Commercial Mortgage-Backed Securities 2.0: …media.straffordpub.com/products/commercial-mortgage-backed... · Commercial Mortgage-Backed Securities 2.0: Structuring Securitized Loans

Commercial Mortgage-Backed Securities 2.0:

Structuring Securitized Loans Navigating New Structures, SPE Covenants, Cash Management and Other Loan Provisions

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THURSDAY, DECEMBER 19, 2013

Presenting a live 90-minute webinar with interactive Q&A

Allen Dickey, Shareholder, Munsch Hardt Kopf & Harr, Dallas

Michael Weinberger, Partner, Cleary Gottlieb Steen & Hamilton, New York

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Structuring Securitized Loans

Presented by:

Allen Dickey

[email protected]

Thursday, December 19, 2013

1:00 pm Central


6

Presentation Outline

Introduction/Background

CMBS 1.0 to 2.0/3.0 and Back

Summary of Changes From CMBS 1.0 to 2.0

Original Goals of CMBS 2.0

CMBS 2.0 – How Were Loan Terms Different From CMBS 1.0

CMBS 1.0 Guarantees Withstood Court Challenges

CMBS 3.0

CMBS 3.0 Loan Structures

Pari Passu

A/B

Mezzanine Loan

Comparison of A/B to Mezzanine Loan


7

Introduction


8

Introduction

Banks have arranged about $72.3 billion of CMBS linked to shopping

malls, office buildings and hotels this year, more than double the amount

sold in all of 2012, according to data compiled by Bloomberg. Issuance

of CMBS is poised to exceed $80 billion by the end of 2013. Bank of

America is forecasting $100 billion of CMBS offerings in 2014. This

number, however, is less than 50% of the U.S. total issuance of CMBS

in 2007 – that year, $230 billion was originated.

Investors are aggressively purchasing CMBS bonds as late payments on

commercial mortgages decline. The delinquency rate fell 32 basis points

to 9.5 percent in November 2013, according to a report from Credit

Suisse Group. That marks the largest monthly decline on record.


9

The surge in sales is fueling concern that banks are allowing lending

standards to slip. Moody’s is increasing the amount of credit protection

required to garner investment-grade rankings on riskier portions of new

deals, meaning underwriters have to build in a bigger cushion to protect

investors from losses. Some dealers are forgoing a ranking on those

securities from the firm.

The size of loans relative to property values (LTV), is climbing, Moody’s

said in an October 28 report. The average LTV increased to 103

percent in the third quarter from 102.6 percent in the prior three-month

period, according to the New York-based rating company. Higher

leverage makes it harder to pay off debt.

Introduction (Contd…)


10

Standards for commercial real-estate lending are seen loosening further

next year. About 43 percent of respondents from investors to developers

surveyed by PricewaterhouseCoopers LLP and the Urban Land Institute

said they expect underwriting to be less rigorous in 2014, the firms said in

a report this month.

With CMBS surging in popularity once again, this presentation will provide

a summary of the legal and structural changes from the prior era of CMBS

ending in 2008 (CMBS 1.0) along with a discussion of current loan

structures being utilized by CMBS loan originators.



11

Various Parties to Commercial Real Estate Capital Stack

Trustee

Lender of Record of Mortgage Loan

Master Servicer

Services Loan Prior to “Specially Serviced’’ Designation

Handles Cash

Responsible for Advancing



12

Special Servicer

Takes Over Active Servicing of Loan Once it Becomes “Specially

Serviced’’

Controlling Holder

Has Consultation and Consent Rights Over Major Servicing

Actions

Has the Right to Replace the Special Servicer

Mezzanine Lender

Holds a Separate Loan With Separate Collateral

Party to Inter-Creditor Agreement With Mortgage Lender



13

CMBS 1.0 to 2.0/3.0 and back


14

CMBS 2.0 refers to the resurgent capital markets commercial real

estate loan origination and securitization industry which restarted in

2010; there were:

