Jonathan Smith

REAL 1080 Negotiation & Dispute Resolution Final Paper

Cooperative Game Theory applied to Securitized Mortgage Workouts

Working Paper

ABSTRACT This paper explores the negotiation of a securitized mortgage workout from the perspective of game theory and option pricing. From the positioning of a borrower pre investment to the calculation of outcomes based on risk aversion and bargaining power, the innovative framework and research of some of the brightest minds is formed into the context of this well suited mortgage structure.

BACKGROUND

Asset Backed Securities

Securitized mortgages are fast becoming the dominant vehicle for commercial mortgage debt. Commercial Mortgage Backed Securities, or CMBS for short, have continued to grow in market share since the early 1980s. By the year 2000, $47 billion in securitized loans were being originated, another $230 billion dollars were originated in 2007, a 40% market share. Though the CMBS market has taken a considerable hit since the financial crisis in 2008, the outstanding debt held by way of commercial asset backed securities, as of the third quarter in 2012, was $562 billion; the second largest share of the $2.38 trillion in outstanding commercial/multifamily mortgage debt next to commercial banks.

Since the peak of CMBS issuance in 2005 through 2007, many investors have seen the value in their properties plummet as demand for space has declined causing vacancies to increase and rents to decrease. Faced with declining property values and negative cash flow, borrowers have sought relief from lenders by attempting to work out the mortgage terms in hopes of foregoing foreclosure and, ultimately, bankruptcy. Unfortunately, many borrowers were ill-equipped to manage the distinctly cumbersome workout process of their securitized loans.

The Structure of Commercial Mortgage Backed Securities

The ownership and management structure of a traditional mortgage held on the balance sheet of a commercial bank, thrift, pension fund, or life company is significantly different from that of a securitized mortgage. Prior to the widespread origination of securitized mortgages, lenders would originate the loans, distribute the funds from cash deposits, and hold the debt investment on their books until maturity. This traditional structure allowed the borrower to develop a personal relationship with the lender, thus facilitating a higher degree of flexibility when it came to loan modifications.

Conversely, the CMBS structure of ownership is highly complicated and impersonal in comparison to that of the traditional mortgage. As part of this structure, the lender is no more than an originator of the loan. Once the loan has been perfected, it is deposited into a holding entity called a real estate mortgage investment conduit (REMIC) for which the lender has virtually no affiliation.

An REMIC is a tax-exempt pass-through entity governed by the terms of a Pooling and Servicing Agreement (PSA), and designed specifically to hold a “static” pool of qualified loans on behalf of its trustee. The trustee holds the loans in trust on behalf of its beneficiaries. These beneficiaries, known as CMBS holders, are essentially bondholders divided into classes, called tranches, by the quality of the debt they hold. The riskiest or most subordinate tranche of CMBS holders, still entitled to receive a dividend based on the value of the pool at any given time, is called the controlling class. It is because these CMBS holders are at the highest risk of losing their investment that they are able to dictate changes to the loan pool. Though the trustees are the legal owners of the mortgages, they do not actively manage the administration of the pool. Therefore, a third party is charged with the task of administering the loans for a fee. This management party, most notably known as the Master Servicer, continues servicing each loan in the pool until a transfer event occurs. Upon initiation of a transfer event, the loan is handed over to a Special Servicer. The Special Servicer has the power to make decisions that will affect the performance of a loan. In certain situations, the special servicer will be required to, first, obtain approval from the controlling class before effectively modifying any loan.

The terms of the servicing standard by which the master and special servicers abide are detailed in the PSA. The servicing standard requires the master and special servicers to act in the best interest of all CMBS holders:

Using the same level of care and diligence that they would use to services their own loans or loans owned by a third party

Without regard to outside factors such as whether the servicers hold for their own account any CMBS or other loans to the same borrowers

With a view to the timely collection of loan payments in the case of performing loans With a view to the maximization of the timely recovery on specially serviced loans on a net

present value basis

Furthermore, the PSA sets forth the rights, duties, and limitations of all parties involved, including the trustee, services, depositors, and CMBS holders.

Complications in Modification of Secured Mortgages

The complications in achieving loan modification are inherent in the tax structure pursuant to Internal Revenue Code section 860A through 860G and entity structure as set forth in the Pooling and Servicing Agreement. As stated in the preceding section, a real estate mortgage investment conduit is a tax-exempt pass-through entity. Therefore, its very existence and purpose is defined by the Internal Revenue Code, which states that the REMIC must hold a fixed pool of qualifying mortgages within three months of its inception. IRS Code further states that no additional loans will be allowed to enter the trust or be substituted out of the trust. In other words, the trust is to remain completely passive with regard to asset and income activities. The IRS specifies “prohibited transactions” as:

The disposition of any qualified mortgage transferred to the REMIC other than a disposition pursuant to:

the substitution of a qualified replacement mortgage for a qualified mortgage (or the repurchase in lieu of substitution of a defective obligation)

A disposition incident to the foreclosure, default, or imminent default of the mortgage The bankruptcy or insolvency of the REMIC A qualified liquidation

Additional prohibited activities include any of the following modifications made within the pool; “modifying the: yield, security, credit enhancement, maturity date, timing of payments, obligor, or the priority of the indebtedness.” Consequently, if the trust participates in any, of what is regarded as, “prohibited transactions”, the trust will lose its tax-exempt status and revert to a corporation. Needless to say, this would have a very dire and costly effect on CMBS holders, as their dividend would ultimately be double taxed.

