By Aric Chang ’13 and Shockey Wu ’13
|Moderator:||Darrell Wheeler, Senior Managing Director, Amherst Securities|
|Panelists:||Robert Lieber, Executive Managing Director, Island Capital Group|
Regina Lubin ’05, Senior Vice President, CW Capital
Stephen Meister, Partner, Meister Seelig & Fein LLP
“Special Servicing—360 Degrees” panelists discussed the evolution, current state, and future challenges of the special servicing industry.
To start, panelists gave their opinions on how commercial mortgage-backed securities (CMBS) have evolved over the years. Lieber commented that the commonly used description of the industry undergoing a “paradigm shift” is dangerous. From 2005 to 2007, the CMBS market experienced five times the transaction volume as it did in the previous two years, and the same paradigm-shift argument was used to justify sloppy underwriting standards. Through the law of large numbers, issuers were theoretically able to minimize risk and boost ratings. The entire industry was described as a game of musical chairs, with issuers relying on this massive transaction volume, investors relying on the issuers, and everyone feeling validated by cap rate compression.
Lubin commented that while working on a New York acquisition during that era, a lender offered more debt on the asset than she originally requested, up to 100 percent loan-to-value. Meister described the boom in CMBS as a sympathetic response to the housing bubble. As residential market prices continued to inflate, there was an expectation that commercial real estate should follow. The housing bubble was accelerated by the development of structured asset-backed securities, such as collateralized debt obligations (CDOs), which the commercial real estate industry soon adopted. The panel agreed on a need for more accountability to rebuild the system.
Moving on to a discussion of the structural problems with CMBS, Meister shared his views on the industry from a legal perspective. Likening the state of CMBS litigation to “trench warfare,” he explained how many of the standard legal documents governing complex real estate capital structures are being interpreted for the first time as a result of litigation. For example, the Cherryland Mall case in Michigan last year invoked an industry debate on non-recourse carve-outs and borrower liability through special purpose entities (SPEs). Standard bad boy carve-outs in SPE covenants often require that “the borrower will remain solvent.” A real estate investor from the audience highlighted a 2012 article by Wheeler on Cherryland as reason that investors should be very careful on what loan documents they sign. Meister went on to describe how the vagueness of this language enabled Wells Fargo, the trustee in this particular case, to argue that non-performance of the loan meant that the borrower failed to maintain its status as an SPE, which therefore triggered full-recourse liability for the guarantor. The trial court ruled in favor of Wells Fargo and an appellate court affirmed the ruling as following the terms of the documents as written, despite acknowledging that it was opposite the spirit and purpose of the loan documents. After multiple rounds of litigation, the Michigan Supreme Court reversed the decision of the lower courts, and the state legislature issued a special law to clarify this borrower liability issue. However, these questions regarding recourse guarantees and SPE-separateness have only been addressed in Michigan. Meanwhile, trillions of dollars in loan guarantees remain at risk around the country, including in New York State.
In structures that include mezzanine debt, there are also questions regarding the legal interpretation of common covenants. Meister discussed the famous case of Manhattan’s Peter Cooper Village apartment complex, in which the senior lender brought suit to stop PSW, a Pershing Square-led investor group, from foreclosing on its mezzanine position. The judge in the case ruled in favor of the senior lender, which had argued that the intercreditor agreement (ICA) required the mezzanine holder to pay off the senior debt before foreclosing on the equity interest. This case is significant because there are different opinions and cases arguing whether standard boilerplate ICAs require a mezzanine lender, as a pre-condition to Uniform Commercial Code foreclosure on the equity, to merely cure the senior mortgage or to pay it off entirely.
The next question Wheeler presented pertained to conflicts of interests in special servicing. In particular, he asked the panel to comment on vertical integration—the merging of special servicers with asset management and brokerage services. Vertical integration helps the servicers better manage assets and generate more revenue but is a potential conflict of interest that could drive up bond recovery costs.