Changes to loan structures (business underwriting) at the borrower

level

Changes to loan structures (legal) at the borrower level

Changes to securitization legal structures at the bond level

Changes to securitization subordination levels and other business

terms


15

Original Goals of CMBS 2.0

Increased Transparency / Disclosure

Risk Alignment

Vastly more conservative underwriting

Lower leverage

Enhanced Representations / Warranties

More input from investors


16

CMBS 2.0 securitizations were far smaller than 1.0, with fewer

loans and limited bond classes

Deal sizes much smaller

Higher average loan size

Higher weighted average DSCR

Lower weighted average LTV

Much higher percentage of amortizing vs. interest only loans

Less mezzanine debt and less allowance for future mezzanine

debt

CMBS 2.0 Deals in 2011-2012


17

Vastly increased % of loans with hard lockbox provisions

Very few loans with no cash management whatsoever

Escrows for real estate taxes in excess of 80% of pool balance

CapEx reserves in excess of 70% of pool balance

Very few loans had a borrower principal that had recently filed for

bankruptcy

Most lenders began requiring that all loan documents be governed by

New York law (except for the creation / perfection / enforcement of

liens, which are still governed by the state where the property is

located)

CMBS 2.0 Deals in 2011-2012

(Contd…)


18

CMBS 2.0 – how were the loan terms different

from CMBS 1.0

Amortization expected / Interest only loans were rare;

Added Independent Directors / national service providers

Most deals require the borrower’s organizational documents to require

independent directors to consider only the interests of the borrower and

its creditors prior to approving a bankruptcy filing (i.e. specifically

excluding consideration of the corporate enterprise)

Very limited exceptions to the “no comingling” SPE covenant

Additional Recourse Guarantees;

Ongoing Financial Reporting and Financial Tests are more common,

including net worth and liquidity requirements


19

CMBS 1.0 - Guarantees have withstood court

challenges

CMBS 1.0 Guarantees have largely held up under court challenges

Upheld claim regarding misapplication of settlement proceeds

Rejected argument that a springing recourse guaranty constituted

an unenforceable liquidated damages provision

Upheld full liability after a voluntary bankruptcy filing

Upheld full liability after misapplication of rents and failure to

maintain SPE status

in some cases court decisions have been contrary to what might

be expected in non-recourse lending, e.g. liability for failure to

remain solvent.

Cash Management / Lockboxes almost mandatory


20

CMBS 3.0 (Second half of 2012 to Present)

The slow recovery in the CMBS market got a big boost in the second

half of 2012 thanks to more competitive financing rates. That

momentum has carried over into 2013.

Originations may exceed $100 billion in 2014, which would be more

than any period except 2005 through 2007, when the market for real

estate bonds surged before rising delinquencies caused demand to

crash.

About 43 percent of respondents to a recent Bloomberg survey said

they expect debt-underwriting standards to be less rigorous next year,

the most since PwC and the Urban Land Institute started asking the

question in 2009. Last year, only 20 percent held that opinion.


21

LTV Creep – self-reported issuer levels have been trending upward, with

levels of 67%; the rate of change is accelerating as the pressure to

originate competitive loans increases.


22

CMBS 3.0 / Loan Structures

Pro forma underwriting is back / particularly for non-stabilized assets

Interest only loans are on the rise again, particularly for large, stand-alone loans

Pari-passu loans are also back (can introduce complexities in a workout scenario)

Cash-out loans – fairly common

Mezzanine Debt is back, and in a big way

In the 4th quarter of 2012, the large transactions were announced with debt

structures totaling almost $7 billion, of which $2 billion was mezzanine debt

Cumulative underwritten LTV increased from 50% (CMBS Trust) to 73%

(CMBS + Mezzanine)

DSCR's are holding firm at 1.50+, but this has more to do with historically low

interest rates than improved underwriting.


23


(Contd…)


24

Split Mortgage Loan - a “split” mortgage loan is a mortgage loan which either is evidenced by more

than one promissory note or which has been otherwise “split” into different lender interests

The most common types of split mortgage loans:

Pari passu loans (A/A structure) - the structure has become more popular due to the increased

risk perceived by investors of single asset CMBS transactions. The pari passu note structure is

an effective method of decreasing large loan concentration in a CMBS transaction; the

corresponding increased diversity is generally treated more favorably in rating agency models.

A “pari passu” loan structure is a mortgage loan structure where the mortgage loan is

evidenced by two (or more) separate promissory notes, each executed by the borrower

and secured by the same collateral

Control over the servicing of the whole loan (all of the pari passu notes) typically resides in

the master servicer and special servicer for the first pari passu note securitization

Each pari passu A Note can be sold into a separate securitization

Evidenced by more than one promissory note


(Contd…)


25

Cons of Pari-Passu Loan Structures:

Potential delays in loan workouts due to the necessity of collaboration

and coordination of multiple parties across CMBS trusts.

