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

Rating Agencies continue to be under a microscope. Here are two recent events, and two points that should be of interest:

1. Moody’s Receives a Wells Letter
2. Information Sharing Under New SEC Rule 17g-5 Addresses Conflicts of Interest
3. Needed: Post-Employment Limitations On Rating Agency Employees Deserve Consideration; and
4. Needed: Rating Agency Focus On Loan Level Fundamentals (Using Databases)

Five year ago, would you have foreseen the following?

1.  SEC Sends Moody's A Wells Letter; Cease & Desist Coming Next? ZeroHedge reports  on the disclosure by Moody’s, in its 10-Q, that it received a “Wells Letter” on  March 18, 2010.  The 10-Q states:

“MIS [Moody's] received a ‘Wells Notice’ from the Staff of the SEC stating that the Staff is considering recommending that the Commission institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006.” 

ZeroHedge notes that this could be the “end for the rating agency.”

Separately, Market Pipeline quotes other portions of the 10-Q, which read like a bad dream for Moody’s.

Wow.

The European Union already is extremely upset with the US rating agencies.  This will only add to their anger.

2.  Conflict of Interest Addressed By New SEC Information Sharing Rule (new SEC Rule 17g-5): Jim Flaherty reports on the Commercial Real Estate Finance Council's "After-Work Seminar - SEC Disclosure Requirements" covering the new SEC Rule 17g-5.  This rule is designed to address the conflict of interest that rating agencies have as a result of issuers paying for ratings. It goes into effect on June 2. Here is Jim’s summary:

“The rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies.

Here are the rule’s objectives (as summarized by Jim):

• Increase the number of ratings for structured finance products,
• Promote issuance of unsolicited ratings and
• Reduce the ability of issuers to obtain better than warranted ratings by exerting influence over hired rating agencies.”

Jim gives a good summary of the seminar, including a summary of the presentation on Rule 17g-5 and a copy of the presentation – read his blog.

This is a great break through for those of us supporting, and working on, data standards in support of B2B information sharing in the commercial real estate industry.   It also is another example of the transparency movement.  (See my earlier posting on CMBS loan level information disclosure.)

3. Needed - Post-Employment Limitations: I suggest that this additional step be taken - just as with the restrictions placed on Federal employees, rating agency employees should face limitations on taking a job at an investment bank or any other company arranging or involved in the issuance of securities.

Is this idea under consideration?

4.  Needed - Rating Agency Focus On Loan Level Fundamentals (Using Databases).  Rating agency focus during CMBS 1.0 seemed to be on the financial structure and payment waterfall (among the bondholder class and the servicers) with  very little focus on the equally important underlying real estate fundamentals.

Am I incorrect in my belief that the rating agencies did not focus on real estate fundamentals?

My suspicion is that since so little of the loan level information (covering real estate fundamentals, such as lease issues, title issues, etc.) was in a database format, they really did NOT have the ability to focus on bedrock real estate issues.

There is an easy technology "answer" for this challenge: require the collection of loan level information as data, and the use of MISMO standards to achieve this information sharing.

Note that I experimented at collecting title, survey, lease and other legal information in a database format.  But the loan originators did not recognize the value in doing so.  Surely this will change in the near future.

If you have other observations or suggestions, please post a comment below.    

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In an earlier post, I commented on a proposed SEC rule that will require the disclosure of specific loan-level information as data, at CMBS securitization and then during the life of the CMBS pool.  In addition, the data will be needed to "support" certain certifications required to be delivered as part of the CMBS securitization process.  Also, the disclosure requirements cover both public AND private CMBS structures.  (Yes, a "private" CMBS deal must implement the same data collection [between the parties to the private deal] as implemented in a public CMBS issuance.)

Read the proposed rule: it will blow you away.

The purpose behind the rule is "transparency" - so that investors can better understand loan level information, and thus better evaluate the risk position of a possible purchase and investment in the CMBS pool.  (See my earlier posting on the CMBS investor's perspective on loan-level transparency.)  This will facilitate the marketability, trading or liquidity of the CMBS bonds, which in turn will "unlock" the CMBS market and encourage CMBS 2.0 to be launched, so that Main Street will have the much-needed capital source of Wall Street.

It makes sense.

Indeed, capitalism depends upon information, and one benefit of technology is that we can collect it and share it.  So, let's share it.

And it makes "political" sense (in an election year).

But the effect of this will be significant.

Here are my current thoughts:

