CrunchedCredit

Innovation In Securitization Is Here: And It's About Time!

Rick Jones — Mon, 07 May 2012 15:35:48 -0500

Rialto Capital – Series 2012-LT1 is a done deal. It represents a huge innovation in commercial real estate structured finance. This is the first liquidating trust vehicle successfully securitized in the United States since the famous RTC N Series and its progeny of the mid-1990s. Briefly, the transaction involved the pooling of sub-performing, non-performing and REO assets pursuant to a plan to liquidate the assets in a measured but reasonably expeditious fashion. The sponsor holds the equity and a single class of debt was sold to investors. The deal has closed; the sponsor has stable, predictable match term financing. Bond buyers got a transparent and robust structure with strong subordination, management and downside protection. A powerful new tool has been provided to the commercial mortgage finance industry.

We began writing about liquidating trusts well over a year ago. We were delighted to have played an important role in bringing the Rialto transaction to the marketplace. This transaction has many innovative features and was structured to address a range of complex legal and tax related problems that are incident to the pooling of sub-performing and non-performing loans. For a general discussion of tax implications of pooling these sorts of battered assets, see this previous post.

At about the same time that Rialto came to the market, another deal we worked on - the A10 Securitization 2012-1 - closed. This was an offering backed by a pool of bridge or unstabilized loans. Some of the loans included in this transaction had future funding components. The structure was a melding of traditional CMBS and CLO technologies which balanced the sponsor’s need to manage and nurture bridge product while providing investors with substantial credit enhancement, downsize structural protection and certainty.

Both these transactions are fascinating in their own respects and each had a relatively long gestation as innovation takes both considerable time and effort. But what is most interesting about these two, and a handful of other recent transactions including such things as the L-Star Securitization from 2011 and a number of other bespoke private transactions, is that innovation in the real estate capital markets is alive and well.

The late unpleasantness (as the Civil War is still today described in parts of the South) taught tough lessons about fundamental underwriting and deal structure. Along with the “Lessons of the Fall”, now canonized as received wisdom, such as “no income, no doc” resi underwriting is an oxymoron, B notes will not continue to pay a coupon during a severe market downdraft and never get involved in a land war in Asia, came an enervating anxiety about structure and change, a conviction that keep it simple stupid needed to be the touchstone of our industry for many years to come.

Really hard lessons tend to be overlearnt and that happened here. Innovation, sophisticated engineering and change are not the enemy. They are central to what we do and mid-wife capital formation. We need to embrace our ability to innovate and adapt.

There are lots of good ideas out there and the industry must continue to be open to them. A10 and Rialto are all about using capital market solutions to provide financing for asset accumulators. CMBS and its analogs are easily adapted to a leverage and not a sale technology. Whether it is par product or a non-performing pool, the capital markets can offer nifty solutions. Innovation married to the basics of credit blocking and tackling, conservative underwriting and robust structures is simply a good thing.

Look, there may not be adequate capital in the banking sector to meet the needs of the users of capital. That niche is where we play. Do some of these leverage structures look a bit like the late lamented CRE CDOs? Maybe it looks more like a securitized repo or securities contract. Maybe there will be elements of covered bonds and synthetics. There are answers here!

So let’s get over our post-traumatic stress syndrome, stop trying to fight the last war and embrace innovation! As we’ve said before in this Blog, the market knows how to underwrite commercial real estate mortgages and knows how to underwrite managers. Putting those two together to provide accumulation leverage technology for high-quality whole loans or, in fact, non- and sub-performing whole loans, in the rights hands, is doable, so let’s do.

By: Rick Jones

Own-to-Rent: New Approach to Overflow REO Gaining Attention

Matthew Clark — Thu, 03 May 2012 14:24:28 -0500

With little good news on the horizon for the U.S. residential housing market, public and private programs offering the sale of bulk residential REO is, in many circles, the topic for real estate investment. The REO-to-Rental play is not without its risks – questions about the availability of financing and the viability of a structured exit remain as key questions. Still, the strategy may present a favorable opportunity for banks and investors alike.

Over the past few months, an inter-disciplinary group of Dechert finance, real estate, regulatory, banking, securitization and financial services attorneys have had several conversations with clients discussing how these deals will work. This week, I co-authored a brief article together with my partners Patrick Dolan, Mac Dorris, Bob Ledig, Ralph Mazzeo, Tom Vartanian, Jay Zagoren and Gordon Miller that highlights an innovative program initiated by the FHFA, designed to convert thousands of single family REO to rental properties. This article focuses primarily on the issues faced by investors, and provides a detailed explanation of the FHFA’s plan and recent events related to the initiative.

Now if only we could convince this year’s crop of college graduates to rent an apartment instead of returning home …

Click here to access the full Dechert OnPoint.

By: Matthew Clark

First Annual IMN CLO and Leveraged Loan Conference Update

Matthew Ginsburg — Sun, 29 Apr 2012 12:00:01 -0500

Seven of our colleagues in Dechert’s active CLO group represented the firm at the first annual IMN CLO and Leveraged Loan Conference in New York a few weeks ago. Strong interest in the collateralized loan obligation technology meant a capacity crowd of more than 750 managers, arrangers and investors, often leaving panel discussions with standing room only.

As participants reviewed CLO performance over the past five years, the theme emerged that CLOs weathered the crisis well compared to other structured finance vehicles. The CLO technology performed as advertised: protecting senior investors and amortizing senior notes during periods when coverage tests triggered.

Dechert Partner John Timperio moderated a panel on legal and structural considerations covering improvements in CLO 2.0 as compared to CLO 1.0 of the pre-crisis 2007 vintage. The consensus was that refinements to the CLO 1.0 technology (already proven during the crisis) will mean a CLO 2.0 that is even more resistant to stress featuring more conservative capital structures, cleaner commercial loan portfolios, stricter collateral quality tests and shorter reinvestment periods. Hand in hand with the technological refinements, greater collateral manager transparency and investor engagement are increasingly important.

CLO 2.0 has been going great guns with north of $5 billion issued in the first quarter of 2012. All this good news is of course tempered by the challenges posed by Dodd-Frank and its progeny, notably the Volker Rule (discussed here), the risk retention rule (discussed in this Dechert OnPoint) and the conflict of interest rule (discussed in this Dechert OnPoint). As regulators struggle to formulate appropriate rules and market participants struggle to educate the regulators, we hope that the baby isn’t thrown out with the bathwater.

Still, the mood was optimism that issuance in 2012 at least will continue apace, which confidence looks well placed as, since the conference, total CLOs pricing for the year has hit $9.78 billion, as counted by the LSTA.

This is great news for 2012, but as the various rules come online, where will the baby be next year (or the year after)?

By: Matthew Ginsburg and John Bumgarner

Cherryland and Peaches: State Politicians' Efforts to Protect Bad Boys Garner Mixed Results

Matthew Clark — Thu, 26 Apr 2012 09:38:07 -0500

A few weeks ago Crunched Credit previewed a (now enacted) bit of Michigan legislation entitled the “Nonrecourse Mortgage Loan Act”, which, in fewer than 800 words, seeks to ringfence recourse guarantors’ assets from attack in connection with the enforcement of post-closing solvency covenants. The legislation was signed by Governor Rick Snyder in the wake of two controversial Michigan decisions regarding the non-recourse nature of mortgage loans. The Cherryland/Chesterfield decisions garnered two opposing, but equally reasonable, reactions amongst industry folk. The first saw the claim for deficiency as mere sophistry – the enforcement of a loan that was non-recourse only to the extent it was repaid (i.e. “that can’t possibly mean what it says”). The second saw a simple contract case – the imposition of contractual recourse liability for violation of SPE covenants pursuant to contracts that imposed recourse liability for violations of SPE covenants (i.e. “words matter”). A majority of Great Lakes State politicians apparently find themselves in the first camp. This Bay Stater tends to find himself in the second.