Control rights vary.

Advancing requirements vary.

Monitoring the loan’s performance becomes more complex.

Event risk of a single asset may negatively impact multiple transactions


(Contd…)


26

A/B Loan Structure

An A/B loan is a mortgage loan evidenced by two separate promissory

notes, each executed by the borrower, and each secured by the same

collateral

The A Note is generally senior to the B Note in rights to payment of

principal and interest

Variations of the A/B Loan Structure

A-1/A-2/B – pari passu senior notes and one or more subordinate

notes

A/B/C – multiple subordinate notes

A/B with mezzanine – one or more subordinate notes, with

additional structurally subordinate mezzanine loans made to the

parent or parents of the mortgage borrower


(Contd…)


27

Generally, the loan is administered by a servicer acting on behalf of the A Note - initially,

pursuant to an interim servicing agreement; post securitization, pursuant to the PSA.

The A and B Notes have a senior / subordinate payment structure; the A Note holder is

paid interest and principal first & the B Note holder is paid interest and principal second.

the B Note serves as “credit support” for the A Note - in light of the B Note’s

subordination and higher risk, the yield on the B Note is typically higher than the yield

on the A Note

Here are a few basic questions that will help you understand some of the most

important aspects of the A/B loan structure:

Are the two notes cross defaulted? If not, then what happens in the event the A

note defaults? or if the B note defaults?

Who services the B note?


(Contd…)


28

Regardless of who services the B note, if note A goes to special servicing (in

a CMBS pool), is the special servicer required to work in the best interests of

the A note holder AND the B note holder (combined)?

What is the payment priority? Does cash flow first go to interest, principal,

property taxes, insurance and other reserves for the A note before applying

any remaining cash to the B note obligations? If the principal balance,

interest rate or scheduled payments on the mortgage loan are reduced, or

any other material modifications are made to the mortgage loan, will the full

economic effect of the modifications be borne by the B Note holder (up to its

then remaining principal balance?

Does the B note holder always have the right to purchase the A note – even

in the event of a default? How is the purchase price determined?

When an event of a default exists under the mortgage loan, what are workout

effects of payments to the A Note and B Note holders?


29

Mezzanine loan

The mortgage lender has a mortgage and a first lien on the real estate

The mezzanine lender does not have a mortgage or a lien on the real

estate

The mezzanine lender does not lend to the mortgage borrower

The mezzanine lender has a pledge of equity

If the mortgage is foreclosed, the mezzanine lender’s equity pledge

will be worthless (because the mortgage borrower will own nothing)


30

Comparison of A/B Loan Structure to Mezzanine Loan Structure

An A/B loan is a mortgage loan (composed, in part, of A Note and B Note) made

by the mortgage lender to the mortgage borrower, secured by a lien on real

estate.

A mezzanine loan is a loan made by mezzanine lender to the mezzanine

borrower (parent of the mortgage borrower), secured by a pledge of the equity

interests in the mortgage borrower.

The B Note is serviced by the master and special servicer of the A Note, subject

to certain consent and consultation rights held by the B Note holder or an

“operating advisor” acting on behalf of the B Note holder

The mezzanine lender services its own loan, independently of the servicing of

the mortgage loan

___________________ ***See U.C.C. § 9-307 cmt. 5 (2009).


31

Control Rights

The B Note holder has little or no control over its investment,

with the exception of certain specific consent and

consultation rights over specific servicing matters, including

foreclosure

modification of a mortgage loan resulting in a discounted

payoff

modification of a monetary term of the mortgage loan

approving any bankruptcy plan of the borrower

waiver of a due on sale or due on encumbrance

provision

right to appoint the special servicer


32

Mezzanine lender has sole control over its mezzanine loan servicing, subject to

specified restrictions set forth in the mezzanine intercreditor agreement

Cure Rights / Purchase Options

B-Note lenders share some of same rights as mezzanine lenders; upon

default, two fundamental rights: (i) Right to cure loan and (ii) Right to purchase

loan

Remedies

B Note holder assigns its right to foreclose upon the mortgage to the A Note

holder, which exercises remedies on behalf of both the A Note and B Note

holders – property foreclosure can take 3-18 months / state dependent

The mezzanine lender, however, can perform a UCC foreclosure upon the

equity pledge (subject to certain conditions and restrictions) – usually takes

60-90 days.