Furthermore, the Pooling and Servicing Agreement, as designed, places safeguards to protect the integrity of the REMIC from the actions of the servicers. In accordance with the PSA, a special servicer may make certain modifications that do not: affect the amount or timing of any payments of principal, interest, etc.; affect the obligation of the mortgagor to pay prepayment penalties, yield maintenance, or permit principal payment during lockout period; release the lien of the mortgage without principal prepayment not less than the fair market value except expressly provided in the mortgage or in connection with adverse environment conditions; if mortgage loan is equal to or in excess of 5% of the aggregate principal balance of all mortgage loans or $25 million or one of the 10 largest Mortgages Loans, permit transfer of (1) mortgage property or any interest therein or (2) equity interest or equity owner that would result in a transfer greater than 49% of the total interest in the mortgagor and/or any equity owner or transfer of voting control without prior written confirmation from each rating agency that such changes will not result in qualification, downgrade or withdraw of the rating; allow additional lien if mortgage loan is equal to or in excess of 2% of the aggregate principal balance of the mortgage loans or $20 million or is one of the ten largest Mortgage Loans; in good faith impair the security for the mortgage loan or reduce the likelihood of timely payment.(Saft)

Therefore, the servicer of the REMIC must operate under strict provisions that limit their authority and ability to modify loans. But, as the next section will demonstrate, tax law and the PSA does afford the REMIC some flexibility given certain procedures are satisfied.

Rights and Obligations of Special Servicers upon Transfer Event

Though the structure of the REMIC affords little flexibility to the discretion of the servicers, there remains certain events, characterized as “special servicing events” or during a “period during which the Mortgage Loan is a Specially Serviced Loan,” which trigger a transfer of the loan from the master servicer to the special servicer. “Usually, the PSA specifies that a special servicer event occurs upon a monetary default that continues for 60 days or more or a balloon payment remains unpaid for one business day or for 30 days if the borrower has delivered an acceptable refinancing commitment to the special servicer. A special servicing event can also occur when a loan default is ‘reasonably foreseeable’ and would undoubtedly remain uncured for at least the applicable period described above. The following is a typical provision:

‘Specially Serviced Loan’: The Mortgage Loan with respect to which:

(a) the Borrower has not made three consecutive Monthly Payments (and has not cured at least one such delinquency by the next due date under the Mortgage Loan);

(b) the Borrower has expressed to the Servicer a hardship that will cause an inability to pay the Mortgage Loan in accordance with its terms and, therefore, in the reasonable judgment of the Servicer, the Borrower is at imminent risk of default of the terms of the Mortgage Loan;

(c) the Servicer has received notice that the Borrower has become the subject of any bankruptcy, insolvency or similar proceeding, admitted in writing the inability to pay its debts as they come due or made an assignment for the benefit of creditors;

(d) the Servicer has received notice of a foreclosure or threatened foreclosure of any lien on the Mortgaged Property securing the Mortgage Loan;

(e) a default (other than a failure by the Borrower to pay principal or interest) which in the judgment of the Servicer materially and adversely affects the interests of the Holders has occurred and remained unremedied for the applicable grace period specified in the Mortgage Loan (or, if no grace period is specified, 60 days); or

(f) the Borrower has failed to make a Balloon Payment on such Mortgage Loan more than 30 days after such payment was due; provided, however, that the Mortgage Loan will cease to be a Specially Serviced Loan (each, a ‘Corrected Mortgage Loan’) (i) with respect to the circumstances described in clauses (a) and (f) above, when the Borrower thereunder has brought the Mortgage Loan current and thereafter made three consecutive full and timely monthly payments, including pursuant to any workout of the Mortgage Loan, (ii) with respect to the circumstances described in clause (b), (c), and (d) above, when such circumstances cease to exist in the good faith judgment of the Special Servicer, and (iii) with respect to the circumstances described in clause (e) above, when such default is cured or other event is rendered, in each case, if at that time no circumstance exists (as described above) that would cause the Mortgage Loan to continue to be characterized as a Specially Serviced Loan.”(Saft)

Furthermore, according to Stuart Saft, “The purpose of special servicing is to maximize the recovery to the MBS certificate holders on a present value basis. The special servicer is also motivated to protect the trust's assets because it frequently owns some of the subordinated MBS certificate classes and will be the first to suffer losses if borrowers default. The PSA usually contains a servicing standard requiring the special servicer to mitigate losses and maximize recovery to permit the highest return to the MBS certificate holders regardless of who the borrower is or with whom it may be affiliated and without regard to the relationship between the servicer and the borrower. The PSA also provides a standard for a workout, which the special servicer can only participate in if it determines that a workout is likely to result in a better result.”(Saft)

INTRODUCTION Given the nature of securitized mortgages and the structure of the REMIC, this paper seek to apply Riddiough & Wyatt’s “endogenized negotiated workout cooperative bargaining game within a non-cooperative mortgage loan/default game” to the process of securitized mortgage workouts.(Riddiough 5) Furthermore, at each stage of the game, the real world situational advantages and disadvantages of, both, borrower and lender will be discussed and exploited from a borrower’s point of view. At the conclusion of this paper, commercial mortgage borrowers will have a logical and concise framework for a calculated strategy that navigates the process from optimal positioning pre-mortgage, into decision to default, and through one of the following four outcomes; Substantial Compliance, Prepayment, Workout, or Foreclosure.

Empirical Research

In crafting this research paper, a number of prior research reports were used in discovery and as a foundation from which this study could build upon. Without the brilliant and meticulous insight from the following researchers, this analysis would be well beyond my capacity of understanding.

Most notably, Timothy Riddiough and Steve Wyatt’s paper, Strategic Default, Workout, and Commercial Mortgage Valuation, in their own words, “extends existing equilibrium commercial mortgage pricing models by endogenizing negotiated workout into the usual non-cooperative lending game.”(Riddiough 5) They found that in the presence of foreclosure transaction costs for either party, workout is a feasible subgame strategy (Riddiough 5) This research and game structure provides the foundation for which the negotiation of securitized mortgage workouts takes place. In this paper, it is their framework, process, and strategy which will be followed, as well as built upon and elaborated on, for the purposes of describing the dynamics of securitized mortgage workout negotiation.

