Tough Times for Lenders : Texas Financial Services Lawyer & Attorney : Winstead Law Firm : Finance, Banking, Bankruptcy

National rating agencies, and Standard & Poor's (S&P) in particular, are developing new analytics to be applied to CMBS and RMBS pools originated in the years 2005, 2006 and 2007.  As a preliminary matter, it looks like the new criteria will, when applied to the Triple-A tranches, result in downgrades of a substantial percentage of Triple-A CMBS for the three years of issuances reviewed.  While the details of the analytical changes have not been made public, investors holding RMBS and CMBS, as well as those with a stake in seeing that the securitization industry be revived in some form (such as the CMSA) are naturally inquiring to S&P about the specifics involved in the analytical changes.

It will be interesting to see if S&P is merely changing the stress assumptions for further declines in the market, or if in fact they are adding new criteria from lessons learned along the way in the financial crisis.  Since not all Triple-A CMBS pools have anywhere near the same kind of risk characteristics, perhaps a reexamination of Triple-A CMBS, in order to make meaningful quality risk distinctions between pools, would be a good thing for the market.  However, S&P's decision is likely to add more unwelcome investor confusion to the mix.

As most of you know, the Federal Reserve created the Term Asset-Backed Securities Loan Facility (TALF) to help borrowers and lenders as market participants meet the capital credit needs across a wide range of asset classes, including asset-backed securities (ABS), collateralized by auto, student, equipment, credit card, and small business administration loans.  More recently, commercial mortgage loans including CMBS were added as an asset class eligible for TALF.

On Tuesday, June 16, TALF offered borrowers the opportunity to participate in one of the first CMBS offerings in a long, long time.  The rate available for a loan with an average life of two years was 3.2710% and for five-year, fixed rate loans the rate was 4.130%.  Surprisingly, (or perhaps not surprisingly) even in the present capital starved environment, no loan requests were submitted for CMBS/TALF borrowing execution.  There could be a number of reasons for this, including continued investors current aversion to risk, particularly in this asset class, a continued belief in future weakening of real estate fundamentals, as well as uncertainty about the precise nature of the TALF execution.  At any rate, the last thing mortgage capital markets need is greater uncertainty caused by rating agencies mentioning (but not fully explaining) significant future downgrades of Triple-A CMBS.

This takes us full circle; back to an examination of the fundamental, underlying assumption that criteria can be developed which will adequately assess risk for securitized pools backed by commercial real estate.  Commercial real estate investments as an asset class, poses very unique risks and rewards, and arguably are not susceptible to precise bond ratings.

The problem is that rating agencies have taken on the task of providing "on going surveillance" for these asset classes.  As S&P collects more information about pool performances, their rating assumptions and general market conditions, they are likely facing a growing need to rerate CMBS pools.

Overall, National Recognized Statistical Rating Organizations risk much by stepping out and being active in the present regulatory/political environment.  If they do nothing, they will clearly draw significant criticism.  As the need to regulate rating agencies draws increased scrutiny and the possibility of creating federal oversight of these agencies increases, the rating agency should be very circumspect in changing rating methodology midstream and the effect such actions will have on an already dormant market.  And it's very difficult to see what type of analytics, when applied to CMBS pools, will shed light on what's happening in the market, given the dearth of reliable activity and data.

Perhaps a better approach would be to simply issue surveillance reports that show specifically what analytics have been employed to arrive at the more generalized conclusion that investors can not rely on the present accuracy of the original rating.

CMBS investors as well as rating agency professionals are invited to comment.
 

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Guest Writer: Brenda Brown, Winstead PC

More from our Lenders' Top FAQs series (use the search term "FAQs" in the keyword search box on the right hand side or use the link provided above to see the entire series)…

4. Do I need to reduce the commitment amount after sending a Notice of Default?

• Typically, no – once the loan is declared to be in default, or once the maturity of the loan is accelerated, the lender has no on-going funding obligation – but confirm this in the documents.
• The lender typically is not required to fund current loan allocations or grant new loan allocations.
• Communicate clearly in writing to the Borrower that the lender has no further obligation to the fund and negotiations, inspections, administrations and even making future draws during a draw period (whether under a construction loan or a partial disbursed loan) do not amount to waivers of pre-existing defaults or can be considered obligations for future fundings.

