Faced with the prospect of refinancing nearly $1.8 trillion of existing U.S. commercial real estate debt in the next five years, real estate investors—borrowers as well as lenders—continue to doubt whether sufficient capital will be available for the commercial real estate finance market to avoid a future catastrophic shortfall in the financing of commercial property. Notwithstanding the anemic and halting recovery of the capital markets for commercial property finance over the last several months, there continues to be a high degree of concern whether the commercial mortgage-backed securities (CMBS) market in its current restaged form (referred to as CMBS 2.0 in this article) can eventually restart with sufficient volume to fuel the recovery in the real estate markets. Some have held the view that the “retention of risk” by the originators/issuers of CMBS 2.0 will help restore confidence in the CMBS market and dramatically increase its volume—just because they believe that the lack of such “risk retention” running up to the crisis was at the heart of the collapse in the market.
Indeed, legislators and regulators prematurely focused the blame for the crisis on the failure of the securitized lenders to retain any risk in the loans originated for securitization, in addition to the rating agencies for abrogating their role of policing the market. The Federal Reserve Board’s published report on securitization reforms (the Fed Report) concluded that “simple credit risk retention rules, applied uniformly across assets of all types, are unlikely [italics added] to achieve the stated objective of the [Dodd-Frank] Act—namely, to improve the asset-backed securitization process and protect investors from losses associated with poorly underwritten loans.” Bd. of Governors of the Fed. Reserve Sys., Report to the Congress on Risk Retention (2010), available at http://federalrserve.gov/boarddocs/rptcongress/securitization/riskretention.pdf (Report to Congress on Risk Retention). This conclusion is correct. What follows is a brief overview of what went wrong in the market and what is the most effective form of risk retention appropriate to the commercial real estate market.
Too much capital, persistent historically low interest rates, excessive leverage, unsustainable property values, and ever-declining capitalization rates have led to booming real estate markets in the past. In this respect the most recent collapse of securitized lending was not an exception. Yet the trouble was not, and still is not, with securitization itself, but rather with the incredible misperception and mispricing of risk by originators, issuers, and investors. It is as though they collectively thought that somehow the securitization process had taken all of the risk out of real estate financing (or at least made it someone else’s problem). Clearly, this was a very erroneous conclusion.
From the inception of the CMBS market until two years before the crisis began, the most cognizant assessor of risk was the purchaser of the lowest tranche (or class) of CMBS certificates—the “first-loss position” (the B-piece buyer)—that paid cash and conducted its own due diligence on the structure and the collateral, knowing it would retain the risk. Such a purchaser cannot afford to ignore the risk inherent in its purchase of CMBS. But in those last two years, the B-piece buyer was not assessing the risk for the entire term of the loan; it assessed only the initial risk—almost at the point of origination—because the credo became “make it and sell it.” The pressure to compete with other lenders—by offering lower rates and making more proceeds available—simply overwhelmed the process. Achieving volume was emphasized over properly assessing and pricing the risk. Although intermediaries always exported risk by parceling it to various end users with different risk appetites, at this point the ultimate purchaser of the risk (the B-piece buyer) did not understand or appreciate the risk because the credit rating agencies failed to properly identify and consider in their ratings the risk of new structured finance vehicles, such as risks posed by the use of collateralized debt obligations (CDOs) to package credit risk assets. The issuers of these securitized debt instruments viewed themselves as exporting risk—it was someone else’s risk after it was securitized—but that someone else did not quite appreciate the risk being undertaken. As we have seen, however, it does not always work out quite like that. Failed assets have a way of migrating back to an issuer’s balance sheet if the assets are held by the issuer’s subsidiary (for example, a structured investment vehicle created by the issuer) or if there is a default in the financing of an asset sale. Thus were the seeds of the current turmoil planted over the last few years before the current crisis.
From Storage to Moving
When a lender sells a loan asset, it does so to remove the asset from its balance sheet, thereby freeing up capital and allowing the institution to make a new loan as well as collect a new fee. Real estate lending went from being a portfolio business to a fee business—from a storage business to a moving business. By providing the financing to its purchaser when it sells a loan asset, the seller is removing the asset from its balance sheet as owner, but it is clearly re-acquiring the risk of the newly-pledged asset as lender. The prospect of being able to remove assets from the seller’s portfolio (or its continuing pipeline) without retaining the risk of the assets on its balance sheet (despite the financing exposure) was a very appealing structure for asset sellers.