Furthermore, research was accumulated that complimented Riddiough and Wyatt’s framework. These additional research pieces served to fill in the gaps caused by the transition from the framework’s original intended use. First of all, Alan Schwartz, in his paper, Bankruptcy Workouts and Debt Contracts, explores the bankruptcy/workout decision, in the context of prohibiting commercial parties from waiving their right to enter bankruptcy, from a game theory perspective.(Schwartz 632) Mr. Schwartz’s research will be invaluable in determining the subgame strategy of the borrower, given the lender, pursuant to the loan documents, finds exception to the (typical) nonrecourse provisions in most securitized mortgage documents. Next, Jun Chen and Yongheng Deng in their research presented as, Commercial Mortgage Workout Strategy and Conditional Default Probability: Evidence from Special Serviced CMBS Loans, use, both, a multinomial logit model and a proportional hazard model to analyze servicers’ choice of workout options and borrowers’ default decision making process under time-varying conditions.(Chen and Deng 1) As a result of Chen and Deng’s research, it was concluded that servicers’ workout decision-making process was largely based on property level cash flow conditions, while borrowers’ default decisions were based on equity position in the mortgage and property cash flow conditions.(Chen and Deng 23) Therefore, the results of their research support the assumptions that (a) the lender will make decisions based on maximizing the recovery to the CMBS holders and (b) the borrower will make default decisions based on the value of their put option. Next, the research report of Brian A. Ciochetti, Yongheng Deng, Bin Gao, and Rui Yao called, The Termination of Commercial Mortgage Contracts through Prepayment and Default: A Proportional Hazard Approach with Competing Risks provides this paper with a model for default decision making. The formula they devise for “Optimal Decision Rules without Transaction Costs” may not suffice for understanding the decision-making process of a cost weighted workout/foreclosure, but it provides the perfect framework to assess the value of prepayment or default against the value of substantial conformance.(Ciochetti et al. 601)

Finally, there are few sources of law and tax specific research that were used in determining the situation specific legal and tax implications of decisions made by both borrower and lender. Frank Appicelli’s article, An Introduction to Securitized Loan Workouts, provided a clear and concise overview of the process that aided in choosing which topics to explore deeper. Next, are the incredible and comprehensive pieces by Peter Genz and Stuart Schwartz named, “Tax Issues in Real Estate Workouts” and “Commercial Real Estate Workouts”. These comprehensive works were invaluable as reference, delving deep into the details of the legal, tax, and contractual implications of securitized mortgage structure.

Assumptions

As a general rule of thumb, securitized mortgage workouts offer significant advantages in regards to applying a rational game theory strategy to the overall process. The strict tax code enforcement of the REMIC holding entity as well as the wealth maximizing language in the

standard PSA set the playing field for a near-optimal rational cooperative game structure. Though not entirely without hazard risk, securitized loan workouts are far more rational that traditional balance sheet mortgage workouts. Therefore, the assumptions below are fairly indicative of a straightforward securitized mortgage workout.

The first assumption is that the Servicers follow the process outlined in the PSA - particularly, when it comes to the “transfer event” distinctions and timeline.

The second assumption is that the special servicer will service the loan in default in a way that maximizes the recovery on the loan to all CMBS certificate holders based on the present value of the loan. Furthermore, the special servicer will not succumb to the pressures of moral hazard, and will make prudent decisions “without regard to outside factors such as whether the servicers hold, for their own account, any CMBS or other loans to the same borrowers.”(Appicelli 2) Moreover, the majority of the Controlling Class will not exercise the rights given to them in the PSA to replace the Special Servicer. This could be, in many cases, due to the fact that the Special Servicer owns the majority of the voting rights in the Controlling Class tranche.

Third assumption is that the mortgage is a senior secured debt position with no subordinate claims. This assumption is presented for simplicity as the PSA gives the special servicer the ability to exercise a purchase option which either permits the servicer to purchase the subordinate debt claim or, in the case of mezzanine lenders, to sell the mortgage to the lender within 60 days of the mortgage entering default. Furthermore, it is assumed that after the 60 days are up, and the special servicer assigns the purchase option to the majority subordinate certificate holder for 15 days as obligated under the PSA, the purchase option is reverted back to the special servicer.(Saft)

In contrast, the borrower will seek to maximize the value of his put option at each period of time (t). In other words, the borrower will seek to make the decision which gives him the largest net present value at each period. Granted this implies that he must have some reasonably reliable information about his options in the future, which leads me to my next assumption.

Therefore, it is assumed that the parties involved are privied to full disclosure with respect to the present value of the mortgagor and mortgagee’s position, as well as the advantages, disadvantages, risk aversion, and bargaining power of the other parties. Additionally, the parties also have some reasonable ability to rely on information equally shared regarding the future value of their positions.

EMPIRICAL STUDY This study centers around the inherent termination option built into any securitized mortgage loan. From the borrower’s perspective this is called a termination put option. It gives the owner the optional right to sell a specified amount of the underlying security at a specified price within a specified timeframe. ("Put Option Definition) The put option becomes more valuable as the price of the underlying security depreciates relative to the purchase price, or strike price of the option. If the value of the underlying security appreciates beyond the strike price, the option becomes worthless.

Figure 1, below, is a payoff graph for a put option with an underlying asset price of $34. Notice that the price of the option is labeled along the x axis, while the return on the option is labeled along the y axis. The blue line is the theoretical profit and loss, which will be discussed later. Also, notice that the kink in the payoff line is located directly under the $34 position on the x axis. The difference between the theoretical P&L line and the payoff line is called the premium, which in this case is $1. The premium as of the purchase of the put option is calculated as a function of time value money, interest rates, dividend yield, and volatility in the price of the security, which will be discussed later on. By following the x axis toward the intersect point of the x and y axis, the graph shows the relationship of price to yield. As is characteristic of a put option, yield increases as the value of the underlying asset depreciates. By moving back away from the intersect point on the x axis, the yield, conversely, decreases as the value of the security increases until it meets the strike price. Upon falling in line with the value of the underlying security value of $34, the slope of the payoff line flattens indicating that the $1 dollar premium paid for the option is the greatest loss possible.

