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

Article Co-Author:  Courtney D. Bristow, Winstead PC

It’s Monday morning and you’re getting ready for work with the news on the TV in the background. By now, you’re practically immune to the daily dose of doom and gloom that has become business news, particularly with regard to real estate and mortgage-backed securities. So you’re not overly concerned when you hear the anchor say, “Vital signs are dangerously low in the commercial mortgage-backed securities market. We’re suffering from a trifecta of decimated bond prices, weakening mortgage performance and drastically reduced loan originations. The threefold combination has pummeled portfolio values and deprived borrowers of a primary source of commercial real estate financing.”1 As you turn off the television and head out the door, you find solace in the fact that you work for a public healthcare company and not a financial services firm.

Your phone is ringing as you walk into your office. It’s your CFO explaining that a $5 million loan on one of your office buildings in Michigan is maturing in three months. He asks you to help the company’s internal business unit that is desperately searching for new financing while, at the same time, communicating with the commercial mortgage-backed securities (CMBS) loan servicer who manages the loan. Did he just say CMBS? Loan servicer?  Find financing upon maturity?  What do you need to know about the CMBS industry and its participants to navigate through this mortgage mess that just fell into your lap? Click here to read the entire article.

Article published in the September issue of American Corporate Counsel (ACC) Docket, the award-winning journal of the Association of Corporate Counsel.
 

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At the September announcement of the REMIC announcements from the US Treasury the IRS, we posted copies of the materials relating to "significant modifications" to CMBS loans.

Last week, Lou Strawn weighed in on his perspective on the significance of these changes.

Today, the Commercial Mortgage Securities Ass'n gives us the industry's "official" perspective in a white paper.

The prediction here is that these REMIC reforms will NOT have a significant impact on the log-jam of distressed loans needing modifcation (in conjunction with a workout).

If you see it differently, or have an experience that you want to explore, please post a comment.

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Sick and beyond tired of the inflexibility of CMBS servicers in making needed modifications to CMBS loans that we all know are in the ditch?  Help might be here:

On September 15, 2009, the IRS and the Department of the Treasury issued three pieces of guidance relating to commercial mortgage loans held by a securitization vehicle (a CMBS loan).

• The final rules (see PDF entitled "TD 9463") regarding "Modifications of Commercial Mortgage Loans Held by a Real Estate Mortgage Investment Conduit (REMIC)" include changes in collateral, guarantees, credit enhancement of an obligation and changes to the recourse nature of an obligation.  These rules expand the list of exceptions that will not be considered "significant modifications" of a CMBS loan obligation held by a REMIC.
  
• The IRS also issued Revenue Procedure 2009-45 (PDF), which is a final ruling that describes the conditions under which modifications to certain mortgage loans will not cause the IRS to challenge the tax status of REMICs.  Specifically, note the factor that allows a servicer to take action more than one year prior to maturity.  Furthermore, a servicer is able to rely on information provided by the borrower unless it has knowledge to the contrary.  More importantly, while past performance of the loan is a factor in assessing risk, a "significant risk of default" (based upon a "reasonable" belief standard) can be found by the holder or servicer even if the loan is currently performing (This is great news for principals who are keeping the loan payments current from sources other than rent).
  
• In addition, the IRS and Treasury issued Notice 2009-79 (PDF) and are requesting comments on what additional guidance, if any, is needed regarding modifications of commercial mortgage loans held by investment trusts.

Additional information can be found on the CMSA's Web site (link to REMIC Reform).

Hopefully, these guidelines will allow CMBS loan servicers and borrowers greater flexibility to assess risk and allow for appropriate modifications to CMBS loans.  It is desperately needed.

We know that the public is in no mood to support a "rescue" plan for commercial real estate.  Maybe,  just maybe, "tweaking" the tax code like this will be the approach that will be taken by the government—sort of a "back door" rescue plan for commercial real estate.  However, I believe that it'll take much, much more than tweaks like this one to help commercial real estate to QUICKLY recover.

Kudos to the broad cross section of the commercial real estate industry that worked on this initiative (Mortgage Bankers Association, Commercial Mortgage Securities Association, ICSC, Real Estate Roundtable, and others).

If you have any questions or other information, please post a comment.

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The first day of the 2009 MBA's Commercial/Multifamily Servicing and Technology conference has ended.

It has been a long day, filled with attending panel presentations and meetings with people over meals, in the halls and at receptions.  It started at a 7:30 breakfast and ended @ 10p (when I refused to join a group that headed toward B___n Street).

