News

Tranche Warfare.

November, 2009

Fried believes once the market restarts it will not only provide much-needed capital for real estate generally - but also prove a great opportunity.

HIGHLIGHT: There are many parties at the table in CMBS workout situations. It is still far from clear who the winners will be, if any. By Zoe Hughes

Born out of the wreckage of the RTC, the commercial mortgage backed-securities model has never been truly tested, until now. Investors who believe they can swoop in and capture value in distressed CMBS tranches may have their dreams dashed in excruciating special servicing workout processes.

Last month, Starwood Capital Group became one of the early movers in challenging CMBS construction when the firm launched a bid to wrest control of the bankruptcy of the Extended Stay lodging chain. Working with existing bondholders, Fortress Investment Group, private investment shop DE Shaw and Five Mile Capital Partners, Starwood proposed a rival plan to the pre-bankruptcy strategy of senior creditors that had called for $4.8 billion of debt to be wiped out. The strategy would have helped senior CMBS bondholders, including Cerberus Capital Management and Centerbridge Partners, get their money back but would have hurt the majority of creditors.

Instead, Starwood offered to buy Extended Stay's $4.1 billion first mortgage (which was carved up into around 18 different components) for $3.5 billion, with the injection of up to $700 million of new equity, according to the Wall Street Journal. The offer has garnered support from some of Extended Stay's largest creditors as well as junior bondholders, but it has brought into focus the pitfalls facing real estate investors when contemplating CMBS deals. The sheer complexity of these securitisations makes outcomes very hard to predict.

As one fund manager joked to PERE, if he was guaranteed $100 million profit from a CMBS deal or $50 million from more plain vanilla debt opportunities, he'd stick to the latter because "my life is more important to me".

There is no doubt the volume of the distressed CMBS opportunity will be vast. CMBS delinquencies in the US approached 4.36 percent in September for loans that were 30 days or more past due, including those that were still current on their interest but had missed their balloon maturity. According to New York-based research firm Trepp, that figure is up from 4.03 percent at the end of August and from 0.65 percent a year ago. Trepp managing director Tom Fink says the rate of deterioration in CMBS loans has been unprecedented and much faster than seen during the 1990s. With the outstanding CMBS universe valued at more than $680 billion, defaults have grown by up to 17 percent a month since late 2008, with an almost seven-fold increase year-on-year. At the end of August, $55 billion of CMBS loans were in special servicing, a number that was expected to grow to $70 billion by the end of the year.

Most industry professionals believe CMBS delinquencies will double within the next year to as much as 9 percent overall, with defaults peaking in 2010, particularly towards the end of the year. Some professionals, however, predict worse. "Frankly these numbers are underestimated," says Bruce Nelson, principal at special servicing firm The Situs Companies. "There has been a huge increase in delinquency rates but it doesn't properly reflect the dynamic of real estate. I think it will continue to rise significantly and will double again."

When the first CMBS pools were created in the wake of the RTC in the early 1990s, the product mirrored the securitisation of loans from failed savings and loans institutions. Conservatively underwritten, the first issuances typically had low loan-to-value ratios, with historic cash flows in place, secured against quality assets and with relatively little slicing and dicing.

For Paul Fried, managing director of advisory firm Traxi, the emergence of CMBS was vital for the recovery of the US real estate markets in the mid-1990s: "CMBS was the means of bringing real estate out of the doldrums. It wouldn't have happened without CMBS." With traditional lending institutions "hobbled" by the savings and loans crisis, and life insurance companies "extremely conservative", the US "could have gone bumping along the bottom for many, many years", Fried adds. This aggressive new form of capital was just what the property market needed.

And it will be again, according to Fried, a former executive with Deustche Bank's CMBS origination group. Although there is no new CMBS issuance today, Fried believes once the market restarts it will not only provide much-needed capital for real estate generally - but also prove a great opportunity. New CMBS issuance "going forward", Fried explains, should provide investors with "good properties at low valuations, with great tenants and a great structure. There should be a pretty significant bump further down the road for investors who capture this window of opportunity", he adds.

Maximum value mandate

The opportunity for existing CMBS loans, however, is less than certain.

financial industry during the 1990s, the volume of CMBS issuance rose. In 2000, $9 billion of CMBS loans were originated in the US, according to Trepp. By 2005 that figure had risen to $123.9 billion. In 2006, a further $168.6 billion was issued followed by $201.1 billion in 2007. Near the peak of the market, CMBS pools comprised of hundreds of mortgages, often sold on the basis of the composition of the largest 10 loans in the pool and rated accordingly, with super senior AAA bonds deemed the "safest" tranche followed by AA, A, BBB, BB and then the unrated, more risky securities, known as the B-pieces.

