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

Overlooked by the recent focus on health care reform, and now by the financial reform bills (see my recent blog posts, is draft legislation prepared by Representative Minnick(D-Idaho). Known as "The Community Bank and Commercial Real Estate Stabilization Act of 2010," his draft legislation has circulated on the Hill but has NOT been introduced into the legislative process.

His bill is based upon this premise: the "too big to fail" approach, which bailed out the largest banks and supported the CMBS market, largely ignored one very powerful economic engine.

Who is this "lost" or forgotten group?  Hints:

• They have the highest concentration of commercial real estate loans (relative to risk based capital) among lenders
• They extend credit to a broad range of customers (not just real estate related)
• They are located near you - even on your Main Street
• Every week, the FDIC seems to close 5-10 of them

The answer: Community Banks.

Hundreds have failed over the last several years; and hundreds will fail in the new future - currently, the FDIC lists 775 banks on its list of of "problem" banks (nearly 10% of all FDIC-insured banks).

I agree with Richard Suttmeier's assessment that community banks are the next key to economic recovery.

In his recent blog posting, he articulates the important role played by community banks -

• The economy on Main Street is driven by small businesses, the housing market and local construction - none of which are "too big to fail" but when taken together . . .
• These are the engine of job growth in the private sector
• Without job growth on Main Street, the economy will struggle [my editing here: Suttmeier predicts a "double-dip"], and consumer spending will suffer
• Community banks are the key to lending to small businesses
• Thus, community banks are crucial to the economy on Main Street

Representative Minnick's bill seeks to address this oversight (or perhaps simply the relative inability of community banks to pull political levers, when compared to Wall Street and the largest banks).  Briefly, his draft legislation addresses two related goals:

• Jump start new lending on the small-balance commercial real estate sector

Here's a quick summary of his bill (as of several weeks ago - so this could change):

• Six-month pilot program of $3 billion, if successful, may be expanded to three years and upsized
• Only community banks will be able to access that part of the program aimed at seriously delinquent loans and REO
• US Treasury will guarantee bonds backed by pools of small-balance commercial real estate loans, including REO properties at community banks
• Program administered by a Board consisting of Treasury Secretary, Fed Chairman, SEC Chairman, FDIC Chairman and four industry experts appointed by President
• $10 million maximum loan size (or appraised value) per property
• Conservative loan underwriting and pricing
• Rating agency involvement to provide an independent view on underwriting and structure
• Treasury will charge a “guarantee fee” similar to Fannie/Freddie, of between two to three percent annually
• Any profit participation back to the originator must be earned over time

I also attach a much longer "term sheet" describing the proposed bill (there might be a more current version).

So, what do you think?

Please post your comments below.

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In two prior postings [first] [second] addressing the CRE finance crisis and market trends, I have explored three (3) topics that point us to answers on these all-important (even personal) questions:

• What does all this mean?
• What is the big-picture?
• Where is this going?

Before we address the 4^th topic (covered bonds), we need to devote additional attention to the 3^rd topic: The Uncertain CMBS 2.0 in that . . . .

(1) Recent Senate panel testimony and (2) a recent decision of a New York trial court both illustrate another hurdle for launching CMBS 2.0, and point to the need for rating agency reform.

The decision also falls in line with my concern that these tough times will result in courts accepting new and novel legal theories – and my prior posting warning all of us to “watch for change in the court house."

The recent case goes to this simple question: what if the rating agency is wrong in its rating? (Hum . . . can we stipulate or agree that this has happened at least a few times in recent years?)

1. Reform: Of course, rating agencies do NOT have any liability for mistakes [see this white paper]; however, rating agency reform needs to be a focus of the financial reform.
2. Liability: So, if there is no recourse against the rating agency (right now), is there another way to get “at” somebody in the deal based upon rating agency mistakes?  If the rating agencies don't have any liability, then who does?

Liability:

Maybe there is liability for "missing" a rating designation . . . here are the facts in a New York state case involving two financial titans: MBIA Insurance Corp. v. Merrill Lynch, Pierce, Fenner & Smith Inc., No. 09- 601324 (N.Y. Sup. Ct. Apr. 7, 2010) [link to copy of opinion]. MBIA’s subsidiary, LaCrosse Financial Products LLC, issued a number of credit default swaps with various counter parties, in which it sold protection on purportedly “senior” and “super senior” tranches of various collateralized debt obligations (“CDOs”) (having a total notional value of approximately $5.7 billion). As is very typical in the financial guarantees of these structures, MBIA executed a financial guaranty insurance policy, which guaranteed the seller’s payment obligations under the credit default swap contracts.   As part of the credit default swap contracts, Merrill Lynch (through its subsidiary Merrill Lynch International), promised to deliver securities that were AAA-rated with senior or super-senior subordination characteristics. The securities were rated AAA; however, the court refused to dismiss MBIA’s claims that the credit quality of the collateral underlying the securities did NOT warrant the AAA rating of the securities, and did not have the levels of subordination represented by Merrill Lynch International.

This might be the first time that for a court to recognize possible liability of a party based upon the party’s statements that securities were AAA-rated (in harmony with the rating agency) when in fact, the rating agency should NOT have rated the securities AAA.

Sure, this ruling is being appealed; and a higher New York State Court could overturn it. But the appeal will take time, which means further delay on a resolution on this issue.

Rating Agency Reform

Separately, on April 23, former credit rating industry executives told the Senate Permanent Subcommittee on Investigations that competitive pressures and poor internal communications led their analysts to award safe ratings to risky investments - which (of course) turned out to be toxic and contributed to the financial crisis. Senator Carl Levin (D-Mich), the chairman of the panel hit the nail on the head, when he focused on the conflict of interest that arises when the credit rating agencies are paid by the same party whose bonds they rate. “It’s like one of the parties in court paying the judge’s salary,” said Sen. Carl Levin, D-Mich.  As Barbara Kiviat notes at The Curious Capitalist, "A purer conflict of interest would be hard to find."  Her comments mirror Tex Gross' question in my earlier posting: ""why would anyone rely upon you (the rating agencies) when the rated party pays the fees of the rating agency?"

Congress needs to address this conflict - and not simply focus on the creation of Office of Credit Rating Agencies at the Securities and Exchange Commission (as a means to strengthen regulation of credit rating agencies).  [see p. 8 of the attached summary of the Senate financial reform bill].  Barbara Kiviat favors a "credit ratings clearinghouse" as the solution to the conflict problem, which makes good sense to me.  Her column is a good read on this keystone topic.

Here is the importance of these two events for me:

• Reliance on Ratings: If parties to a securitization can NOT rely upon a rating agency designation (which is the lesson from the MBIA case), then how can the market rely upon it?
• Future of Rating Agencies: What is the future of the rating agencies?  Surely change is on the way.
• Congressional Debate & Meaningful Reform: Will this case and this alarming testimony focus Congress on the need for real rating agency reform? What about changing the way that rating agencies are paid?  This is a must do.
• Huge Hurdle: How can CMBS 2.0 get off the ground, in any meaningful way, with this rating agency cloud on the horizon?  Can it really be ignored?
  

A meaningful CMBS 2.0 platform must include rating agency reform.

Question for you: do you see it any other way?

Post your comment, perspective or correction below. 

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