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Insight ® Reprinted with permission from the July 2008 issue The Anatomy, History And Future Of Commercial Designed to stabilize commercial values by increasing liquidity, standardizing underwriting and buffering against dislocations, the CMBS market has also fundamentally altered the roles of many participants.

By Susan E. D. Neuberg

he securitization of commercial In a commercial mortgage-backed referred to as the unrated class - holder real estate was intended securitization, loans secured by com- of the most subordinate tranche. to transform an illiquid asset mercial real estate are typically di- Transactions involving pools of Tclass, real estate, into versified by type, commercial mortgages and commercial a liquid one by insuring an geographic location and size. mortgage-backed securities (CMBS) uninterrupted They are originated, funded involving a single large loan or pools of to certificateholders. These and pooled into a trust ve- commercial mortgages were closed in certificates were thought hicle known as a real estate the early 1980s. Nevertheless, a strong to be freely tradable in the mortgage investment con- market never developed due to height- capital markets. duit (REMIC) trust in order ened in traditional commercial This concept of liquid- to distribute uninterrupted real estate lending on the part of life ity is in sharp contrast to Susan E. D. Neuberg cashflow to different tranches companies and traditional the protracted realiza- of certificateholders (also re- Main Street lenders. tion of the actual real state collat- ferred to as bondholders) without be- The oversupply of capital that re- eral traditional Main Street lenders ing taxed at the trust level. sulted in a frenzy of commercial real painstakingly executed in a one-off The principal and interest from the estate lending in the mid-1980s stunt- fashion on each defaulted mortgage mortgages are distributed to the cer- ed further development of the CMBS loan during the late 1980s and early tificateholders in a defined sequence market. With an abundance of capital 1990s. This process involved fore- or order known as the waterfall. The available on Main Street, there was no closures, most often certificateholders own fractional, undi- need for capital from Wall Street. that had the propensity to extend vided beneficial in the loans. However, deteriorating under- beyond a two- to three-year horizon The pooled loans are managed by writing standards, an abundance of before the asset could be liquidated master and special loan servicers, each one type of property class, isolated (typically at a value far below that of rated by the rating agencies based up- geographic concentrations and mul- the original ) and any on their servicing capabilities, includ- tiple loans to a nucleus of nefarious proceeds realized by the lender. ing the ability of the master servicer to borrowers in each lender’s respective make advances for borrowers’ delin- portfolio brought the availability of quent principal and interest payments. Main Street capital to a screeching Susan E. D. Neuberg is a partner in the Through this process, the certificate- halt in the early 1990s. real estate and structured- prac- holders receive an uninterrupted flow of tice groups at Nixon Peabody LLP. She funds generated by the mortgage loan CMBS resurgence is chair of the investment management regardless of whether each borrower Illiquidity of real estate as an as- and asset recovery team, a multidisci- remains current in its payments. set class was the perceived Achilles’ plinary team of Nixon Peabody attorneys The bonds created by the securitiza- heel that resulted at the end of the last who provide legal services and solutions tion vary in , duration and payment commercial real estate downturn cycle. to financial institutions and priority. The rating agencies assign Declining real estate values, pro- engaged in transactions credit ratings to various tranches based tracted workouts, bankruptcies, fore- and portfolio management. Neuberg can on benchmarks ranging from invest- closures and ultimate disposition of the be contacted at (212) 224-6390 or sneu- ment grade to below-investment grade. “bricks and sticks” (tangible real es- [email protected]. Those bonds that receive no rating are tate), along with the resulting mark to