Finally, the last piece of information given by this graph is the relationship of the payoff line and the theoretical P&L line. One of the characteristics of options is their relationship to time value. The time value can be thought of as the spread between the strike price and the intrinsic value. As the strike price of a put option increases, the time value diminishes. This is called “being in the money”. In the other direction, if the strike price is below zero, the option is worthless, which is called “being out of the money”. As stated previously the option’s time value is determined by the characteristics of the capital markets, the time until expiration, as well as the volatility in the underlying security. Thus, an option with a highly volatile security value will have a larger time value. This larger spread is meant to compensate the investor for the added risk as compared to the risk/return ratio of less volatile securities. As the option nears expiration, the time value diminishes until the option expires worthless.

Now, to put the theory of option pricing into the context of a mortgage termination option, only the changing of variable values and terminology need to be addressed. Therefore, just as in the example in Figure 1, the underlying security, called the mortgage, has an inherent, implied option imbedded in the loan document. This implied option allows the borrower to “put”, or sell, the mortgage back to the lender when the present value of the property, and its cash flows, have depreciated to such a level that the present value of exercising the put option, thereby freeing himself from the obligations of the mortgage, is greater than either holding on to the option to use at a future time or allowing the option to expire worthless.

Of course, this is a very simplistic view of how this works. As will be demonstrated later, there is a barrage of implications and considerations to determine if this action is the most valuable course of action. And though the model presented in this study is controlling for various exogenous variables, the externalities are large in numbers.

Figure 1: Put Option Example {{59 Anonymous ;}}

Pre-mortgage Positioning

As in most negotiations, there are various keys to success. Generally speaking, preparation, positioning, and knowledge are the three most important factors of increasing the probability of a successful negotiation. In most cases, a negotiator’s most powerful weapon is forged prior to a negotiation. A securitized workout is no exception.

Many of the variables that dominate the probability of success in a workout situation are created years in advance of a default decision. For example, the expression given by:

( )

( )

represents the utility-exogenous bargaining power of both parties. (Riddiough 11) These two little symbols, α and β, represent the bargaining power each party brings to the negotiation. It does not appear to be so, but the whole negotiation rests on the ability of the borrower’s bargaining power (β) to be equal or greater than the servicer’s bargaining power (α) all other things being equal.

For the purpose of this study, a borrower’s bargaining power consists of financial sophistication, solvency, legal knowledge, credit history, and management/ownership skills. These attributes have a significant effect on the mortgage termination decision by shifting the exercise boundary of both the prepayment and default options.(Riddiough 5-22)

FINANCIAL SOPHISTICATION

The financial sophistication of the borrower is detrimental to his bargaining power. The borrower must be capable of protecting his assets from creditor recourse at every stage of the game, while also being acutely aware of the lenders financial risk. Furthermore, the borrower must also understand the tax implications of every decision made along the way, and have positioned, well in advance, his estate for a potentially detrimental taxable event.

The borrower’s understanding of shielding his assets from creditors ensures that the losses incurred by a poor investment are limited to the investment made. In the context of securitized mortgages, most commonly they are considered non-recourse liability. In the context of a securitized mortgage workout, the advantages and disadvantages of recourse versus non-recourse will be discussed in detail later. For now, it will suffice to say that the borrower, and if the borrower is an entity, the principals of the borrower, do not have to be readily concerned about the liability of their personal assets as collateral.

Although, for the purposes of bargaining power, they might be inclined to be liable under recourse debt. Though recourse debt leaves a borrower's personal assets exposed to the creditor claim, the borrower may position himself in such a way as to protect his assets and use bankruptcy as a bargaining chip. Creditors faced with the threat of an insolvent borrower filing for bankruptcy should choose to work out the debt as the Pareto dominant strategy. (Schwartz 595) Another advantage of recourse debt is that under IRS Tax Code, recourse debt is treated as an obligation to repay. Thus, any cessation of the outstanding debt can be excluded under certain terms of the tax code. Particularly, the gain realized on a debt obligation may be excluded if the debt is recourse debt and the borrower is insolvent or bankrupt. Also, there is a special election for “qualified real property business indebtedness” that is available to recourse borrowers. (Genz 1)

On the other hand, non-recourse debt is not privied to the exclusions in the tax code. Any forgiveness or modification that reduces the obligation of the borrower, and does not result in a transfer of the collateral, gives rise to COD Income. The realized gain of COD income from non-

recourse debt is taxed at ordinary income rates. However, if the non-recourse debt is discharged to a lender in bankruptcy or in a foreclosure proceeding (or a deed in lieu of foreclosure) the transfer gives rise to sale gain instead of ordinary income gain. Sale gain is taxed at capital gains rates.

Furthermore, it is important to understand the implications of the lender’s tax rights and obligations. As stated earlier in the paper, the holding entity of securitized mortgage debt is a pass-through tax advantaged trust called an REMIC. The tax exempt status of the REMIC limits the servicer’s ability to modify the general pool of the trust. In recent years due to the implications of the financial crisis, the IRS has modified the code restrictions of the REMIC to provide for greater flexibility when it comes to modifying mortgage debt. In accordance with the new regulations, servicers are able to release, substitute, add or otherwise alter a substantial amount of the collateral for a guarantee on, or other form of credit enhancement, and also a change in the nature of an obligation from recourse to non-recourse. (Genz 90) However, greater flexibility comes with new ambiguity about the liability for realized gain of modification. In other words, “If investors have acquired fixed investment trust certificates at a discount (as is typical in the current abysmal market conditions), significant modifications of the underlying mortgages as to which the investors are treated as owning undivided interests (under the grantor trust rules) may cause the investors to recognize taxable gain”(Genz 88) Again, this is very ambiguous, and given the nature of the mortgage crisis, there is little evidence the IRS will enforce any such regulation at risk of drying up the mortgage pool for the foreseeable future.

