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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Commercial Mortgage-Backed Securities 2.0:
Structuring Securitized Loans
Presented by:
Allen Dickey
Thursday, December 19, 2013
1:00 pm Central
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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
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Introduction
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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.
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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…)
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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.
Introduction (Contd…)
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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
Introduction (Contd…)
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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
Introduction (Contd…)
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CMBS 1.0 to 2.0/3.0 and back
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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
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Original Goals of CMBS 2.0
Increased Transparency / Disclosure
Risk Alignment
Vastly more conservative underwriting
Lower leverage
Enhanced Representations / Warranties
More input from investors
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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
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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…)
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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
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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
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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.
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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.
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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.
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CMBS 3.0 / Loan Structures
(Contd…)
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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
CMBS 3.0 / Loan Structures
(Contd…)
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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
CMBS 3.0 / Loan Structures
(Contd…)
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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
CMBS 3.0 / Loan Structures
(Contd…)
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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?
CMBS 3.0 / Loan Structures
(Contd…)
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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?
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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)
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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).
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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
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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.
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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.
Commercial Mortgage-Backed Securities 2.0:
Structuring Securitized Loans
Michael Weinberger
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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