As the securitized market grew exponentially on the back of the strong and steady increase in leverage at all levels of the real estate capital stack, competition for loan products heightened because of relatively stable markets, the availability of too much capital, and the entrance of new players, many without any tradition of principal investment. Loan underwriters began to ignore the looming refinance risk created by the maturity dates of balloon loans and relied instead on pro-formas that showed ever-rising rents. As the process further commoditized, investors looking to improve their returns began to employ even more leverage in the acquisition of these assets. The investors’ desire to increase their returns in this way required them to stray out of their traditional comfort zones and down the credit stack. Cash buyers became, or were replaced by, more highly leveraged buyers.
Wall Street, in an attempt to increase its return or to avoid retaining any risk whatsoever, now adapted new CDO structures already used in other markets to the commercial real estate finance market. In stark contrast to the traditional short-term warehouse or “repo” financing of financial assets, the CDO offered a long-term fixed rate, without the risk of mark-to-market requirements or margin calls. The availability of CDO financing led to a further explosion of junior loan products. United States tax law limitations prevented these subordinate B notes (junior notes in a single mortgage loan), mezzanine debt, and loan participations from being disposed of in traditional ways, but the CDO structure gave lenders a way of depositing these junior loan assets into a trust sold to investors. The mortgage loan origination community was more than willing to accommodate the ever-increasing appetite of capital market investors for subordinate debt products by increasing loan production. These lenders were able to serially remove from their books their financed junior debt inventory—inventory that would otherwise have been retained in the lenders’ portfolios—which they deposited in CDOs. Thus, the lending volume of B notes and mezzanine debt grew significantly, supported by the growth of the commercial real estate CDO market, allowing the issuance of CMBS to reach record levels. The commercial finance markets began to build financial capital stacks that overleveraged real property rather than creating physical buildings.
CDOs—The Tipping Point
The critical development that had the worst consequence for the CMBS markets, however, was the ability of B-piece buyers to use CDOs or re-securitizations to sell their positions. This ability to finance out of risky loan positions encouraged more than a dozen new highly leveraged finance entities—entities that did not have the traditional loan-to-own discipline of the original five or six cash B-piece buyers—to enter the CDO or re-securitization market. With this development the synthetic asset market began to grow and to distort the discipline of the cash market.
Many, including federal regulators and the Federal Reserve, assumed that the subprime loan meltdown (as the media coined it) would be a self-contained event of risky overleveraged residential loans to uncreditworthy individuals. But the interdependence of the global capital markets and the teetering of major financial institutions led to investors viewing all structured finance securities, including CMBS, as a single bad asset class to be avoided at all costs. This was the definitive step in the perfect storm that developed from the confluence of a series of seemingly unrelated and disparate events.
As this continued, market turbulence disrupted pending securitizations and caused buyers of certain types of bonds to leave the market completely; it became almost impossible (or at least extremely risky) to attempt to value an asset or to price a risk. Fearing all real estate collateral, investors initially demanded higher yields but then withdrew entirely from the market, being unable to assess the risk.
Looking for culprits, investors and the media began to focus on the national credit rating agencies, accusing them of becoming “toll takers” instead of “gatekeepers” for the marketplace. But the new buyers were more to blame. Many investment grade investors had relied almost entirely on letter ratings, deal sponsorships, and the ever more attractive pricing. They almost never read the offering disclosure documents or, if they did, they did not fully understand and appreciate the nature of the risk being described; neither did the new leveraged B-piece buyers that purchased to resell the asset in a new financial instrument, retaining risk only as an investment. Unlike the pre-crisis buyers that entered the market in 2005, traditional B-piece buyers understood their role as the most junior noninvestment grade investors and conducted their own due diligence and re-underwriting to assure themselves of the prudence of their investments in the risky first-loss position of a CMBS trust. They required and obtained full access to information about the borrower, the property, the leases and cash flow, the loan, all third-party and originator reports on borrower and guarantor credit and the collateral, as well as the lender’s underwriting. Because they understood the inherent risk of their most subordinate investor position in the CMBS trust, the due diligence and re-underwriting that they undertook was far greater than that undertaken by most primary mortgage market lenders—securitized or portfolio—and more similar to the comprehensive credit and collateral diligence of a junior mortgagee. This is horizontal risk retention; that is, the first loss is to the most subordinate class in the CMBS capital stack, and is held by the B-piece buyer.
B-Piece Buyers— The Real Gatekeepers
Thus, it was not the credit rating agencies that rated the deals but rather the original cash B-piece buyers that were the market’s “true” gatekeepers. As a condition to their purchase of the first-loss tranche they, and not the credit rating agencies, regularly and routinely questioned and demanded documents, information, and updates and even rejected loans that were deemed substandard to prevent their being deposited in the fixed rate CMBS trust. The credit support or enhancement provided to the CMBS trust and its senior certificate holders by these buyers of the first-loss position was not only that the buyers provided a subordination cushion but also, and more importantly, the comfort that the B-piece buyer had focused its expertise and experience on understanding and managing the credit risk associated with each asset in the CMBS trust.