Michigan is not alone in its efforts to protect recourse guarantors from their obligations under bad boy guaranties. The least furtive (and most, well, obnoxious) attempt by State politicians to shield their constituents from liabilities under recourse guaranties recently emerged in Georgia. In late February, the Georgia State Senate unanimously passed the “Small Business Borrower Protection Act", a bill targeting carpet-bagging distressed-debt investors in Georgian real estate loans. The bill sought to limit recovery under bad boy guaranties to the amount paid for the loan plus accrued interest from the date of purchase; effectively eliminating any economic incentive for distressed-debt investment in the State.

The history here harkens to Georgian banks and borrowers alike being particularly hard hit by loan sales conducted by the FDIC after taking receivership of regional banks. Many Georgian bankers were unhappy because they, too, owned positions in many of the loans that were being auctioned. The FDIC’s sale set a market value for these positions that, we can only assume, landed well short of the lenders’ internal marks. Borrowers were unhappy as the distressed-debt investors sought to resolve the loans to their favor Cap’m Charlie Croker-style.

Common reaction from the real estate industry to the proposed legislation was visceral. As a result, in March, the Georgia House Banking Committee devised a watered-down proposal – limiting the scope of the bill to loans purchased from federal bank regulators and by non-bank investors. Ultimately, the revised bill never met with a vote and died on the floor at the end of the legislative session.

In each of these cases, the legislation was retroactive in effect, a concept that raises questions both of constitutionality and policy; should a State legislature be overriding the effect of privately negotiated contracts among sophisticated parties with tersely-written, quickly-enacted laws? This conversation is only beginning: $700 billion is coming due in the next 24 months and the first piece of paper lenders look at upon maturity default is the bad boy guaranty. And words matter.

By: Matthew Clark with Dave Pildis

The European Bank De-Risking Continued: The Buy Side

Rick Jones — Fri, 20 Apr 2012 10:02:25 -0500

For the last few weeks, I’ve been writing about investing in distressed bank assets, with a particular focus on the European markets. As you know, we think there are huge opportunities as the European banks disintermediate to meet capital thresholds, while the economy in Europe grinds slower and slower. Last week in this blog we talked about considerations on the sell side. Now, near and dear to my heart; the buy side.

First, we can start by thinking about everything said in last week’s article on the sell side and turn it over and look at it from the buy side. The asset pools will continue to be heterodox. The collateral, the loan documents, the economic terms of the loans will all be heterodox. Notwithstanding my plea to the sell side to get their house in order before pools are exposed to the marketplace, you should anticipate that pools will not be cleaned up for prime time before being exposed for sale. Files and data tapes will be incomplete and will be corrupt, documents will be missing, and underwriting information will be woefully hard to come by.

That’s what it is, get over it. We play the cards we’ve been dealt and we bid on what we got.

If it’s an auction environment, you’ll have no idea how many serious bidders there are. As we mentioned last week, pulling a confi and looking at a pool for sale is a little like financial porn. Everyone does it. How many serious bidders there are will be unclear. That means you’re confronted with a massive diligence project with an uncertain likelihood of success.

So the first major issue is to see how you can winnow the buy side without spending a fortune on diligence. Hopefully, the sell side will set up at least a two-stage auction, where indicative pricing can be provided without hard commitments before real heavy lifting on diligence will be due. If it’s a one-stage affair, you need to think long and hard about willingness to spend enormous money on what amounts to a flier. You may also think through the strategy of lobbing in a bid without complete diligence and assuming you’ll be able to work out a diligence protocol once you win, notwithstanding the sell side protestations that such a post-bid diligence process was not the deal. You’re retrading! I’m shocked, shocked!

Of course, if it’s a negotiated transaction, these problems will be avoided, but don’t bet on seeing many negotiated transactions in this environment. The herd is following the bell cow of the Irish auction deals. It is darn hard for a bank to embrace a negotiated transaction when the siren song of the “You will never get fired for running an auction” is blaring loudly in their ear.

Getting one’s arms around a relationship lending product is hard, complex and time consuming. It’s certainly possible to substitute some level of rep and indemnity protection for diligence, but this is usually the structural equivalent of spitting into the wind. Pool sellers have been uniformly allergic to strong reps and, frankly, in some cases there is a serious question as to what the reps are worth. Are the reps provided by the parent, or by a U.S. subsidiary? If it’s a U.S. subsidiary, will it remain in business? Will the parent remain solvent? For some institutions that are national “champion” banks, sovereign immunity could become an issue. So, I have a breach, I have a claim, I have a solvent counterparty, but, I’m unable to maintain the suit without the consent of the sovereign. Pretty useless set of reps. On European assets, all of this is made more complex by bank privacy laws and a penchant for extraordinary confidentiality. In some cases, it just may not be possible to obtain all the diligence one would typically see on a U.S. domestic transaction.

Buyers' diligence process is often flawed. Figure out what you need to know and how information will be socialized with the deal team before you launch. We have seen many Ready, Fire, Aim diligence initiatives. Members of your business side diligence team and counsel should have to hit the files once, not repeatedly, as new issues and concerns, not identified up front, are now raised. Moreover, how does critical information get to the deal team decision makers? The diligence team of business and legal does a deep dive. They know everything. But the senior deal team has barely a clue. If you lack a process to transmit information cogently and efficiently to the deal team decision makers, then there was no diligence. If a tree falls in the forest but no one hears it, did it happen? The fix seems simple, right? Maybe, but this is a recurring problem; we have the data, but cannot retrieve it nor analyze it in an efficient manner nor have it accurately and thoughtfully reflected in deal negotiations.

The biggest single substantive problem in deals we’ve seen is restrictions on transfers contained in the underlying loan documents. There may be transfer restrictions in the actual loan documents themselves, or in the swaps and hedges which are an integral part of the credit and where a substantial part of the value of these financial assets may lie.

It is not unusual to find a swap requiring a bank as a counterparty. If the buyer is not a bank, it will need a bank to play a role in the transaction. Either way, some form of a back to back with either the seller, which stays in the deal nominally to hold the swap position, or with a substitute bank, which meets the transfer restrictions of the swaps, will be necessary. All these workarounds have flaws, all these workarounds are complex and all these workarounds are time-consuming and expensive. On the other hand, broadly, they can work.

Some transferability issues simply cannot be fixed without going back to the borrower. One could hope that seller had done that, but so often it has not. The only fix for dealing with this type of restriction is some form of 100% participation or total return swap between seller and buyer so that seller can nominally stay in the transaction. This, once again, raises counterparty credit issues and sovereign immunity issues and everything else discussed above. A better fix is to get the seller to sell the asset on a deferred closing date and get the seller to go back and fix the transferability problem. This, of course, raises a host of questions, even if the seller will agree, including allocating risk of loss, hedging, etc.

A final issue worth talking about today is financing the position. There are buyers that need and want no financing, particularly on a par product which is simply adding to the portfolio of a buyer which is, itself, an insured depository institution. But many buyers want or need financing. What we’ve seen in the past is a financing auction as bidders run multiple lenders against each other to provide financing. This, of course, is a painful exercise for the lender. Bidding to back a party which is itself a bidder starts to look like a sucker’s bet. Nonetheless, to date, there has been a robust offering. Will that continue? Good question. My advice to bidders needing leverage is to pick a lender quickly, get the lender comfy with the trade, the transaction, the quality of the diligence, what’s doable and not doable, what needs to be achieved, etc., all as early as possible. Do not let the perfect be the enemy of the good. That early coordination with the leverage will pay enormous dividends if you are so lucky (lucky?) to win the bid.

