CrunchedCredit

The Shadow Banking Market: The Shadow Knows

Rick Jones — Mon, 20 May 2013 12:17:54 -0500

There’s a lot of talk these days about the growth of a shadow banking market. Shadow is right! The growth of the commercial lending market outside of the universe of insured depository institutions and life insurance companies is real and its growth is accelerating, yet it is not easy to discern its size, shape and taxonomy. The shadow banking market, which simply means the community of lenders outside of the bank and lifeco cadres, is a logical response to a worldwide tsunami of regulatory activity designed to constrain innumerable facets of financial institutions’ operations which often seems more about retribution than the safety, soundness or integrity of the financial markets life.

With apologies to the old radio show “The Shadow”: Who knows what evil lurks in an excessively complex and ill-thought though regulatory briar patch? The shadow banker knows!

Just look around to see what’s happened to the traditional lending community over the past few years. An impressionistic take:

• One bank deeply cuts the compensation of its entire commercial real estate lending group, and shockingly, the great bulk of the team leaves.

• Another, for reasons of its own, excised commercial real estate lending from the bank twice over the past five years.

• The GSEs will be lucky not to be restructured to look like the Post Office. Do you want to rely on the Post Office for 95% of the residential mortgage lending in the U.S.?

• Europe wants to pay banking employees for less than the world market pays for their talent (and then tax away the rest). Sacre bleu! Banks and bankers are fleeing Europe.

• Basel III thinks sovereign debt is just terrific, but will punish banks with extraordinarily high capital charges for holding commercial real estate debt in general, and particularly for structured products, construction and development loans, all critical parts of the commercial real estate market place.

• The Volcker Rule is driving banks out of the funds world even as we do not yet know how the Rule will actually work.

• Dodd Frank Risk Retention, and Rule 122a and the new AIMFD Rules in Euroland, all requiring some form of skin in the game, has or will badly damage the business model regarding capital formation through the sale of commercial mortgage-backed securities.

• The new hedging and derivatives rules simply made it harder for a bank to provide designed derivatives products to facilitate lending transactions.

• Commercial mortgage lending is apparently bad and has caused the collapse of hundreds of small banks. I previously discussed this issue in "Undue Commercial Real Estate Risks Are Bad: The Mathematical Proof of the Blindingly Obvious."

• The FASB and IASB are both proposing new accounting standards for banks that would bring forward loan loss changes on fully performing loans long before any evidence of deterioration of the credit occurred. This is both mechanically difficult and will substantially decrease the profitability of the loan book even though there is actually no evidence of problems with the loans. All it will do is increase the cost of credit.

• And on the ground, up and down the halls of our banks and life insurance companies, as these institutions try to respond to an intense culture of criticism and second guessing, “Yes” is often punished while “No” is celebrated.

All this pushes people and capital to leave the traditional regulated community for the more unregulated world of hedge funds, private equity and specialty finance companies.

And if all that regulatory and legislative hostility represents a push, there is a concomitant pull not to be overlooked. As we have long known, there is a wall of money seeking somewhere to go. In a zero bound interest environment, where many of the old verities about asset allocation and the like simply don’t make sense anymore, money is in desperate search of yield, and this money is the high octane fuel for the asylum seekers from the regulated banking world. While Volcker will prevent banks from investing in fund vehicles in any material way (and the logic behind this continues to escape me) it does permit banks to invest in operating companies such as finance companies. Fund investors from pension plans, endowments, wealthy individuals and corporations with billions sloshing around the balance sheet who had looked for a 12-15% return, have finally come to realize that 6-8% is the new black and that money can fund core commercial mortgage lending. So the push-me / pull me of increasing difficulties of operating in the highly regulated sector and the attraction of money flowing into the unregulated sector guarantees the turbo-charged growth of the shadow banking market.

Is it good that commercial mortgage finance is moving off the balance sheets of the banks and life companies? Not particularly, although it’s not horrible either. There is, however, a certain loss of efficiency as the source of commercial mortgage financing moves from a low cost of funds world of banks and lifecos to an inevitably somewhat higher cost of funds environment. This amounts to a sort of transactional friction, or tax, on the efficient operation of capital markets, as funds need to be disintermediated from the banks and life companies into and through the shadow market, before getting to the ultimate users of capital. Perhaps, from a public policy point of view, if commercial mortgage lending were considered uniquely risky, maybe this could be considered a better alignment of risk and reward by removing this business from the arena of the insured depository base, but there doesn’t seem to be a compelling reason to view commercial real estate lending as fundamentally different than other species of finance. Indeed, in some respects, it is the bread and butter of the U.S. banking system.

So, the shadow banking world is expanding, and it seems likely to continue to expand as more of Dodd-Frank rolls out and populist anger continues to be directed (and, in some cases, stoked) toward the banking sector while resources flow away. But will the diminished banking and lifeco segment and the growing shadow banking market have the capacity to provide all the capital needed by the commercial real estate industry?

And as we’ve often commented in this blog, the government seems to be somewhat insensate to the unforgiving law of unintended consequences. Now, it’s not that the government’s worse at sorting unintended consequences than other large institutions; it’s just that it has more power, and consequently, its mistakes are magnified and its errors more consequential. Here, in an effort to regulate capital formation, they have just pushed that business into a non-bank environment. So what governments do now is a really good question. If the developed world governments react with a visceral hostility to capital formation “escaping” the traditional regulated world and commence a game of Whack-a-Mole trying to punish what they view as risky lending wherever it goes, the game of demonizing the financial sector, reducing compensation to bankers and penalizing what is perceived of outsized risk may lead to governments finding reasons to impose bank-type regulation on the shadow banking market. One can already see the green shoots of this crop growing across Europe with the European parliament considering compensation caps on hedge funds and other non-depository taking institutions. How this is intellectually justified is entirely beyond me, but never underestimate the power of democratically elected, perpetual ruling elites to react with a thoughtless tropism when confronted with the opportunity to stoke and then indulge populist anger.

For now, the hope of the commercial real estate industry is that somewhere between the banks and the shadow banking market there just is enough credit and investment to keep our markets functioning and growing.

Anyone interested in the success of the economy as a whole has got to hope that too.

On Appeal: The Michigan Court of Appeals Overturns It's Prior Ruling and Affirms the State's 2012 Legislation, Nonrecourse Mortgage Loan Act, Which Invalidates Recourse Carveout Guaranties Triggered by Borrower Insolvency

Matthew Ginsburg — Tue, 30 Apr 2013 10:25:00 -0500

As we have discussed numerous times in this blog (here, here, here and here), the downturn in the commercial real estate market resulted in much litigation as to guarantor liability for non-recourse debt. As a brief refresher, many of the non-recourse loans made during the CMBS boom included an agreement that, in an event of default, the lender would only exercise remedies against the property securing the loan and not against the borrower (or its principals or sponsors), with an exception for certain borrower “bad-acts” (such as misappropriation of rents, fraud, and in certain instances, borrower bankruptcy or insolvency). In the event the borrower perpetuated any of these bad acts, the guarantor agreed to be liable either for the losses incurred by the lender, or for the full amount of the loan, depending on the bad act committed.

The Cherryland case (discussed here and here) concerns one lender’s enforcement of a non-recourse guaranty pursuant to which the guarantor agreed to be personally liable in the event the borrower failed to maintain its status as a single purpose entity (which included an agreement by the borrower to remain solvent). As you might have guessed by now, the borrower failed to make payments due under the loan and the lender foreclosed, leaving a $2.1 million deficiency. The lender sued the guarantor for the deficiency, arguing that the borrower’s insolvency breached its single purpose entity requirements. A Michigan lower court agreed with the lender, finding the guarantor liable for the full amount of the loan under the guaranty as a result of the borrower’s inability to remain solvent. The Michigan Court of Appeals initially agreed with the lower court, noting that the failure of the borrower to remain solvent, regardless of the reason, was a violation of the single purpose entity requirements of the loan documents.

The guarantor appealed this ruling, and while on appeal, the Michigan legislature passed the Nonrecourse Mortgage Loan Act (the “Act”), a quirky bit of legislation which sought to protect guarantors from their own bad bargains. The Act provides, in relevant part, that a post-closing solvency covenant should not be used, directly or indirectly, as a nonrecourse carveout or as the basis for any claim or action against a borrower or any guarantor or other surety on a nonrecourse loan (with any such provision being deemed invalid and unenforceable).

With the Act then on the books, the Michigan Supreme Court remanded the Cherryland case back to the Michigan Court of Appeals, which overruled its prior ruling and found that, as a matter of public policy, a guarantor could not be liable to a lender as a result of a borrower’s insolvency. While any first year law student can tell you that invalidating a contract entered into by two sophisticated parties with a statute passed years after said contract is entered into raises numerous constitutional concerns, the Michigan Court of Appeals determined that the public purpose of averting “a broader economic problem of immense proportion in the interest of the public good” outweighed any such constitutional concerns. A more cynical blogger might interpret the legislation as protecting the very private interests of local landowners and developers at the expense of banks and investors (not always local) – but we won’t draw those same conclusions.

Where does this leave us? Prior to the Cherryland decision, there had been a string of recent cases in which courts either found or upheld recourse liability on the part of guarantors (discussed here) giving lenders confidence that their guaranty would be similarly upheld in court if the need for litigation ever arose. This decision has brought unwanted uncertainty to non-recourse lending as this case lays out a map to effectively undermine guaranties contracted between sophisticated parties. The Michigan Court of Appeal’s decision to affirm the 2012 legislation, which invalidates a guaranty made years prior to its enactment, may embolden other states to pass similar laws (protecting local guarantors and sponsors from the bad bargains they made in the boom years, and preventing lenders from exercising their contracted rights), which is something we should all pay attention to.

