Eighteen months or so into the crisis in residential mortgage loans, the sight of the words “bank owned” on a for sale sign is commonplace. The crisis in commercial mortgage loans is, however, just beginning. The commercial mortgage crisis is born less of loose underwriting (though there was some of that) and more of the economic downturn that became fully recognized in September 2008.
As explained below, the very structure of many commercial loans, and the relationship between rents collected and mortgage payments, have the effect of deferring loan defaults for a while. Signs are beginning to appear, though, that delinquencies are sure to accelerate. When they do, there will be an avalanche of defaults, of which perhaps 20% will be of loans that are now held in commercial mortgage-backed securities trusts, or similar investment vehicles, falling under the general description of “commercial mortgage-backed securities,” or CMBS.1
While our nation’s real estate experts have experience from previous downturns about how to approach workouts, few of them have dealt with loans that are governed by the transaction documents of a securitization.
Statements in the popular press to the contrary notwithstanding, the parties to CMBS transactions have a considerable range of options for dealing with problem loans. Those options are, however, limited by various contractual constraints, as well as by some practicalities deriving from the economics of the transactions. For borrowers, servicers and investors, now is the time to invest in developing an understanding of the rules of this new environment. Only with this knowledge can the traditional approaches used in workouts be cross-matched to the permissions and economic realities of CMBS.
Myth of Servicer Limitations
In all securitization structures, the “ownership” of the loans (or other financial assets) is divided among investors. Management of these assets is placed in the hands of one or more “servicers” that act for all of the investors, in the position of “lender” vis-à-vis the borrower. The servicers have this authority to act by virtue of the terms of the governing documents for the securitization — usually either a Pooling and Servicing Agreement or an Indenture coupled with a Servicing Agreement.
Securitization documentation includes limitations as to the servicer’s authorization to consent to loan modifications. When the loan is in default, however, those limitations are substantially relaxed, in favor of authority to negotiate what is in the best interests of the “lender” group, which is to say the investors in that securitization, considered as a whole. Securitizations of single-family residential loans (SFMBS) typically are fairly restrictive about the range of remedial actions that the servicer can entertain. Even in those deals, though, the servicer tends to have more latitude than has been widely reported in the popular press. In the case of CMBS deals, the servicer usually has more options.
Before Loan Default
Most CMBS transactions have two servicers. The first, called either the “servicer” or the “master servicer” (and which will be referred to here as the regular servicer), handles the loan servicing while a loan is performing. The job of the servicer is mainly to collect payments, pass them along to the trustee for distribution among the investors, and maintain records. This regular servicer needs to be a company with good systems for handling cash and data. Some of the biggest banks in the country take on this role, as do specialty providers of the servicing function.
When a loan becomes significantly delinquent — normally 60 days of delinquency — the servicing is moved to a “special servicer.” The special servicer is a company that has expertise in working out problem loans and handling foreclosed real property. At the outset of the CMBS transaction, the special servicer signs on to the documents and waits in the wings until problems develop. Then, it receives the file and the credit history from the servicer, and begins to work with the problem situation.
While the regular servicer is servicing the loan, it will normally have limited rights to modify. Some kinds of modifications are completely prohibited. Others may require consultation with, or affirmative approval by, the special servicer, even though the special servicer is not yet involved with the loan. The exact range of permitted modifications during this period varies, so it is essential to review the CMBS transaction documents to know what the range of options are during this period. Often, the powers of the regular servicer are limited to non-monetary changes, such as collateral substitution and release, substitution of credit support, and assignment of the debt in connection with a sale of the underlying real property. There may also be a limited authority to defer loan payments, but no power to change the amount of principal or the interest rate.
After Default
When the servicing is moved to the special servicer, there is usually considerably more flexibility in permitted workout options. These often include reducing or deferring payments of interest and principal, subordinating the loan to new cash financing, and forbearing from taking enforcement actions such as foreclosure for an extended period of time. In some transactions, there is also a power to sell the loan itself out of the CMBS trust.
Various parties, in addition to the servicers, may have a say in how a loan is handled. One or another class of investors may have the right to comment on, or even control, the decisions about one or another type of workout. Also, some of the parties that were involved in the securitization process are, in some transactions, afforded a right to purchase the loan out of the trust.
Although CMBS documents appear to be similar to one another, there are actually many significant variations, some of which affect the available workout choices and the procedural mechanism for selecting among those choices.
Servicing Standard & Net Present Value
The goal of the servicers when deciding on a course of action is always supposed to be maximizing the amount of the recovery for the investors in the securitization trust. Usually, the CMBS transaction documents include an express provision to the effect that this means maximizing the recovery for the investors “considered as a whole” or “without distinguishing among the classes of investors.” Nevertheless, CMBS servicers agonize over whether the potential courses of action are better for one class of investors yet worse for another class of investors. The composite financial outcome for all investors as a group will be a function of the amount of the recovery, the timing of that recovery, a discount factor related to that timing, and the risk of that recovery not happening. This last factor, most especially, has a differential impact on investors of different classes.
Most CMBS transactions direct the servicers to select among potential remedies by comparing the net present value (NPV) of each alternative, based on a prescribed discount rate. The prescribed rate is usually based on the interest rate of the asset (mortgage loan) itself, minus certain fees. Most commercial lenders do not look at loans and workout options in this way. Yet such an approach should be adopted when developing options for consideration by special servicers, since that is their contractually prescribed frame of reference.