Have at it. We’re all going to get a lot of practice buying these pools over the next 24 months.

By: Rick Jones

CREFC Distressed Debt Conference Update

Matthew Ginsburg — Thu, 12 Apr 2012 15:03:32 -0500

Last month three of our colleagues attended the Distressed Debt Conference sponsored by CREFC at the New York Athletic Club. Since the topics of distressed debt and loan sales are frequently covered by CrunchedCredit, we thought an update on this conference was worth providing. For those of us not in the New York office, travelling to NYC is always an excellent opportunity to catch up with clients and colleagues. Given that we were talking about distressed debt and there is a lot more of it than there used to be, it was a welcomed change to see that the mood of the conference was very upbeat, and that there was general enthusiasm about the numerous opportunities available in the distressed debt market.

One of the themes of the conference as well as one of the more important lessons we are learning as we in the industry deal with this volume of distressed debt, is that the same workout strategy will not work for every property. The type of collateral and the jurisdiction where the collateral is located are extremely important in determining the best workout strategy. In particular, lenders working out loans and buyers acquiring distressed debt all indicated that when analyzing distressed debt, it’s all about “Location, Location, Location!” Now this is nothing new in the real estate market, but when it comes to distressed debt the location consideration is unique. Lenders and purchasers are asking whether this is a favorable location for foreclosure. Not surprisingly, lenders are learning that taking back a property in Texas through a non-judicial sale (which can be done in less than 1 month) is very different from foreclosing on a property in New York (which can take years). Similarly, certain states will allow receivers to step in and immediately control the cash at a property, but in other jurisdictions, the lender would need to prove that the owner is committing waste at the property before the court would even consider appointing a receiver, and even then, the receiver may be anything but an expert on managing real estate. In this case location is not just about value, but how quickly and efficiently the workout process can proceed.

As with many things during the great credit bubble, many did not focus on the variations in local foreclosure law and how it would impact their realization on the underlying real estate. Now that the issue is front and center, the question is, how long will we remember the lesson?

By: Matthew Ginsburg and Jessica Seger Bula

Time to Sell the Silver

Rick Jones — Mon, 09 Apr 2012 15:58:13 -0500

Sometimes a bank just has to sell assets. For many banks confronting capital shortfalls, this is one of those times. Last week, we wrote generally about the "Investing in Distressed Bank Assets Conference" in London. Great conference. Marquee headline: EU Banks Will Sell Risky Assets. Time for a deeper dive into issues confronted by the sellers.

So, if you want to sell a big pile of assets (steaming or otherwise), what do you do? You can certainly hire one of the well-known brokers (er, I mean loan sale advisors) in the market and tell them to have their way with you. They will do some level of loan file organization; produce some type of tape; produce a book (pretty pictures); and set up a war room. They will run a public auction process. They will jawbone the bidders. Do they do a really good job? Read on. Is this the only option? No.

The auction sale is designed to produce a market clearing price. Note, however, that as disintermediation continues, buyer fatigue is beginning to set in in the auction space. The cost to make a competent bid on a sizeable pool of loans with an unlimited number of eager bidders is enormous. Will that process continue to pull in the best and most well-heeled bidders? Don't know. It is clearly best to structure the auction as a multi-step process so first look bids can be made with limited diligence expenses and the non-real culled. A good bid process will work hard to qualify the truly serious and create a bidding environment where the real bidders don’t feel like they are bidding with a herd. Thus, only the truly serious have to execute a truly deep dive. Is the right number 3? 10? Certainly not 20 plus!

In addition, a public auction is, well, public. What does it say about the seller? What information is available to any bidder who can hit send on the confi? Rooting around in a selling bank’s financial drawers has become a sort of financial porn – almost irresistible. Dirty laundry comes out and the rumor mill is fired up about the seller, its health, its prospects, plans and management. At the very least, that may be less than entirely enjoyable. And market chatter can move markets and influence regulators and political constituencies.

Moreover, an auction is a one-size-fits-all execution. Sure, the broker can set up an infinitely complex array of alternative bids (Pool A, single loans, all loans in Milwaukee CBD, etc.), but it’s still a straight sale of loans. That may not always be the ideal execution.

The seller should always consider a private, negotiated deal. In a negotiated deal, there is much more structural flexibility as buyer and seller work together to sort out what works best. This can have huge value to the seller if it feels it has selected the right counterparty. And the sausage making is private. On the other hand, did you get the best, market clearing price? It is hard to prove the counterfactual to the market, senior management and the Board.

An alternative to either of these sale processes is securitization. We have recently seen seasoned portfolios securitized; indeed, we are on the cusp of industrializing the securitization of sub- and non-performing loans. Can a bank find a high-yield buyer to take the risk piece and sell some IG bonds? Absolutely! This could maximize control over the process, control confidentiality and disclosure, and perhaps produce the highest return.

In any case, if you want to sell loans, you start by rounding up (warming up and qualifying) the usual suspects. In the States, there has been a very strong bid from well-capitalized banks for performing par product, while the hedgies and private equity are a strong bid for distressed and sub-performing. Notably, the high-yield players may also be a bid for par product. Pools can be flipped through securitization, with the high-yield player keeping the bottom while the top is sold to the IG gang, providing long-term leverage for the transaction.

Pick a sales process, warm up the crowd, but don't forget to put some lipstick on the pig.

Diligencing a pool of seasoned loans can be painful, really painful (and about as bad for the seller preparing a book as for the buyer). Seasoned loans were not originated for sale. They were not serviced for sale. They are relationship loans. Getting a data tape that is not incomplete or corrupt is enormously hard. Sorting out non-customary servicing records is hard. Finding the loan documents is hard. One missing note, an inconvenience; all missing notes, existential problem. The harder it is to diligence the pool, the bigger the uncertainty discount in pricing.

Valuation is made much more difficult because of heterodox collateral and heterodox loan documentation. A loan secured by a commercial building is good. A loan secured by a commercial building, a fleet of delivery vans and an undivided interest in a race horse is less than ideal. In documentation, we customarily see multiple basis provisions, pay dates, grace periods, swap and hedge structures, recourse features, maturity and amortization, etc. What a headache.

Best in class in the bad news category are restrictions on the lender's right to assign the loan. Maybe for future funding loans or the like, these restrictions could make sense. Otherwise, they do not. Drafting point going forward: don’t go there. But go there, many have done, and the headaches from these restrictions reverberate through the note sale market. We find these most often in the loan documents of the European banks. There are several flavors of these restrictions, and none are good. We have seen restrictions that limit assignability to other banks, or to other banks and financial institutions (often an undefined term), or to financial institutions with a certain credit rating. We’ve also, and this is the most painful of all, seen transfer restrictions that simply require the borrower’s consent. It’s a borrower payday when that loan has to move.

If the lender has sufficient lead time, document flaws and structural flaws can be fixed, borrower consent can be obtained (although be prepared to pay a price) and other problems resolved. But, even if problems cannot be fixed, if the seller can get its arms around document and structural problems before it exposes the pool to the marketplace, it will pay dividends. Regrettably, we have yet to see a pool cleaned up good before it got to the party.

Abandon all hope, you who enter the land of swaps and hedges. OK, that’s an exaggeration, but swaps and hedges deserve a separate circle in Hell when trying to sell loans. Many European bank loans (and, of course, many loans in general) have embedded swaps, collars or other derivatives. In many cases, the value of the loan is, in significant measure, dependent upon the value of the derivative. Unfortunately, derivatives typically have their own transfer restrictions and these are regularly overlooked when the loan is made. We have seen derivatives that can only be transferred with the consent of the borrower, while many others contain a litany of transferee restrictions. Cutting to the chase, the most common restriction is that the derivative must be held by a bank, and often a bank with a stipulated ratings level. If the potential buyer universe includes non-banks, this creates problems. And while there are lots of workarounds, including Total Return Swaps (TRS), 100% participations and back to back structures, they are hard, carry negative externalities and, certainly, are best sorted out before the dance begins. Fix it before exposing the pool to the marketplace. Did I say consider? I think it is insane not to fix up what can be fixed up before exposing a pool to the market. Any residential broker who can fog a mirror will tell you that a fresh coat of paint, new kitchen appliances, a mowed lawn and a new carpet gets the sale done. Same here.