By: Matt Ginsburg and David Pildis

Ace in the Hole: NY Court Gives Hotel Owner New Way to Oust Hotel Manager and (Re)Claim Management of the Property

Krystyna Blakeslee — Wed, 24 Apr 2013 08:57:41 -0500

A recent decision of the New York state appellate court has given hotel owners a new way to override contract provisions in long-term property management agreements and oust hotel managers from managing the property. In Marriott Int’l, Inc., et al. v. Eden Roc, LLLP, 104 A.D.3d 583 (N.Y. App. Div. 2013), the appellate court vacated a lower court’s imposition of an injunction requiring Eden Roc, LLLP (“Eden Roc”), the hotel owner, to allow Renaissance Hotel Management Company, LLC (“Renaissance”), the (now former) hotel manager and subsidiary of Marriott International Inc. (“Marriott”), to perform its role as manager of the hotel in accordance with the management agreement.

Before we continue, let us set the stage: In 2005, Eden Roc purchased the Eden Roc Renaissance Hotel (the “Hotel”), located in Miami, Florida, originally designed in 1956 by Morris Lapidus, who also designed the famous Fontainebleau Hotel, and known for being host to Hollywood celebrities such as Elizabeth Taylor and Katharine Hepburn. In connection with the purchase, Eden Roc assumed the existing management agreement with Renaissance. This agreement, among other things, entitled Renaissance to manage the Hotel for 30+ years. The relationship soured.

After sending a January 18, 2012 notice of default and giving Renaissance until February 28, 2012 to cure, on March 30, 2012, Eden Roc terminated the hotel management agreement, effective June 29, 2012, citing Renaissance’s mismanagement of the Hotel after Eden Roc had invested more than $300 million in the Hotel, including a $240 million renovation, and claiming that “[u]nder Marriott’s management, Eden Roc lost market share despite its exceptional amenities and legendary reputation”. Shortly thereafter, on April 2, 2012, Eden Roc commenced an action in NY Supreme Court (Eden Roc, LLLP v. Marriott Int’l, Inc., et al., NY Supreme Court, Index No. 651027/2012 (the “Eden Roc Action”)) against Renaissance, Marriott and Marriott International Design & Construction Services, Inc. (collectively, the “Marriott Entities”), asserting, among other things, that the Marriott Entities have cost Eden Roc more than $75 million in damages, have “irreparably dragged the reputation of the Hotel through the mud” and have mismanaged the Hotel as evidenced by, among other things, allegedly (a) refusing to pay to Eden Roc the amount of $285,000 (representing an amount that was allegedly stolen by a Renaissance employee) and (b) extending a $350,000 line of credit to a guest without Eden Roc’s consent (which amount was never paid back). According to Eden Roc’s amended and restated complaint, in an April 12, 2012 letter, the Marriott Entities claimed that no default had occurred entitling Eden Roc to terminate the management agreement and “announced that they have “no intention of cooperating with the transition of the hotel to a new management company””.

Following a second notice of default, on May 23, 2012, Eden Roc sent a second notice of termination of the management agreement, effective as of August 10, 2012. Thereafter, the Marriott Entities refused to recognize the termination and vacate the Hotel, forcing Eden Roc, in the predawn hours of October 14, 2012, to attempt a coup complete with uniformed security guards spread throughout the Hotel to take back the Hotel. The Marriott Entities were able to thwart Eden Roc’s takeover attempt by obtaining a temporary restraining order permitting the Marriott Entities to continue to manage the Hotel while a New York court considered the merits of the parties’ arguments.

Later, on November 7, 2012, a NY supreme court denied Eden Roc’s motion to vacate the temporary restraining order and instead converted said order into a preliminary injunction to maintain the status quo during the pendency of the ongoing litigation. The lower court rejected Eden Roc’s argument that the management agreement was a personal services contract, which would allow Eden Roc to easily remove the Marriott Entities as hotel manager because of the general rule (rooted in the 13th Amendment’s prohibition against slavery and indentured servitude) against enforcement of personal service contracts. The judge reasoned that “[h]istorically, the distinctive features of a personal service contract is that it must follow the person with the skill at the root of the contract,” whereas here, the management agreement did not “rely on services rendered by any specific person or group of persons . . . but rather create[d] a long-term commercial relationship between corporate entities.” Additionally, the lower court found that there was no principal-agency relationship between Eden Roc and the Marriott Entities as Eden Roc failed to “exercise the degree of control over the day-to-day functions of [the Marriott Entities] that would give rise to an agency relationship”. Finally, citing language in the management agreement making specific performance available as a remedy, the lower court refused to decline to enforce the specific performance remedy without controlling law to the contrary.

On March 26, 2013, a NY appellate court reversed the lower court’s ruling, and held that the parties’ management agreement is a “classic example of a personal services contract that may not be enforced by injunction”, as the management agreement gave the Marriott Entities full discretion to execute tasks that cannot be objectively measured. Further, the appellate court noted that the Marriot Entities were not agents of Eden Roc given their unfettered discretion in managing the Hotel.

The NY appellate court’s decision makes it clear that hotel owners now have two bases—principal-agency relationship and personal services contract arguments—for terminating long-term hotel management agreements and blocking managers’ attempts to commandeer the hotel owners’ property. But, this decision does not free hotel owners from liability for breaching the management agreement. Accordingly, the decision whether to terminate the hotel management agreement needs to be closely examined and the risks of terminating v. not-terminating assessed, as in some cases the financial cost of terminating may be extraordinarily high. And, this decision does not resolve the Eden Roc Action….the parties agreed to extend the stay of the Eden Roc Action (which was originally implemented by agreement of the parties and so ordered by the court on February 26, 2013 to be coterminous with the NY appellate court action discussed above) until April 19, 2013 (as of publication, nothing new has appeared on the docket) and the deadline for the Marriott Entities to serve their reply in support of their motion to dismiss is extended until May 10, 2013 (for the full docket click here).

By: Krystyna Blakeslee and Margaret Budnik

Undue Commercial Real Estate Risks Are Bad: The Mathematical Proof of the Blindingly Obvious

Rick Jones — Mon, 22 Apr 2013 08:40:25 -0500

I was entertaining myself early this morning by looking over a joint agency report just released entitled “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance”. This report summarizes the performance of bank CRE portfolios following the issuance of interagency guidance in 2006 entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices”. Everyone will be shocked, shocked to know that through the course of the worst recession in post-war history, banks lost money because of commercial real estate exposure and many smaller and regional banks went casters up. Well, there’s startling news. We taxpayers pay for this sort of thing. Where is the sequester when we really need it?

Now I can’t quibble with the data or much of the analytics. This report looked at the performance of the 7,000 plus insured depository institutions, and focused on those who had high CRE concentrations. By high, we’re talking institutions where construction, land and land development loans (CLD, to the trade) represented 100% or more of a bank’s risk-based capital and institutions where total investment (as opposed to owner-occupied) CRE (including the CLD portfolio) represented 300% or more of an institution’s risk-based capital. That, by the way, describes almost all regional and community banks. So which way is the causation arrow pointed? That seems to be a question the authors found curiously uninteresting.

While many conclusions are drawn from this data, the headline, above the fold, marquee conclusion is:

During the three year economic downtown, banks with high CRE concentration levels, proved to be far more susceptible to failure.

I’m breathless. Really?

I suspect equally rigorous academic studies could have come up any of the following headline conclusions:

Small, Poorly Capitalized Banks Fail a Lot
Banks in Geographic Areas Where the Economy Sucks Didn’t Do Really Well During a Really Bad Recession
Banks With Nothing Else to Do Except Make CRE Loans Probably Didn’t Do Very Well, or
Banks Run By Dopes Fail a Lot

The 2006 Guidance, which was certainly not a hot read, actually doesn’t impose a cap on CRE lending, but simply suggested that banks with high concentrations of CRE lending should have good practices, protocols and a knowledge base to justify being so concentrated in that space. Nothing to quibble about there. (Although one might observe that our policy of encouraging formation of lots of small banks with limited capital and a limited geographic footprint almost dooms those institutions to embrace over concentration in the CRE space as there is often precious little else to do.)

The problem, of course, is how something like this gets woven into a narrative that commercial real estate is a dodgy business full of executives whose compensation has not been “fairly” restrained by the populism-fed political fury unleashed on the banks and the real estate “moguls” somehow have suborned the world of Jimmy Stewart-led banks to do dumb things that probably should be illegal. It gets wound into the narrative not as a dry, unexciting and perfectly commonsensical notion that small banks with limited management systems should probably avoid excess concentrations of lending activities in asset classes in which they have no strong knowledge base but as part of the broad miasmic hostility to CRE capital formation. We have over 7,000 banks scattered across the country, many of which are in communities where everything is essentially a real estate loan, and those loans are probably as good as or better than the commercial loans which do not have the benefit of a mortgage on some dirt. When the whole world flirts with a depression, these loans will not work really well. I need a long, laboriously compilied academic report full of rigorous mathematics to figure that out?

This is not news and my anxiety here is mostly a concern that some will misuse this report as part of a narrative that commercial real estate is a source of all evil and needs to be more highly regulated (read, constrained) just at the time where we need the banking market, as well as other lending sources in this country, to meet the needs of the commercial real estate industry. Without that support, economic activity in general will be depressed.

We in the commercial real estate industry need to be vigilant that the narrative, like a metastasizing virus, doesn’t get used to further both political and regulatory hostility to CRE capital formation and commercial real estate.

OK, maybe I’m over-reacting, but I was thinking about taxpayers’ dollars at work and wondering why we really needed an interagency report to tell us that a lot of commercial real estate loans went bad when the commercial real estate market collapsed, and a lot of small banks got left holding the bag? A man bites dog moment it ain’t.