Another new form of integration causing conflict concerns involves having special servicer ownership transferred from institutional control to real estate investment managers. This ownership structure causes trustees to question whether their interests are properly represented, or whether the servicer is being used by its owner as a source of acquisitions. The mechanism that trustees worry can be abused is the fair value option (FVO), which allows controlling stakeholders in the debt stack to buy a defaulted loan at a fair value that they help determine. So, this mechanism raises additional questions about determining fair value. The panel discussed a case pending in the New York Supreme Court involving a $160 million loan in which the senior note holder sued a junior position in order to prevent the B-note holder from exercising its FVO. The plaintiff argued that the appraisal was flawed and the B-note holder and special servicer conspired to purchase the loan for less than fair value.
Lubin discussed property manager integration. Although a servicer’s property manager may want to manage an asset, the asset managers select the property manager based on their assessment of the best way to maximize value to the trust taking into account fees and expertise. Lieber argued that the key for special servicers is to balance transparency, integrity, and market orientation. In addition, there is an abundant supply of assets in secondary and tertiary markets that need to get worked out. Quality servicing is hard to find for these smaller deals, and there is a need to create competition in these secondary markets. More integrated servicers are better equipped to provide creative solutions such as bundling REOs with defaulted loans into portfolio sales or utilizing new channels such as Auction.com.
When asked about future investment opportunities in CMBS, the panel discussed the challenges in analyzing these investments. Wheeler shared his belief that the best values are found in legacy CMBS as opposed to new issues. To illustrate, he described one case in which he saw a legacy bond with a loss-adjusted 18 percent yield, six-year term, trading at 50 percent of par. Asked by an audience member why such an attractive deal could exist in the market, Wheeler outlined the challenges faced by an investor and detailed the bottom-up property analysis that his firm, Amherst Securities, performs on every bond, including analyzing each underlying asset and its rent roll. Lieber supplemented that in addition to this vast computing-power requirement, significant real estate expertise was needed to scrutinize each bond property-by-property and loan-by-loan on a qualitative basis. This level of real estate and technological sophistication is a significant hurdle for many investors. Meister cautioned that attractive returns exist because many of these bonds are often collateralized by many small assets. Although the yield on the B-piece or mezzanine in a hundred-loan portfolio might seem attractive at first, investors should realistically assess the likelihood of foreclosing across a hundred $1-million assets, for example.
The next topic was whether new issuances, commonly referred to as CMBS 2.0 or 3.0, are actually resulting in better securitized products. No significant changes have been made to legal documentation, and the root of the problem still lies in bad underwriting by lenders. From the borrower’s perspective, they often have difficulty finding a party—whether the issuer, special servicer, or a junior mezzanine holder—with which to discuss operating issues regarding the real estate, and this matter has not been resolved in new issuances. One provision in Dodd-Frank will require originators to retain five percent of the most junior tranches of an issuance for risk retention. As long as first-loss buyers hold five percent of each CMBS provision most of the panel felt this requirement was met. In practice, however, exposure can easily be hedged, bypassing the original intent of the provision. In summary, there was general consensus that CMBS 2.0/3.0 was unfortunately just window dressing that fails to address the real structural flaws in securitization. In addition, most of the participants felt that leverage within new CMBS issuance would continue to increase in the future.
A question from the audience asked for comment on special servicing fees in the future. With recovering credit markets and property values, many loans that were originally expected to default and go into special servicing are now instead being refinanced. The two panelists representing special servicers, Lieber and Lubin, responded that there is a need for special servicers to diversify their businesses. This means leveraging the existing servicing platform into property management, asset management, and bond analysis.
In closing, each panelist was asked to give final comments on CMBS and special servicing. Meister worried about the U.S. debt trajectory, noting a similarity with Greece’s debt levels in 2009. The current debt overhang means there is a likelihood of rising interest rates in the future. Lubin expected more refinancings and performing loans, but also more maturity defaults. The aforementioned rise in rates would exacerbate this problem. Lieber noted the lack of any significant shocks in 2012 despite the looming fiscal cliff, but is keeping his fingers crossed looking forward.
The fifth annual Real Estate Symposium took place on December 4, 2012, at Columbia University’s Faculty House, with more than 180 alumni representing classes from 1961 to 2012. Please visit the event page for more details and reports on other speakers. Hosted by the Paul Milstein Center for Real Estate and the Real Estate Circle of Columbia Business School, the Real Estate Symposium is an annual educational forum that brings together accomplished Columbia Business School alumni and top industry leaders for a broad-based discussion of topical issues, high-profile transactions, trends, and challenges facing the real estate industry.