5. After a Default Notice, should I send statements showing Regular Monthly Interest or statements showing interest at the Default Rate?

• Statements to the borrower should reflect the Default Rate of interest (rather than the prior regular interest rate), late fees, and any other fees due the lender (such as legal fees) – all of which usually do not appear in the "standard" statement.
• So, typically it is best to STOP sending the regular monthly statements.

6. What else should I put in writing?

• Agreements Regarding Interim or Protective Advances
• Forbearance Agreement

All of these first six questions underscore the fact that the status of the property and the loan must be looked at with current and fresh eyes so that the opportunities for solutions are enhanced, and the risks of encountering questions of waiver are avoided.

Stay tuned for more Lenders' Top FAQs.

Please post comments or questions below.
 

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Guest Writer: Brenda Brown, Winstead PC

Lenders' Top FAQs: This will be a series of blogs in which we will put forth, in no particular order, some quick answers to Lenders' Top FAQs.

At the outset two things should be kept in mind. First, none of these questions can be answered in a vacuum but are shaped and answered correctly only after a thorough review of the file and an interview of appropriate loan officers. And second, many of the questions are worth revisiting from time to time because subsequent events will impact the answer.

Without further ado:

1. The Borrower is how far behind – now what?

• Analyze the entire situation: the collateral, the loan documents, the file, any co-lender or intercreditor agreements, financials on the parties, the market - in other words, the entire picture. Act like you're about to own it.
• Consider restructuring – But send a "Discussion Letter" – to help avoid waiver of lender's rights under the loan documents
• Determine whether a default – as defined in the loan documents – has occurred. If so, consider sending Notice of Default and Notice of Acceleration.
• Generally Borrower has "terminal euphoria" and no reason to change unless it is in default.

2. What if the default was not a monetary default?

• "Default" vs. "Event of Default" – check defined terms in the loan documents.
• Look for Grace / Cure Periods to see if expired.

3. What can I do besides calling a default?

• Alternatives to calling a default include à Restructure (i.e., amend the loan documents so the borrower is no longer in default – if the borrower's financial deterioration is not too great)
• Simple Notice of Default à Just to create a written record that it exists and is continuing.

Stay tuned for more postings on Lenders' Top FAQs.

Please post comments or questions below.
 

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This is the second of a two-part series (PART ONE) covering initial due diligence topics for workouts involving co-lender structures, with a focus solely on the participated or syndicated co-lender structure. The series is not a comprehensive listing of possible issues on this topic, but merely a basis template to assist you as you review the co-lender and other relevant loan documents.

Typical Servicing issues:

• how are on all decisions made within the co-lender group on these subjects?
  • waivers and consents
  • default\enforcement (special servicing issues)
  • after enforcement (expenses to protect\preserve, to sell, to complete; title of the property [name of servicer; tenant in common; nominee entity jointly owned]
  • advances, expenses and losses
  • excess recovery
  • is there a buy\sell provision if co-lenders are not able to resolve disagreement?
• what decisions may servicer make without input from co-lenders
• duties of servicer: what must it do (reporting, inspections, etc.)?
• standard of care of servicer
• what if servicer has an equity position?
• rights of co-lenders to examine and copy
• notification rights (when must servicer notify a co-lender)
• fees (primary servicing; special servicing; asset management and disposition)
• future property inspections and reporting (review reports only; or more active role, such as accompany servicer during on-site inspections)

Does the loan seller or originator have any liability?

• contractual duties and warranties
• fiduciary duties

Transfers

• buy\sell for disagreements
• transfers to affiliates
• transfers to third parties (right of first offer?)
• is sub participations\syndication prohibited?

Sharing of payments: on sums paid by the borrower, are payments applied -

• proportionately to all co-lender?
• non-proportionately to co-lenders?

If you have any comments, suggestions or additions to the foregoing, please post a comment.

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1st in a series of 2 postings

Much of the focus in the media on troubled real estate debt focuses on sophisticated debt structures, or on investors holding bonds in pools of loans. This focus, however, misses an important, intermediate player between these two ends of the barbell: the real estate lender.