By: Rick Jones

IMN's REO-to-Rental Forum 2013: Welcome to Miami

Ralph Mazzeo — Fri, 19 Apr 2013 09:32:54 -0500

The Miami Heat’s home playoff games are not going to be the only events drawing attention to sunny Miami next week as IMN hosts its annual REO-to-Rental Forum in Miami. As we have previously discussed numerous times (here, here and here, and OnPoint Updates here and here), the REO-to-Rental asset class has become quite a hot topic and this conference is sure to provide invaluable insight into current trends in the market, as well as where market participants see this class of assets going over the near- and far-term.

This year’s panelists appear ready to discuss the many different facets of the REO-to-Rental market and the opportunities and potential pitfalls related to owning and investing in this portion of the market. Some highlights will surely include the panels on Securitizing Rental Streams and Equity and Debt Financing, as well as the panels on Note-to-Rental and Pre-Foreclosure Buying.

As this asset class continues to change and evolve with the broader real estate market, so do the strategies on how to profit from owning REO-to-Rental properties, and this Forum is sure to advance the dialogue surrounding this asset class and those strategies. Dechert will continue to blog from the conference and we hope to see many of you there.

By: Ralph Mazzeo, Matt Clark and David Pildis

Second Annual IMN CLO and Leveraged Loan Conference Update

Ralph Mazzeo — Wed, 17 Apr 2013 12:06:02 -0500

The second annual IMN CLO and Leveraged Loan Conference returned to New York this past week. Building on last year’s momentum (discussed here), over 1,500 managers and investors, in addition to structurers, bankers, lawyers and other industry actors, filled the convention space at the Conrad Hotel, doubling last year’s attendance and causing standing room only conditions in the large downtown venue. Yes, many conference attendees were literally prevented by conference staff from entering the fully packed Conrad ballrooms.

Dechert Partner John Timperio once again moderated a panel on the legal and structural considerations in effectively analyzing a CLO, particularly the comparison of the improvements made in the current CLO 2.0 structure in relation to the pre-2007 vintages (typically referred to as CLO 1.0).

CLO issuance has been exceedingly strong this year with north of $29 billion of CLO securities issued in the first quarter of 2013 alone (roughly half of 2012’s total), though industry participants attending the conference were divided on what to expect over the remaining three quarters. At the low end were predictions that 2013 will end up matching 2012 with issuance in the $55 to $60 billion range due to the limited supply of leveraged loans available in the marketplace. However, the general consensus was that CLO issuance will likely not continue on the prolific pace set in the first quarter but will still likely top $80 billion by the end of the year which would make 2013 one of the busiest years on record for CLO security issuance.

There are, however, significant hurdles to overcome if the more bullish of these prognostications are to come to fruition. For example, senior tranche investors have been resisting any further tightening of spreads on such top rated tranches and the FDIC rules that recently became effective (discussed here and here) have given certain of those senior investors leverage to try and push spreads wider or, alternatively, have caused such investors to put on hold any further investment in CLO notes until the effect of the FDIC rules can be further analyzed. Moreover, the most active rating agency in the CLO space, Standard & Poor’s, has recently announced it will be increasing the requirements necessary to earn the coveted “AAA” rating for such senior CLO tranches. Finally, the CLO market as a whole continues its discussions with regulators over implementation of the risk retention rules under Dodd-Frank as it has become clear that there will be no general exemption for CLOs.

In the face of these headwinds, everyone at the conference seemed to agree that CLO collateral managers will continue to require a steady supply of quality credits at attractive spreads to continue to put together transactions that make economic sense in this market environment.

However, optimism abounds as many within the CLO market are betting that these challenges in the structured credit market, as well as those in the wider economy, will not inhibit investor appetite for the yield available on CLO notes. We did not meet any conference commentator that expects a contraction in CLO issuance relative to 2012’s stellar performance.

By: Ralph Mazzeo, John Bumgarner, and Sean Solis

Cyprus: Yesterday's News

Rick Jones — Tue, 16 Apr 2013 10:50:28 -0500

As we predicted a few weeks ago (discussed here), Cyprus has rapidly fallen off the screen. Back to business as usual, based upon an iron-willed refusal to see the spreading cracks in the edifice of the common market financial system and willful blindness to the implication of such events.

Sir Mervyn King, the late Governor of the Bank of England, recently said that to start a bank run is stupid, but to fail to join one underway is irrational (or something like that). This trenchant bit of advice should be considered by pretty well everyone long the euro. What one wonders is whether the absence of a full scale bank run so far is evidence that all is well, or a symptom of a commonly shared psychosis that perhaps if no one notices the broken system, no deluge will follow.

I have been taken aback by the number of pronouncements by the political and economic chattering classes that Cyprus was, well perhaps not good, but not bad. It was a special case; or no one cares about Russian oligarchs; or that it was too small to matter; or it was about time someone other than the taxpayers cleaned up a banking problem.

I have sympathy with some of those notions, but, on the other hand, didn’t Cyprus just establish that all of these zombie and aspirationally zombie banks are on their own? When the policy community of the EC is trying their darndest to preserve business as usual and keep the lid on while hoping that the passage of time is the balm that cures all ills, was this, in any sense, a good idea?

Didn’t they just establish that deposits aren’t safe? Didn’t they just establish that senior bondholders and equity investors can no longer rely on the sovereigns to cushion the risk of their bets? Didn’t they just establish that these banks are on their own, and if they have not the resources to continue to support the capital needs of the marketplace, it’s just too bad?

Didn’t Cyprus raise the really nifty question of what’s the value of a euro in a bank in Cyprus? Would you buy one of those euros for a euro? I certainly wouldn’t.

Mr. Dijsselbloem, the now famous erstwhile Dutch agro-economist who is serving as the Chair of the Eurogroup Finance Ministers probably spoke truth, albeit perhaps unintentionally, when he confirmed that Cyprus was the model for the resolution of banks going forward. Look, as we’ve said before in this Blog, any chance of fixing Europe depended upon the balm of cheap credit and the passage of really serious periods of time for the system to self-repair. The plan, assuming there is a plan, seems to have been to shoot the Indian closest to the stagecoach by fixing each failing problem bank with bailing twine and duct tape, and so give the continent time to grudgingly embrace what needs to be done. If the EC could get a common bank supervisory scheme it could, in turn, lead to EC wide deposit insurance, which could lead indirectly to mutualization of debt and all that could, could become part of the solution to fix what’s wrong.

It’s gone. Cyprus killed it. Mr. Dijsselbloem added an exclamation mark. Mr. Draghi’s assurances, which had kept the lid on since last summer, now seem rather empty. Capital controls in Cyprus are now expected to last a very long time. If a euro in a Cyprus bank is not worth a euro, if a small business in Italy, Spain, Portugal, Greece (and perhaps soon, France), cannot borrow except at a spread hundreds of basis points higher than borrowing costs in Germany and the northern tier, do we really have one currency anymore? Do we? If the currency stops functioning like a currency, is it still a currency? Why hold on to the dreary thing if fixing your national economy requires significant devaluation of the currency to succeed, when the benefits of a common currency are rapidly disappearing?

I know I’ve been harping on the irrationality of the European monetary system for some time and waiting for it to unwind, and trying to help people think of what happens when it does. I also know an awful lot of folks (many with PhDs) think that I just don’t get it. With apologies to Jeff Foxworthy, here’s a test for you:

If those capital controls in Cyprus stay in place and don’t go away soon, then you ought to think maybe I’m right.
If the borrowing spreads in the middle market in southern Europe continue to be wide to Germany, then you ought to think I may be right.
If another bank fails, and it’s not bailed out by the EC and IMF, then you ought to think I might be right.
If the borrowing costs in the southern fringe sovereigns start to creep out again, you ought to think I might be right.
And if capital flows begin to move from the weaker banks in the southern fringe to the northern banks or out of the EU entirely, you might want to think I’m right.

So there’s a set of benchmarks on my doom and gloom analysis, let’s run the movie forward a couple of reels and see what happens.

By: Rick Jones

Dechert OnPoint: NDNY Bankruptcy Court's Broad Interpretation of the Definition of "Interests" in 363 Sale

Matthew Ginsburg — Thu, 11 Apr 2013 10:38:15 -0500

A recent decision out of the Bankruptcy Court for the Northern District of New York has brought greater certainty to the interpretation of what qualifies as an “interest” when determining the scope of a Section 363(f) “free and clear” sale in bankruptcy. The decision in In re Tougher Industries, Inc. became the latest in a recent trend in the Second Circuit and elsewhere towards an expansive interpretation of what constitutes an “interest”, which should help bankruptcy estates (and creditors!) maximize the purchase price in asset sales.

As a bit of background, the sale of substantially all of the assets of two debtors was authorized by the Bankruptcy Court, which also expressly provided that the assets were being sold free and clear of all liens, claims, encumbrances, and interests as allowed under Section 363(f) of the Bankruptcy Code. The sale order specified that this included interests “relating to taxes arising under or out of, in connection with, or in any way relating to the operation of the Assets prior to the Closing….” The purchasers of the assets then continued to operate the business of the debtors after the sale.

Subsequently, the New York Department of Labor asserted that the debtors’ experience ratings (based on the time before the sale) would be used to calculate unemployment insurance tax premiums due from the purchasers. In response to a motion by the purchasers, the Bankruptcy Court adopted an expansive definition of “interest” to include the debtors’ experience rating as calculated by the DOL. The Bankruptcy Court specifically noted that its interpretation of “interest” was appropriate because it was consistent with the policy of maximizing the value of the asset and the return to creditors.

To read more about this recent decision, as well as the implications it will have on the price of assets sold in bankruptcy sales, check out this Dechert OnPoint by Dechert’s Business Restructuring and Reorganization group.