Attendance this year seems down by @ 40%-50% from prior years.  Indeed, several companies told me that they would not be attending this year.  And many companies seem to have sent only 1 or 2 people this year; instead of the usual 4 or 5.

It is late, and if I don't get this down-load out soon, tomorrow will hit with more panel presentations and meetings - and I'll "lose" these data points.  They are in the order collected by me during the day - and so they are NOT ordered by relative importance.  Here is the down-load  (remember, this is a blog and not a thesis or brief; and it is very late).

(One other preliminary and important thought: if your boss requires that you prepare a memo on the conference, consider this permission to cut'n paste as you wish . .  . . )

From the opening general session:

• during the next 2-3 years, the commercial mortgage finance industry will focus on servicing & asset management, which will be the new front line for the industry
• unemployment remains a key leading indicator of the performance of real estate as an asset class (and since unemployment is expected to increase, it will take several years for the asset class to recover)
• while defaults presently are @ 3%, some predict that the default rate will increase to 6%; consequently, special servicing will become busier, and the need for greater transparency will be increased (in order to support better decision making) (Note the Fitch report described below.)
• one speaker articulated five areas of focus for the industry: (1) greater transparency (with "real time" property performance data); (2) the need for high quality and detailed physical asset condition inspections; (3) greater focus on customized business plans for each asset, which points to the need for more expertise by special servicing; (4) the increase in defaults will strain human resources at companies (and require greater recruiting, more training and better integration); and (5) companies must be better at understanding macro trends and changes

From a session on developments in Washington, DC:

• expect more changes and experimentation by policy makers
• accounting issues include: (1) FASB 140 (true sale changes); (2) FIN 46(r) (balance sheet consolidation with the "primary beneficiary" of securitization vehicles); and (3) FASB 157 (fair value); all due to "FASB's perceived suspicion" of real estate structures
• REMIC reform will take a back seat to other issues at Treasury
• Single Purpose Vehicle (or single purpose entities) and separateness covenants: the General Growth Properties bankruptcy will be an initial stress test of this "bankruptcy remote" structure; although one panelist labeled the GPP structure as "SPE light with bad cash management."  Another panelist called the GPP case simply "bad facts, which should not be followed by other situations."  (This last point puzzles me: a clever borrower might view the GPP case not as "bad facts" but as a "helpful road map.")
• One panelist expects to see a new securitization in 3rd or 4th Q of 2009.  Wow.  Given all of the accounting and structure "issues" detailed during the day, anticipated increase in the default rate, etc. - a securitization in 2009 would be . . . well  . . . wow.
• Federal limits on executive compensation are a huge problem for investors; and are chilling the market by impeding companies from participating in Federal programs
• Terrorism insurance needs to be addressed . . . but the Executive Branch needs to cut programs - not increase the funding of them.
• Welcome to the "Age of Regulation"

From a panel session on dealing with troubled securitized loans:

• even life companies are starting to see their mortgage portfolios in distress (so they are focusing in-ward on their portfolios; and not outward to refinance CMBS loans)
• the demand for new commercial mortgages exceeds the supply
• long term, fixed rate interest mortgages are limited in amount
• property values are difficult to establish
• debt service coverage & loan-to-value criteria are very conservative (and thus underwriting is tough)
• CMBS structures do not offer refinancing (with only a limited ability to extend)

From a panel session on today's servicing challenges:

• servicers are surprised that subordinate lenders do not understand their rights (relative to the rights of the first-lien secured lender)
• communication among the lenders in the credit stack can be "challenging" (Wow; that was an understatement.  I've seen some deals where the disparate balance sheets and agendas of the lenders present the biggest hurdle to resolving a distressed project.  The project and the borrower can almost be an afterthought)
• valuation is a huge problem: every party at every point of the debt stack and the equity stack needs a good\reliable value in order to make decisions.  No value=No decisions=No peace
• as reported by Fitch Ratings in an April 29, 2009 special report, CMBS special servicing volume increased by more than 5.0X in the 15 months ending March 31, 2009 (from $4.6B at 12/31/07 to $23.7B at 3/31/09).  And these figures do not address distressed bank debt, nor distressed life insurance company debt.  More wow.

Taken together, I come away from the day with much the same impression as I did on that day three session at the EU conference last fall: no one is clapping.

Time to go to bed.

If you have your own comments, or follow up questions, please post a comment below.