And here’s a thought for overachievers. This is the bonus round stuff. Consider prepackaging leverage; a cover bid from a lender prepared to lever the portfolio might be an interesting added feature to maximize the value of the bids.

In any event, enough about the sellers. Next week - some thoughts about buying: diligence, reps and other concerns.

By: Rick Jones

Michigan Legislature Proposes Bill in Response to Recourse Cases

Matthew Ginsburg — Thu, 29 Mar 2012 10:17:18 -0500

Well, that didn’t take long . . . Flashback to last month, when we highlighted two eye-opening judicial decisions from Michigan that could potentially have a dramatic and costly impact for recourse guarantors of many CMBS loans. The Cherryland and Chesterfield cases provoked widespread feelings of uncertainty and unease, as well as the belief that the courts had sacrificed the parties’ (and perhaps the entire industry’s) intent in exchange for a strict reading of the loan documents. Despite the supposedly nonrecourse nature of the loans at issue, guarantors were faced with the possibility that they could be stuck with a whole lot of personal liability, simply because of a borrower’s inability to pay back its loan when due. If upheld and looked to as persuasive authority in other jurisdictions, some believed the Michigan cases could run a wrecking ball through the foundation of American real estate finance.

But faster than you could say “deficiency judgment,” it appears as if both rulings will be written off the books. A mere 24 hours after we weighed in on the topic, the Michigan Senate introduced Senate Bill 992 – a bipartisan creation known as the “Nonrecourse Mortgage Loan Act” (click here for a full text of the bill). Not only would the bill prevent any forward looking solvency covenant from being used as a non-recourse carveout going forward, it would also retroactively apply to all nonrecourse loans now in existence, and to any pending action for which appeal rights have not been exhausted (ie. Cherryland and Chesterfield). The bill sped through both chambers of the legislature and is now only a few strokes of Governor Rick Snyder’s pen away from becoming the law of the land in the Great Lakes state.

No doubt that investors and developers across the state are patting themselves on the back (though constitutional scholars - see Article I, Section 10, Clause 1 - may be cringing). The strong and swift legislative response was the result of a determined effort by Michigan real estate heavyweights to offset the damage done by the courts. Industry leaders and trade groups, all with much at stake, conferred with legislators and even drafted a letter to warn them of the destructive implications of the rulings – the prevention of future development and the continued weakening of the state’s economic recovery – as part of their ultimately successful lobbying effort in support of the bill.

So – at least for now – the effect of these cases may not be so remarkable after all. Still, it remains to be seen how other states’ judicial and legislative branches will react if faced with a similar issue. Luckily for the stunned recourse guarantors left to pick up the tab in Michigan, it looks like this one’s “on the house.”

By: Matthew Ginsburg and Eric Kotloff

MORE ON OPPORTUNITIES IN EU BANKLAND

Rick Jones — Mon, 26 Mar 2012 11:05:07 -0500

Last week, I spoke in London at a conference, “Investing in Bank Assets” sponsored by the Association of Financial Markets in Europe (AFME). The Conference had a titillating, if a tad alarming, subtitle “The European Purge Begins”.

The question is, of course, is it true? The purge, I mean. Is there a European purge afoot, and are there massive opportunities to invest in European bank assets? I, for one, certainly hope so.

Let’s test the case. Those who read this blog regularly will be aware we’ve been chirping about these opportunities for quite some time. Having participated on one side or another in most of the recent European banks’ initiatives to dispose of dollar denominated US assets, we’ve become quite fond of this nascent trend. And, not to bury the lead, we think there is a very large opportunity in the disintermediation from European banks, and a particularly large opportunity with respect to US commercial mortgage loan assets held by our European friends over the next 12 to 24 months. By the way, kudos to AFME, Gilbey Strub, Managing Director for Resolutions and Crisis Management at AFME and her colleagues for putting on a terrific show. It was co-sponsored by Dechert and by Alvarez & Marsal.

The one-day program was eye-opening and fascinating. The speakers, present company excepted, were extraordinary. The keynote was delivered by Chris Flowers, one of the savviest investors on the planet. Speakers included Jim Lockhart, who’s Vice Chairman of WL Roth & Co. and currently running what’s left of the UK bank previously known as Northern Rock, our partner Tom Vartanian who is a genius on structuring private equity to save open but damaged banks, John Moran, the Secretary General of the Department of Finance of Ireland, Nils Melngailis and Steve Franck, Co-Head and Senior Director respectively of the Financial Industry Advisors team at Alvarez, Mike Krimminger, the General Counsel for the FDIC (who has certainly seen this movie before), Sophie Bertin-Hadjiveltcheva, the Head of State Aid for Financial Services of the European Union, Andrew Gracie, the Head of the Special Resolutions Unit at the Bank of England, Piers Haben the Director of Oversight for the European Banking Authority, and a host of others. A financial glitterati prepared to slog into the detritus of a bruised, if not broken, bank system.

A lot of great take-aways:

Every bank on the continent is engaged in the naval gazing exercise of dividing risk assets into core and non-core. In some significant measure, and because of politics, “non-core” is code word for the financial NIMBY: “Loans not made to my citizens.”
When folks like Chris Flowers and Jim Lockhart of WL Ross & Co. think it’s worth hanging around the European bank rim, it’s worth hanging around the European bank rim.
The European Commission has provided in excess of €5 trillion in aid to the European financial service sector. €5 trillion. There’s an attention grabber!
The recent massive infusion of liquidity into the sector by the ECB will, on balance, make it slightly easier and more likely the European banks will dispose of non-core assets. The notion that this liquidity means assets will not be sold is wrong-headed.
There’s something like $2 trillion in commercial real estate assets on the balance sheets of the European banking community as a whole. Largely, it’s marked at par. Largely, it’s worth 80 cents on the dollar. That’s a $400 billion hole in the collective balance sheets of the banks. Because of Basel III, the ECB is requiring that the banking community provide something in the range of $300 billion of additional capital before summer. Is that really $700 billion?
The ECB defines capital needs as a ratio of capital to risk assets. Adding liquidity doesn’t fix that ratio. Raising equity or selling assets does. The bet is assets will get sold before capital will get raised. John Moran, the Irish finance minister, pointed out the Irish government is way out ahead of largely everyone else with a creative and aggressive assault on bank solvency with a comprehensive bad bank, good bank, government assisted scheme. The herd is not following the Irish bell cow here.
Major EU banks are enormous. Many of these institutions have assets exceeding the gross domestic product of their host countries. Note that Lehman at its height had assets amounting to about 4% of US GDP. How does the mouse hoist the elephant?
The European banks are also woefully at risk because of their reliance on wholesale funding. US deposits as a percent of bank liabilities are almost 60%. In the Euro area, just over 30%. Yikes.
To maximize the opportunities for buying European bank assets, we need a Goldilocks moment. If the banks’ capital is too low, kicking the can becomes the only strategy and they simply cannot sell assets to improve capital ratios. This compels a strategy of comprehensively fibbing about capital and hoping cheap liquidity will somehow fix the problem. If they are lavishly recapitalized by their respective host governments (see above; not likely in most cases), then they can afford to kick the disposition can down the road. Bet is we’re getting Goldilocks. The EC and host countries are doing everything they can to prop up these banks. It’s likely to be just enough to allow the banks to sell non-core assets but not so much that they can ride out the storm and just hope for a tsunami of appreciation.
Assisted deal to fix open and at least notionally solvent banks is the best way to fix the European bank problem. There are, regrettably, massive headwinds in the way of this getting done. The bank regulatory structure of Europe is vast, diffuse, overlapping, confusing and highly politicized. One thing the regulatory community agrees on though, is that Anglo-Saxon private equity is pretty much evil. If you cannot invite in private capital, assisted with a modicum of state aid, and you cannot face the dilutive consequences of selling vast quantities of common stock, you better sell assets.