By: Matt Ginsburg and Linda Ann Bartosch

No Marriage for Mortgage Resolution Partners Yet (But Proposal Still Being Considered)

Krystyna Blakeslee — Fri, 05 Apr 2013 13:51:05 -0500

Last summer, we at Crunched Credit wrote (here, here and here) about Mortgage Resolution Partner’s (“MRP”), a San Francisco-based venture-capital firm, proposal whereby underwater performing residential mortgage loans held in private label securitization would be seized, refinanced, or restructured and sold to third party investors, with the government recovering the administration costs and MRP earning a fee on each transaction (the “Program”), which (or some version of which) was (and in some cases still is) being considered by, for example, the County of San Bernardino (which has dropped the idea), the City of Chicago (a decision on whether to move forward is still pending), Wayne County, MI (Detroit area) (Wayne County has dropped the idea), and the City of Salinas, CA (which has entered into an agreement with MRP to provide residential foreclosure data but has indicated that this agreement does not mean that they are considering the Program at this time).

Now, among the list of towns, cities and counties considering the Program (or some version of it) is the City of Brockton, Massachusetts. Brockton, MA like a lot of municipalities across the U.S. has seen its share of falling housing prices, unemployment and homeowners living in underwater homes (approximately 7,000 of them are underwater as of January 2013). With that said, things aren’t just gloom and doom. As interest rates continue to remain low and housing prices slowly creep up, the situation in many areas (including, Brockton, for example) has improved: in 2010, Brockton had 422 foreclosures filed and 766 notices of foreclosure issued, while in 2011, there were 281 foreclosures and 500 notices issued, and in 2012, there were 266 foreclosures and 489 notices issued. Rest assured, the market will continue to correct itself (albeit slowly).

In an effort to help struggling homeowners, the Brockton City Council, at the end of last year, voted to form a group tasked with exploring “using eminent domain power to seize bad mortgage loans that have devastated many residents and, with a private financial partner, sell them back at lower interest rates to help people keep their homes.” The working group will consider the eminent domain program, the legal ramifications of such program and may even consult with MRP. The first meeting was held on or about March 7 and a second meeting was held on March 21st. A third meeting on this topic is scheduled for April 11th.

Before the first meeting on or about March 7, one of the Brockton City Council members published a working paper which outlined the proposal being considered and its goal. According to the working paper, “there will be no problem in translating eminent domain law to apply to mortgage debts because mortgages are considered a type of ownership of property in Massachusetts, a type of title in property” and the “goal of this initiative is to purchase all underwater, securitized mortgages to re-stabilize the local market, to protect the homes of those who hadn’t been foreclosed yet but were already in the foreclosure pipeline or in danger.” The working paper goes on to tout the benefits of the eminent domain proposal by stating that (a) the purchasing of loans at current fair market value immediately stabilizes the local housing market creating a floor to the downward price slide created by foreclosure sales, (b) stops the market push of rental costs as major banks empty foreclosed properties, and (c) getting homeowners out from underwater mortgage loans will cause homeowners to spend the savings elsewhere—estimating $2.7 million in spending per year mostly in Brockton. Moreover, the working paper estimates that the cost to Brockton to purchase all of the underwater mortgage loans would be about $200-$400 million (the entire Brockton City budget is $330 million). Brockton will need to consider fundraising proposals like bonding and loans to pay for the proposal.

At the March 21st meeting, the working group was to investigate the use of eminent domain to acquire and restructure underwater mortgages. The working group has targeted about 2,300 mortgages which could result in more than $15,600,000 in savings to property owners. The working group plans to finalize a strategy for consideration and review by May.

The eminent domain plan being considered by Brockton, MA is opposed by the usual suspects (e.g., the American Securitization Forum and SIFMA) making arguments we have discussed previously here and here. The American Securitization Forum issued a comment letter (which I highly recommend reading) setting forth its arguments against the proposal, including, (a) the fact that the Program raises fundamental legal concerns, (b) to the extent that the Program targets ‘performing’ loans, the proposal is not a valid “public use”, as required by eminent domain jurisprudence, (c) the Program would run afoul of the prohibition against impairing the obligations of contracts, (d) Brockton’s power is not broad enough to affect mortgage loans held outside of its jurisdiction, and (e) MRP’s valuation model is flawed and would not withstand a “fair value” challenge, thereby making the Program uneconomical for MRP (which, as we all know, is the real reason for MRP’s proposal). SIFMA also commissioned a memorandum, which found, among other things, that “Brockton’s plan is wholly incompatible with the lawful and constitutional exercise of the eminent domain power delegated by the Legislature to Brockton under the governing statute and the Massachusetts Declaration of Rights.”

MRP isn’t laying low either. Steven Gluckstern, the chairman of MRP, is campaigning in favor of the Program, arguing that “everybody is better off” if foreclosure is prevented and the homeowner is able to stay in his/her home. It looks like Salinas, a farming town located in central California, is working with MRP. If Salinas decides to adopt the Program (or some version of it) this would be a win for MRP as Gluckstern considers Salinas “just the right size” with 2,500 underwater mortgages. This “right size” appears to be necessary so that the nation’s attention is grasped and, ultimately, MRP’s lawyers can argue “during the all-but-inevitable Supreme Court case that reducing homeowners’ mortgage payments has macroeconomic benefits such as boosting consumer spending.” MRP has reached out to at least one member of the City Counsel of Merced, California regarding the Program (and likely others in CA, Nevada and across the country), and it appears that Gluckstern has found a town willing to partner with MRP stating that “[t]hey are ready to go and we [MRP] are just holding them off for the moment because it is so small that it might even be dismissed as irrelevant.”

Even as I write this article, another city has joined the ranks of Salinas, CA and maybe has gone even further. On April 2, 2013 (see agenda here) (see webcast of the council meeting here), the City Council of Richmond, CA approved an agreement with MRP, pursuant to which MRP will “assist the City of Richmond in reducing the impact of the mortgage crisis, by advising on the acquisition of mortgage loans through the use of eminent domain, in order to restructure or refinance the loans and thereby preserving home ownership, restoring homeowner equity and stabilizing the communities' housing market and economy by allowing many homeowners to remain in their homes.” From listening to the City Council meeting (but without the benefit of having a copy of the agreement), it appears that the City of Richmond is ready and willing to move forward with the Program (or some other version of it). The City Council is looking to set loan criteria in advance and to evaluate such criteria before MRP moves forward with implementing the Program with respect to specific properties. It will be interesting to see what that criteria looks like—underwater, performing, profitable for MRP. According to the city attorney, MRP will be paying all the costs and indemnifying the City of Richmond. There is some debate about whether MRP has enough money and insurance to cover all of the City’s losses but, in the end, it looks like the City will be relying on MRP’s insurance.

I doubt this is the last we have heard of the Program and its various permutations, as more and more cities, towns and counties are considering the Program. Hopefully, the fact that none of San Bernardino County, Wayne County or Chicago have implemented the idea will weigh heavily on Brockton’s decision (even some members of the Brockton City Council seem to have considered that there may be inherent flaws in the proposal) but you just need one city council willing to act in the face of the better argument and we may be discussing and fighting more than just proposals. And then there is the City of Richmond . . . . We will keep you updated as we hear more.

By: Krystyna Blakeslee

Terrorism Insurance Redux

Rick Jones — Tue, 02 Apr 2013 15:39:10 -0500

Terrorism insurance has been boring for the past several years. It risks becoming not boring. In the lee of the terrorism attack of 9/11, the Terrorism Risk Insurance Act, or TRIA, was rapidly passed by the Congress and signed by the President. TRIA provided a federal backstop for private terrorism insurance responding to the unwillingness of the private insurance market to provide meaningful terrorism insurance in light of the unpredictability of the risk and, therefore, perceived inability to price the insurance. TRIA was initially passed in November 2002 and reauthorized in 2005 and 2007. It expires on December 31, 2014. An extension is far from certain.

First, a quick primer on how this all works. TRIA requires property insurers to offer terrorism insurance coverage in a manner similar to the way other more traditional coverages are provided. In exchange, the government provides a re-insurance backstop in case of catastrophic loss. The mechanics are complicated but, essentially re-insurance kicks in for individual loss events greater than $100 million to the aggregate insurance industry after the insurance company kicks in a deductible based upon a percentage of its terrorism insurance direct premium income. It all caps out at a loss of $100 billion.

Ever since TRIA, our loan documents have generally required terrorism insurance. For those of you who don’t get that certain frisson of excitement for reading mortgage loan documents, you may not have actually memorized what our documents say about terrorism issues. A typical formulation looks something like this:

"insurance with respect to the Improvements and the Personal Property insuring against any peril now or hereafter included within the classification “All Risk” or “Special Perils” (including, without limitation, fire, lightning, windstorm, hail, terrorism and similar acts of sabotage, explosion, riot, riot attending a strike, civil commotion, vandalism, aircraft, vehicles and smoke), in each case (A) in an amount equal to 100% of the “Full Replacement Cost,”…"

In some, but not all cases, the following language may be found:

"Notwithstanding the foregoing sentence, Borrower shall not be obligated to expend more than [$___________] in any fiscal year on Insurance Premiums for Terrorism Insurance (the “Terrorism Insurance Cap”) and if the cost of the Terrorism Insurance Required Amount exceeds the Terrorism Insurance Cap, Borrower shall purchase the maximum amount of Terrorism Insurance available with funds equal to the Terrorism Insurance Cap; provided, however, in the event such Terrorism Insurance is customarily maintained by owners of [_______________] properties in the United States as part of the all risk coverage required pursuant to Section______ hereof, Borrower shall maintain such Terrorism Insurance as a part thereof, regardless of the cost of the related Insurance Premiums."