In early 2010 the Congressional Oversight Panel predicted $200–$300 billion in commercial real estate loan losses for banks alone for 2011 and thereafter. Congressional Oversight Panel, February Oversight Report: Commercial Real Estate Losses and the Risk to Financial Stability 2 (2010), available at http://cybercemetery.unt.edu/archive/cop/20110402035627/http://cop.senate.gov/documents/copy-021110-report.pdf. Moreover, regional and local banks—which provided substantially more capital to the commercial real estate markets than insurance companies or CMBS lenders—were seen as significantly overexposed to commercial real estate as an asset class, their investment being multiples of their capital. These bank lenders are a cause for serious concern for federal banking regulators notwithstanding their retention of 100% of the credit risk in their portfolios. It is a clear, cautionary tale about the illusory value of credit risk retention by loan originators or subsequent whole loan purchasers.
Clearly, the benefit of the horizontal credit risk retention by the B-piece buyer is precisely that it is not the originator (or subsequent whole loan purchaser for securitization) of the mortgage loan. The originator has its own competing motives of compensation, lender competition, borrower relationships, property envy, industry league table standings, achieving issuance size, and PR/marketing opportunities, that is, “bragging rights.” These factors delay, color, and even sometimes interfere with an originator’s clear assessment of the credit risk of a mortgage loan. What is necessary is a truly independent second review of each loan by a real estate specialist—not by the credit rating agencies. If CMBS 2.0 is to restart successfully, we cannot revert to the post-2005 leveraged B-piece buyers that collected fees and quickly exported their first-loss position risk to a CDO.
As discussed below, regulators have proposed new rules to implement the Federal Reserve’s recommendation of different retention requirements for various types of securitized assets that recognize differences in market practices and conventions. Credit Risk Retention, 76 Fed. Reg. 24,090 (proposed Apr. 29, 2011). The comment period for the proposed credit risk retention rules was initially set to expire June 10, 2011. On June 7, 2011, because of the complexity of the rule and the overwhelming response from industry participants, the Securities and Exchange Commission together with the federal banking regulators and housing agencies published a notice extending the initial comment period from June 10, 2011, to August 1, 2011. It is unclear, however, when the final rules relating to credit risk retention will be adopted, especially in light of recent regulatory developments and the upcoming presidential election. The debate over the efficacy of different forms of credit risk retention will continue.
Section 15G of the Securities Exchange Act, newly enacted under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, requires that the Federal Deposit Insurance Corporation, the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission (together with Federal Housing Finance Agency and the Department of Housing and Urban Development for residential mortgages) promulgate joint regulations governing the risk retention requirements for the securitization of different asset classes. Pub. L. No. 111-203, 124 Stat. 1376 (2010) (Dodd-Frank Act), codified as amended at 15 U.S.C. § 78o-11.
On March 29, 2011, nearly 400 pages of proposed regulations were issued as the regulators’ proposed risk retention rule for all asset classes, generally requiring that securitization sponsors retain a 5% unhedged economic interest in a portion of the assets pooled in a securitization for sale to third parties (Regulation 15G). Credit Risk Retention, 76 Fed. Reg. 24,090 (proposed Apr. 29, 2011). Following the Federal Reserve’s recommendation to adopt different retention requirements for the various types of securitized assets that recognize the “differences in market practices and conventions,” the regulators have proposed new rules with limited specific exemptions from risk retention for certain loans qualifying under regulator-promulgated conservative underwriting standards for the different asset classes. Report to Congress on Risk Retention, at 3. In addition, a sponsor is permitted to share its required risk retention with the originator of an asset (but not with subsequent purchasers from the asset originator). Under the regulation, however, any type of retention that the sponsor is permitted to allocate to another (including a CMBS B-piece buyer) requires the sponsor to monitor the other party’s compliance with the regulations and to notify its investors of any noncompliance. There are several variations of risk retention for other asset classes: eligible horizontal slices of pool assets, pro rata vertical slices of all classes, combined horizontal and vertical (“L”) slices, cash reserve accounts, as well as other alternatives not significant to CMBS. Although the general provisions are applicable to all asset securitizations, specific provisions are applicable to commercial mortgage loans. Credit Risk Retention, 76 Fed. Reg. 24,090, 24,109 (proposed Apr. 29, 2011).