• Data Standards:  collecting and sharing data among all parties to a mortgage loan is NOT a new concept.  The MBA formed the Mortgage Industry Standards Maintenance Organization (MISMO) years ago in order to facilitate sharing information in a data format, so that one computer could convey information to another - without human intervention (this is called "B2B communication").  Note that when one working group heard of the proposed SEC rule, it was called a "tectonic event" and a "tsunami" - and for good reason.  (Winstead is a member of MISMO since it is important to our on-line information service that I briefly describe below)
• This Will Change CRE - the Halo Effect: clearly, CMBS 1.0 showed us that the CMBS product did influence other CRE finance products, and we're still seeing CMBS influence those products.  For example, the wealth of information reported from the current CMBS pools has people complaining about the lack of information on bank loans and life insurance company loans.  Well, if this rule passes - and my bet is that it will pass - these complaints might not continue. Yes, CMBS has a "halo effect" in that it influences the entire market.  This data collection requirement will effect the entire CRE market.
• Private Information No More: One change will be that private will be the new public.  This means that . . . .
• Private Is the new Public:  Let's admit something - brokers already know the terms of leases in the market, and they share it with each other and with their customers.  Right? I've seen a stunning presentation of the terms of commercial lease terms covering the entire downtown of Dallas.  But why should I be surprised?  Is there really a legally protected commercial expectation of privacy?  Do leases and mortgage loan documents expressly prohibit one party from sharing contract information with others, or even with an entire market (or the public)? Will this prompt parties to add provisions prohibiting this sharing in future leases and mortgages? But will landlords and owners "fight" this request, because adding this will reduce the marketability and value of the building?  This proposed rule could really start all kinds of reactions.
• Portfolio Loans Designed To Be Securitized: Here's a new thought - even if your lending product will NOT be securitized, IF there is any chance that you will want to do so in the future, then you need to collect this data.  Portfolio loans no longer are an inland to themselves - if the lender wants to kick the loan off the island.
• Workouts and Loans to Facilitate Sales:  And the same concepts and comments apply to workouts and loans made to buyers of REO: if there is any intent or possibility that the loan will be put in a private or public CMBS pool, then information needs to be collected as data.
• Collecting Data From All Participants: one obvious result is that lender will require that vendors (title companies, appraisers, surveyors, inspectors, lawyers, etc.) furnish relevant information in a data format.  No more e-mails with "hard copy" attachments.  Instead, the vendor will be required to furnish information in a usable format - which means as data in a database.
• Role of Lawyers: this change really excites me.  I've been noodling around with - even creating- databases on all sorts of topics (lease reviews; survey reviews; entity reviews; etc.) for years, but clients simply did not have a pressing need for legal information as data.  Except in one area: risk management.  We have an on-line service that one client uses.  I'll be discussing it (maybe even doing a demo) at the MBA Loan Servicing & Technology Conference this month.  I hope to see you at the conference.
• Costly Change:  change is NOT free.  This will impose an additional cost to everyone in the data generating-sharing chain.
• Tsunami Change: I agree with those who call this rule a HUGE change for the CRE industry.  The all-important political winds are in place to push this long-anticipated change into reality.

 If you have any questions or comments, please post below.

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Earlier this month, the Corporate Executive Board announced (Bloomberg story) that it will collaborate with Legal OnRamp in an initiative to bring new resources to law department members of the General Counsel Roundtable (which is a program of the Corporate Executive Board).  The goal of the initiative is to enable in-house counsel to network and share knowledge with one another through the use of Web-based collaboration tools.

So what?  What does that have to do with dealing with distressed debt?

It is important because we've (finally) reached the tipping point (ok, the starting point) where, over the next few years, all of the talk of "how technology will change our business" will be transformed into "technology sure has improved the process and the results of how we manage risk in our commercial investment portfolio."

You're probably thinking "whoa, that's a huge A to Z leap" and "what are you talking about?"

Understanding "how" disruptive technologies will change (for the better) my relationships with clients and the commercial finance industry is a passion of mine.  I've worked on MISMO committees  (Winstead is a member), written about eMortgage [PDF], created a legal database used in the sale of an equipment lease portfolio, dabbled in databases for commercial mortgage loan originations, and launched a Web-based tool used for monitoring workouts (on a national basis) for an apartment lender.  I get the value proposition in technology as the tool for collaboration and separate deliverables.

However, I also understand that the commercial side of the financial services industry, and certainly most lawyers do NOT really understand the value proposition.

This announcement has spurred me to blog about it.

It is a huge subject.  And "huge" can be difficult.  Transforming high level, broad generalizations into practical pieces can be daunting (Or at least a sure path to joining the Don Quixote brotherhood).  But the topic must be addressed.  I'll write about both ends of the space.

This first piece will be a broad overview.  In future postings, I'll be more practical.

Clearly, technology promises to dramatically change how we work with distressed investments.  And all of us can point to tangible examples of this within the 4 walls of our offices when we look back to the downturn of the late 80s.  The mag cards are gone.  Spreadsheets are now everywhere.  Databases now abound.  We have e-mail.  We have PCs.  We're all "connected" (Perhaps with too much data and not with the "right" type of connectivity).

However, the next 10 years promise to bring even more dramatic changes--and it will be technology driven.

The changes will seem most dramatic in the following:

• Our interaction with each other as we handle distressed investments (new, different knowledge collaboration tools; [a form of social networking])
• New deliverables between lenders\servicers and vendors--even outside counsel (new format: paper to electronic)

We've already seen how disruptive technologies bring huge changes to newspapers, medicine, banking, etc.

We're about to experience similar changes in our handling of commercial investments, including distressed debt.  We'll see the changes between all points of the vendor compass in the financial services industry.  We'll even see it in the interaction with outside counsel.

From the legal perspective, various thought leaders have been harping on this for some time, including sharp thinkers such as:

• Richard Susskind, author of the book The End of Lawyers?
• Mark Chandler, GC of Cisco and one of the founders of Legal OnRamp
• And in my hometown of Dallas, Tom Mighell, co-author of a book published by the ABA on Legal Collaboration

In future postings, I'll comment on their work, and the work of others on changes coming to us through disruptive technology.

The "new" economy has changed.  For those of us handling distressed commercial investments, disruptive technologies will form a basis for new relationships with richer, new business processes.  The commercial finance service industry will be different, with new dialog and relationships.  And technology will be the reason "why"-- and the back bone of it all.

Finally.
More to come . . .

If this topic is of interest to you, or if you have your own perspective, please post a comment.

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