A bill was recently introduced by Congressman Grimm and others to reauthorize TRIA. The bill essentially extends the current program for five years without any material change. (Sidebar: How delightful to read Congressional work product that is only two pages long! There may be hope.) The politics of TRIA are complex and the dividing lines in the Congress and Senate do not run along traditional party lines. There is an element of the Republican party that says private enterprise should provide the solution, fullstop. The constituencies who understand the importance of TRIA to capital formation, as well as those who represent major urban centers which have been traditionally thought to be at particular risk of terrorism attack, support it voraciously. It’s very hard to tell at this stage whether reauthorization occurs, although policy wonks already seem to think that, at the end of the day, it will be.

As reauthorization began to creep into the collective conscience, more borrowers have begun to negotiate caps on the aggregate cost of terrorism insurance. Given uncertainty, it’s time to start thinking about risk with and without TRIA, or materially revised but with a totally different TRIA. Here is what we’re thinking:

• The coverage may get more expensive in the run-up to expiration; therefore, as a lender, consider pushing back on caps, and if you agree to cap coverage, make sure the cap makes sense both in the current environment and the run-up to reauthorization. As a borrower, run this paragraph backwards.

• As a lender, think about tying some aspects of loan document architecture to the presence or absence of coverage. Does the disappearance of the coverage trigger some sort of hyper-amortization or more rapid amortization to reduce LTVs? Might extension options be curtailed if coverage went away? I have some personal experience attempting to enforce terrorism insurance in a high premium environment, and I’m here to tell you the judiciary, broadly, is not going to be terribly sympathetic to an asserted event of default tied to the lack of terrorism insurance which is not commercially available at economically reasonable rates. As a lender, one would have to think twice about utilizing a breach of terrorism insurance coverage as a basis of an event of default. Better, perhaps, to think about other adjustments to the credit profile of the transaction in light of the deteriorated coverage.

• Consider tying some element of the coverage into recourse covenant.

• For issuers and underwriters, revisit risk factor disclosures, particularly for vulnerable properties such as large, standalone assets in major metropolitan area environments. Be crystal clear that terrorism insurance coverage at any level or at levels which are economically feasible might not be available 20 months from today.

If TRIA goes away, the private market will either be diminished or disappear entirely. That’s altogether possible. Several commentators have suggested that if TRIA goes away, there will be no terrorism insurance available from the private markets at all and, of course, at some level of pricing it becomes economically unfeasible in any event.

We’ve got some time here. This needs to get fixed. Other outcomes do not bear thinking about. We have a shot at bettering the odds by trying to effect policy. I would urge everyone to work with their trade organizations, CREFC, MBA, SIFMA, ASF, etc., (and, yes, contribute to their PACs) to ensure that the views of the industry are heard. Last time I was deeply involved in the TRIA Advocacy initiative, it was frustrating to see that many in Congress viewed this as an insurance company issue with the greedy insurance companies attempting to shift risk to the federal government. We in the commercial real estate industry shouted (but were not heard) “It’s not about them, it’s all about us!” This insurance is necessary for successful capital formation in commercial real estate. It’s not about the insurers. They will happily stop offering coverage without TRIA. It is commercial real estate that will take it on the chin.

We never really succeeded in changing the shape of the debate. We need to frame the debate early and forcefully. We need to make sure our Congressmen and Senators understand that the TRIA backstop is all about protecting the viability of the commercial real estate finance marketplace. As the Grimm Bill progresses this year (that just doesn’t sound right, does it?), or as other legislative efforts are undertaken between now and its expiration, our duly elected leaders need to understand that this is a reasonable governmental function to meet a need which cannot otherwise be met in the private marketplace, and which is critically important to capital formation.

By: Rick Jones

CLO Update: New FDIC Rules on "Higher Risk Securitizations"

Matthew Clark — Wed, 27 Mar 2013 13:40:46 -0500

The FDIC's new rules (promulgated per the requirements of the Dodd-Frank Act) for calculating deposit insurance assessments for insured depository institutions, including "large institutions" and "highly complex institutions," are set to become effective on April Fool's Day, 2013. No kidding. As institutions of this type are active investors in CLOs, particularly the “AAA”-rated tranche of CLOs, there has been significant consternation among market participants on the immediate and long-term effect of such new rules.

Dechert partners John Timperio and Gordon Miller have done an in-depth analysis on the new rules and their potential impact on the CLO market and, as outlined in a recent legal update, see the likely impact of such rules to be less adverse than some of the predictions of other commentators in the market.

Initially published on February 25, 2011, the new FDIC rules replace the existing supervisory ratings-based and capital-based methodology with an asset-based methodology, which assesses large institutions and highly complex institutions for the risk each applicable asset poses to the Deposit Insurance Fund using a “scorecard” that combines any such institution’s CAMELS ratings and certain forward-looking financial ratios, including the ratio of “higher risk assets” (including leveraged loans, nontraditional mortgage loans and subprime consumer loans), and “higher risk securitizations” of such higher risk assets (encompassing securitizations of such “higher risk assets”) to Tier 1 capital and certain reserves.

Such institutions have been required to include such “higher risk assets” in their calculation of their deposit insurance assessment rate during the transitional period that began when the FDIC published the final rule in 2011. However, in making such calculations these institutions have been permitted to identify leveraged loans and CLOs using each such institution’s existing internal methodologies or the criteria in existing supervisory guidance. As of April 1, such institutions will be required to use a new single standard, set forth in revisions to the final FDIC rules issued in anticipation of final implementation, to identify leveraged loans and CLOs. While such single standard may be more or less inclusive than the standards employed using their applicable transitional methodologies, it is likely that for many institutions the new single standard will result in an increase in the identification of leveraged loans and CLOs.

The impact of this new single standard for each applicable institution will be fact specific and particular to such institution’s asset mix. It will also be materially impacted by any material differences between the applicable methodologies employed by an institution during the transitional period and those methodologies required to be used under the terms of the final rule set to take effect on April 1. As each applicable institution assesses the new requirements in identifying “higher risk assets” and “higher risk securitizations”, some institutions that purchase CLO securities may temporarily withhold buying such securities while their internal regulatory experts evaluate the new rules of the road. However, it is possible that other institutions may be incentivized to buy CLO securities if such institution was maxed out under the concentration criteria for “higher risk assets” such that purchasing additional CLO securities would not negatively impact their deposit insurance assessment rate.

For the broader CLO market, the new required FDIC standards may result in an uptick in the pricing of leveraged loans and CLO securities for transactions effectuated after April 1. However, as the market digests the new rules and market participants more clearly understand the rules of the road going forward, it is likely that the impact of these FDIC rules will not result in a significant slowdown in CLO issuance, a material increase in the pricing of CLO securities or any material attrition in the CLO investor base.

By: Matthew Clark, John Bumgarner and Sean Solis

Cyprus: Not the Archduke Ferdinand Moment, This Time

Rick Jones — Mon, 25 Mar 2013 11:03:33 -0500

Among the more technical topics we cover in this Blog, we keep an eye on Europe as we fundamentally continue to worry that Europe’s disease could infect our markets. As I write this, Cyprus is trying to sort out the terms of the proposed EU bailout for the banking sector which is eight times the size of the GDP of the whole darn island. The US commodities and stock markets have fluttered in response and may continue to flutter for several days, but now a deal has been announced and the betting is Cyprus will drop out of the headlines and become yesterday’s news. We’ll be back to business with nary a backward glance at Europe; until next time.

Yet it seems that every time someone puts a match to the keg of dynamite that is Europe and the fuse sputters out, we conclude there really is no dynamite. But the dynamite’s still there, and the risk to the world’s financial markets remains, in my mind, unabated by the happy talk about “turning the corner”, “light at the end of the tunnel”, or another day of Mr. Draghi channeling Clint Eastwood.

As I’ve said repeatedly in this Blog, the underlying reality is pretty simple. The countries of the European common markets have given a basket of goodies to their citizens that the wealth generation engine of those countries cannot afford. That stark reality was masked (Black Swans in Camo) for a long time by the ability of European sovereigns, in a Faustian bargain with their national champion banks and the ECB, to balloon sovereign debt at relatively benign costs and keep the banks afloat on a sea of faux liquidity. EU monetary policy activism can certainly delay any final denouncement, but, absent robust growth, the problem will not get fixed.

We see every day now proof that democratic governments have not yet (yet!) found the courage to pull the punch bowl away from the party. The structural changes in labor markets, tax policies and other regulatory policies likely necessary to re-light the fires of the engines of growth simply cannot get done. The headlines, although anecdotal, provide a pretty clear picture. In France, the current government campaigned on promises of growth and reduced deficits, without any diminution of social services. These were promises made without a hint of how they could be met (and apparently without a clue as to how it might be done), but were irresistible to the electorate, sated by generations of public largess. Now the government is unable to deliver. So we see no growth, worsening employment, and little capital formation. Apparently, there is a price for egality, fraternity and the French way.

Spain continues to economically unwind as entropy does its work. In Italy, the populace just rejected a relatively benign and modestly ambitious reform agenda of the technocratic government of Mr. Monti and now has a completely unworkable political situation. Portugal and Greece stay a mess and no one cares or notices.

The Hail Mary plan to fix all this was built, in the first instance, on decoupling the banking crisis from the sovereign debt crisis. This, in turn, was dependent upon centralized bank supervision and resolution powers and a more United-States-of-Europe type banking system. This would provide a framework for effective (albeit indirect) mutualization of bank debt and a continent-wide deposit insurance scheme to inoculate the system against uncontrolled capital flows.

So now for the Boneheaded Award of the Year (so far): the Cyprus EU “rescue” plan. The leadership of Europe had become complicit in a plan that would have actually undermined deposit insurance. Why now and why there? The whole European integration experiment is being threatened over such a tiny amount of money in such a tiny place. “Bailing in” insured depositors to reduce the bill to be paid by northern Europe is a savaging of the rule of law. It seems, now, that the protagonists have drawn back from that lunacy, but are still taxing (looting?) depositors with funds above the insured threshold to pay for a large part of the rescue. At the end of the day, I guess it appeared better than the withdrawal from the ECB liquidity teat which meant default and a quick and unmanaged exit from the Eurozone by Cyprus.

