REAL ESTATE LAW
Disruption in the Capital Markets: What Happened?
Unlike prior disruptions, two new significant factors drive recent events in the markets: the continuing trend toward globalization and the enormous growth of mortgage securitization. Although dispersion of risk through securitization and globalization may be a good thing, market players failed to appreciate that dispersion also spreads exponentially the potential losses from that risk throughout the global capital market. With diverse investors crossing over from their traditional markets and their usual asset classes and using increasingly available leverage to invest in newly developed structured-finance products, liquidity grew enormously, but the actual risk of loss permeated and eventually overran the entire system.
Prior market dislocations. The creation of the Resolution Trust Corporation (RTC) led to the development of a broader securitization market for commercial properties built on the already developing nascent private label residential mortgage-backed securities (RMBS) market. The real estate securitization market broadened the existing investor class beyond the traditional portfolio institutional investor, expanded the asset class beyond residential, educated the new players, tested new securitization structures, and legitimized the commercial mortgage-backed securities (CMBS) market.
The August 1998 market disruption for the so-called “Asian contagion” was a totally new experience. It was different from the 1987-89 disruption in the speed at which global events in the capital markets affected the local real estate finance business. A mortgage loan that closed in the morning could not be priced or sold later in the day. The lesson from that market disruption was the risk of duration: How long could an originator or issuer risk holding an asset before it was removed from its balance sheet? The long-term effect of that disruption has been to significantly increase the velocity of loan transactions and concomitantly reduce the accumulation period of assets for the securitization in an attempt to mitigate the risk of sudden adverse market movements by holding fewer assets for a shorter period of time.
Another outgrowth of the 1998 dislocation was deal partnering—several issuers/originators joining together in branded programs to accelerate their ability to securitize their production in a single securitization trust while retaining the ability to issue larger deals in shorter time periods with the concomitant benefits of economies of scale for the sponsors. The effect of the terrorist attacks on September 11, 2001, was a serious shock to the real estate structured- finance business. Suddenly, the risk of the complete loss of a single asset and the lack of terrorism insurance for so-called “target” buildings required a significant shift in the way certain assets were to be deposited into CMBS trusts. There would no longer be single “trophy” asset securitizations.
The immediate solution was the componentization of loans to mitigate the risk of a total loss if there were only one or a few large assets. Componentization is slicing and dicing a single large mortgage loan into several disparate senior/junior component parts. These notes could be further divided and the subordinate pieces sold into the capital markets outside of the securitization.
Current market conditions. Wall Street adapted collateralized debt obligations (CDOs) for use in the commercial real estate finance segment of the market. The availability of CDO financing led to a further explosion of loan products, which, because of federal Real Estate Mortgage Investment Conduit (REMIC) tax limitations, could not otherwise be disposed of by depositing them into an MBS structure such as B-notes, mezzanine debt, and B-pieces, and permitted the most subordinate CMBS investors (the “B” piece buyer), who as the holders of the “first loss” position were the original CMBS gatekeepers, to cease being cash investors to become leveraged investors, allowing the B piece players to grow from four or five to more than two dozen. Lending volume grew significantly, supported by growth of such real estate CDOs, allowing the issuance of CMBS to reach record levels.
Unfortunately, the residential mortgage market had already made even greater use of CDO technology earlier. For several years there had been substantial issuance of residential MBS comprised entirely of so-called subprime loans to borrowers whose credit (and lenders whose underwriting) was substandard. The below A-rated tranches of these subprime securitizations, which would be more prone to default than prime residential loans, were perfect candidates for inclusion with other unrelated, often non-real-estate, assets into CDOs. Driven by this accelerating, readily available financing to subprime MBS investors, the subprime market exploded onto the scene, financing otherwise uncreditworthy borrowers in the acquisition of the American dream, a home of their own.
As the investments became more diverse, so did the pervasion of any problem into seemingly unrelated or unconnected portfolios. It was akin to an uncontrollable contagion. With most American floating-rate debt sold to European and other foreign investors or foreign subsidiaries of U.S. companies, the contagion affected international as well as domestic investors. The connectivity of the global capital market and its common investors went into overdrive. When it all went bad, overseas investors in floating-rate debt financing went on strike, refusing to purchase any real estate structured-finance instruments.
Ultimately, all structured finance was viewed by investors as a single bad asset class to be avoided at all costs. Soon financial institutions and institutional investors were taking unheard-of write-offs for an esoteric asset class in the context of a spreading market contagion. It soon became apparent that much of the investment in CDOs was by so-called structured investment vehicles (SIVs)—bank-sponsored, off-shore entities using short-term commercial paper borrowings to make investments in long-term CDOs, which were often populated with subprime loans. To avoid wholesale failures of their sponsored SIVs, the banks began to fund the SIVs, importing their problems onto the banks’ balance sheets—precisely what SIVs had been created to avoid. As this trend continued, market turbulence disrupted pending securitizations and purged buyers from the market completely; it became almost impossible to value an asset or price a risk. Investors demanded higher yields or withdrew from the market.
In the CMBS market, without any “cash” marks available from other traders (two are necessary to mark an asset to market), the participants turned to the newly created Commercial Mortgage Backed Securities Index (CMBX). It is widely believed that this highly technical and thinly traded CMBX market actually makes it harder to determine the value of, or to establish the price for, an asset acceptable to market participants. As hedge funds and other nonregulated investors began to replace insurance companies as the principal purchasers of senior CMBS bonds, the benefit of transparency provided by public ownership disappeared and concern arose over who actually owned the CMBS certificates.
The future. The problem is not with securitization but with securitizers’ and investors’ almost incredible mispricing of risk. Investors must once again perceive real estate markets to be predictable and reliable. Investor trust must be renewed in the asset class, in the underlying collateral, in the rating agencies, and in the other participants in the marketplace. Whatever route the capital markets take to eventual stabilization, the inevitable destination facing returning real estate investors is the world of “de-leveraging.” There has been no significant overbuilding in the last few years. What has been overbuilt are not physical structures but the financing capital stack of most real estate transaction with serious overleveraging. The much-feared balloon refinancing risk has arrived. The recent exponential growth in leverage at all levels of the property financing stack must be “de-levered” in the new market as investors adjust their appetite for risk and pricing. The loss of leverage will be neither absorbed by tra- ditional portfolio lenders nor by securitized lenders facing new underwriting criteria and more conservative investors. New players are needed to refinance the shortfall between senior and subordinate debt.
For More Information About the Real Property, Trust and Estate Law Section
- This article is an abridged and edited version of one that originally appeared on page 8 of Probate and Property, September/October 2008 (22:5).
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Joseph Philip Forte is a real estate, finance, and investment partner in the New York, New York, office of Alston & Bird LLP. He may be reached at email@example.com.