REMIC & Other Tax Rules
Besides satisfying the expectations of the investor community, the contractual agreements used for establishing securitizations include provisions designed to minimize taxation at the entity level. For CMBS transactions, this usually means that the transactions are designed to be Real Estate Mortgage Investment Conduits (REMICs) for tax purposes.2 To satisfy the REMIC rules, the securitization trust must generally be a passive pool of specified assets that does not change very much during the life of the transaction. The need for passivity in regard to management of the pooled assets, and for stasis in the pool’s composition, have led to contractual terms that restrict both loan modification and loan sale out of the trust. Securitization documents often require an opinion of counsel to conclude that the REMIC rules will not be breached before certain types of loan modifications may be undertaken.
The REMIC rules include, however, several exceptions from their general rules about passivity and static pool composition. Some of these exceptions are enormously helpful in dealing with loan modification. One type of exception applies to loans that are not in default or expected to go into default. These are loans that are still being serviced by the regular servicer. Modifications to these loans will not affect the REMIC status of the pool or trust if the modifications are not considered to be significant. Significance is a concept, borrowed from a different part of the tax laws,3 and a few of the borrowed principles may be useful. A loan modification that extends the maturity date slightly, but does not alter the yield of the loan will not be considered significant. A modification that defers loan payments for up to the lesser of five years or half the original loan term is not considered to be significant.4
If a loan goes into default, or a default is reasonably foreseeable, then there are virtually no restrictions imposed by the REMIC rules for a modification that is occasioned by that development.5 Thus, even before a loan gets to the special servicer, there is an expanded range of modification and workout approaches that would be in compliance with the REMIC rules.
In some CMBS transactions, one or more classes of investor securities have been issued not pursuant to the REMIC rules, but pursuant to the tax rules for grantor trusts. This is based on an alternative technique for avoiding an extra layer of taxation at the entity level. If the securitization includes a class of securities that were issued by a grantor trust, modifications will be prohibited unless they can be accomplished without destroying the grantor trust status. Rules for meeting that requirement are somewhat less precisely laid out in regulations than are the REMIC rules.6 Earlier in the current crisis, the IRS was asked to and did issue a revenue procedure regarding modifications of single-family home loans under the grantor trust rules. There is as yet no comparable position on commercial mortgage loans.
Economic Considerations
Given the wide berth granted to the special servicer in restructuring a loan, particularly after a default has occurred or is reasonably expected to occur, the differences between an old-fashioned lender and a special servicer in a CMBS transaction are practical, as opposed to legal: 1.) the securitization trust has no money to lend, and therefore is not going to be able to provide additional financing, 2.) the securitization trust cannot refinance the loan itself. Even if the current interest rate environment would support a refinancing, the borrower would need to find financing elsewhere, and 3.) the special servicer is charged with maximizing NPV, and so may not be in a position to credit “soft” or ancillary benefits.
The Coming Avalanche
When the subprime mortgage crisis began in 2007, there was a rapid effect on home prices and sales. This translated almost immediately to troubles in SFMBS securitizations, as well as in commercial loans for the development of residential tracts. Development loans had not, however, been securitized to any significant extent. The entire process of lot-by-lot development and release, as well as subordination to construction loans, made those loans less appealing for securitization than retail, office, industrial and multifamily. Therefore, the problems in the residential market did not roll to the CMBS world.
Commercial real estate loans in general started to show signs of problems in this first phase of the economic downturn only in the case of buildings that were occupied by companies that went out of business. The main categories initially affected were office buildings that housed mortgage-related businesses (e.g., subprime mortgage companies; Land America Title) and retail centers with tenants that failed (e.g., Linens ‘N Things). When the broader economy took a nosedive in 2008, though, the entire sector started to be at risk for loan default and potentially in need of workout options.
Even so, the impact has not been swift, in large measure because of factors that tend to mitigate defaults. For example, many commercial real estate loans have interest reserves that can be drawn by the lender to make loan payments for some months before an actual payment default is triggered. Also, even in the boom times, the loan underwriting criteria on the commercial side were never as loose as in single-family loans. So some loan-to-value cushions remained, until the bottom fell out of the market.
Finally, the terms of tenant leases in office and retail properties have tended to defer the day of reckoning on at least some properties. It often takes time for declining revenues in a tenant’s business to turn into nonpayment of contractual rent. For tenants that are continuing in business, the juncture at which a rent adjustment is most likely is when the lease is up for renewal. A further lag may result from efforts by borrowers to make ends meet — or to pretend that their property is the exception that will weather the storm.
The result of these delays is that only in the last few months have most borrowers under CMBS conduit loans begun to consider requesting a loan modification. The community of special servicers is beginning to see an accelerating flow of loans that have already become 60 days delinquent, as well as other loans about which the borrower has, either directly or through the regular servicer, requested an opportunity to discuss loan modification or workout.
In anticipation of the coming volumes, CMBS special servicers are staffing up, developing their analytical tools and discussing with one another the industry standards. Borrowers, meanwhile, are gathering their data, preparing their property analyses with a view toward the NPV comparison that is mandated by the applicable CMBS transaction documents, hoping to facilitate informed discussions and swift decisions. Time will tell whether these efforts will have the desired results, whether properties will be salvaged from deterioration, whether business communities will be abandoned or repopulated, and who will be the ultimate winners and losers.
Ellen R. Marshall is partner and co-chair of the Banking and Financial Industry practice group at Manatt, Phelps & Phillips, LLP. She has practiced banking, corporate and finance law in Los Angeles and Orange County since 1975. Marshall has extensive experience in public and private securities issuance, M&As and specializes in business transactions. She has developed a thriving pension fund investment, trust and ERISA compliance practice, and has also become a recognized provider in subprime mortgage lending advice. She handles securitization of unusual financial assets and has worked on bringing securitization techniques to new international markets. Marshall maintains an active practice advising banks, trustees and employers on benefit plan matters, including individual retirement accounts, 401(k) programs, ESOPs and health benefit plans.
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