One market insider tells the story of a German bank that bought a BBB-rated tranche of a CMBS deal, believing it was getting an investment grade security, with a low probability of payment default. Today, with property values down between 25 percent and 45 percent and many borrowers unable to either make payments, refinance or repay their debts, many first-loss B-piece buyers have been wiped out. It is now the German bank which finds itself in a controlling position working with the special servicer. That situation has come as a bit of a shock to many.

And that is where the inherent problem lies for potential investors in existing CMBS deals. The special servicer's job is to achieve maximum value recovery for all parties for the particular loan in default. By assessing valuations, opportunities for adding value to an asset and the need for additional equity, a special servicer will determine whether a loan should be extended, modified or a property taken back. They work closely with the controlling classes, the tranche that is most at risk, however the number of voices at the table can be overwhelming, professionals concede, not least because all have different motivations.
Senior creditors may be calling for foreclosure in order to get paid back today, while junior creditors who didn't realise their principal was at risk are keen to hang on. And even among the senior and junior tranches there are differences of opinion. "A special servicer may find he's talking to three AA-buyers," Ryan Krauch, of Los Angeles debt platform Mesa West Capital, says. "Two of those interests may have bought at par, but what happens when one bought at a discount. Does he have the same incentive as the others?"

Krauch continues: "It's not as simple as buying debt at deep discounts and going along for the ride. It really is tranche warfare out there." The Extended Stay case is a perfect example of this new battlefield. According to the Wall Street Journal, Five Mile Capital, which owns $77 million of a junior piece of Extended Stay CMBS bonds, argued in a New York lawsuit that the deal struck by Extended Stay's owner, the Lightstone Group, and creditors, such as Cerberus and Centerbridge, awarded senior bondholders "a higher rate of return" at the expense of other further down the capital stack. The CMBS loan agreement "makes clear that no individual may take any action ... in an effort to improve its position vis-ŕ-vis the positions" of other bondholders, the suit said.

David Schonbraun of SL Green's special servicing arm, Green Loan Services, says: "At the end of the day your job as a special servicer is about maximum recovery. You have to have an open and honest discussion with everyone and in some cases you'll have to agree to disagree, but as long as they understand why, that's the important part. It's a balancing act."

In the course of this "tranche warfare", it has also been suggested that some special servicers may have their own "agenda", with a few holding B-pieces in the CMBS deals they service. During the market peak, the practice was thought to align interests if the special servicer also had some skin in the game. Today, some creditors are wondering instead if it isn't a material conflict of interest. Neither Green Loan nor Situs hold B-pieces, but both Schonbraun and Nelson say there has to be just one overriding concern for special servicers: recovery of value. "That's your job, you have to provide value to the transaction," Nelson adds.

One reality that cannot be avoided by any party involved in a CMBS deal is that, with delinquencies at historic highs, special servicers are already overwhelmed. If defaults double, as projected, over the next 12 months, special servicers will face unprecedented workloads. "Everyone is trying to hire more people but there is limited real estate workout experience out there. Remember the last big market event occurred in the early 1990s," Nelson says.

"As if you owned it"

Critics have voiced concerns that as a result of this workload, special servicers are keen to extend existing CMBS loans at maturity, rather than foreclose on an asset, particularly if it is still performing. A second quarter report by Deutsche Bank's head of CMBS research Richard Parkus showed that of the 40 percent of loans that were outstanding at their maturity at the end of March this year, 25 percent were still due three months later. For loans due for repayment at the end of December 2008, 27 percent were outstanding at their maturity date, with 8 percent still outstanding six months later.

"If you have an asset that is fully leased and the sponsor is willing to put money in, it may not be to your advantage to go through the foreclosure process," Schonbraun says. "The sponsor may just need time to work out his debt situation." Extensions of six to 12 months are being openly talked about by industry participants, but Schonbraun adds: "If there is a lot of vacancy, the sponsor isn't the right person and interests are not aligned you take the property back. As a special servicer, you have to underwrite it as if you owned it."

For opportunistic fund managers though, extensions provide borrowers with, what Sam Zell on p. 22 calls, a "hope certificate" that valuations - and equity - might recover in the near future. And without pressure from creditors to sell, the anticipated volume of distressed opportunities simply hasn't emerged. "A lot of the industry is frustrated," says Fried. "They have spent the past year-plus looking for opportunities and they're not finding them. I don't think we are going to see a significant change in that situation in the near term."

Krauch offers a slightly more optimistic viewpoint: "Legacy CMBS deals are going to take a long, long time to sort through, but out of all the mess and chaos comes opportunity. Is there a clear path as to how the opportunities will play out? Not exactly, but you know it ultimately has to because the value destruction is massive and the workout is unavoidable."