From where I sat on the podium, all of this seemed to be a validation of our view here at Dechert that the disintermediation of the European banks is a trend that will continue to provide real opportunities to entertain the US players for the next couple of years. I love validation. Next time, practical pointers on how to buy and sell pools of bank assets.

By: Rick Jones

If It Looks Like a Duck, err, a SARE Debtor...

Krystyna Blakeslee — Thu, 15 Mar 2012 15:23:41 -0500

Recently, the Ninth Circuit Court of Appeals brought smiles to the faces of many lenders (especially Bank of America, the appellee and secured lender) when it refused to combine the assets of related debtors without a substantive consolidation order and held that a single asset real estate debtor will be treated as a single asset real estate debtor.

Let’s take a little detour – some background information may be necessary. In 1994, the Bankruptcy Code (§ 362(d)(3)) was amended to include provisions relating to the “single asset real estate” (“SARE”) debtor. A SARE debtor (§ 101(51B)) is a debtor that owns a single property (commercial or residential with 4 or more units) which generates substantially all of the gross income of the debtor, is not a farmer and is not engaged in any other business (other than owning and operating that property). These provisions are fondly (at least in some circles) referred to as the “SARE Provisions.” The SARE Provisions require a debtor to propose a confirmable plan or commence making payments equal to the contract rate of interest (as opposed to default interest) due on the loan within a short time frame (90 days after entry of an order for relief or 30 days after the court determines that the SARE Provisions apply). If a SARE debtor fails to comply, a creditor (well, any creditor whose claim is secured by the property) may obtain relief from the stay and commence foreclosure. The effect of the SARE Provisions has been to shorten the life of a case and the economic burden placed on creditors whose claims are secured by a SARE debtor’s property.

Now, back to the Ninth Circuit. The Ninth Circuit case discussed here and alluded to above involved Meruelo Maddux Properties, Inc. (“MMPI”), the parent company of more than fifty subsidiaries, all of which filed for bankruptcy in 2009. MMPI’s business was operated on a consolidated basis – cash was swept into a general operating account that was also used to pay the expenses of all of the entities (MMPI and all of its 50+ subs). MMPI and its subs filed consolidated financial reports with the SEC and filed consolidated tax returns with the IRS. The subsidiary at issue, Meruelo Maddux Properties – 760 S. Hill Street LLC (“MMP HILL”), owned a swanky 92-unit Los Angeles apartment complex commonly known as the Union Lofts.

The cases of MMPI and MMP Hill were jointly administered but not substantively consolidated. This is a distinction with an important difference having legal consequences for all parties involved. Substantive consolidation allows a Bankruptcy Court to pierce the corporate veil of related debtors and use the assets of one debtor to satisfy the debts of another (see footnote 1 of the decision). Joint administration is merely a procedural way of dealing with a case aimed at streamlining the process to make the case administration easier for all parties involved.

I digress…. The Bankruptcy Court found that the SARE Provisions would not apply to MMP Hill due to “the consolidated interrelated nature of the business operations of MMPI and its subsidiaries” (even though MMP Hill was a separate and distinct entity and the cases of MMP Hill and its parent corporation and sister subsidiaries were not substantively consolidated). On appeal, the Ninth Circuit overturned the decision of the Bankruptcy Court (affirming the District Court), and held that since MMP Hill qualifies under the SARE Provisions, “absent a substantive consolidation order, we must accept MMP Hill’s chosen legal status as a separate and distinct entity from its parent corporation and sister subsidiaries, and look only to its assets, income and operations in determining whether it is a single asset real estate debtor.” In short, absent substantive consolidation, the Ninth Circuit Court of Appeals refused to ignore MMP Hill’s existence as a separate legal and distinct entity from its parent and sister subs and found that what looks like a SARE debtor, acts like a SARE debtor and smells like a SARE debtor IS a SARE debtor.

This is great news (at least if you are in the Ninth Circuit)! This case has made it clear that when entities are treated separately and distinctly a court will not (should not is probably more accurate) disregard that status without a court order (which means without a hearing and findings of fact and time to object). The Ninth Circuit has confirmed the belief that the bankruptcy of an SPE’s affiliates will not per se result in substantive consolidation. Importantly, the Ninth Circuit has confirmed that single asset real estate debtors will be treated as contemplated by the Bankruptcy Code (even the most debtor-friendly judge may find this difficult to get around). Lenders are given some comfort that if the debtor is a SARE debtor, one way or another (i.e., plan confirmation, payment of contract interest or relief from stay) the lender will be afforded some relief.

So what does this mean going forward? In addition to just giving lenders some extra comfort, it means that lenders should ensure that their borrowers are not receiving funds from their parents or sister subs in exchange for labor or services or as a profit from investments. Some extra reps to that affect are worthwhile.

The Bankruptcy Court’s order telegraphed that substantive consolidation may be a way to circumvent the SARE provisions. If this is so, we may see more debtors trying to have their cases substantively consolidated. Their success, however, is doubtful, since debtors will have to set the stage (e.g., comingling funds, sharing labor and services… in other words, lots of things that will cause a default under most loan documents) for substantive consolidation way ahead of the bankruptcy petition date.

The Ninth Circuit’s straightforward reading of the Bankruptcy Code is an affirmation of a common deal structure for commercial loans, but we will still keep an eye on the rest of the circuits to see how other courts come down on this issue. In the meantime, lenders may consider adding some extra reps and can continue with business as usual.

By: Linda Ann Bartosch and Krystyna Blakeslee

Recent Cases Interpreting Intercreditor Rights

Matthew Clark — Wed, 07 Mar 2012 13:59:39 -0500

Recently, several courts have published decisions interpreting the rights granted to mezzanine lenders under intercreditor agreements - I've recently co-authored this Dechert OnPoint detailing the cases. These decisions, in large part, follow the holding of the Stuytown decision (not great news for many subordinate lenders). Also, a recent decision from the United States Bankruptcy Court for the District of Massachusetts, which holds that the assignment of a junior mortgage lender’s voting rights contained in an intercreditor agreement is unenforceable in a bankruptcy case, indicates there are some limits to how far bankruptcy courts will go to serve senior lenders (better news for subordinate lenders).

As we approach a time where an increasing number of mezzanine lenders may seek to enforce their rights, insight into how courts will interpret intercreditor agreements becomes increasingly important. For even more in-depth information and analysis about these recent cases, and their potential impact on senior and junior lenders, click here to read Dechert's OnPoint.

By: Matt Clark

Pay Me My Money Down: Recourse Guarantors Pick Up the Tab in Michigan

Matthew Clark — Tue, 28 Feb 2012 10:03:52 -0500

That great whooshing sound you heard a few weeks back may have been the air being sucked out of the room for thousands of warm bodies that penned recourse guaranties on (now) underwater loans during the market’s run-up. The cause: two recent cases coming out of Michigan (Wells Fargo Bank, NA v. Cherryland Mall and 51382 Gratiot Avenue Holdings v. Chesterfield Dev. Co.) sticking recourse guarantors with deficiency judgments on heretofore non-recourse loans based on the interplay of two fundamental tenets of CMBS lending – “bad boy” carve-outs and single purpose entity covenants.