With this single proposal, however, faith in the banking system and the willingness of the EU and ECB move towards a real banking union, which could become a basis of debt mutualization has been deeply compromised. The damage is done. Who now will trust the ECB to fix a bad bank without dinging bondholders and depositors? Every country and every bank for itself? Bank-run anyone?

We have lost ground in this little contretemps. The threat of social unrest defeats meaningful reform and the lack of meaningful reform may cause more social unrest. Now the plan of using banking integration to buy more time for the system to heal itself has taken a huge hit. Not to get too dramatic here, we’ve seen this movie before; roll the credits for 20th century Europe. Something could give.

We’ll stare at the headlines about Cyprus for a day or two and probably move on until the next crisis. But Europe keeps getting closer to having played out its rope-a-dope policy of waiting for bad things to go away and better things to come. The next crisis, or the next, or the next after that, might be the Archduke Ferdinand moment. The center will not hold and the system will unwind with very real negative consequences for Europe. In the lee of that event, economic activity all over the world is already somewhat suppressed.

We have repeatedly seen a European crisis (really, just one long multi-year metastasizing crisis) causing a periodic startle effect in the US markets that rapidly dissipates. Fundamentals continue to look better and better here in the US. I remember the received wisdom in 2007-2008 that the subprime lending problem would not infect other parts of the capital stack. Well, that turned out to be breathtakingly wrong. On the other hand, we’ve all heard the Chicken Little claims that markets are so integrated that the flapping butterfly wings of a Cyprus banking crisis across the pond will inevitably result in doom here at home. I frankly don’t know how robust the transmission mechanism is between crisis in Europe and economic growth in the US and it has not seemed to be terribly powerful to date, but it’s a serious question.

From where we sit, as one of the largest commercial real estate finance practices in the world, the markets seem pretty robust and our strategic view remains the US economy and the commercial real estate finance sector will continue to grow and prosper. On the other hand, it’s certainly worth taking a moment to think defensive thoughts once in a while.

By: Rick Jones

Reflections on the 2013 CREFC Distressed Debt Summit

Krystyna Blakeslee — Wed, 20 Mar 2013 14:32:10 -0500

Last week, we and a few of our colleagues here at Dechert attended CREFC’s 2013 Distressed Debt Summit. Echoing the mood at January’s CREFC conference, the mood at the NY Athletic Club last week was upbeat about the CMBS market as a whole but the general sentiment, with respect to the distressed debt market, is that good deals (in other words, deals worth making) are harder and harder to come by.

Many of the panelists illustrated this general sentiment by noting that:

(1) spreads are compressing—strike that—have compressed,

(2) it is harder and harder to get the yields desired (again, something we can all probably relate to),

(3) it is challenging to find distressed debt worth buying (would Europe just hurry up and sell already??),

(4) low interest rates are making this a good time to be a borrower but the concern regarding refinanceability in 5-10 years is starting to creep into the market (but not enough worry to stop lending—thank goodness!),

(5) risk retention and all of the bad things that will likely go with it (freezing the B-piece buyers market, making investment grade bonds illiquid if B-piece buyers buy them to make the risk retention thresholds and then have to hold onto them (who thought of this again?), CMBS market becoming less competitive as a result (good news for lifecos)…) are on folks’ minds, especially those in the B-piece bracket, and

(6) Europe’s crisis is looming on the horizon (this may be the Black Swan in Camo).

At this point in 2013, it appears that the market is bustling. Now, in the U.S., if only the regulators will either act or not act (the latter being our desired outcome) and bring finality to the guessing game and, with respect to Europe, well…we’d like to think that the proposed legislation regarding the safety of bank deposits in Cyprus, for example, will make the US more and more attractive (which isn’t a bad thing) and at some point, we will see banks selling portfolios like we saw over the past two years in the U.K. but for now we are enjoying the bustle!

By: Krystyna Blakeslee and David Pildis

Distressed Debt Conference in Bloom in NYC

Krystyna Blakeslee — Tue, 12 Mar 2013 08:31:53 -0500

The warm weather is not the only thing descending on New York City this week as CREFC hosts its annual Distressed Debt Summit at the New York Athletic Club overlooking Central Park. March in New York City is famous for the Big East Tournament (speaking of distressed…), St. Patrick’s Day parades and love blooming along with the flowers. But it won’t be all buzzer beaters, green beer, horse carriage rides and proposals in the park as industry leaders look to discuss the market trends and opportunities in the distressed debt market for 2013.

The conference kicks off on Wednesday with a series of panels discussing distressed debt issues and opportunities for 2013. First up is a panel titled “Market Trends and 2013 Opportunities,” moderated by TriMont’s John D’Amico. The panelists will include David Harrison of PNC Real Estate/Midland Loan Servicers, Gregg Chiota of Garrison Investment Group, Shari Linnick of Trepp, Bliss Morris of First Financial Network and Brian Olasov of McKenna, Long and Aldridge.

The discussions continue throughout the day on Wednesday and include panels such as “Creative Workout Structures” (hosted by Joe Sarcinella of Thompson and Knight) and “New Capital, Bridge and Rescue Lending and Equity” (hosted by Greta Guggenheim of Ladder Capital Finance LLC).

Next up, the balance sheet lenders will take center stage as Dechert’s own Rick Jones moderates a panel on balance sheet lender viewpoints. The panelists will be David Bouton of Citigroup Global Markets, Mike Moran of Allstate Investments, Elizabeth Fitzpatrick of Bank of America, Brian Furlong of NYLIM, Ivan Lehon of Ernst & Young LLP and Greg Null of Carlton Fields. This all-star group will discuss opportunities in the distressed debt market for portfolio lenders as well as hurdles portfolio lenders face in the distressed debt market.

Next up, the mezzanine lenders get a word in edgewise during the “Tranche Warfare” panel moderated by Bill O’Connor of Thompson & Knight. And it wouldn’t be a distressed debt conference if the special servicers didn’t get a say – day one of the conference closes out with “Special Servicer’s Roles in CMBS Secondary Markets” in a panel hosted by Kevin Donahue of C-III Capital Partners. Panelists include Jim Callahan of Pentalpha Capital Group, Bill Landis of Raith Capital Partners, Lea Overby of Nomura Securities International, Isaac Pesin of LNR Partners LLC and Tom Ruffing of CT Investment Management Co., LLC. The panel will discuss structural changes in CMBS 2.0/3.0 as well recent trends and current challenges of special servicing in the debt markets and is sure to be riveting.

Day two starts bright and early with a panel on exit strategies (moderated by Jan Sternin of Berkadia) and continues with “Enforcement of Foreclosure Rights” (moderated by Craig Welin of Frandzel Robins Bloom & Csato). The conference closes out by lunchtime on Thursday with back-to-back panels on the perspective of the B piece buyer, moderated by Nelson Hioe of Raith Capital Partners, and of owners and operators, respectively. Wrapping up at 12:30 on Thursday will give everyone an opportunity to network with old and new friends, and possibly sneak over to the Garden for day three of the Big East Tournament.

Dechert will continue to blog throughout the conference, and we look forward to seeing many of you there. Welcome to New York.

By: Krystyna Blakeslee and David Pildis

Left Out in the Cold: New Jersey Court Holds Condemning Authority Not Required to Negotiate with Lenders in Eminent Domain Proceedings

Krystyna Blakeslee — Mon, 04 Mar 2013 13:00:07 -0500

Early last month, in Borough of Merchantville v. Malik & Son, LLC, 429 N.J. Super. 416 (App. Div. 2013), the New Jersey appellate court held that a condemning authority, under the State’s eminent domain law, was not required to negotiate with a mortgagee which had obtained a final judgment of foreclosure on the relevant property, was in possession of said property and had the right to sell said property at a sheriff’s sale. Additionally, the appellate court held that the property owner’s express rejection of the condemning authority’s offer to purchase its property and invitation to discuss more reasonable compensation was inadequate evidence that the property was worth more than the amount offered by the condemning authority and constituted a rejection of such offer permitting the condemning authority to proceed with litigation.

By way of background, the Borough of Merchantville (the “Borough”) sent a written offer to Malik & Son, LLC, the record property owner (“Malik”), to acquire a 54-unit apartment complex based on the Borough’s determination that the property qualified as an area in need of redevelopment. The Borough offered to purchase the property for $270,000 “as is” based on an appraisal. Malik rejected the offer by letter stating that the offer was far less than the amount owed to the lender for the property and invited the Borough to increase its offer. LB-RPR REO Holdings, LLC, Malik’s mortgagee (“LB”), informed the Borough that it had obtained a judgment of foreclosure, that it was the real party in interest, as it was in possession of the premises and had the right to sell the property, and, accordingly, the Borough should be negotiating with it instead of with Malik. The Borough did not respond to either letter and instead filed the condemnation lawsuit. During the condemnation proceeding, LB filed a motion to dismiss the complaint arguing, among other things, that it was the real party in interest and the Borough was obligated to negotiate with LB before filing its complaint. LB also argued that the Borough did not engage in bona fide negotiations and that the appraisal report did not represent the fair market value of the property. The trial court disagreed.

On appeal, the appellate court affirmed the trial court’s ruling holding that the condemning authority is only required to negotiate with the record title owner of the property and explaining that this rule “avoids the difficult requirement of negotiating with each condemnee having an interest in the property.” The appellate court pointed out that the law protects other parties in interest (like the mortgagee) by allowing them to participate in subsequent valuation and allocation eminent domain proceedings.

