Posted on December 16, 2009 by Keith H. Mullen

Capital Market Scorecard: Financial Services Committee hearing - Covered Bonds testimony

The CMSA has published the text of the testimony by Christopher Hoeffel, from his appearance yesterday before the US House Financial Services Committee.  As noted in my posting earlier this week (link), the Committee is investigating the use of the "covered bond" product as one tool to revive the CRE capital markets (and solve some of the problems with the CMBS model).

Here is a link to the testimony: LINK

The testimony is very instructive, and a must read.

I suggest that you research the covered bond.  We've been collecting materials for the last year.

If you have any questions, comments or help full materials on covered bonds, please post a comment.

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Posted on December 14, 2009 by Keith H. Mullen

Capital Market Scorecard: Hope on the Horizon - Congressional Hearings on Covered Bonds

More on my series commenting on the CMBS loan market and the broader capital markets for commercial real estate . . . .

Previously, we've brought to your attention a type of commercial real estate debt structure that HAS worked in the EU (for hundreds of years), and it HAS been tried at least twice in the U.S.  [link to prior posting]

 

It is called a "covered bond." 

 

Click here:  Wikipedia has a good description of it .

 

Covered bonds offer the best hope for improving the current capital grid lock, which has the commercial real estate market on its knees.  Covered bonds will be an important piece of the credit stack for the U.S. commercial mortgage market.  It will help the commercial real estate market recover.

 

We've meet with a EU bank that handles this product (during our trip to the EU in 2008) and we've closely followed this important topic since the then.  So, stay tuned.  We'll write more on it.

 

All that you need to know right now is that covered bonds are similar to CMBS pools, with this important difference: the issuer (read: the original lender) retains some risk on the performance of the pool.  This means that the issuer services the individual loans and literally cares for the loans—yes, this is the "retained risk" phrase that you'll start to read about.  For example, when a loan in a mortgage bond pool goes "bad," the issuer can swap out the "bad" loan with a "good" loan.  (What an idea!)  Sure, there are hurdles to this concept in the U.S., including probably amending the U.S. Bankruptcy Code.  And the public probably is in no mood to do that right now.  But as the real estate "recession" extends into 2010 and beyond, the time will come . . . .

 

 . . . maybe sooner than later.

 

A recent announcement from the CMSA (Commercial Mortgage Securities Association Web site) got me going today on this topic - tomorrow the U.S. House Financial Services Committee will hold a hearing entitled "Covered Bonds: Prospects for a U.S. Market Going Forward."  Here is the CMSA announcement:

"CMSA Executive Committee Member and immediate past president Christopher Hoeffel will testify before the full House Financial Services Committee on Tuesday, December 15 at 10:00 a.m. ET. The hearing, “Covered Bonds: Prospects for a U.S. Market Going Forward,” will provide a forum to discuss how such a market could be structured in light of current changes and the recovery efforts occurring within the financial markets.  For its part, CMSA supports efforts by policymakers to facilitate a U.S. commercial covered bond market in order to provide an additional source of liquidity through new and diverse funding sources, and the association continues to advocate for the inclusion of commercial mortgages in a covered bond market.  Mr. Hoeffel’s remarks and the hearing itself can be watched live through the House Financial Services Committee’s video sever shortly before the 10:00 a.m. ET start-time December 15."

IF Congress and IF the American public can stomach including covered bonds as part of the financial reforms, then the commercial real estate market will finally have some capital relief.

There is hope.

If you have thoughts, comments, questions or resources covering covered bonds, please post a comment.

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Posted on October 13, 2009 by Louis F. Strawn

Protecting the Interest of Bondholders as the "Controlling Class" in CMBS Investment Pools

As most of you are aware, The Pooling and Servicing Agreement (PSA) is the operative document in defining the rights and obligations of the trustee, master servicer, special servicer, and classes of bondholders.  As an overall matter the PSA defines the relationships between the parties to the securitization.  It is an agreement that is hundreds of pages in length and incorporates a voluminous amount of reports and ancillary exhibits and schedules to the document itself.  Asset managers charged with the responsibility of understanding the investment risks inherent in their CMBS bondholdings have the nightmarish job of reviewing these reports to understand the extent to which their bonds are put at an increasing risk of economic erosion and/or default.

The problem comes in when the "controlling class" of bondholders (which at the outset of the securitization is the "B piece" buyer) which can change if the aggregate certificate balance of the controlling class falls below 25% of the initial Certificate Balance for such class at the time of the closing.  In other words, if the B piece's buyers interest, based on certificate balances, falls below 25% of its original balances (usually based on realized losses), then the controlling class will change to the next subordinate class of regular certificate holders which have a balance of 25% or more of their original certificate balance.  Reporting these changes is a surveillance obligation of the master servicer and the trustee.