P.S.:  Returning to the eating theme from my posting on Tuesday, and before I get some sleep -  here's another good restaurant in New Orleans: Herbsaint Bar and Restaurant.  This is the second restaurant recommended to me by a New Orleans native.  I now understand.  It is very, very good.  Not as fancy as Nola; much more stylish than Jacques-Imo's. And not in the French Quarter. Together, all three restaurants will pull me back to New Orleans.

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Over the last 8 months, we've blogged in October from the EU, where we attended a real estate convention and visited with several clients (link to last day), and then in February from the MBA-CREF convention in San Diego (link to last day),

This week, we're attending the MBA's Servicing & Technology Conference in New Orleans.  This will be my 9th or 10th time at this conference.  In the past, the focus at each conference has been the nuts'n bolts of master servicing (i.e., servicing performing loans after loan origination) and the growing use of technology as the servicing backbone.  Bread and butter stuff, with a growing awareness that technology could make significant improvements to the production and servicing model.

Each year at this conference, the special servicing "naysayers" (i.e., those handling the servicing of distressed loans) darkly predicted that the loan production party was about to end - that the workouts surely were about to start.  Surely.  Sometime.  Simply a matter of time . . . .

Well, it has ended, and the conference this week has a heavy focus on distressed debt.  Broadly stated, here is a quick, high-level summary of the topics to be covered at the conference:

• Loan workouts and restructures
• Default management and delinquencies
• Risk mitigation
• Insurance issues
• Bankruptcy & receivership
• Accounting & tax issues (including REMIC issues & implications)
• Servicing issues in a changing environment
• Transparency issues
• Issues in foreclosure

As it turns out, this conference completes a trifecta for us - this is the last of  three meetings which, when taken together, would be fertile material for Shakespeare:

• Act One: The Global Hurricane Hits (our EU experience)
• Act Two: Loan Production in the Big Ditch (our MBA-CREF experience)
• Act Three: Special Servicers to the Rescue (this week in New Orleans)

Stay tuned.  I'll be posting from the conference.  And I suspect that we'll be collecting materials for many more postings after this week.

P.S.: OK, so I snuck into town several days before the conference - simply to eat and sleep.  Top restaurants so far - on two extremes:

• Jacques-Imo's: full of locals for a funky, affordable creole & cajun food (eat with the locals); 30 minute ride on the St. Charles Street car from downtown (more fun)
• Nola: great food but expensive (relative to Jacques-Imos); white table cloth

If you have any questions or comments for us to investigate while we're at the conference, please post a comment.

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By Guest Writer – Christopher T. Nixon, Winstead PC

CMBS Master Servicers typically lack the ability to modify a CMBS loan to preemptively address a potential loan problem. A CMBS borrower frustrated with such inability may elect to purposefully default on the loan to circumvent the restrictions placed on the Master Servicer and force the transfer of the loan to the Special Servicer. The borrower's expectation is that the Special Servicer will have the ability and agree to modify the CMBS loan to address the potential loan problem.

Risks:  If it is apparent to the Special Servicer that the borrower intentionally defaulted on the loan, the Special Servicer may elect to accelerate the debt and pursue foreclosure of the real estate collateral. The Special Servicer may determine that an aggressive foreclosure of the defaulted loan will maximize recovery for the bondholders as compared to attempting to negotiate a loan workout with an untrustworthy borrower acting in a manner detrimental to the economic interests of the REMIC Trust in which the CMBS loan is pooled.

Potential Solution:  Rather than taking the inflammatory step of defaulting on the CMBS loan to reach the Special Servicer to address a potential loan problem, a borrower should consider discussing the potential loan problem with the Master Servicer. If the Master Servicer determines that the loan problem constitutes a "reasonably foreseeable default," the Master Servicer may have the ability under the Pooling and Servicing Agreement (PSA) to transfer the loan to the Special Servicer at that time (without waiting for an actual loan default to occur) to address the loan problem. A Special Servicer may be more inclined to consider a loan modification as compared to a foreclosure if the Master Servicer and borrower present the loan problem to the Special Servicer at this stage. The effectiveness of this approach will largely depend on the quality and sophistication of the Master Servicer and Special Servicer. Given the current bad economy, Master Servicers are increasingly aware of the need to proactively discuss borrower loan problem concerns and to involve the Special Servicer early in such discussions.