In several real estate workouts that I’m handling now, the most difficult discussions are not with the borrower or its lawyer. Instead, the difficulty is within the mortgage lender group itself. Indeed, one distinctive in the current workout environment from the late 80’s is the large number of real estate loans involving multiple lenders holding a portion of the same mortgage loan or lien position.

Now, I’m not describing the situation where one lender has the mortgage lien, a second lender has a lien on the ownership interests in the borrower, and perhaps a third lender has an unsecured loan with the entity owning an interest in the entity owning the borrower.

Instead, I’m describing a single mortgage loan or facility that has been syndicated or participated among multiple real estate lenders. While the multiple or “co-lender” mortgage structure is not new to life insurance company lenders (nor to balance sheet lenders), in the last 15+ years the co-lender mortgage structure became widely used by the broader creditor market; and banks, Wall Street (the investment banks) and mortgage funds joined life companies in “structuring” the first-lien position.

This posting is Part One of a two-part series covering initial due diligence topics for workouts involving co-lender structures, with a focus solely on the participated or syndicated co-lender structure. The series is not a comprehensive listing of possible issues on this topic, but merely a basic template for your use as you read the co-lender agreements and related loan documents.

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Guest Writer - Mike Cook, Winstead PC

2nd in a series of 2 postings
(Part 1: The Insolvency Exclusion to Cancellation of Debt (COD) Income;
The Effect of Exempt Assets Under the Carlson Rule)

The Court, having determined that the use of “assets” was ambiguous, pointed out that “[t]he stated purpose of the 1980 Bankruptcy Tax Act was to ‘accommodate bankruptcy policy and tax policy.’” Both Senate and House reports indicate that the proposed insolvency exception in Section 108(a)(1)(B) was intended to ensure that an insolvent debtor outside of bankruptcy (like a debtor coming out of bankruptcy who is accorded a ‘fresh start’ under Federal bankruptcy laws) is not to be burdened with an immediate tax liability.

The Tax Court, however, concluded that although an asset of a debtor may be exempt from the claims of creditors under applicable law, if that asset and the debtor’s other assets exceed the debtor’s liabilities, the debtor has the ability to pay an immediate tax on income from discharged indebtedness. By implication, therefore, the same Congress that decided that it was in the public interest that exempt assets be removed from the reach of creditors so that debtors could obtain a fresh start intended, nevertheless, to impose an income tax on the value of those assets in the event that a taxpayer negotiated a debt settlement with creditors outside of bankruptcy. In effect, the Carlson Court concluded that Congress intended to impose a penalty on taxpayers that handled their financial problems without resorting to the bankruptcy court.

Under the Carlson rule, an individual with substantial exempt assets pays a high penalty for not filing bankruptcy. The opposite viewpoint, however, is that the reason the Tax Court has sided with the government is because the cases from the late 1980s showed the gross disparity in tax treatment that could occur from the differences in exempt assets allowed from state to state. In Texas, a person with substantial exempt assets could successfully take an insolvency position under the old law. It should be noted that only the Tax Court has addressed the issue, and if the economic conditions currently being experienced produce the same quantity of workouts from commercial debt (COD from residential loans is currently excluded from gross income) as occurred in the 1980s, the issue of whether exempt assets should be excluded from the insolvency calculation will surely reach several courts of appeal.
 

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Guest Writer - Mike Cook, Winstead PC

Part 1 of 2

During the current economic crisis, debtors will be negotiating workouts with lenders and if the debtors successfully obtain debt relief, they will also be seeking tax relief from the taxation of COD income. The ability to use the broadest exclusion from COD income, the insolvency exclusion, has been severely restricted in recent years. The relief from taxation of COD income by reason of insolvency of a taxpayer has a common law history, but it was codified in 1980 as Section 108(a)(1)(B) of the Internal Revenue Code. The legislative history of the Bankruptcy Tax Act of 1980 made it clear that a purpose of the statutory insolvency exclusion was to put insolvent taxpayers on the same footing as those who filed bankruptcy, which also excludes COD income from taxation. But recently the Tax Court has penalized taxpayers for not filing bankruptcy; the insolvency exclusion does not now produce the same tax results as does bankruptcy. So are debtors better off filing bankruptcy than entering into a debt settlement with lenders?