The question of how close a securitized pool is to experiencing a controlling class change can only be determined by digging into the voluminous reports issued by the trustee and the master servicer.  Furthermore, those reports are generally only issued as a routine matter to the "directing certificateholder" who is elected by 50% vote of the controlling class certificateholders and must sign agreements that the directing certificateholders are willing to serve in the capacities required under the pooling and servicing agreement (the directing certificateholder is required to provide contact information, meet monthly and carry out the duties imposed upon the directing certificate holder under the PSA).

However, all controlling class holders and indeed most bondholders are entitled to significant reports upon their request.  It would seem prudent for bondholders to periodically request and review those reports in order to determine if their investment as bondholders is getting close to a "change of controlling class," and understanding what effect that will have on their bonds.

An additional problem is that sometimes the PSAs are unclear as to the relationship between "appraisal reduction events" which generally apply to cash advancing mechanisms within the pool but not directly on change in the controlling class.

It is incumbent upon bondholders to understand their rights and responsibilities with respect to changes of controlling class and to anticipate notices they may receive from the master servicer or the trustee with respect to such change in control so they can proactively develop a strategy to deal with the management of their bond assets should such a change occur.  It is very possible that investment bondholders could end up having the "controlling class" status dropped in their lap with no governance mechanisms in place with which to elect or determine who will act as the "directing certificateholder."

Questions such as the size of the new bondholding class that will act as the controlling class, its various investment motives with regard to the identity of who holds the bonds, as well as the commercial real estate mortgage expertise of the bondholders will all go into a "Bondholder Agreement" under which the new controlling class will make decisions and elect a directing certificateholder.

These important strategy decisions should be proactively developed by bondholder classes as they anticipate a change of control notice from the trustee or the master servicer.

This is clearly not what the bondholders bargained for, but they must develop a road map and a strategy for dealing with controlling these securitized pools should that responsibility get dumped in their lap. 

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Posted on July 14, 2009 by Keith H. Mullen

Into the Looking Glass: Will the Next Dagger Be Loss Rates at Regional and Local Banks?

Last Thursday, the Joint Economic Committee of our U.S. Congress heard testimony calling for the "return" of the CMBS market as a means to promote the recovery of the U.S. commercial real estate finance markets.  Attached (PDF) is the testimony of Richard Parkus (who, of course, expressed his personal view and NOT those of his employer).  (His employer only paid him to do the research; the analysis is just a hobby!)

I agree with him: we do need the commercial real estate finance markets to "return" or at least improve.  OK, even to simply turn on.

We've heard or read most of his testimony before from other sources - including the large percentage of total losses in CMBS (he says between 9-12%, or about $65-$90 billion), with the highest looses in 2005-2007 commercial mortgage loans placed in CMBS pools.

Interesting, but "old" news by now.  Maybe even dull since many of those CMBS loans merely are being extended.

More startling to me is that he actually articulated exactly what I've been expecting: it's all about commercial real estate exposure at the regional and local banks.

Parkus reminded the committee that banks own @ 50% of all commercial real estate.  (Note: the Mortgage Bankers Ass'n has great information on all of this.)

So, what about the banks?

On the topic of construction loans

  • "Moreover, exposure to construction loans rises rapidly as one moves from large money center banks to smaller regional and local banks - the four largest US banks have an average exposure of less than 2% of total assets, while the 31-100 largest banks have an average exposure of about 12%" (Wow).
  • "In my view, losses on construction loans are likely to be in excess of 25%, possibly well in excess, which will imply losses of at least $140 billion.  This, of course, will be disproportionately borne by regional and local banks" (Wow, again).

On the topic of core commercial real estate loans

  • "The four largest banks have an average exposure of 3-4% to commercial real estate loans, while smaller regional banks have an exposure of 15-20%" (I'm catching a trend here).
  • " . . . loss rates on core commercial real estate loans in bank portfolios . . . will imply losses of at least $120-$150 billion on banks' core commercial real estate portfolios" (Oh, no).

Parkus' main point is that the CMBS market must be revived (OK, that's his employer speaking).

More perceptive to me is his articulation of the extremely dire, even horrible, condition of the real estate portfolios of regional and local banks.  He gets it.

The tough times might not even have arrived - the residential sub prime thing could just be the first course.

If you're experienced in workouts, many a meal could be coming your way from your regional or local bank.

Please post your thoughts or comments.

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