Subscription information available online at www.cmi-online.com. Copyright © 2008 Zackin Publications Inc. All Rights Reserved. market of the impaired value of mort- property type diversification, and stan- of subordinate - thus generat- gage investments, caused a total melt- dardized underwriting, loan docu- ing new sources of and income. down in the and loan industry mentation and servicing - all of which Portfolio lenders, experienced mort- and commercial real estate markets. would result in the stabilization of gage loan servicers for their own loan For many institutions, this even commercial real estate values. portfolios, now had the opportunity was the catalyst for significant merg- Several of the risks discussed during to leverage this experience by becom- ers, acquisitions and change in con- the early years of CMBS included the ing third-party loan servicers. trol. The trend was especially apparent loss of the traditional borrower-lender In doing so, a small number of mas- among the life insurance companies, Main Street-esque relationship: In ex- ter and special servicers ranked highly both mutual companies (e.g., Home change for a lower rate of interest, by the rating agencies dominated and Life Insurance Co., Connecticut borrowers who availed themselves of captured a significant market share - Mutual) and publicly traded ones (e.g., conduit loans originated for securiti- thereby greatly enhancing profitability. Travelers, Aetna). zation lost the ability to modify their Rating agencies had played a role In addition, borrower defaults un- loans as their business needs changed. in downgrading insurance companies der mortgage loans caused the failure and other financial institutions due to of many local and regional savings New roles balance-sheet issues and risk-based and loan institutions, and ultimately During the early years of CMBS capital requirements penalties. These resulted in a government bailout. The lending, most borrowers and their coun- penalties resulted from a dispropor- disposition of the mortgages acquired sel were not mindful of this wrinkle. tionate allocation of real estate mort- by the government as a result of its It was only until many of them were gage loans in the late 1980s and of failed savings and loan burned did their counsel begin to under- distressed mortgage loans and real es- institutions became an impossible stand that once a loan was originated for tate assets in the early 1990s. nightmare to navigate. securitization, there could be practically Now, the rating agencies had the This problem resulted in the for- no modifications to such loans. opportunity to assign credit ratings mation of the Resolution Trust Corp. This prohibition was in place due to to the various tranches of the issued (RTC) - directed by Congress to sell the REMIC rules, which, if violated, securities by examining the structure off mortgage loans and distressed real would destroy the value of the securi- of the securities, the underlying col- estate assets. ties and the integrity of the investment lateral and borrower structures. With this mandate and the RTC’s class unless such circumstances or situ- A whole new market of investors daunting task of having to liquidate ations (transfer of beneficial owner- developed, ranging from the issu- a massive volume of mortgage loans ship, substitution of guarantors, partial ers, B-piece buyers and opportunity - along with traditional real estate release of , built-in loan ex- funds - purchasers of the unrated lenders’ operating within the confines tensions or renewals to name a few) certificates - to funds, insur- of a market requiring them to adjust were negotiated as part of the original ance companies, domestic and for- their investment allocations in order loan documents. eign , and monolines. to avoid further action by the credit According to a 1996 report issued rating agencies or state regulators - by the Ernst & Young Leventhal Residential fallout market conditions were ripe for a re- Group, between 1991 and 1995, the Since 1995, the success of the surgence of the CMBS model. RTC issued in excess of $17.8 billion of CMBS industry has seemed unprec- This CMBS model was, at that CMBS. At the end of 2005, as reported edented. However, for the past two time, neither strongly developed nor by Commercial Mortgage Alert, $141 years, there was a pervasive sense that highly sophisticated. CMBS nonethe- billion of CMBS had been issued - $100 this high could not continue at the less became the vehicle by which the billion domestic and $41 billion non- same pace or volume. RTC and financial institutions could U.S. originated, representing a 729% With property values continuing to pool and sell off many assets at a time, growth in product origination over a escalate and an abundance of capital rather than one transaction at a time. 10-year period. pouring forth from Wall Street, no For the financial institutions, the The success of CMBS origination one was quite sure when and how this CMBS model became a vehicle for created an entire market of third- bonanza would end. Yet with the ad- the ultimate disposition of investment party players, along with a greater vent of the subprime crisis during the assets that had become a drag on their market share for Wall Street’s invest- summer of 2007, the CMBS market books and earnings and resulted in ment banks. The success of securitized began its grind to a screeching halt. credit upgrades by the rating agencies investment vehicles created new roles Following the disclosures by major that also brought a renewed sense of and relationships for many financial financial institutions of the devastat- confidence. institutions, along with a cheaper cost ing losses hemorrhaging their bal- The perceived benefits of CMBS of funds for conduit borrowers. ance sheets from the RMBS fallout, included increased liquidity, avoid- Investment banks took on various lack of investor confidence began to ance of cyclical credit dislocations, roles - underwriter, originator, par- invade the commercial securitization increased geographic, borrower and ticipant, warehouse lender and holder markets as well.

Subscription information available online at www.cmi-online.com. Copyright © 2008 Zackin Publications Inc. All Rights Reserved. Frightened by the speed at which asset class backed by the cashflow of the commercial real estate markets? the subprime calamity unfolded, the real estate assets typically deemed il- Hardly likely. If the commercial real rating agencies began to lower the rat- liquid by Wall Street and regulators estate markets begin to decline and bor- ings on a great deal of CMBS despite a alike today has resulted in an im- rower defaults begin to rise, will there rate well under 1% for the en- paired and battered investment class be further downgrades, or will that tire asset class. The downgrade of the - despite the strength of commercial be the test to see if the system per- certificates forced a mark to market of real estate fundamentals. forms as created? In other words, will the securities on the books of institu- The explanation for a situation there continue to be an uninterrupted tional investors, even though the fun- where institutions have had to re- cashflow to investors backed by the damentals of the underlying collateral duce the market value of CMBS on advancing obligations of highly rat- (real estate) generating cashflow to the their balance sheets as a result of ed and skilled master and special loan certificateholders remained healthy downgrades, despite stable valuations servicers? and unimpaired at the time the bonds of the underlying mortgage loans, is In these uncertain times, there is were downgraded. counterintuitive. only one thing to be certain of: We What began in the early 1990s as Have these downgrades - all must be prepared to expect the the creation of a liquid investment ed for a perceived future softening of unexpected. ●

Subscription information available online at www.cmi-online.com. Copyright © 2008 Zackin Publications Inc. All Rights Reserved.