Dodd-Frank requires that a sponsor (that is, the issuer) retain a risk of 5% on all transactions, but for CMBS only this retained interest percentage can be reduced by commensurate risk retention by the originator or qualifying B-piece buyers; and the regulators’ determination that (1) the commercial mortgage underwriting standards and controls are adequate, (2) adequate representations and warranties concerning the commercial mortgages being sold are made to CMBS investors, and (3) the representation and warranty breach enforcement provisions are adequate to protect investors in a loan put-back. Dodd-Frank Act, § 941(b).
The new regulation recognizes that B-piece buyers have been central to fixed-rate CMBS and permits them to continue to serve as a risk retention alternative, yet it has imposed several new conditions for a third-party purchaser to be counted as qualifying risk retention for purposes of Dodd-Frank.
Available only in CMBS transactions, the third-party purchaser must
- purchase a subordinated horizontal interest in the securitization in the same form, amount, and manner as a sponsor, that is, it must be the first-loss position with same limits as a sponsor;
- purchase the interest at closing for cash without financing, directly or indirectly, from any party to the securitization (other than another investor);
- conduct significant due diligence on the credit, collateral, and cash flow of, and underwriting for, all of the individual assets of the pool in the context of the whole pool before, not after, issuance of CMBS;
- have its investment experience and the other material information disclosed by the sponsor together with the B-piece purchase price and percentage of the pool acquired;
- comply with all limitations on the sponsor that prohibit hedging (except in limited circumstances), transfer, or pledging of the asset; and
- not be affiliated with any other party to the securitization (other than another investor), or have any control rights not shared with the other investors.
Credit Risk Retention, 76 Fed. Reg. 24,090, 24,109 (proposed Apr. 29, 2011).
Although the last condition would prevent a B-piece buyer from being, or having its affiliate appointed, the special servicer, it would be permitted to do so if the CMBS documents provided for appointment of an operating advisor who was to be consulted on major servicing decisions (material modifications, waivers, foreclosures, or REO). The operating advisor would also monitor, report, and be able to recommend removal and replacement of the special servicer (subject to a majority of investors deciding to retain the special servicer).
The conditions for qualifying as a B-piece buyer for risk retention were clearly aimed at the recent abuses of the leveraged B-piece buyers immediately before the credit crisis. They will now have to pay cash, do due diligence, and hold their investment for the term of the CMBS. A B-piece buyer will not be permitted to export the credit risk into a financial arrangement like a CDO or otherwise reallocate its credit risk to another.
Although there is also a risk retention exemption for pools of loans made in accordance with the regulators’ promulgated commercial mortgage underwriting criteria, the 33 enumerated prescriptive underwriting standards of this so-called qualified loan exemption should assure that few (the most conservative) loans will qualify a CMBS pool for a risk retention exemption (historically less than 1% of CMBS loans outstanding). Id. This exemption, however, would require a buyback obligation by the sponsor.
Several other risk retention structures have been proposed by the regulations, such as the sponsor’s retaining a representative sample of the pool assets that also includes a sponsor obligation to buy back loans not conforming to the sample.
Unfortunately, Regulation 15G fails to provide guidance for dealing with single loan securitizations or short-term floating rate CMBS. It does, however, impose new obstacles such as the Premium Capture Cash Reserve Account (PCCRA). Credit Risk Retention, 76 Fed. Reg. 24,090, 24,151 (proposed Apr. 29, 2011). As proposed, the PCCRA would require that CMBS structures direct excess cash flow from collateral into an account as a first loss reserve that would eliminate the issuance of interest on CMBS certificates. Believing that the PCCRA is “well beyond Congressional intent,” a bipartisan group of 12 U.S. senators has written a letter to the federal regulators that concludes:
The PCCRA, which was not envisioned by Congress, would require securitizers to set aside the premium from the sale of securities in [a] separate acccount for the life of the security. This account would occupy the first loss position and would be in addition to the 5% risk retention requirement. The end result would be that securitizers could not recognize compensation until the security matures many years later and would be forced to bear all downside risk associated with interest rate exposure while waiting years to recognize any potential profit from the risk.
Letter from 12 U.S. Senators to Six Federal Regulators (June 19, 2012)(on file with author). Thus, rather than promoting the flow of credit the PCCRA will effectively eliminate the financial incentives for securitization and could seriously disrupt the recovery of the CMBS market.