SOLVENCY

The solvency of the borrower is a substantial issue in many mortgage workout negotiations. For recourse debt, it could mean the difference between a workout and a foreclosure, while the implications for non-recourse debt are much less severe. Because many securitized mortgages are non-recourse debt, we will focus on this specific type of debt and it’s exceptions under the terms of a standard securitized loan agreement.

As stated in the previous section, a non-recourse loan has significant tax implications. All gain realized on the forgiveness of debt is taxed as ordinary income unless there is a transfer of property to the lender, which will still result in a capital gains tax on all realized gain from the sale. In structuring any workout agreement it is imperative that the tax implications be considered in a borrower’s decision. This is where insolvency comes in, if the borrower is insolvent, he is still not afforded relief under the tax code, but the amount of any non-recourse loan that is above the fair market value of the asset it secures, may be applied to a borrower’s liabilities in determining insolvency. This only provides relief if there is COD income from a portion of modified recourse debt on the same property or attached to another modified asset. Additionally, if by careful and diligent analysis, it is determined that the bargaining power of the borrower and the repercussion that would follow in a worst case scenario, warrant the preference of a recourse loan workout negotiation environment , the borrower may breach the contract pursuant to the exceptions of the non-recourse clause discussed further in the next section.

LEGAL KNOWLEDGE

It is the borrower’s responsibility to understand his rights and obligations enforceable to the fullest extent of the law. It is in the language of the law and legal documents pursuant to the activity and conduct being undertaken that the borrower may find the bargaining power needed to effectively negotiate workout terms. For instance, pursuant to the loan documents, the lender insists the ownership be placed in a single purpose entity, “In order to prevent another property

from creating a problem for the property that is going to become part of the pool or used to be collateral for the senior indebtedness.” (Saft) This structure is optimal for the lender as it streamlines the foreclosure process, due to the inability of the borrower to declare bankruptcy and tie up the property in the proceedings. However, it also creates a situation where the lender cannot force the borrower to provide additional funds or a guaranty from other assets or another guarantor.

Securitized Mortgage Option Theory

Up to this point the focus of this paper has been setting the playing field and positioning the borrower for optimal exogenous bargaining power. This was accomplished by increasing the borrower’s knowledge base as to the rules and regulations that all parties must abide by in order to play the game effectively. Without a foundation of knowing how the game is designed to be played, one stands little chance of ever succeeding against a skilled opponent. For this reason, it was absolutely imperative to disclose the information decidedly recorded in the last ten pages of this paper. The following decision based cooperative and non-cooperative bargaining game will be built on the knowledge gained by the borrower up to this point.

THE MORTGAGE CONTRACT AND OPTION ETHICS

Once upon a time, there was a world where spiritual acquiescence, gut-feeling and the honor of good men were factors in assessing the risk adjusted reward for mortgage investments. Too often in today’s data driven world of instantaneous information and quantitative analytics, the moral and ethical stigmas of the past continue haunting the present. Thus there is no greater example of this than in mortgage obligation.

As the sophistication of investment analysis continues to mature, the ability to make decisions based on quantitative facts and statistical probabilities has vastly altered the way investment decisions are made. No longer does the subjective interpretation of facts and the emotion-driven guess-timation process have to dictate investment decisions. Furthermore, no longer do lenders have to rely on social stigma and public humiliation to effectively mitigate default risk. The only place morality and ethics has in the investment contract decision-making process is in the moral hazard of agents and fiduciaries charged with acting in the best interests of their constituents, yet failing to properly analyze the potential outcomes, assess the probabilities of risks and rewards, and make wealth maximizing decisions on behalf of their constituents due to either inaptitude or the moral hazard of conflicting interests. Thus, as a collective body, let the burden of righteousness be shed and the facts seen in a new light as they relate to the context of mortgage contract decision making.

Upon entering into a contract with the lender the borrower has agreed to the terms expressed in the contract. These terms are designed to mitigate the inherent risk of investment in an unpredictable and chaotic market environment. The yield the CMBS holder receives for risking the present value utility of exercising his put option, thereby liquidating his stake and either finding another investment that maximizes his utility or spending the investment, thereby, maximizing his utility through consumption, should be equal in risk/reward ratio to the other options he has.

In a perfect world, all investment decisions would be made on highly calculated rational terms that maximize the utility of the exchanging parties to the fullest extent. Unfortunately they typically are not. Thus the highest efficiency of maximization is rarely achieved. In the context of the securitized mortgage contract, all the legal jargon containing rights and remedies is, in essence a framework for which the lender and borrower understand the rules of the game. In

other words, it provides a quantifiable set of potential outcomes and a set of standards for dealing with these outcomes.

Given that the lender in concert with its servicers, CMBS holders, and Trustee, have fully and thoroughly evaluated the probability of the potential risks and rewards inherent in their investment, and have accepted the risk adjusted return as comparable to other investments with varying risk/reward ratios, the decision of the borrower to exercise his option to terminate the mortgage should not only be acceptable as implied by the contract terms, but included in the risk adjusted return of the lender.

VOLUNTARY MORTGAGE TERMINATION OPTION (REVISITED)

At the beginning of the Empirical Study section, the basic characteristics of a put option were explored. Additionally, the put option was briefly described in the context of a mortgage termination option. In this section, that distinction will be elaborated on in terms of the value to both parties, as well as, the effect the “premium” has on the borrower’s decision to exercise the termination option. “Termination” of the mortgage, for the sake of this paper, is defined as either the prepayment of the mortgage or default. For securitized loans, default occurs when the borrower chooses to forego scheduled payments for (up to) 90 days. Upon entering default the loan is transferred to the special servicer, as described above. Pursuant to IRS Tax Code and the PSA agreement of the REMIC trust, the servicer has the obligation to maximize the CMBS holder’s net present value through the possibility of three options: Foreclosure, Loan Modification or relinquishment of the debt. Prepayment of a securitized mortgage will typically be subject to prepayment penalties.