The appellate court also held that, at a minimum, “the condemning authority is required to provide the owner of record with a copy of all appraisal reports relied upon in making the offer so there can be an appreciation by the condemnee of the value on which the offer is based.” Here, the Borough provided Malik with the appraisal report and Malik failed to provide a meaningful response to the Borough’s offer. Accordingly, the appellate court found that Malik’s formal rejection of the Borough’s offer and “lukewarm invitation” to negotiate constituted a sufficient rejection of the Borough’s one-price offer and permitted the Borough to file suit.

This worst case scenario underscores the fact that until the lender has title to the property, the lender needs the borrower to act as a conduit between it and the condemning authority. Accordingly, it is important that loan documents contain, among other things, strong covenants (subject to traditional thresholds) to include lender in all negotiations with the condemning authority.

By: Krystyna Blakeslee and Margaret Budnik

When Lenders are the Losers in Bankruptcy Court...Well, Not so Fast

Krystyna Blakeslee — Tue, 26 Feb 2013 08:33:56 -0500

Last October, I wrote about a scheme employed, in three separate bankruptcy cases, by debtors seeking to evade the absolute priority rule in order to keep the real property owned by the debtor in the hands of the ‘family’ at the expense of the debtors’ creditors.

The scheme went like this: The single asset real estate (“SARE”) debtor owned a retail shopping center on which it had taken out a secured loan. The debtor defaulted and before the lender could realize upon its collateral, the debtor filed for bankruptcy. The debtor’s chapter 11 plan contemplated that the debtor’s principal’s wife would purchase the debtor’s assets in exchange for a cash infusion, thereby keeping the property in the ‘family’. In the end, the cram down plan was confirmed.

In one case, In re Castleton Plaza, L.P., the owner owned the equity interest (98% directly and 2% indirectly to be exact) in the SARE debtor that owned a retail shopping center in Indiana, on which it had taken out a $9,500,000 loan. The court confirmed a plan of reorganization in which (A) the equity in the debtor was transferred to the owner’s wife in exchange for a $375,000 (actually, the offer was $75,000 initially) cash infusion, (B) the lender’s secured loan would be extended 30 years, with little to be paid until 2021 and the interest rate cut from 8.37% to 6.25% (not to mention, the cash management provisions would be deleted), (C) the management contract between the principal and the manager would be continued, giving ‘the family’ an additional $500,000 in revenue, and (D) promised to pay unsecured claims 15 cents on the dollar over 5 years. While the bankruptcy court did find that the principal’s wife was an insider and any proposed sale to the missus, therefore, was subject to a higher degree of scrutiny (for an explanation of the Absolute Priority Rule please refer to the original post), the court held that competition was unnecessary (i.e., there was no reason to hold a competitive bidding process to let the market decide the fair value for the equity in the debtor) and confirmed the plan. To make matters worse, the court confirmed the plan despite the fact that the lender had offered $600,000 for the equity in the debtor and promised to pay all other creditors 100 cents on the dollar. The lender appealed.

On appeal, the United States Court of Appeals for the Seventh Circuit holding that “[c]ompetition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider” reversed the judgment of the bankruptcy court and remanded the case with directions to open the plan to competitive bidding. The appellate court found that the Absolute Priority Rule did in fact apply since the principal would indeed receive value from the equity purchased by his wife: (i) the principal would continue to receive income, as the CEO of the management company, (ii) the principal would receive an indirect benefit from his wife’s ownership of the equity interests (and indirectly, her ownership of the property), and (iii) the principal (not to mention the entire family) received value in an amount equal to the difference between $375,000 (the price the wife paid for the equity interests) and the price that a market bidding process would have fetched (at least $600,000, the lender’s bid).

The Appellate Court’s decision is exactly what we had hoped for. Insider relationships should be closely scrutinized, and insiders should not be allowed to use their (uneven) bargaining power to the detriment of creditors. Now, hopefully, the two other ‘sister’ cases, discussed here and here, will be similarly resolved. One step at a time, I guess.

By: Krystyna Blakeslee

HUD's Final Rule on Fair Housing Act Liability Explained in New Dechert OnPoint

LexBlog — Thu, 21 Feb 2013 13:36:46 -0500

February has certainly been a big month for federal agencies to issue long-awaited final rules. The latest agency to throw its hat into the ring is the U.S. Department of Housing and Urban Development, which recently codified its long standing position that liability under the Fair Housing Act may be proven by disparate impact without any discriminatory intentions. This final rule provides additional support to potential government and private plaintiffs seeking to challenge “facially neutral” practices as violations of the Fair Housing Act. We have previously blogged about the different types of liability related to discrimination in lending here. This rulemaking comes at a time when lenders have already begun to reexamine how they will structure their residential mortgage lending activities in the face of the CFPB’s new qualified mortgage rules. (See our DechertOnPoints for more information on the new QM/ATR rule and the additional proposal).

In its final rule, HUD set out a three pronged burden-shifting formula to determine whether FHA liability has been triggered. First, the plaintiff has a burden to demonstrate that a practice has a discriminatory effect. There is no requirement that the plaintiff prove discriminatory intent. Second, the burden shifts to the defendant to prove it had a legally sufficient justification for the challenged practice, which will require a showing that the challenged practice is (i) necessary to achieve one or more substantial, legitimate, nondiscriminatory interests of the defendant, and (ii) those interests could not be served by another practice that has a less discriminatory effect. Third, the burden shifts back to the plaintiff, who may prevail by showing that another practice with a less discriminatory effect could be used.

HUD downplayed concerns that complying with the QM rule could cause lenders to be at greater risk of fair lending litigation on the grounds that their new rule does not change the substantive law recognizing discriminatory effects liability. Nonetheless, the banking industry is strongly opposed to this rule. HUD did not provide any comfort or safe harbors and instead chose to leave the question of “sufficient justification” to the courts. This rule will only compound the concerns lenders must sort through as they work to develop underwriting practices to comply with the QM/ATR rules. Patrick Dolan, Robert Ledig, Thomas Vartanian and CrunchedCredit’s own Ralph Mazzeo have provided a summary and analysis of HUD’s new rule on behalf of Dechert’s Finance and Real Estate Group and Financial Services Group, which can be found here.

By: Laurie Nelson and Linda Ann Bartosch

Dechert OnPoint Details Recent SEC Report on Credit Ratings for Structured Finance Products

Ralph Mazzeo — Wed, 13 Feb 2013 12:17:07 -0500

While we’re on the topic of Dodd-Frank rules and regs that could have a significant impact on the securitization market, the SEC recently reported the findings of a study it conducted regarding assigned credit ratings for structured finance products – a report required under Section 939F of the Dodd-Frank Act that will subsequently lead to new rulemaking.

Members of the Division of Trading and Markets of the SEC published the report to Congress after an extensive information-gathering process involving meetings with various stakeholders and the review of 32 comment letters from the major rating agencies and other interested parties. In addition to being asked to examine matters such as the accuracy of the credit rating process, conflicts of interests associated with different pay models and alternative means for compensating the rating agencies, the SEC was tasked with offering recommendations for regulatory or statutory changes that could be made to implement the findings of the study. The report highlights several “systems” of providing initial credit ratings to structured finance products, breaking down the pros and cons of each system and ultimately determining that more information is needed to choose the best course of action – making it clear that a final rule is likely in the distant future. Patrick Dolan and CrunchedCredit’s own Linda Ann Bartosch teamed up to provide a summary and analysis of the SEC’s report on behalf of Dechert’s Finance and Real Estate Group, which can be found here.

By: Ralph R. Mazzeo and Eric J. Kotloff

It's Time to Revisit Risk Retention

Rick Jones — Wed, 06 Feb 2013 18:40:10 -0500

Two and a half years after Dodd-Frank and almost two years after the first hurriedly issued proposed rules, the six agencies (Department of Housing and Urban Development, Federal Deposit Insurance Corp., Federal Housing Finance Agency, Federal Reserve, Office of the Comptroller of the Currency, and the U.S. Securities and Exchange Commission) charged with creating risk retention architecture for commercial mortgage securitization have yet to issue a final rule, interim final rule or even a new proposed rule. Since Dodd-Frank provides a two year transition period after publication of a final Rule (or perhaps interim final rules), we might think, no Rule, no risk retention; all is good, no worries. Bad way to think about this. Something is coming out soon. It will be important. It may start affecting our business now. I don’t think we can or should be complacent. More on this later.

What we’re hearing from the panjandrums of the regulatory community is that the horrific concept known as premium capture cash reserve account (PCCRA) is finally cold and dead (although until I see sunlight shining in its grave and a stake in its heart, I won’t be sure), and that the regulation writing committee is settling on an alternative, focusing on risk retention to be satisfied through a B-piece buyer holding a horizontal 5% first-loss strip (the B piece fix was, of course, added to the statute by amendment by Senator Crapo, bless his heart). On this topic the statute said:

The regulations prescribed under the risk retention requirement shall (B) require a securitizer to retain (i) not less than 5 percent of the credit risk for any asset (I) that is not a qualified residential mortgage that is transferred, sold, or conveyed through the issuance of an asset-backed security by the securitizer, and …(E) with respect to a commercial mortgage, … (ii) retention of the first-loss position by a third-party purchaser that specifically negotiates for the purchase of such first loss position, holds adequate financial resources to back losses, provides due diligence on all individual assets in the pool before the issuance of the asset-backed securities, and meets the same standards for risk retention as … the securitizer. (Dodd-Frank Section 941)

After having vigorously and stubbornly embraced premium capture, having to walk it back in the face of compelling objections from the regulated community (structurally, it would have entirely ended securitization as a viable business) the agencies have, as a consolation prize, embraced a new version as the 5% retention rule. Under this provision, the B buyer, in order meet the risk retention obligation of the issuer, would have to buy 5% by value of the underlying assets, and hold that position for five years.

