December 2001The CMBS Market is Huge ...and Largely a Mystery
The CMBS (Collateralized Mortgage Backed Securities) market has fundamentally changed the landscape in the United States for commercial real estate finance—the legal structure, ownership, management and rules of the game. Securitization has also forever altered the behavior of the troubled loan participants and consequences that follow in the mortgage default dance.
Given the pervasive “success” of CMBS financing, it is nothing short of amazing that so many borrowers and their advisors appear to have little understanding of the process, structure and practical implications of their securitized debt or how to deal with it when times get tough. This article provides an introduction to some of the major differences that borrowers will confront.
New Paradigms Replace Old Ones: The Fundamentals
In contrast to traditional, non-securitized commercial real estate loans, the structure for CMBS loans is far more complex. A bank or other loan originator makes a loan secured by a mortgage on commercial real estate. The originator holds the loan until it accumulates a sufficient number of loans for securitization. Then the originator or accumulator sells the mortgages to a depositor. The depositor transfers the loans to an entity which will pay no federal income taxes. Normally, to assure this tax transparency, the entity used will be a Real Estate Mortgage Investment Conduit or REMIC.
The sellers, underwriter and rating agencies decide the makeup of the ideal pool. The rating agencies determine how the pool will be tranched into classes for requested ratings. The underwriters, working within the rating levels, design multiple classes of securities to be sold at various terms to satisfy market conditions determining how many securities will be offered at each rating and maturity.
Typically the management structure of the CMBS pool is established by a Pooling and Servicing Agreement or PSA. This complex document provides extensive detail governing the duties of the servicers in handling the loans, and allocation of cash flows to different classes of investors. It is designed to protect the REMIC tax treatment of the trust, and to balance the sometimes conflicting interests of the various classes of bondholders, as well as those of the issuer, servicers and others. The parties to this agreement usually include the Trustee and Custodian for the trust holding the mortgages, a Master Servicer, and a Special Servicer.
The Master Servicer is responsible for collecting and monitoring all mortgage payments and ensuring that all payments are made to the security holders. On loan default, the Master Servicer will transfer servicing to the Special Servicer. who usually hold the lowest rated tranche of the offering and is the party who handles the workouts.
Practical Implications of REMICs For Troubled Loans
The practical implications of securitization can be profound. Compared to traditional pre-CMBS models, securitized loans invoke different players, documentation, structures and inflexible tax rules. These differences affect the incentive, ability, and willingness to workout or liquidate troubled loans.
Most of the CMBS vehicles are REMICs. This REMIC status is crucial to the securitization market, because the REMIC status assures bondholders that the trust will be a pass through entity for tax purposes, avoiding a devastating double tax if the loan pool or trust were to be taxed as well. REMIC status is gained by compliance with complex and rigid rules that prohibit prepayments (unless executed in accordance with defeasance procedures) and sales or exchanges of mortgages in the trust, including modifications to the mortgages, unless in compliance with very strict guidelines. These tax-driven mandates severely limit when and what a Special Servicer can do when a loan is in trouble.
The REMIC rules, pooling and servicing agreement, and loans documents provide a strict regimen for securitized troubled debt. Failure to strictly observe these rules is the tax equivalent of Armageddon for REMIC investors, servicers and other participants.
Here are a dozen differences in REMIC workouts:
REMICs have changed the landscape of commercial real estate finance forever. We will soon see how they will change the processing of troubled loans. The complexities of the structure make it imperative for all parties to know what they are doing. If borrowers are to succeed in workouts, they must solve the maze to find the right party to whom they should talk, and know how to present options that are within the power and prerogatives of the servicer.
Jeffrey Steiner is a senior member of JMBM’s Global Hospitality Group and real estate department. He has extensive experience with hospitality and real estate workouts, financings, development projects, management and franchise issues, acquisitions and dispositions, joint ventures and other complex transactional matters.
The Global Hospitality Group(r) is a registered servicemark of Jeffer, Mangels, Butler & Marmaro LLP
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|Also See:||Avoiding Liability for Lay-Offs / The Global Hospitality Advisor / December 2001|
|The Worker Adustment and Retraining Notification Act: Impact on the Hotel Industry / JMBM|
|When is an Apartment a Hotel ... and Who Cares? / The Global Hospitality Advisor / JMBM / September 2001|
|The 'Perfect Storm' / The Global Hospitality Advisor / JMBM / September 2001|
|Richard Kessler's Grand Theme Hotels - Interview with GHG Chairman Jim Butler / March 2001|
|Stephen Rushmore's Industry Trends / Top Markets, Predictions & Opportunities / Jan 2001|
|Outlook 2001: A Roundtable Discussion The Global Hospitality Advisor / Jan 2001|
|Perspectives on Hotel Financing in 2001; Jim Butler, JMBM's Global Hospitality Group Chairman, Interviews Two Active Players in Hotel Finance / Jan 2001|
|Robert J. Morse: Millennium’s New President / Interview with GHG Chairman Jim Butler / Nov 2000|
|Special Reports / Jeffer, Mangels, Butler & Marmaro LLP|