Non-recourse lending is a lynchpin of American real estate finance. The lender is limited in the exercise of its remedies upon default to the collateral – for all intents and purposes, the Borrower gets a check at origination and a put at maturity should things go south. But there are limits – carve outs for fraud, selling the property, stealing rents, filing bankruptcy and other naughtiness will give the lender the right to look to the guarantor to make good on the loan.

A corollary concept common to almost all sizable CMBS loans is the single-purpose entity borrower. Because the loans are nonrecourse, the importance of proper underwriting of the underlying collateral is heightened and asset isolation is critical. SPE covenants seek to ensure that the underwritten collateral is the only asset that will have a material economic impact on the success (or failure) of your borrower. This isolation extends to make the SPE “bankruptcy remote” – a commonly, sometimes ruthlessly, misunderstood phrase. A duly formed, validly existing, properly structured, perfectly documented, independent director possessing, rating agency-compliant, Delaware governed SPE with twenty seven eight-by-ten color glossy pictures with circles and arrows and a paragraph on the back of each one is most likely bankruptcy-remote and most certainly not bankruptcy-proof. Rather, the structure seeks to isolate the assets of the SPE from a bankruptcy of a parent entity – the thought being, even if a sponsor is underwater on all of its other investments and goes casters, the lender will be comfortable that its collateral will not become subject to the bankruptcy estate.

One common SPE covenant that takes various incarnations - that the borrower will remain solvent and pay its debts when they come due – found itself at the very center of both of Cherryland and Chesterfield. There was no question that the covenant had been breached. Rather, the issue before the bench was essentially whether the enforcement of the recourse provisions as written contradicted the very non-recourse nature of the loan (“It can’t possibly mean what it says”). The courts were un-persuaded by the guarantors’ arguments and, in each case, found the failure to pay the loan back violated the relevant SPE covenants and triggered carve out liability.

The industry is split on this issue. There are those who tend to think it is unlikely that a lot of loans were intended to be non-recourse so long as they were paid back. And there are those who welcome this new arrow (this really, really long arrow with green eyes and sharp teeth that scares the hell out of everyone) to their quiver when dealing with the realities of negotiating a seemingly inexhaustible supply of DPO’s, DIL’s and DOA’s. Both, to be sure, are taking a fresh read of the loan files.

By Matthew Clark and Matthew Ginsburg

Leaving Las Vegas: Further Thoughts on the ASF 2012 Conference

Ralph Mazzeo — Mon, 13 Feb 2012 16:55:43 -0500

The ASF 2012 Conference held last month in Las Vegas was a success by any measure and attracted an impressive number of attendees (4,500). Attendees were happy to escape New York and other chilly locales and attend some great panel discussions on securitization, regulatory developments and mortgage servicing (or, for some, at least read about those panels the next morning on their iPhones while waiting to tee off). The owners of the Aria will definitely be able to make their mortgage payment this month with all of the money left behind by ASF attendees.

My Dechert colleagues and I who attended the Conference cover almost all of the securitized asset classes. As I described in my blog from the Conference, your particular view of the Conference depends largely on what asset class you focus on in your practice – autos and CLOs, for example, look very strong. As someone who spent unimaginable amounts of hours of my pre-credit crisis life drafting RMBS deal documents, I yearn for the return of the public RMBS deals - and not just because I miss spending my days (and most nights) trying to describe in “Plain English” the waterfall on a multi-group negative amortization deal. I truly believe that we can’t have a meaningful recovery in the housing market without the return of private-label RMBS. But regardless of what particular asset type you follow, there was undeniably a lot of buzz surrounding a couple of topics.

It was clear from a Tuesday afternoon panel that the waves of civil litigation in the RMBS industry will continue to crash on the shores of every major financial institution. Did you actually think that the statute of limitations would prevent plaintiffs from pursuing claims? Unfortunately, in an effort to prove that the government can perform any task better than private actors, President Obama announced at his State of the Union address (televised on the last night of the Conference) that he was forming a new financial crimes unit to pursue mortgage securities fraud during the financial crisis. Wells notices are flying out of D.C. at a rate only surpassed by the dollars coming off the printing presses at the U.S. Mint. It’s ironic that this new focus of investigation is kicking off at the same time that a $25 billion agreement was reached with five large mortgage banks to settle federal and state investigations in 49 states into alleged foreclosure abuses. (Oklahoma reached its own settlement with the banks on Thursday.) Note also that the “settlement” doesn’t prevent individual borrowers from continuing to bring claims. Some of my litigation partners and I plan to host a seminar in our NY office this spring to offer our clients and friends much more detail on all of these developments - I’ll inform you of the particulars of that event in a subsequent blog.

But the other big topic that continues to garner a lot of attention is how to effectively manage the liquidation of the huge inventory of foreclosed homes on the balance sheets of the banks and the GSEs. Analysts estimate that there are 500,000 REOs on the balance sheets of the GSEs and private lenders, and the number is obviously expected to increase as foreclosures continue at a high rate. How then do banks liquidate these properties without having to sell them at fire sale prices and without putting downward pressure on a housing market that is desperately trying to plateau and inch upward in many markets? With demand for rentals rising in many markets, there is a lot of buzz among private equity investors with the idea of buying up bundles of REO, renting them out for 1-5 years, and then flipping those properties when home values recover. And the lenders sitting on a huge inventory should welcome this new investment strategy as such investors should drive up the bids for REO. But the key to all of this happening is on what terms can investors get financing for the bundle of REOs they intend to buy up. I think this discussion will dominate the residential market for the next year and may well be the key to a meaningful economic recovery. Stay tuned for more information on a Dechert sponsored webinar on this topic.

By: Ralph Mazzeo

The Eurozone Sovereign Debt Crisis: Investment Risks and Opportunities

Matthew Ginsburg — Thu, 09 Feb 2012 10:24:45 -0500

We at CrunchedCredit.com hope that our written words provide insight and amusement on topics our readers care about. And although we enjoy putting pen to paper (so to speak), we are always looking for new ways to connect with our client base and readership. Recently, CrunchedCredit.com blogger Rick Jones joined his partners George Mazin and Holland West of the Financial Services Group, Thomas P. Vartanian of the Financial Institutions Group, James Waddington of the Banking and Finance Group in Dechert's London office and Ian Hartman of the Corporate and Securities Group in the first installment of Dechert’s Video Briefing Series: “The Eurozone Sovereign Debt Crisis: Investment Risks and Opportunities.”

Spend a few minutes with Rick and his partners as they present their comments on the continuing sovereign debt crisis. Although the crisis began in Greece more than two years ago, fears of the financial contagion have spread to several other Eurozone countries. Such uncertainty continues to shape the behavior of the U.S. financial markets. The next few months will be critical in determining whether European leaders can hash out a long-term solution to deal with the debt crisis looming over the Eurozone countries. Watch this Video Briefing to find out why Rick thinks this could be an enormous opportunity for those who have capital and can absorb risk.

By Matthew Ginsburg

Pre-Game Reading

Matthew Clark — Fri, 03 Feb 2012 19:15:01 -0500

For those of us with a rooting interest in Sunday’s festivities, it’s been a long two weeks. By Superbowl Saturday, Coach Belichick’s game plan will be set, the Material Girl’s setlist will be planned and the most famous ankle since Curt’s Bloody Sock will (hopefully) be mended, and it is with that in mind that I’ll suggest some pre-game reading to pass the hours leading up to kickoff.