When an individual files bankruptcy and is relieved of personal liability, the debtor comes out of bankruptcy with his/her exempt assets and there is no taxation of the relief of liability because COD is not income pursuant to Section 108(a)(1)(A). In the late 1980s, when the banking and real estate industries collapsed in the southwest United States, taxpayers relied on old case law to the effect that their exempt assets were not included in the insolvency calculation. The IRS seemed to back away from its initial litigating position and agreed with the taxpayers’ exempt asset position, but in the 1990s the IRS put taxpayers on notice that its position was that the insolvency calculation should be calculated without inclusion of the exempt assets. The Tax Court subsequently addressed the issue in Carlson v Commissioner, 116 T.C. 87 (2001) and it adopted the IRS’ position.

The Carlson Court noted with some frustration that Congress did not define the word “insolvency” or “assets” as used in Section 108(a)(1)(B) and turned to several dictionaries to find the meaning of “asset.” The court noted three definitions: (i) the property of a deceased person subject by law to the payment of his or her debts and legacies; (ii) the entire property of a person, association, corporation, or estate applicable or subject to the payment of debts; and (iii) the items on a balance sheet showing the book value of property owned. The first two definitions support an exclusion of exempt assets while the third definition supports an inclusion.

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Guest Writer - Tom Alleman

More from our That Ticking Sound  series (use the search term "ticking" in the keyword search box on the right hand side for other postings on insurance issues) . . . .

Back in the "good old days" when foreclosed and REO property was promptly sold, it was all too easy for lenders and servicers to ignore problems with a borrower's insurance. Sadly, those days are gone, and to cope with today's new world, lenders and servicers now must understand how insurance works and how the coverage in the policies obtained by borrowers and by lenders or servicers themselves does – and sometimes doesn't – provide protection.

The focus on insurance coverages needs to start early in the surveillance process, and most certainly as the deal heads toward the ditch.

To assist lenders and servicers in understanding insurance, I attach (as a PDF) part one of "Insurance for Lenders and Servicers; Part One (Insurance Basics; Insurance for Property)."  In coming months, I'll post future portions (or parts) as I complete other parts of this new resource guide.

If you have specific insurance topics for me to cover, or questions based upon Part One, please post a comment below.

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We've now had a few weeks to review and react to the release by the Board of Governors of the Federal Reserve Systems stress test. See The Supervisory Capital Assessment Program: Overview of Results, dated May 7, 2009.

The Fed goes out of its way to state what the stress test IS, and what it is NOT. Specifically, it is NOT a prediction about the future downward movement in the economy, but simply a measurement device that the Fed will use to determine how much of a buffer certain selected large US bank-holding companies (BHCs) would need under a significantly negative set of economic assumptions about the future. The idea is to ensure that even under a relatively dark set of assumptions, major American banks will have the capital to survive.

To that end, a detailed paper on the Supervisory Capital Assessment Program ("SCAP") was released on April 24. The "SCAP buffer" requires that the BHC's attain by the end of 2010, Tier 1 capital of at least 6% of assets and Tier 1 common capital at least equal to 4% of total assets. Of the 19 BHC's in the study, 9 of them already have capital sufficient to meet this requirement. Of the remaining 11 that must add Tier 1 capital, the vast majority of the 185 billion will be added to Tier 1 common capital to attain the 4% requirement.

The Fed makes a point of noting that these hurdles are not designed to be an ongoing regulatory requirement imposed by either the Federal Reserve System or the FDIC. The most important point is that the Fed is acting decisively and quickly in an effort to have major banking institutions design, within the next 30 days, programs to reach the results called for in the stress test mentioned above by December 31, 2010.

Interestingly, the Treasury has not only put in place requirements for shedding certain assets (home mortgages, second tier commercial mortgages and both commercial and residential mortgage back securities (RMBS and CMBS)). Further, the Treasury through offering to the TARP program (principally TALF loans and the Legacy Loan Program and Legacy Securities Program) is not only setting out the requirements but is also providing the tools, for accomplishing the tasks placed before BHCs over the next 2 years.

In effect, we have a road map for the way out. The FDIC, the Fed and the Treasury have acted decisively and in close coordination in an effort to get capital flowing at what may turn out to be surprisingly increased levels toward the end of this year.

Will it work? Stay tuned.
 

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