SEC Regulation Under the Dodd-Frank Act
In January 2011, the Securities and Exchange Commission (SEC) adopted several new rules and amendments to existing rules, intending to enhance transparency “relating to the use of representations and warranties . . . and an investor’s ability to consider historical information when making an investment decision.” Issuer Review of Assets in Offerings of Asset-Backed Securities, 76 Fed. Reg. 4231 (Jan. 25, 2011) (Issuer Review Rule) and Disclosure for Asset-Backed Securities Required by Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 76 Fed. Reg. 4489, 4510 (Jan. 26, 2011) (Asset-Backed Disclosure Rule). Although not technically risk retention requirements, they strengthen the pending credit risk retention rules and establish a new regulatory framework that seeks to level the playing field for both investors and issuers.
Three of the SEC’s rules are of particular interest, as their changes involve better disclosure requirements and improved enforcement of representations and warranties. These rules seek to enhance transparency and heighten the incentive for deal participants to pay close attention to the individual assets in the underlying transaction and the enforcement mechanisms and remedies in place. Under Rule 15Ga-1, a securitization sponsor is required to periodically disclose in sufficient detail the existence, current status, and final disposition of demands for repurchase due to breaches of representations and warranties related to loans deposited in its securitization; and to file such disclosure reports (looking back three years) with the SEC quarterly. Asset-Backed Disclosure Rule, 76 Fed. Reg. 4489, 4499. Similarly, Rule 17g-7 requires credit rating agencies to prepare and deliver to investors on the issuance of any credit rating (including expected or preliminary ratings) a report comparing the representations and warranties and related breach enforcement mechanisms provided for the new securitization with “historical benchmarks” for the related asset class. Asset-Backed Disclosure Rule, 76 Fed. Reg. 4489, 4504. In addition, sponsors must review the underlying assets, highlight when deposited loans differ from the published underwriting criteria, and provide information about the loan exceptions. Issuer Review Rule, 76 Fed. Reg. 4231, 4237, 4238.
As originators, intermediate loan sellers, depositors, and issuers are typically required to make representations and warranties relating to the deposited loans for the benefit of the CMBS trust, these SEC rules are clearly intended to prevent poor underwriting from being conducted by originators and condoned by securitizers, and substandard loans from being made and deposited into securitized CMBS pools.
Pre-CMBS Loan Sales
In the early 1990s, when traditional lenders initially approached the commercial secondary mortgage market to sell their commercial mortgage loans, they were often unpleasantly surprised by the additional obligations and requirements that the typical capital markets investors imposed in any transaction. For example, it was a well-established secondary market requirement that the mortgage loan seller provide the purchaser with (and pass through to the ultimate investor in the mortgage loan) certain representations and warranties for the mortgage loan.
Before the advent of mortgage securization, a loan seller would ordinarily transfer the mortgage loan to a purchaser “without recourse, representation or warranty.” A pre-CMBS purchaser, however, would ordinarily conduct its own due diligence for the mortgage loan and would condition its obligation to purchase on its satisfactory re-underwriting of the credit and collateral for the mortgage loan. Thus, a purchaser would investigate and rely on its own independent risk assessment of the borrower and property for each individual mortgage loan purchase.
Advent of Secondary Market
As the residential secondary mortgage market developed, purchasers quickly determined that the due diligence traditionally conducted for the acquisition of individual mortgage loans was neither cost-effective nor efficient for bulk loan pool sales. Soon Wall Street investors began to develop their own methodology for selective due diligence sampling of mortgage loans when purchasing a large portfolio. Each investment house crafted its own “proprietary” program for due diligence sampling of mortgage loans. Yet the limited due diligence undertaken by purchasers in the secondary mortgage market did not satisfy the needs of capital market investors or credit rating agencies. Obviously, this limited investigation did not provide the capital markets purchaser with sufficient information to properly conduct its full risk analysis of the credit and collateral risk for the mortgage loans in a securitization pool. Similarly, the credit rating agencies were unable to evaluate a mortgage loan pool for eventual rating purposes based on this information. To accommodate investors (as well as the credit rating agencies) in the bulk sale of mortgage loans in large pools, the practice of requiring detailed representations and warranties from a mortgage loan seller developed quickly as the secondary market expanded. As a substitute for their own due diligence of the mortgage loans in a pool, capital market investors began to rely heavily on very detailed seller representations and warranties for the disclosure of basic mortgage loan information needed for their investment decisions.