As I mentioned in my post from Miami, our industry faces a mountain of maturing CRE debt in the next 24 months. We’ve been dusting off our default letters, updating our pre-negotiation agreements and spending a lot of time talking with our Bankruptcy, Business Restructuring and Reorganization group about how we can help our clients. This week, Dechert partners Michael Sage (who just happens to be on his way to Indianapolis this weekend to cheer on the Pats) and Brian Greer published an article detailing a recent Delaware Bankruptcy Court decision confirming that in multiple-debtor Chapter 11 cases, the cramdown rules must be applied on a per debtor basis, as opposed to a per plan basis (this is really good news for lenders with performing collateral that get caught up in a sponsor’s mass bankruptcy filing). Michael and Brian see this decision as having a significant impact for securitized debt stacks. Also, next week, Kathy Burroughs, Jon Rini, Jill Lavacchia and I will be publishing an article summarizing recent case law following in the wake of the Stuytown decision and another decision striking down the assignment of bankruptcy voting rights from a junior lender. Lastly, both CrunchedCredit blogger Rick Jones and his partner and FRE Group co-chair Joe Heil were interviewed by Law360 this week – offering their thoughts on market conditions and areas of opportunity in 2012. The interviews can be found here and here.

I hope all of our readers enjoy the game, whether you’ll be rooting for NFL MVP Tom Brady and the AFC Champion New England Patriots, or that other team.

By Matthew Clark

Learning to Love Disintermediation

Rick Jones — Thu, 02 Feb 2012 17:31:50 -0500

We’ve been writing a lot recently about the likelihood that European banks and, to a lesser extent, U.S. banks would be strongly incented to sell assets to improve capital ratios. We had a client briefing in New York on the Eurobank crisis a few weeks ago. We brought together our North American and European regulatory and transactional counsel to cover a wide range of issues from the sale of assets to rescue capital. We had a lively conversation on the panel and with the audience about asset sales. It was pretty clear to one and all that if assets are not disintermediated, bankers will be defenestrated. Given the choice, we are pretty sure the banks will sell assets.

De-risking of banks’ balance sheets might be less than terrific macroeconomic policy at a time when economic activity is weak and could be very bad if it touches off a powerful credit contraction and a descent into a continent full of zombie banks. That’s bad. But, always look on the bright side of life, in a Life of Brian sort of way. In the short to medium run, the velocity of transactional activity around financial assets will go up. Indeed, we have been very busy since mid-year buying, selling or financing pools of loans bereft of the love of the bank who made ‘em.

Of course, banks can meet capital targets by either selling assets or raising new capital. Our European friends seem to have a strong predilection for meeting necessary capital ratio targets by trimming the numerator as opposed to growing the denominator. Commerzbank is a good example. The Wall Street Journal reported recently that Commerzbank is back on the regulatory griddle after actually raising significant new equity. But the bank used that equity to pay off governmental investments and avoid dilution as opposed to simply deepening the capital cushion. That seems emblematic of a continental mind set. We think it will be a while before the European banks and their regulators will broadly embrace all that new capital that is just awaiting the invitation to shore up those balance sheets and impatiently sitting in the coffers of those nefarious Anglo-Saxon private equity shops. And, by the way, this is a capital problem, not a liquidity problem. A few weeks back, the ECB deposited over half a trillion dollars into European banks, which of course they gobbled up and neatly re-deposited back in the ECB. While the markets got giddy for a day, it didn’t fix the capital problem. Liquidity is not the problem. Solvency is.

So, shedding alligator tears at the woes of the European bank market, U.S. transactional players are quite excited about the opportunities in 2012 and beyond as the slow motion train wreck that is the Eurobank crisis continues and continues and continues. And the even better news for us transaction junkies is that these assets are moving from hold-to-maturity players to folks with a much more dynamic approach to the management of financial assets. So as assets are sold by the European banks, they will enter a high velocity environment here Stateside where they will be re-financed, re-structured, re-packaged and re-sold.

The pattern we’ve seen, which we think will continue, is that the healthy U.S. banks will be the strong bid for high-quality performing loans. These institutions continue to struggle to grow their loan book and buying pools moves the needle. The more transitional, or dodgier, assets will be snapped up by the high-yield community using leverage from those self-same major banks. There is a robust bid to finance successful buyers. Most of this financing is repo based, but has proved to be very flexible structurally to accommodate the business realities of a dynamic pool of loans. What I expect to see during the year is some of this bank financing replaced on a long-term, durationally-matched basis by CMBS or CDO type structures which will be very effective stable leverage for players in the space. Lonestar’s L-Star transaction in mid-2011 is the poster child for this trade. We will see many more.

Before getting too giddy over the opportunities flowing from the European banks, remember that every rose has its thorn.

Whether buying or financing, these trades can be difficult. First, many of the banks are turning to established auction shops like Eastdil and HFF to sell pools of assets. While the optionality and transparency of the bid process may be compellingly attractive to the sell side, it creates material barriers to entry on the buy side. The pattern of recent transactions has been a due diligence period followed by a brief contract period and a brief period to closing. The ante is an incredible amount of diligence work prior to making the bid. This has and will continue to limit the number of bidders and it’s conceivable we’ll see more transactions occurring on a private, negotiated basis as bidder fatigue shrinks the pool of willing buyers.

Second, these loans are seasoned and were originated for portfolios as opposed to the secondary market. That means the documentation is all over the lot and the quality of the data captured at origination and through servicing is, in some cases, woeful.

Third, interest rate calculations and payment terms in the underlying loans are, in many cases, downright weird. It’s fascinating how bankers left to their own devices will find new and heretofore unimagined mechanics around setting the interest rate, the interest accrual period and the pay dates. Cutting through this hodge-podge of payment terms is complex to say the least. And if temporary bridge financing is to be taken out by a capital markets execution, it just gets very much worse.

Fourth, for reasons which may be somewhat cultural, the loans coming from the European banks often have restrictions on transfers in either the loan document or in the attendant hedges that makes transferring these loans to new ownership difficult. One can certainly call the borrowers and say, “May I please have a waiver, but I don’t want to pay for it”. But where that doesn’t work, the fixes are complex and typically involve workaround structures such as participations, back-to-back and total return swaps.

Finally, sellers in this market seem to be more than usually allergic to reps. Where data is not good and real, comprehensive representations can’t be had, pricing or taking on more risk become the only fixes. The rep problem is made more serious when there are questions about the long-term viability of the sellers and, in some cases, about the potential impact of sovereign immunity upon residual claims. Nothing’s easy.

So, in summary, European banks will sell assets, U.S. banks and funds will buy assets, U.S. banks will initially finance assets, long-term financing will ultimately be provided directly by capital markets execution, bankers who buy these assets will work them hard to restructure, sell, buy-down, DPO or foreclose these assets to lock in yield. We’ll be there every step of the way. Isn’t that a beautiful thing?

By Rick Jones.