In order to demonstrate the characteristics of a mortgage termination option, the put option chart from Figure 1 will provide visual representation. Consider that the chart in Figure 2 represents the payoff frontier for a termination option measured by the price per square foot of $34 of the gross rentable area of the mortgaged property. At point one, the value of the option is equal to the strike price. The spread between the strike price at point one and the intrinsic value at point A represents the premium to the borrower for holding the option to terminate. The premium is a function of the present value of the borrowers alternatives in lieu of substantially conforming to the loan terms set forth in the loan documents. A successful premium will take into consideration all the borrower’s options given a defined set of probable market conditions at all payment period points over the life of the mortgage. According to Ciochetti et al. 2002, the following are some statistically significant variables related to default and prepayment: Loan-to value, low DCR in connection with insolvency, interest rates, and property prices. (Ciochetti et al. 595-633) Theoretically, the premium should be properly priced based on taking into account the varying probability of each factor causing default. Unfortunately, there seems to always be statistically insignificant events that disrupt the underlying assumptions and cause the model to fail. For instance, based on reasonable projections regarding market conditions a lender determines that an LTV of seventy percent along with a 150 basis point default risk premium and a prepayment penalty (or defeasance) equal to the present value of the remaining cash flows at time, t. In this example, the lender creates a scenario where, given his assumptions are correct, the premium should yield a high probability of conformance from the borrower.

If, only briefly, reality is suspended and LTV were the only tool used by the lender to mitigate default risk, so as all volatility in market conditions and creditworthiness of the borrower where exercised in the range of loan-to-value ratios, the premium would be the amount of equity the borrower has to commit in relation to the mortgage amount. With a substantial amount of equity in the property, the borrower must assess the value of his ever-present put option. Given the value of the put option at the strike price, point A, the borrow has a strong disincentive to exercise his option because it would result in a negative equity position and is a suboptimal strategy in comparison to substantially conforming to the loan terms.

This initial decision of whether or not to terminate the mortgage through the inherent prepayment or default option, in the absence of transaction costs, (as is the case for securitized mortgage borrowers), is given by the following expression:

Dr

PEfBLVL t

f

t

tttttt

1

10;;max (1)

Equation 1: Optimal Decision Rules w/o Transaction Costs (Ciochetti et al. 601)

“where is the value of the property at time t and is the market value of the securitized mortgage debt. can be expressed as the sum of remaining mortgage payments discounted at the prevailing market mortgage rate, . is the accounting outstanding balance of the debt, which equals the sum of the remaining mortgage payments, discounted at the contract rate, . is the prepayment penalty specified in every securitized loan contract. Thus ( ) defines the intrinsic value of the put option, while ( ) defines the intrinsic call value to the borrower at time . The left-hand side (LHS) of Inequality (1) defines the payoff of the termination option if exercised at time . On the right-hand side (RHS), is the value of the termination option that is (at least) a function of , , , and . is the

Figure 2: Mortgage Termination Put Option Payoff

max[(K-S); 0]

A

1

scheduled payment at time . is the risk-free rate between and , and [ ( )]

defines the expected (discounted) value of the option in the subsequent period if not exercised today. Expectation on is taken over all possible realizations of property value and mortgage rate, , which relate to and , respectively, through property value and mortgage rate processes.” (Ciochetti et al. 602)

In other words, unless exercising the termination option today has a present value less than the expected present value of exercising the termination option in the next period given all the possibilities for property value, loan market value, prevailing mortgage rate, outstanding balance of the loan and debt contract rate in the next period, the borrower should make the decision to exercise the option and enter default.

In context of the example in Figure 3, the decision inequality says that the borrower’s decision to default is a function of the (discounted) expected value of , , , and at time , as it relates to their values at time . Notice that in Figure 3, the premium to the borrower of holding the mortgage termination option makes the option worthless until the square foot price of the option depreciates beyond $33 per square foot denoted at point B. Furthermore, as long as the property value remains at $33 per square foot, the model tells us that as long as all value to the borrower has been properly quantified, the borrower should be indifferent towards the decision to default. Any price below point B would be, as they say in option terminology, “in the money,” and the borrower would want to exercise the termination put option. However the question that the inequality is designed to address comes into play if the value of the property is expected to continue to decrease. In the case that, the value in the property continues to depreciate, how long will the borrower be able to hold onto the option before the value of exercising in the present is greater than the value to exercise in the future.

The major factor that would trigger the value to turn positive in favor of exercising the option in the present would be a function of the slope, m of the property’s DCR, given by

B

1

A 1

Figure 3: Termination Put Option Chart

1tDCR tDCR

tDCR and the slope of, (

(

Dr

PE t

f

t

t

1

1

)

( fBLVL ttttt

; )

)

fBLVL ttttt ;

,where

slope of the change in value of the termination option is less than the absolute value of the slope change in the ratio of operating income over debt service.

Therefore, a situation such as this would create a payoff similar to the payoff represented in Figure 4. As the chart shows, the value of holding onto the option begins to decrease at point C because the rate of depreciation in the property’s ability to cover Debt Service is steeper than the appreciation in the value of the termination option as the property value decreases. This situation displays a restriction on the amount of time the borrower has in order to initiate default. Furthermore, upon the decision to initiate default, a series of payoff scenarios must be evaluated. In this stage of the default process, the borrower typically has 90 days before the loan is officially in default. However, IRS Tax Law governing the tax-exempt REMIC structure has made changes to IRS Code Section 860 since the financial crisis to allow the servicers greater flexibility in dealing with defaulted mortgages or, most notably, properties facing “Imminent Default”. The game plan of a borrower may have to be expedited based on the process outlined in the loan agreement and PSA agreement. As stated previously, the negotiation of default is ideal for cooperative game theory scenarios due to the strict fiduciary responsibility of the servicer.