Purpose of Representations and Warranties
To assure that the lender fully appreciates the reliance that capital market investors place on representations and warranties as an initial disclosure device and, in the case of investment grade investors, as a substitute for due diligence (which below investment grade investors are permitted to undertake), capital markets require that the mortgage loan seller also contractually bind itself to either cure or repurchase (or indemnify the investor for) any mortgage loan that is the subject of a breach of the representations and warranties. This requirement is an added incentive for the seller to fully investigate and carefully review the mortgage loans in its pool in conjunction with the information it discloses in its representations and warranties. In theory, a seller continuing to bear the risk of loss for its misrepresentations or nondisclosure should discourage the seller from including mortgage loans that do not conform to their representations and warranties or should encourage full disclosure of such exceptions.
To be a truly reliable and effective remedy for the capital markets investor, however, the cure or repurchase obligation should be provided by a seller that is financially capable of curing the breach or repurchasing the mortgage loan. Otherwise, any perceived market value that the seller’s cure or repurchase obligation added to the transaction would be illusory. If the seller of the mortgage loans is not a financially responsible party, there is no market incentive for the seller to disclose accurately or to exclude nonconforming mortgage loans. Representations and warranties are integral to commercial secondary mortgage market transactions although credit rating agencies (and investors) do not consider them to be a credit enhancement or support for a transaction—they are considered more of a disclosure device.
In the capital markets, while the mortgage loans are assigned without recourse of record, the typical mortgage purchase and sale agreement contains seller representations and warranties that constitute a contractual derogation of the “nonrecourse” endorsement and assignment of the mortgage loan transferred under the agreement. The typical mortgage loan and purchase and sale agreement contains substantially the following provision:
The representations and warranties set forth in [the Agreement] shall survive the sale of the Mortgage loans to Purchaser and shall inure to the benefit of Purchaser and its successors and assigns, notwithstanding any restrictive or qualified endorsement on any Mortgage Note or Assignment of Mortgage or Purchaser’s examination of any Mortgage File.
Evolving almost as a due diligence substitute, the original representations and warranties developed in the residential secondary mortgage market were (aside from covering some basic seller issues) a broad-based sweep of the legal, economic, and physical characteristics of the mortgage loans and mortgaged properties that a purchaser would (or should) discover during a full due diligence review of the mortgage loan files, payment records, and servicing files of the seller, a site inspection of the property, and a title search update. But the average capital markets investor (albeit wrongly) had viewed residential mortgage loans in pools as homogenous and in some ways similar to corporate bonds. To compensate for the vast array of differences, the capital markets developed representations and warranties for commercial mortgage loans that were more extensive than, as well as different from, the market representations and warranties for residential mortgage loans.
Core Representations and Warranties
Although several of the credit rating agencies have from time to time published criteria for representations and warranties for commercial mortgage loan transactions, the representations and warranties current in the CMBS market are neither static nor fixed. They can vary with the seller, the mortgage loans, the properties, the transaction, and, at times, the risk appetite of the purchaser. Yet a core set of representations and warranties can be discerned from most transactions and can be categorized into three distinct types: basic, mortgage loan, and collateral. The basic representations and warranties encompass such fundamental issues as the seller’s authority and mortgage loan ownership, the pool’s compliance with law in mortgage loan origination and servicing, and the fact that the pool contains only whole mortgage loans and not participations. The mortgage loan representations and warranties address economic issues such as the payment terms, history, and delinquency; lien priority; the existence of waivers, modifications, releases, extensions, counterclaims, or setoffs; obligations for future advances or liability for reserves, holdbacks, and escrows; the maturity date; and whether the mortgage loans are cross-defaulted or cross-collateralized or contain collateral outside the pool. Finally, the collateral representations and warranties cover physical condition, title, and other legal issues surrounding the encumbered properties, such as real estate tax status; physical damage and condemnation; encroachments and other title issues, environmental condition and compliance, building, zoning, and other legal use or occupancy compliance; mortgage loan title insurance coverage; and the status of any ground lease.
The nature, type, and scope of the representations and warranties provided by the commercial loan seller should probably affect the pricing of the transaction with the investors as well as the rating levels accorded by the credit rating agencies. Credit rating agencies like to see the representations and warranties conform to their published criteria. Nonetheless, capital markets investors are often willing to negotiate the scope and substance of deal-specific representations and warranties. For example, sellers request that the many representations and warranties be made “to the best of their knowledge,” which is a qualification that both credit rating agencies and investors do not like. A loan purchaser must be certain, however, that accepting lesser representations and warranties from a seller will not result in the purchaser’s incurring sandwich liability if it must make greater representations and warranties to the credit rating agency. Sellers also frequently request that their representations and warranties survive only for a short period and not for the life of the transaction. Again, certain investors may agree to shorten the survival of the seller’s representations and warranties, although the credit rating agencies are prone to require a life-of-transaction term for all representations and warranties.