33

Unlike an A Note, which is always cross-defaulted with the B Note (i.e., a

default under the B Note constitutes a default under the A Note and vice-

versa, a mortgage loan is typically not cross-defaulted with the

mezzanine loan (i.e., a default under the mezzanine loan does not, in and

of itself, constitute a default under the mortgage loan); the mezzanine

loan, however, is cross-defaulted with the mortgage loan (i.e., a default

under the mortgage loan automatically constitutes a default under the

mezzanine loan

© 2013 Cleary Gottlieb Steen & Hamilton LLP. All rights reserved.

Throughout this presentation, “Cleary Gottlieb” and the “firm” refer to Cleary Gottlieb Steen & Hamilton LLP and its affiliated entities in certain jurisdictions, and the term “offices” includes

offices of those affiliated entities.


Structuring Securitized Loans

Michael Weinberger

[email protected]

December 19, 2013

Generally, underwriting standards have been more conservative post-

downturn.

• Lower LTV

• Less use of pro forma underwriting

• Increased focus on quality of sponsorship

Increased use of debt yield instead of debt service coverage ratio

(DSCR)

• Debt Yield = net operating income / principal amount of loan

• DSCR = net operating income / debt service

Underwriting

35

During the downturn courts have, in some

cases, looked for ways to support

troubled borrowers.

Practitioners must be particularly alert to

developments that may impact loan

documentation or lending practices.

Representative Cases

In re Crane - Although reversed on

appeal, bankruptcy court held that

mortgage could be avoided if the

recorded mortgage did not include

maturity date and interest rate of

the loan.1 Illinois legislature also

amended mortgage statute to

clarify provisions interpreted by

bankruptcy court.

Glaski v Bank of America -

California Court of Appeals voided

a foreclosure based on the

untimely transfer of the loan into a

securitization trust. Court

determined that the loan was

transferred after the date the trust

closed, therefore trust improperly

foreclosed.2

Loan Documentation Changes

36

1. In re Crane, Case No. 11-90592, U.S. Dist. Ct. C.D. Ill., February 29, 2012; Supplemental Opinion and Order, April 5, 2012

2. Glaski v. Bank of America, National Association, et al., 160 Cal. Rptr. 3d 449 (2013)

GGP bankruptcy3 and other experiences in the downturn have brought

about some changes to SPE provisions in lending transactions.

Independent Directors

• Use of national providers of independent managers / directors

Example definition:

“ ‘Independent Director’ of any corporation or limited liability

company means an individual who is provided by CT Corporation,

Corporation Service Company, National Registered Agents, Inc.,

Wilmington Trust Company, Stewart Management Company, Lord

Securities Corporation….”

• Independent directors may only be terminated for cause

• Lenders require notice from borrower prior to replacing independent

directors; some lenders may require consent to replace

37 3. In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009)

SPEs

• Borrower operating agreements permit independent directors to

consider only the interests of borrower and its creditors. Fiduciary

duties to members and other affiliates should be specifically

eliminated, i.e., don’t take care of the “corporate family”. Example:

“To the fullest extent permitted by law, including Section 18-1101(c) of

the Act, and notwithstanding any duty otherwise existing at law or in

equity, the Independent Managers shall consider only the interests of

the Company, including its creditors, in acting or otherwise voting on

the matters referred to in Section 9(d)(iii).”

SPEs – Independent Directors (cont’d)

38

Litigation stemming from downturn has increased focus on SPE

covenants.

Imprecisely drafted SPE covenants create unintended recourse liability

triggers, e.g. solvency covenants.

• Cherryland & Gratiot Avenue4: In these two cases, courts in Michigan

held that the borrower’s insolvency triggered full recourse liability under

the non-recourse carve-out guaranty based on interpretation of solvency

covenants.

• Michigan legislature enacted the Nonrecourse Mortgage Loan Act

(Public Act 67 of 2012). Prohibits “post-closing solvency covenants” in

non-recourse loans from being used as non-recourse carve-outs or as

the basis for actions against a borrower or any guarantor.

