for P and I, but for working capital and protective advance needs. Remember these deals were effectively the securitization of an active business.
What type of assets went into these things? Everything including the kitchen sink. All the major food groups of typical CRE securitization, plus residential assets, raw land, partially developed land and even some unsecured loans, all subject to limited reps as mentioned above.
Bond structures were relatively simple. This is not the land of the AAA securities. Waterfalls were sequential pay and based on available funds, the junior bonds (if any) were PIK-ED.
Typically, there was material leakage to the equity, as long as the pool was performing in accordance with plan. Leakage might be based on whether or not a Targeted Amortization Amount was paid out on each distribution date and the transaction may have other performance tests. If the Targeted Amortization Amount was not met or certain other circumstances occurred, a trigger toggled and cash flow was cut off from the bottom of the capital stack. This also happened if a Scheduled Outside Payment Date (generally, in these deals that was sometime within three years) wasn’t met. In these transactions the bond holders were protected with reserves for interest payments, for working capital. Replenishment of those reserves was high in the waterfall.
Listen, no one ever said my friend the Liquidating Trust was pretty, but it was purpose built for a time and place and I think that time and place may be returning soon. Looking back, many of these pools performed better than their best case scenarios and rewarded investors and managers richly. Not a bad reason to become reacquainted, eh?
So let’s welcome the Liquidating Trust back to the party. How important a role my friend will play will depend largely upon the depth and length of the recession we are now beginning to enjoy. Certainly, I can already see a role for this technology in hospitality and retail where a significant erosion of values has already taken place and is not likely to reverse anytime soon. When the pandemic tide goes out, it’s not hard to conceive of a world in which a great deal of commercial properties simply does not longer work.
So I’ve dusted off my documents, I’ve started to clean up my precedents and update deal features and risk factors (it’s been a very long time since me and the Liquidating Trust hung around together on a regular basis) and I’m getting ready for what’s to come.
Welcome back to the party, Liquidating Trust.