Tips for the Borrower:

• Be honest about the potential loan problem when discussing it with the Master Servicer.
• Provide sufficient information to the Master Servicer for it to objectively determine that the potential loan problem constitutes a "reasonably foreseeable default."
• Do not create a potential loan problem merely to seek economic concessions from the Special Servicer. The borrower should have a sincere concern that a loan default is likely to occur if the loan problem is not promptly addressed.
   

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(This is part of a series of postings from the 2009 MBA-CREF convention in San Diego.) (Trends; Arriving;  Day One; Day Two; Day Three)

It is no surprise that the convention is markedly different from previous years.  Everything has changed (unfortunately that's almost NOT a terrible understatement): lenders have a new focus (and those with "real" investment allocations to lend are few in number), servicers are under scrutiny in the face of looming defaults, and mortgage bankers are seeking ways to serve (read "save") their best borrowers.

Kudos to the MBA for directly addressing these changes and challenges.  The sessions were informative.  The discussions were frank.  Too bad attendance at the convention is down.

Here are some of the topics, observations and comments:

• Servicing is servicing.  While servicing CMBS clearly has unique twists and challenges (such as the servicing standard of care, "tension" among the investor classes, etc.), portfolio lenders and CMBS servicers share many common hurdles in dealing with troubled loans.  (My next post will address some frequently asked questions about dealing with troubled CMBS loans.)
• The erosion of credit and value is a critical challenge.  Yesterday's debt service coverage and loan to value definitely is not today's story.
• The stack of first lien mortgage, mezzanine debt and even holding company leverage, which I affectionately call the "Other People's Money" mantra of the "old" economy, is yesterday's story and today's headache.  In prior conventions, sessions focused on these "tools" of the finance market.  This convention didn't even mention it - for good reasons: we're now dealing with the hangover.
• It is difficult to identify the correct asset disposition strategy when relative values are difficult to determine - values seem to change weekly.  In all sectors (products) and markets, appraisal valuations are problematic.
• Life companies are placing greater emphasis on debt service coverage, with less reliance on loan to value measures.
• The ability of borrowers to pay off a loan at maturity (the inability to pay is called a "maturity default") is under question due to the fear that community and regional banks are tapped out in their ability to place mortgage debt on their balance sheets.  And since these loans are limited term floaters, with equity pay-downs and guaranty agreements, they are only a temporary "fix" to the larger credit problem.  In other words, the boomerang remains in the air.
• Generally, the strategy of CMBS servicers and portfolio lenders is this: extend (if possible), wait and increase surveillance.  However, an extension has a price: new underwriting of the market, the project and the sponsor, with an extension fee, new reserves, lock box structures, amortization, etc.  An extension needs to make sense.
• Regulatory reform is coming.  For the life company, this means possible changes to risk-based capital (and the dreaded "mortgage experience factor") and possible "opt in" Federal licensor.  For the CMBS servicers, this means possible REMIC reform (again) addressing seller financing, control over the special servicer, etc.
• The need for greater information flow.  For the life company, this plays out in rating agencies asking for loan level information - like the information available in CMBS pools.  This second guess is totally new for life companies.  (For years, I periodically ask my life company clients: do you want outside counsel to prepare a loan and property summary like the ones we prepare when we close a CMBS loan? The prediction here is that the time has come for this change.)  For CMBS servicers, investors are asking for even more loan level information.  They've learned that they can not simply "trust" the certificate rating - they need to understand the current status of each loan in the pool (beyond the data contained in the current investor reporting package).
• Note sales are problematic.  On the CMBS side, they have slowed, with a wide gap between the bid and the ask price.  It was noted that there exists a correlation between AAA CMBS spreads and the volume of note sales.  Thus CMBS prices need to stabilize in order for loan sales to increase.  On the portfolio lender side, the risk-based capital rules literally rob the portfolio of the ability to craft loan restructures that place the lender in a position to increase its yield (and profit from a rebound in the market).
• Life company underwriting is now a return to the basics: 1.50x minimum debt service coverage; maximum 55% maximum loan to value (slightly higher for multifamily); shorter term; avoid hotels; beware of retail and "transitional" projects (which is a problem for banks seeking takeouts for construction loans); closely examine employment base of local market; scrutinize debt maturities of the principal; consider the use of lock box and SPE structures; less reliance on appraisals (due to valuation challenges) and more reliance on debt service coverage; etc.

This convention has been "rich" - not in the sense of money being thrown at deals (as in prior years); but rich in information, determination and the resolve to navigate these challenges.