As those in the securitization world know, the current architecture of the business is that a B buyer buys roughly the bottom 5% of the face amount of the certificates at a significant discount to par or face to reflect the risk of owning the bottom of the capital stack. Broadly, this is the non-investment grade portion of the capital stack. It is also free to sell or hypothecate that position at any time. If compelled to buy 5% by value, it will virtually double the size of the B piece and significantly torque the business model. Bottom line: does the B buyer buy investment grade bonds at the yields that such bonds would attract in the open market, therefore, radically reducing the value of the investment to the B buyer, or does the B buyer buy the entire position up through the investment grade bonds at the same yield at which it buys the non-investment grade, thereby, significantly increasing the cost to the issuer? One side of the trade or the other is going to get gored by this regulatory change. Free market outcomes will be frustrated. Consequently, as the business is torqued to meet regulatory goals, securitization will get less efficient, the cost of capital to the end user will go up and the availability of capital will diminish. That’s what we call unintended consequences.

Well, that’s the headline bad news. But we’re not here today to rehash all the arguments that the rule is intellectually fraudulent and horribly ill-designed to serve its intended purposes of improving the function of the capital markets. Water over the dam. Today, let’s focus on all the second tier questions such a rule, when drafted, needs to address.

Imagine an exposure draft (or, worse, a final or interim final rule) comes out tomorrow (and it might come out tomorrow). What will it say? We don’t know and the tea leaves have been few and far between on this. Here are some of the things that really need to be addressed to make this Rule operational:

Who will qualify as a B piece buyer? Will there be criteria for minimum net worth, minimum liquidity, capabilities, track record, etc.? Must it be a QIB? A QIL? Or something new?
Can the position be levered? The statute says that if the Issuer holds the 5% horizontal strip, it cannot lever the position with non-recourse debt. What will be the rule as to the B piece market? The realities of the business model are that yield needs to be quite high to pay for the assumed risk of holding first loss paper. Will there be no more non-recourse lever? Is recourse to an entity that just owns the bonds OK? Must there be a guarantor or sort of net worth liquidity or AUM requirements applicable to it?
What happens when appraisal reduction eliminates the B piece buyer control (as it does under CMBS 2.0 deal structures)? Must the B buyer continue to hold yet have no control? It would certainly make no sense to anyone entering the B piece business. Does this even carry out the Congressional intent?
How about when realized losses eat the B piece away? Is the vehicle still in compliance? Must a new B piece holder be designated and agree to hold its bonds in accordance with the obligations of the original B buyer? That seems absurd, not to mention hard to implement and would certainly be the end of liquidity in junior investment grade bonds.
What happens when the B buyer breaches its covenant regarding leverage, assignment, hypothecation or the like? Remember the retention obligations attached to the issuer, or in some cases the originator. The B buyer undertook its retention obligations under the pooling and servicing agreement. Who gets to enforce it? What happens if the enforcement effort fails? How about during the period in which the enforcement effort continues? We know that litigation of complex commercial matters in the U.S. courts is not a quick or easy process. Remember that if the issuer fails its B piece obligation it faces civil penalties including three tiers of fines. (Dodd-Frank Section 929P)
What happens if the B piece buyer becomes insolvent and its assets are transferred by operation of law? Same issue?

What do we do with deals with only investment grade bonds? Shouldn’t there be another exception, maybe based on Section 943 of Dodd-Frank dealing with high quality representations and warranties or the qualified commercial loans or qualified commercial real estate ("CRE") loans (§__.18 to §__.20 of the proposed rules) that might alleviate the need of a B piece in deals tranched only to investment grade? Wouldn’t it be silly to create a B piece in that case just to meet the requirements of the statute? When one thinks of the underlying policy purpose of the statute, a low leverage deal without a B piece should meet it. The proposed rules contain the concepts of qualified commercial loans and qualified CRE loans which could easily fix this. The qualified loan in the proposed rules was insanely narrow and industry research indicated that virtually no loans ever originated for securitization would have met it. The chatter is that it will be designed to be unavailable, forcing issuers to some other form of risk retention. It’s silly when prescriptive rules conflict with sensible policy descriptions and this seems to be the case here.

Finally, in just the musings of a paranoid lawyer, it’s been two and a half years since Dodd-Frank and these regulations were supposed to be effective two years after implementation which, I suspect, Congress thought would happen tout suite after publication of Dodd-Frank. Now, if the regulations come out in final or interim final form (which, the regulatory types tell me, an interim final rule will begin the two year tolling on effectiveness), the industry will have almost five years since Dodd-Frank. Might some regulatory agency try to shorten that time by adopting this Rule or the substance of this Rule in another context where there would be no two year transition rule? It seems to me the temptation is there and we need to be diligent for any hint that such a bad surprise is being cooked up. OK. So I’m paranoid. But in this political environment I worry about ill-thought through regulations that have more to do with the ideology than the practical delivery of the risk mediation the rules were designed to provide.

By: Rick Jones

Black Swans in Camo: Continued Concern about the European Community

Rick Jones — Wed, 30 Jan 2013 15:29:34 -0500

I have written periodically in this Blog about my persistent concerns about the European economy and its capacity to negatively impact ours. I get wound up, then I get swayed by the majority views of the chattering class who gently explain I’m indulging in alarmist adolescent flights of fancy and I should leave the big issues to the smart people, e.g., the overwhelmingly Europhile policy glitterati.

The worry always comes back, though, as it did last week while listening to the comments of both David Malpass at the CREFC Investor’s Conference in Miami and panelists on Jeff Fastov’s terrific panel “Why Do I Want to Go to Europe?”

I’m not indulging in some weird post Victorian form of neuralgia or the vapors. We should be concerned. The problems of the European fiscal and monetary systems have not abated. We just have stopped looking hard enough; we get distracted. Black Swans in Camo can sometimes be hard to see.

Look, the problems of the European community are fundamentally simple but, unfortunately, fairly intractable and severe. The reality is masked by noise, surficial complexity, and static from the 24 hour news cycle. Strip all that away and here’s what we’ve got: a majority of EC member states have economics that cannot support the goodies the populace not only want but has come to see as entitlements (Washington, you listening?).

When you look through the fog of chatter by governments, EC officials and the aforementioned Europhile glitterati, the fundamental structure of reality looks like this:

• Europeans are used to a high level of government transfer payments to fund pretty good lives for almost everyone. Generations have come to feel insulated from the economic risk of a faltering economy.

• Sheer demographics started to shake the foundation of the European system years ago.

• Slowing economies. Even the German economy is slowing; recession is spreading through most of the European community. Most EU countries are suffering an economic slowdown largely because of lack of competitiveness. Germany, while preserving competitiveness, exports a large percentage of its products to Europe. Europe slows; it slows.

• Now virtually unsustainable unemployment levels exist in much of the community. And it’s getting worse. A lot of someones have to get back to work to fund the goodies. As the number of employable people goes down, and governmental constraints continue to drag on employment markets and productivity, the machine simply cannot produce sufficient wealth. As Margaret Thatcher famously said “the problem with democratic socialism is eventually you run out of other people’s money.”

• Very high levels of government debt. Market complacency has been sustained for a time by, in large measure, “incenting” the European banks to buy the debt and soak up the excess supply (Federal Reserve, you listening?) and by promises of unlimited liquidity from the Draghi Put. The ECB is pushing on a string. Liquidity is not creating growth. It is only making it easier to pretend that things are OK for a little while longer. Spain borrows cheaply because Mr. Draghi promises to buy its bonds. What happens if the ECB actually does have to perform? The market will instantly understand this promise always was untenable. One cannot shovel back the tide with a spoon. Pretend time will end.

• There is both popular and intellectual hostility throughout Europe to the price to be paid to enhance competitiveness. The conviction that there is a form of painless economic dynamism that can fund the European entitlement state if the pols just get the laws and regulations right is unshakable. That’s largely because it has worked to date. Subtract unlimited debt growth, and it fails. The notion that the price of less fettered capitalism is more disparate outcomes and less the state can do to mediate the consequences of lack of individual economic success, that there are winners and losers, is anathema to large segments of the polity.

• Social unrest is bubbling at some level in every country where there are actual efforts to scale back the goodies.

• Further austerity, which has come to mean first higher taxes and then reduced governmental expenditures, is not likely to fix the problem. All the pain, but little gain.

The bottom line is that the European community cannot afford its goodies. It hasn’t been able to afford them for quite a while. It has been living on a credit card and that card is now just about at its limit. Fiscal, economic, social and maybe even political change cannot long be avoided on the road they are treading. I understand the conviction of much of the commentariat that European governments will be able to somehow walk the situation back down the tightrope stretched over the chasm of economic chaos to something sustainable, to a market where sufficient growth can be squeezed out of the system to provide enough government revenues to cover expenses. That conviction informs the enthusiasm for the current ECB liquidity bubble. Just keep the wolves at bay for a little longer and all will be well. They are going to fall off the tight rope. Social unrest is already forcing the politicians in Spain, Italy, Portugal and France to renege on efforts to scale back the entitlement state, loosen employment markets and encourage dynamic economic growth.

The Hail Mary choice for government’s wobbling on that tightrope is to reacquire control over monetary policy. If the ECB cannot provide it, the unwinding will begin. It’s not just Greece, I don’t see how Spain, Ireland even France avoids the need to devalue their currencies. It cannot be long before many European countries join the race to the bottom already underway around the globe. Maybe that won’t even be enough, but it’s got to be part of the endgame. In any event, it will be messy, it will hurt world economic growth, it will hurt us, and it won’t be good. We can ignore it for a bit, let the eye be tricked by this black swan in camo. But we should not pretend we’ll not eventually have to deal with more trouble in Europe.

By Rick Jones