• Ohio has similar statute: Ohio Legacy Trust Act, Ohio Rev. Code § 5816

SPE Covenants

39

4. Wells Fargo Bank, N.A. v. Cherryland Mall Ltd. Partnership, et al, 493 Mich. 859 (2012) &

Gratiot Avenue Holdings, LLC v. Chesterfield Development Co., LLC, 835 F.Supp.2d 384

(E.D.Mich.) (Jan. 24, 2012), appeal dismissed by stipulation of the parties April 19, 2012.

SPE Covenants – Comparison of Solvency Covenants

“The Borrower is and will remain

solvent and will pay its debts and

liabilities from its assets as the

same shall become due.”

“The Borrower shall pay its own

liabilities out of its own funds,

including the salaries of its own

employees, if any (provided that the

foregoing shall not require such

Person’s equityholders to make any

additional capital contributions to

such Person) and shall maintain

adequate capital in light of its

contemplated business operations

(provided that the foregoing shall

not require such Person’s partners,

members or shareholders to make

any additional capital contributions

to such Person).”

40

Increased focus on comingling of borrower funds post – GGP

bankruptcy

• Typical SPE covenants prohibit comingling of SPE borrower’s funds

and other assets with those of its parent or other affiliates.

• In GGP, funds from multiple SPE borrower accounts were swept daily

to the account of the parent company, giving parent company access

to all funds in excess of debt service, escrows and reserves.

SPEs

41

Increased use of hard lockboxes

Increased focus on borrower operating

accounts or segregation of funds by

property manager to mitigate comingling

concerns

Reserves for tax, insurance and other

items are more common

Cash Management

42

Courts have generally enforced terms of

non-recourse carve-out guaranties. Some

notable outcomes:

• Springing recourse guaranty does not

constitute an unenforceable penalty or

liquidated damages 5,7

• Courts have examined non-recourse

guaranties and upheld liability based

on:

– Misapplication of funds6

– Voluntary bankruptcy7

– Failure to maintain SPE status8

Representative Cases

5. CSFB 2001-CP-4 Princeton Park

Corporate Center v. SB Rental I, 410

N.J. Super. 114 (App. Div. 2009)

6. Blue Hills Office Park v. JPMorgan

Chase Bank, 477 F. Supp. 2d 366

(2007)

7. Bank of America, N.A. v. Lightstone

Holdings, LLC, July 14, 2011, Case

No. 601853

8. Cherryland & Gratiot Avenue cases,

see page 6

Non-recourse Carve-out Guaranties

43

Increased focus on having a creditworthy entity as guarantor coupled

with ongoing financial reporting and financial tests, e.g., net worth,

liquidity.

Increased use of carve-outs for bad faith interference with lender’s

exercises of remedies.

Increased focus on mezzanine foreclosure issues and non-recourse

carve-out guarantor’s exposure to continuing liability. Issues include:

• Conditioning mezzanine foreclosure on replacement of original

guarantor in senior loan documents and in mortgage / mezzanine

intercreditor

• Full release or release from liability for guarantor / sponsor in the

event new owner files for bankruptcy (i.e., when the original sponsor

no longer has control)

Non-recourse Carve-out Guaranties (cont’d)

44

Special servicing costs imposed on borrower

Greater focus on conforming loan agreement representations to

increasingly standardized securitization representations

Fewer loans with subordinated B-Notes, but corresponding increase in

use of mezzanine debt structures

New REMIC rules require additional restrictions on property releases,

e.g., 125% LTV test

Other CMBS 2.0 Changes

45

Intercreditor agreements, which had been highly standardized prior to

downturn, have evolved as a result of hard-learned lessons. Increased

areas of focus include:

• Substitute guarantors and guarantor criteria

• Criteria for “Qualified Transferees”

• Opportunities for mezzanine lender to purchase senior loan in

advance of proposed deed-in-lieu

• Permitting cures of most senior loan defaults to occur post-

mezzanine foreclosure by clarifying provisions that were

misinterpreted by court in Stuyvesant Town decision.9

– Stuy Town court held mezzanine intercreditor agreement required

cure of all senior loan defaults prior to mezzanine foreclosure,

which in this case included payment of entire $3 billion senior loan.

Intercreditor Agreements

46

9. Bank of America, N.A. v. PSW NYC LLC, 918 N.Y.S. 2d 396 (2010)

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