Back to the Future: ASF Conference 2012 Returns to Las Vegas

Ralph Mazzeo — Tue, 24 Jan 2012 15:23:19 -0500

The American Securitization Forum (ASF) Conference returned to Las Vegas on Sunday after short stints in DC and Orlando. As you may recall, the Conference’s last hurrah in Vegas in 2009 was not well received by the Fourth Estate – the juxtaposition of investment bankers meeting in Sin City with the then-recent creation of the $700 billion Troubled Asset Relief Program was low hanging fruit for a media eager to assign blame for the credit crisis. Three years later, over 4,000 securitization professionals, including investment bankers, originators, servicers, trustees, accountants and of course, lawyers, are back in full force here in Vegas. The mood here stands in stark contrast to 2009 when we were staring into the abyss. We have since survived the worst of the credit crisis and have been steadily rebuilding the securitization machine. The dismay and depression of 2009 have been replaced with the sense that we can, in fact, see the light at the end of the tunnel. But how close we are to the end of that tunnel differs greatly by asset class. For example, Monday’s CLO panelists noted that they expected to see continued strong growth in 2012, building on a very successful 2011. On the other hand, the future of non-agency RMBS is unfortunately not looking as bright in 2012. Panelists discussing the 2012 Market Outlook again pointed to the regulatory as well as domestic and international fiscal issues that still need to be resolved before we can see a true recovery in securitization. Looking back at the 2009 ASF Conference Agenda, I found that the program included “substantive panels on critical policy challenges confronting the market, including TARP, TALF, mortgage finance and foreclosure avoidance legislation, loan servicing and loss mitigation initiatives, GSE reform, and what to expect from the new Congress and administration.” Well, we’ve worked our way through TARP and TALF. For better or worse (mostly worse) we now have Congress’s answer to the credit crisis – the Dodd-Frank Act. And of course, GSE Reform is still TBD or possibly RIP. So the near future will in many ways be similar to the past few years: more proposed rules and more comment letters to the SEC et al. I’ll follow up with more news from ASF which concludes Wednesday and will provide insights from the eight other Dechert attorneys here with me in Las Vegas.

By Ralph Mazzeo

CREFC January Conference Recap: Riding the Wave

Stewart McQueen — Wed, 18 Jan 2012 19:59:53 -0500

The image of the cresting wave looming behind the dais in the Loews' Americana Salon during Douglas Holtz-Eakin’s keynote address posed a central, if unintended, question that was addressed by more than one speaker during the three-day conference. Are we riding a wave to recovery or facing a deluge of maturing debt? For most of the 1,200 industry participants that occupied Miami’s South Beach for CREFC’s annual January conference last week, there seems to be no certain answer (other than almost unanimous agreement that South Beach is a better Winter destination than our Nation's Capitol).

Notwithstanding, the overall tenor of the conference seemed to be a determined optimism projected against the overarching blanket of volatility. European instability, a jobless recovery, a newly normalized, lumbering pace of economic growth and a constantly evolving regulatory framework continue to make uncertainty the only sure bet. As one might expect, a number of clients we spoke with last week are adopting a cautiously optimistic demeanor for 2012 and plan to tread the market’s murky waters slowly.

Will CMBS rebound (or continue to rebound)? Will the life co's and other non CMBS lenders be able to fill the void? How will regulatory reform be implemented? These questions are so 2010, and yet they stay with us. Depending on who you believe, CMBS output in 2012 is estimated to be anywhere from $25 billion to $45 billion (compared to approximately $28 billion in 2011). And even if the portfolio lenders have a gangbuster 2012 (which is, in fact, likely), they won't be able to bridge the void left by $360 billion of maturing debt this year. As for Washington, we can’t even determine a cogent agenda for regulatory reform at this point, much less predict what the rules of the game will look like.

Perhaps we’ll have answers (or at least a lessened degree of uncertainty) by the mid-year in June.

By: Matthew Clark and Stewart McQueen

The Return of the Liquidating Trust

Rick Jones — Tue, 17 Jan 2012 13:42:54 -0500

Recently, the Wall Street Journal highlighted the arrival of “bad loan securities.” If this is a trend, and I both hope and think it is, we clearly have to get a better deal name for these than “Insert Bank Name”, Bad Loan Securities 2012-1. Securitization of less than ideal conduit product has been with us since the birth of securitization, but reached its apogee in the RTC series, for non-performing loans, in the early to mid 1990s. That transaction architecture is being revived, and it’s about time. Both Fitch and DBRS have published criteria, or at least guidance and the other agencies are beavering away, busy working with bankers to come up with workable ratings technology.

To be clear, this is a financing tool, not a sales tool. Depending, of course, on the depths of ugliness in the pool, this is 35-55% leverage with a sponsor holding the risk piece. Nonetheless, it is peerless, durationally matched leverage that is terrifically useful for buyers of the distressed debt inventory. As the holders of non- and underperforming debt have increasingly fessed up to their marks, we’re now at a point where these transactions can be done without creating massive capital charge problems for the banks and other financial institutions holding this paper.

These structures are designed to allow an active, dynamic manager to liquidate a portfolio of loans, hence: liquidating trusts. The manager anticipates selling and resolving all of these loans and reducing them to cash in a finite and relatively short period of time. The ratings models work off individual business plans for each loan, taking into account current period income, liquidation proceeds and haircutting the bankers’ views both on the level of achievable proceeds and the time required to resolve the assets.

But these are not easy deals and we haven’t found the magic bullet to make them easy. First, these are management intensive transactions that are dependent upon the investors’ confidence in the quality and performance capabilities of the manager. Second, the quality of data available on seasoned non- or under-performing loans tends to be a bit dodgy, and that impacts the quality of disclosure and the difficulty of delivering high quality information to manager and investor. Finally, and most frustrating, is what needs to be done to achieve tax transparency. The assets typically can’t be subjected to a REMIC election because they’re not performing. For reasons, which for the life of me I cannot fathom, our Internal Revenue Code punishes pools of mortgage loans with corporate level taxation. Why are mortgages treated as the bad boys of the financial neighborhood such that they need to be rousted by the tax cop when they gather together on the street corner? The Code doesn’t pick on other asset classes in the same way. It’s inexplicable.

When mortgage loans are pooled, the so-called taxable mortgage pool rules (TMP) apply and these rules make it nigh unto impossible, in many cases, to issue more than one time-tranched class of debt. Therefore, these vehicles tend to be somewhat inefficient with only one class of equity and one class of debt. Seriously better pricing could be obtained if the debt could be both credit- and time-tranched like in most other structured finance products. Now there are ways around these problems, but none of these fixes work terribly well. So, for instance, if the loans are really bad, so that a large enough portion can be treated effectively as equity interests in the underlying collateral rather than as mortgage loans for tax purposes, you may be OK. If somehow you can be sure the loans will all be liquidated in 3 years, you may be OK. If the vehicle can be structured as a Qualified REIT Subsidiary (although watch out for dealer income that is bad REIT income in a liquidation strategy), or if the structure is entirely offshore, the TMP problems can be avoided. Each of these fixes, though, has, shall we say, material negative externalities which limit their use.

With all that said, this structure is very useful in the right situation. It’s going to be used, and it’s going to be used extensively in 2012. It is a way to move assets that one party does not want, or cannot hold, into the hands of those who want the exposure. It’s a way to tidy up the balance sheets for financial institutions, create market velocity, move risk to investors who want it and set the table for more capital creation.

Now that’s a good news story.

By: Rick Jones

January Conference 2012: CREFC Brings its Talents to South Beach

Matthew Clark — Mon, 09 Jan 2012 16:01:00 -0500

Over a thousand lenders, borrowers, servicers, lawyers and other service providers have descended on Miami for three days of networking, meeting and doing things you just can't do in DC. After a Sunday spent checking in, catching up and Tebowing, the conference kicked off in earnest this morning. I started my day with a PSA Task Force meeting - an important industry initiative. The committee is working hard to develop a standardized format for the more mechanical aspects of a pooling and servicing agreement, with an eye toward making loans work for borrowers and servicers alike (Rick offered some prescient comments regarding the importance of emphasizing the exercise as something that will, at the end of the day, make the servicing of securitized loans more efficient and user friendly). As I type, I'm listening to the opening general session, an overview of CRE fundamentals and where we are in the cycle (the common themes being the effect of the jobless recovery and the specter of $700 billion or so of debt maturing in the next 24 months). Tonight, Dechert will welcome over two hundred clients and colleagues for dinner at Asia de Cuba - we are looking forward to a great opportunity to talk to our friends. Tomorrow's schedule is similarly packed, highlighted by a keynote address by Douglas Holtz-Eakin. We will continue to blog from the conference.

By Matthew Clark.