The unspoken mantra seems to be: we can do tough times.

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Guest Writer – Christopher T. Nixon, Winstead PC
(2nd in a series of 2 postings)

In my prior posting (Part 1),   I covered some of the key differences between a workout of a CMBS loan and a workout of a portfolio loan.

Here are some more:

• Flexibility.  Due to REMIC rules and the restrictions and limitations set forth in the PSA, a Special Servicer is not able, or has less flexibility than a portfolio lender, to substitute collateral, take additional collateral, capitalize past due interest, bifurcate the debt, take an equity or contingent interest position, operate an REO property, or lend additional money as a loan default solution.
• No CMBS Loan Dragnet Clause.  The borrower has no other source of repayment for a Special Servicer to consider in the workout of a CMBS loan, which may not be the case in a portfolio loan workout scenario.
• SPE Provisions.  A CMBS loan borrower is bound by bankruptcy-remote SPE provisions in its organizational documents.

a.) Bankruptcy Remote.  There are structural impediments to the borrower's ability to file bankruptcy. Even if the borrower files bankruptcy, the CMBS lender is likely the only secured creditor.
b.) Single Purpose.  The borrower has no ability to substitute or add collateral to address a CMBS loan default.

• Carve-out Guaranty.  While many portfolio loans are recourse loans, CMBS loans are typically non-recourse. With respect to a CMBS loan, the borrower and the principals of the borrower may face recourse liability for certain bad acts described in the loan documents.
• Cash Management.  Many CMBS loans have a lockbox cash management component, which facilitates the control of cash collateral. Portfolio loans typically do not have any such component.
• Regular Borrower Financial Reporting.  While portfolio loans typically do not have rigid borrower financial reporting requirements, regular borrower financial reporting requirements of a CMBS loan keeps the Servicer apprised of the financial status of the real estate collateral. The information in such financial reports may be critical to a Special Servicer in making an informed decision about how to address a loan default.
• Property Management Control.  CMBS loans typically assign to the lender the right to replace the property manager with a lender-approved property manager. Portfolio loans typically do not have any such assignment provision.

The differences between the two types of loans are significant. And this list is not all-inclusive. So, be careful – and as self servicing as this sounds, use legal counsel who is experienced in handling CMBS loan workouts.

If you have any questions or  suggestions, please post a comment.
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Guest Writer – Christopher T. Nixon, Winstead PC
(1st in a series of 2 postings)

In the commercial loan default scenario, CMBS Special Servicers are not able to provide to borrowers many of the accommodations that may be provided to borrowers by portfolio lenders. CMBS Special Servicers are subject to many more restrictions and limitations than to which portfolio lenders are subject in a loan default situation.

Understanding the key differences between CMBS loan workouts and portfolio loan workouts will facilitate a borrower's efforts in attempting to address a CMBS loan default with a Special Servicer. Some of the key differences between CMBS loan workouts and portfolio loan workouts are as follows:

• Standards. A portfolio lender applies its own individualized standards in addressing a loan default; and a third-party servicer will administer the loan in accordance with the servicing standard articulated in its servicing agreement with the lender. A CMBS Special Servicer must administer the loans in accordance with the Servicing Standard set forth in the applicable Pooling and Servicing Agreement (the "PSA") and comply with REMIC rules to protect the federal income tax-free status of the REMIC Trust in which the CMBS loan is pooled.
• Continuity of Relationship. A portfolio loan has continuity in the origination, servicing, and workout of the loan. The portfolio lender has an ongoing relationship with the borrower and retains tight control over any third-party loan servicer. On the other hand, a CMBS loan involves the fragmenting of the obligations, responsibilities, and liabilities for the loan between multiple parties involved.
• Workout Goals. A portfolio lender attempts to preserve the value of the asset and, in some instances, its relationship with the borrower. A CMBS Special Servicer attempts to preserve the integrity of the Trust, while maximizing recovery for the bondholders.
• Preemptive Abilities. A portfolio lender may make additional loan advances or enter into preemptive loan modifications to address a potential loan default. A Master Servicer typically lacks the ability to preemptively address a potential loan default.
• Due Diligence Review. A CMBS Special Servicer's review of due diligence may be more challenging than that of a portfolio lender because the Special Servicer is often not familiar with the loan before the transfer of the loan from the Master Servicer to the Special Servicer (i.e., the "Servicing Transfer Event").

My next posting will list several other differences.  If you have any questions or suggestions, please post a comment.
 

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