In either case, the investor must be satisfied that it has conducted sufficient due diligence to fully investigate the mortgage loan characteristics of the pool that would traditionally be encompassed within the representations and warranties current in the marketplace. Although some agree to permit a shortened survival term for representations and warranties, transactions often extend beyond the applicable limitations period, and breaches are often discovered during a foreclosure or workout of the mortgage loan much later in the term.
The credit rating agencies do acknowledge that with appropriate due diligence and investigation of the mortgage loan pool, some limited modification of the representations and warranties is acceptable. Transactions are often rated and sold in the capital markets with much less extensive representations and warranties than those the credit agencies’ published criteria require for a rating.
As CMBS is structured, investors can ultimately look to the representations and warranties made by the loan originators, any intermediate loan sellers, the depositor, and the issuer, which are passed through to the CMBS certificate purchasers.
Industry Response to Dodd-Frank
Before the extended August 1, 2011, comment period for Regulation 15G expired, many real estate finance and securitization industry trade associations and individual institutions and other market participants provided extensive comments as well as alternative recommendations for aligning interests in risk retention among CMBS participants. Recognizing the critical significance of “who” writes the rules in any effort at market reform, the Commercial Real Estate Finance Council (CREFC) provided federal regulators with much more than just comments. CREFC early seized the opportunity afforded by its reputation as a recognized industry standard setter to develop industry best practices and standards in direct response to the earlier proposed SEC Regulation regarding risk retention. Building on existing standards that it has developed over the last 18 years for the CMBS industry, such as its Investor Reporting Package™ (which is well regarded by investors and regulators alike), and to assure that the views of issuers, originators, investment and non-investment grade investors, servicers, and other market participants were taken into account, CREFC organized industry participants to produce and adopt a number of new industry standards. CREFC submitted these standards to the federal regulators in response to their regulatory initiatives. Among other best practices, it published and submitted to federal regulators a principles-based underwriting framework with an annex with disclosures concerning assets underlying a securitization, model industry representations and warranties, and a new mandatory, nonbinding mediation process for related loan sale breaches. A well-respected senior investor recently commented on the CREFC effort:
The Model Representations provide a clear benchmark for comparison, and the need to blackline to the Model Representations is a disclosure best practice that makes any variations from the Model Representations easy for investors to evaluate. Use of the [M]odel Representations as a reporting template is a disclosure best practice that helps investors understand what underwriting and documentation practices were applied, and what was found in the underwriting process. This provides investors with a key tool necessary if they are to police the quality and completeness of underwriting procedures, and do their part in funding good origination practices while defunding bad practices that generate risks that can damage market sustainability.
The State of Securitization Markets Hearing before the Subcommittee on Securities, Insurance, and Investment of the Committee on Banking, Housing, and Urban Affairs, United States Senate, 112th Cong. (May 18, 2011) (responses to written questions of Chairman Reed from Lisa Pendergrast, CREFC President).
To jump-start CMBS 2.0, the “skin in the game” conundrum must be resolved to the ultimate satisfaction of investors—investment grade and non-investment grade—and not just the regulators. Without investors there is no market regardless of the regulatory scheme put in place. The recovery of CMBS will best be protected from poor underwriting being conducted and condoned, and from substandard loans being made and deposited, if (1) adequate representations and warranties encompassing factual assertions about “loan attributes, underlying property characteristics and lender due diligence” are made by the originator of the loan when the loan is first sold and deposited in the securitization trust and by the issuer at the issuance of interests in that trust; and (2) the first-loss position is purchased in an arm’s length negotiation by an independent third party for cash. Although a powerful reporting template for investors in their decision making—allowing investors to actively police their investments rather than relying on third-party representations and warranties—the representations and warranties made by the originator, issuer, or subsequent seller are only as effective as the strength of the par buyback enforcement process for material breaches. Further, the B-piece buyer must have adequate financial resources to back losses and conduct significant credit and collateral due diligence of all of the individual assets in the pool in the context of the whole pool before, not after, issuance.
Thus, although a loan may be sold to a third party, the risk of its underwriting and origination must be retained by its originator or issuer, or both of them, and not reallocated to another. Although it can finance a proportion of its purchase with an “at-risk” loan (from other than the originator or issuer’s sponsor), the third-party investor must retain its first-loss position and not export the credit risk into a financial arrangement like a CDO or otherwise reallocate its credit risk to another.
