One need only peruse the recent headlines to learn that the credit markets are in a tailspin. Mortgage defaults (both commercial and residential) continue to rise, and foreclosures are overwhelming the court system. Likewise, lenders are tightening credit, and interest rates are at their highest point in nearly a decade. Amid all of this turbulence, holders of securitized loans—whether in commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs) or some other structure—are staring risk in the face with no historical record on which to bank. On a national scale, loan foreclosures are up 93 percent from a year ago.

Changing Times

Not that long ago, a real estate purchaser or developer would enter the local bank with his longtime lawyer, visit with a familiar banker, and after a conversation or two, leave with a commitment to fund a project. At the closing, documents would be signed, money exchanged and the deal completed. With very few exceptions, real estate deals no longer come together in that fashion. Even local transactions now involve multinational lending sources and often employ complex financing structures that require seemingly endless underwriting and other due diligence processes. Cross-collateralizations and escrows are the norm. Ownership is typically held by REITs and other investment vehicles, while the loans themselves are bundled, securitized and sold on the public market.

Within this model, the lengthy documents that accompany these real estate transactions merely mask the increased uncertainty inherent in the new forms of ownership and complex financing structures. From a lender’s or a borrower’s perspective, the underwriting process is merely a springboard for uncovering a host of other issues that may not come to light until years after a transaction is consummated. These new, relatively untested financing structures are unpredictable in a downturn, which adds a layer of complexity in dealing with troubled or defaulted loans. This uncertainty is exacerbated by the lack of discretion and judgment common among the servicers of these financing structures when they are called upon to work out issues with particular loans or borrowers.

An Example in Oregon

This level of uncertainty was typified by an Oregon case in which a bankruptcy filing affected a company’s CMBS debt in unforeseen ways and brought a number of issues to the fore. The case involved a franchise and management company operating 27 hotels under a single brand. When the hotels experienced a series of operating challenges, all of the non-CMBS loans were driven into bankruptcy, even though the borrowers had negotiated various forbearance arrangements with the non-CMBS lenders. The controlling owner, the management company, the franchisor and the other hotels did not enter bankruptcy.

The 27 loans were each made to a different special-purpose entity (ownership structure) and then allocated among three pools, each of which contained other loans as well. The loans incorporated fairly common features, including cross-collateralization and cross-default provisions within the separate pools. At least one pool was structured to expressly permit the release of the primary debtor from the loan, provided the property was sold to a buyer that would assume any outstanding debt. The properties were operated by a management company affiliated with the borrower. Although the hotel revenues were pledged to the lender, the loan documents allowed that money to be used to cover operating costs as long as the existing management company continued to operate the property.

One pitfall of this complex structure arose from the interplay between the servicer for the CMBS pool holding the 27 mortgages and the post-default special servicer (i.e., the entity that takes over once a loan falls into default). Prior to the bankruptcy filing, the servicer refused to agree to a workout or forbearance, claiming that it needed the consent of the special servicer. However, the special servicer refused to involve itself in a loan that was not in default because no servicing transfer event had occurred. As a result, the borrower attempted to trigger a technical default by making a late mortgage payment. Even then, the special servicer maintained that it could release the first lien but not effect the cross-collateralization lien, and still refused to make concessions prior to any actual default. Once the loan truly fell into default, the special servicer commenced foreclosure and receivership procedures, with an ultimate goal of liquidating the properties. Simply put, the roles of the different servicers—a creation of the CMBS structure—led to additional complexities and problems.

After the non-CMBS loans entered bankruptcy, the following dominoes fell:

• The management affiliate was allowed to use hotel revenues for continuing operations and apply excess funds to reserves and capital projects. That meant the holders of the various CMBS tranches got nothing.
   
• The special servicer initiated litigation that claimed mismanagement and commercial defamation, requiring the holders of the CMBS tranches to incur even more legal fees.
   
• The special servicer also claimed that the borrower had guaranteed the entire debt via a “bad acts” guarantee (i.e., one that becomes effective when a borrower commits certain “bad acts,” including defaulting on a loan). As a result, the borrower was cornered.
   
• Because hotel management kept vendors current, employees paid, the hotels operating and the traditional lenders happy, the CMBS investors were left holding the bag.

Although the lessons from this case are many, a few bear special attention. First, the anticipated benefits of the separate special-purpose entities did not come to fruition and, therefore, provided no effective defenses in the bankruptcy. For example, the fact that employee relationships and vendor contracts were handled by a special-purpose entity (an affiliate of the borrower, rather than the borrower itself) was of little practical benefit under the bankruptcy code. Also, the inclusion of cross-collateralization requirements in the loan documents directly undercut all other efforts to separate the various entities and minimize the associated risks.

Second, there are clear indications that the inherent conflicts of interest in the CMBS servicing structure led to this bankruptcy. Consider this: the default rate for securitized loan pools is reportedly higher than that of a comparable pool of institutional loans. In all likelihood, the higher default rate is a result of the unique CMBS structure and the awkward interplay between the servicers. In the Oregon case and others like it, the performance of the non-CMBS loans after a negotiated forbearance provides further evidence that the CMBS structure itself caused additional problems that led to negative results.

Third, the powers of the post-default special servicer were held under a microscope. On what issues were the various note holders entitled to speak or to vote? What were the restrictions on the special servicer’s powers? Although the special servicer may have claimed authority to act under certain circumstances, the intersection of typical servicing agreements and the bankruptcy code leads only to confusion and differing answers concerning the rights and powers of all involved.

In the Oregon example, the parties thought they had considered all likely ramifications from the underlying transaction at the time the loans were made. But the case underscores the fact that these increasingly complex financing and ownership structures fail to provide the protections that most borrowers expect, particularly when it comes to troubled loans.

What’s Next?

With billions of dollars in real estate mortgages having been bundled and securitized, borrowers should prepare themselves for a range of problems. Areas to watch carefully include the grant of power to and the restriction of power on a CMBS servicer, as well as the structuring constraints on a borrower’s ability to work out a troubled loan.

As a borrower, you may need to rethink even your most carefully crafted plans because you may not have the protections that you expect. From a lender’s perspective, even careful underwriting and monitoring may not be sufficient to safeguard your interests. Whatever your position, it is important to read the loan documents carefully, and consider how the structure in which the loan is held may affect your rights, obligations and abilities to work out a solution before or after a loan becomes troubled.