Securitized Commercial Mortgage Workouts and Game Theory

Just as Riddiough and Wyatt developed the structure and strategy that is being employed in this paper in the context of securitized mortgage workout, the borrower is faced with an evaluation

C

A 1

Figure 4: Termination Option Chart w/ DCR

of his situation and strategy of termination. The borrower’s decision to exercise his termination option is given by the formula,

Dr

PEfBLVL t

f

t

tttttt

1

10;;max (1)

Equation 2: Optimal Decision Rules w/o Transaction Costs {{Ciochetti et al. pg. 601}}

And will yield three pure outcomes in the context of a non-cooperative mortgage game; Substantial Conformance, Prepayment, or Default.

The first is substantial conformance to the terms of the loan agreement, S. If the borrower chooses S, he will continue to have full ownership in the property and the subordinate rights to the cash flow of the property while the property is mortgaged. This scenario will yield a payoff for the borrower of ( ), and the lender receives( ).

The second strategy is prepayment, A. Prepayment under the conditions of the securitized loan agreement typical will call for defeasance, which is the substitution of the remaining value of the loan with other income producing collateral, usually US Treasury bonds. Thus the payoff to the borrower is ( ) . The payoff to the lender would be ( ). (Ciochetti et al. 601) One reason to pursue this choice is if the market value of the mortgage is costly enough, due to lower interest rates, that , where is the market value of the outstanding loan amount, is the accounting balance of the outstanding loan amount discounted at the contract mortgage rate, is the prepayment penalty, which in this case is defeasance, and which is the present value of the market rate loan.

Lastly, the third pure strategy the borrower can employ is strategy, D or default. In response to entering default, the lender has one pure recourse strategy and that is Foreclosure, F. If the pure foreclosure strategy on the part of the lender is pursued, the borrower’s net payoff is always the cost of foreclosure to the borrower or, and the lender’s payoff is (

), the property value less the lender’s cost of foreclosure.

Contained within the and payoffs are a number of tax implications that must be factored in to the equation, on both the lender and borrower side, that exacerbate the spread of exercising this pure strategy. If the loan is non-recourse, as most securitized loans tend to be, there are a couple issues that need to be taken into consideration. In the event of a deed in lieu of foreclosure, the borrower’s amount realized equals the face value of the loan. (Genz pg. 79) Conversely, in the normal tax situation, under section 166(a) of the IRS Tax Code, the lender takes a tax basis in the property equal to the fair market value and is entitled to a bad debt deduction under section 166(a) equal to the difference between the amount of the debt and the fair market value of the property. (Genz 79) However, due to the tax-exempt structure of the REMIC, the servicers are restrained by the rules set forth in IRS Reg. 1.860 and must maintain collateral valued at least 80% of the debt obligation to forego incurring a taxable event. ("REMICs/Investment Trusts for Certain Modifications to Commercial Mortgage Loans." 63525) As stated previously, revisions to the tax code have loosened the restrictions of REMICs on performing significant modifications that would normally be prohibited transactions or acquisitions of non-qualified mortgages resulting in transaction taxes. (Genz 90) Although the lender may have greater flexibility in modification, so far as the modification to the obligation or underlying real property collateral falls subject to section 1001 modification rules, the REMIC still may incur a taxable gain. ("REMICs/Investment Trusts for Certain Modifications to Commercial Mortgage Loans." 63526)

This option does not appear to be in the borrower’s best interest as it completely eliminates the leverage that the borrower has in factoring the cost of foreclosure. The borrower realizes a gain equal to the accounting outstanding balance of the debt or , and is thus taxed at capital gains rates on the amount realized. Furthermore, so far as the lender does not modify the loan, the payoff equals the basis in the property value equal to and a deduction in the amount of ( ) at time t of the deed in lieu. Depending on the value of , , and , when the termination option is sufficiently “in the money”, it seems the lender has the clear advantage in the deed in lieu scenario.

Comparatively, in the event of foreclosure, the lender will undoubtedly incur costs to foreclosure, whether that entails the extra fee incurred by the special servicers to foreclose the loan or the fee incurred to find “qualified replacement debt” to fill the void, as well as the normal foreclosure costs including attorney’s fees, appraisal fees, engineering survey fees, environmental report fees, court fees and the opportunity cost of capital. On the other hand, the structure of the typical securitized loan documents creates a comparatively streamlined foreclosure process. The property is usually required to be held in a single purpose entity with the stipulation that the entity not be used as collateral against any other debt obligation. (Saft) This allows the special servicer to be the only creditor with a claim against the property, thereby preventing a cram down situation. Also, there is typically a non-recourse carve-out that may include full recourse against the principals of the borrower entity if the borrower files for bankruptcy. (Saft)

On the borrower side, per Reg. 1.1001-2(a)(4), a discharge of nonrecourse debt pursuant to the transfer of the property to the lender in bankruptcy or in a foreclosure proceeding, “gives rise to sale gain rather than COD income, even though the fair market value of the property is less than the amount of the debt”. (Genz 56) In this scenario, the fair market value is deemed to be not less than the fair market value of the debt. Given the current tax code environment, the capital gains tax rate is 15% (with stipulation that by 2013 it will be raised anywhere from the low of 18.5% up to 23.5%), the non-recourse borrower realizes the difference between his basis in the foreclosure property and or , whichever is greater.