Rather than rely on an originator and securitizer solely interested in selling loans or CMBS certificates without effective accountability, CMBS investors will have more confidence in the securitization process if they are better able to rely on (1) representations and warranties and disclosed exceptions if a breach of those representations and warranties carries an enforceable par repurchase indemnification by the originator/seller or the issuer and (2) the purchaser of a first-loss risk in a specific pool that analyzes and evaluates each individual loan to be deposited. These representations and warranties and this loan-by-loan analysis of the overall pool risk provide a more reliable assessment of credit risk for the certificate holders than can be provided by the originator or depositor, who assembled the pool based not on overall risk but rather by individual loans with competing motives.
Accountability of the originator and issuer is crucial to the securitization process, but CMBS investors also have serious concerns in the alignment of interest of participants in a securitization. In letters to, and meetings with, the SEC, CMBS investors have expressed specific concerns with the CMBS process in spite of the federal regulators’ proposals. Investors want a full description of the financial strength of the originator, issuer, or loan seller that provides the representations and warranties; the delivery by the issuer of a blackline or other comparison of loan seller’s representations, warranties, breach remedies, and exceptions against the CREFC model rather than the issuer’s (historic) model and a loan-by-loan representation exception report identifying loans that do not conform to representations; the adoption of the proposed CREFC Disputes Resolution and Remedies procedures in all Pooling and Servicing Agreements (PSAs); the delivery of a copy of the PSAs to all investors; and the SEC’s support of “loan resolution fee rate parity” (that is, compensation) for servicers in the PSAs for successful breach claims. Many PSAs do not compensate servicers for put-back activities, which clearly acts as a disincentive for their undertaking the often costly process. Consistent with their continuing concern with special servicers and B-piece buyers not being aligned in interest with the CMBS investors, senior CMBS investors have been strong proponents of operating advisors in CMBS deals. For situations in which the B-piece buyer and the special servicer are the same party or affiliates, they support Regulation 15G’s adoption of operating advisors to oversee the special servicer and possibly remove a special servicer for breach of an applicable contractual Servicing Standard. Although CREFC supports the appointment of operating advisors, it is concerned with the overbroad reasons for removal of the special servicer absent an investor veto of removal. CREFC believes a special servicer should be removed solely for willful misconduct, bad faith, or negligence. Senior CMBS investors believe the proposed required investor quorum and threshold vote to remove a special servicer is too high to be an effective policing mechanism for senior investors.
The restaging of the CMBS market as CMBS 2.0 has to be accomplished with a new generation of structures, not a fancy repackaging of the same old structures. First, structures need to be more transparent and not overly complex for investors. New originators need to understand their mistakes and the problems facing servicers as well as investors from the “old” origination environment. Second, CMBS cannot be, or even be perceived as, a moving business, and although not a “storage” business, there must be real “skin in the game” to foster the confidence of investors in the “new” origination process. Ultimately, bridging the current gap between originators/issuers and investors will best be accomplished by requiring (1) adequate representations and warranties by originators and issuers, (2) full disclosure of loan underwriting and documentary exceptions, (3) a blackline or other comparison of the particular securitization representations and warranties against an SEC-approved industry template, and (4) an enforceable breach repurchase protocol that will foster investor confidence. In addition, the new CMBS requires the return of B-piece buyers to their original role as the gatekeepers, self-charged with maintaining discipline in the CMBS market. Thus, if a substandard loan somehow is deposited with adequate representations and warranties, a diligent B-piece buyer can re-underwrite the loan and, if it is found unacceptable, “kick” the loan out of the pool, but if the “kick-out” fails to occur, the breach can be used to compel a par repurchase of such loan. Only the continuity of this process can provide investors with the degree of predictability and stability that they seek when they can once more rely with some degree of confidence on truly enforceable representations and warranties and redundant loan-by-loan review by an “at risk” first-loss holder with the right to putback a loan for a representation breach.
What is not yet fully appreciated or understood by market participants are the potential enforcement consequences for originators and issuers of the SEC Regulation’s requirements for representation and warranty comparison against an historical or established benchmark (SEC or industry), as well as disclosures in mandated originator/issuer quarterly reports of loan putback requests for all securitized assets, including details of whether the request has been resolved and, if not, why not. The credit rating agencies are required to consider these disclosures in their ratings, which investors may use in their loan-breach put-back litigation, and which the SEC may use for its own yet unknown purposes.
But what will the federal regulators finally decide constitutes adequate risk retention for CMBS? Will it be a multi-faceted approach? Will investment grade and non-investment grade investors be satisfied with the federal regulator’s Final Rule, or will they lobby for more market-driven protections and better pricing of risk to assuage their continuing concerns? Only one thing is certain in this reform process: whatever the final regulations provide will not be the final chapter in the recovery and eventual resurgence of the CMBS market.