In addition to the conformance, prepayment, and foreclosure strategies, the cooperative subgame from Riddiough and Wyatt is introduced, denoted as cooperative game B. (Riddiough 8) Because the costs of foreclosure are factored into the F path, the borrower and lender can agree to bargain over the terms of a workout, thereby creating the potential for both parties to be better off. For ( )

, the borrower’s Best Alternative to a Negotiated Agreement (BATNA) is at least,

through negotiation. (Riddiough 4) Conversely, the lender’s BATNA can be expressed by

. Therefore, a combined game value of , rather than

can be realized. In the event that ( ) , the

borrower may consider the strategy of negotiating a workout with the intention of extracting a concession from a lender who might be motivated to mitigate the cost of foreclosure. (Riddiough 8) In other words, if at time the value of the property minus the sum of the book value of the outstanding balance of the mortgage and the last periodic payment are less than the cost of foreclosure to the borrower, the borrower and the lender can, at least, do as well as their respective cost of foreclosure. Furthermore if it is observed by the borrower that his cost of foreclosure is less than the value of the property minus the sum of the outstanding book value of the mortgage plus the last periodic payment, while the lender’s cost of foreclosure is greater than the aforementioned values, he would be in a strategic position to negotiate concessions from the lender. Stated more eloquently, “The maturity date bargaining region that the borrower and lender face in terms of wealth is the set of allocations . Let ( ) represent actual workout allocations between borrower and lender with bargain set defined as {

}.” (Riddiough 8) Based on the given bargaining game by the Riddiough & Wyatt, a failure of lender and borrower to reach an agreement would default to strategy pair (D,F), which is equal to either party’s BATNA. Therefore, all the outcomes within the range of

and

where is considered the Pareto efficient bargaining set. (Riddiough 9) Given the functions defined for the cooperative subgame of negotiated workout, it becomes apparent why the wealth maximizing motivation of, both, investor/borrower and special servicer/lender conform to this framework so well. However, even with the most rational of borrowers and lenders at the helm, there exists a human element that determines the allocation of the bargaining set.

Therefore, in order to capture the variables that may affect a pure rational outcome, the borrower and lender’s utility functions are defined as ( ) and ( ), respectively, with a utility set given by {( ( ) ( )) ( ) }. (Riddiough 10) By applying a

generalized Nash bargaining solution given by the assumption both borrower and lender are risk neutral, Riddiough & Wyatt devise the following optimization problem to be solved:

[ ( )] [ ( )]

( )

( ) (

)

where and represent the bargaining power of the borrower and lender. (Riddiough 10) In other words, given that the total bargaining set is equal to the sum of borrower and lender’s share of the foreclosure costs, and the outcome of the bargaining game is greater than or equal to the cost of foreclosure to the borrower, and the value of the property minus the cost of foreclosure to the lender, while the bargaining power of either party is equal or greater than zero, the party with the greatest utility will achieve the greatest allocation of the bargaining set. If either or equal 1, the chosen player has total bargaining. (Riddiough 11)

When risk aversion is included the solution can be obtained for , given ( ) ( )

, and ( ) ( ) : (Riddiough 11)

As stated in Riddiough & Wyatt (1994), “[…] Whenever the borrower’s utility exogenous bargaining power increases ( ) or his risk aversion reduces ( ) relative to the lender’s situation, he increases his workout allocation. In turn, this raises the point at which the borrower is willing to default since he can extract relatively higher concessions from the lender given the loan terms and foreclosure costs. (Riddiough 11)

Conclusion The variables of bargaining power and risk aversion constitute the preparation and knowledge the entire first three quarters of this paper outline. It is only by understanding the strategy afforded by the law, contract terms, tax code and financial triggers of both parties, that the best possible outcome of negotiation can be achieved. The borrower who maintains a clear, logical, calculated approach to exercising his termination option, knowing the present value of his put option now and the expected (present value) value of exercising his put option in the future while at the same time weighing those values against the value of the call option held by the lender now and in the future, will have the highest probability of success in a securitized mortgage negotiation.

Works Cited

Appicelli, Frank A. "An Introduction to Securitized Loan Workouts." Real Estate Finance (Aspen

Publishers Inc.) 26.1 (2009): 6-8. Print.

Chen, Jun, and Yongheng Deng. "Commercial Mortgage Workout Strategy and Conditional Default

Probability: Evidence from Special Serviced CMBS Loans." The Journal of Real Estate Finance

and Economics (2012): 1-24. Print.

Ciochetti, Brian A., et al. "The Termination of Commercial Mortgage Contracts through

Prepayment and Default: A Proportional Hazard Approach with Competing Risks." Real

Estate Economics 30.4 (2002): 595-633. Print.

"Commercial and Multifamily Mortgage Debt Outstanding Increases for Fourth Straight Quarter

"Web. 12/12/2012

<http://www.mortgagebankers.org/NewsandMedia/PressCenter/82891.htm>.

Genz, Peter. "Tax Issues in Real Estate Workouts." Tax Conference (Marshall-Wythe School of

Law).William and Mary Tax Conference.55 (2009): 3. Print.

"Put Option Definition | Investopedia "Web. 12/13/2012

<http://www.investopedia.com/terms/p/putoption.asp#axzz2EyrWCmW9>.

"REMICs/Investment Trusts for Certain Modifications to Commercial Mortgage Loans." Tax

Management Tax Practice Series Bulletin 21.19 (2009): 11. Print.

Riddiough, Timothy. "Strategic Default, Workout, and Commercial Mortgage Valuation." Journal

of real estate finance and economics 9.1 (1994a): 5-22. Print.

---. "Strategic Default, Workout, and Commercial Mortgage Valuation." Journal of real estate

finance and economics 9.1 (1994b): 5-22. Print.

Saft, Stuart. Commercial Real Estate Workouts. Eagan, MN: Thomson WestPrint.

Schwartz, Alan. "Bankruptcy Workouts and Debt Contracts [Comments]." Journal of Law

Economics, Vol.36, Issue 1 - Part 2 (April 1993), pp.595-632 36.1 - Part 2 (1993): 595-Part.

Print.