REMIC Modifications and Their Impact

One year ago, one of the most intriguing questions on the minds of commercial real estate investors was what was going to happen to large, performing CMBS loan that matured and the owner was not able to refinance. Since then, 528 CMBS loans valued at nearly $5 billion matured and were unable to be refinance even though 75% of these loans were throwing off more than enough cash to service their debt. The evaporation of the CMBS market and the entire shadow banking industry has created an extremely challenging financing market for all large loans, even for properties which have the cash flow to cover debt service payments. This lack of liquidity has continued to be a tangible concern for the industry. 

A potential solution to this problem was announced by the IRS last week when they issued guidance (Revenue Procedure 2009-45) that provides significantly greater flexibility to modify the terms of commercial mortgage loans that have been securitized into commercial morgage backed securities. RP 2009-45 makes it clear that negotiations involving modifications to the terms of these loans can occur at any time (the servicer only has to believe there is a “significant risk of default” even if the loan is performing) without triggering tax consequences. It applies to all modifications made after January 1, 2008.

Until now, a borrower with a CMBS loan had no one to speak to at the master servicer. The master servicer serviced the securitized loan and the borrower would have to essentially go into default to have the loan transfered from the master servicer to a special servicer. The borrower could then have a dialogue with the special servicer to discuss reworking the terms of the loan.

Administrative tax rules applicable to Real Estate Mortgage Investment Conduits (REMICs) and investment trusts imposed severe penalties for changes made to commercial morgages or investment interests after the startup date of the securitization vehicle. The trusts could have been forced to pay taxes if the underlying loans were modified before they became delinquent, according to the old CMBS rules. Therefore, borrowers were unable to even begin discussions with their loan servicers until they had already defaulted of default was imminent. Often, however, by the time a loan reaches this status, options are generally limited and it is too late to work anything out. Foreclosure would be a likely result, further depressing valuations.

This new IRS guidance puts CMBS borrowers on almost a level playing field with borrowers who have loans with traditional banks. Those bank borrowers have always been able to call their banker at any time to discuss any potential problems that the loan might face. Now borrowers with CMBS loans can do the same thing thereby enhancing the possiblity that the loan can be salvaged and the property can be maintained.

While this modification is applauded by many in the industry, there are some concerns.

First, this program will really only help those borrowers who are conservatively leveraged and simply cannot refinance because of the extraordinary condition of the credit markets today. Any borrowers who have negative equity and are highly leveraged are out of luck (whether they can arrange a modification or not) and may only be delaying the inevitable if they are able to convince the servicer to modify.

Second, it is feared by many that the guidance could open the floodgates for everyone to try to get some sort of loan modification whether it is justified or not.  Some borrowers may take a shot just for the heck of it. It will be interesting to see what criteria servicers use to determine who gets help and who doesn’t.

Third, servicers will come under tremendous new pressures from several participants with different objectives such as competing classes of investors. Some investors holding CMBS bonds are watching nervously because the modifications might not always be in their best interest. CMBS have senior and junior pieces (known as the “A-note” and the “B-note”). The senior piece is in a better position and has incentive, in most cases, when a borrower defaults, to foreclose and liquidate the property. Junior holders, on the other hand, might benefit from a modification because they may not get any proceeds back in a forced sale.

Fourth, the fiduciary responsibility of the servicer is to all bondholders and they should modify loans only when that can be expected to reduce losses. That puts servicers in the challenging position of trying to figure out which borrowers are essentially sound versus knowing when it makes sense to foreclose quickly. My guess is that, based upon the relentless pile of files mounting on servicer’s desks, modifications will be the path of least resistance.

Fifth, from the brokerage perspective, this modification will only further constipate the pipeline of distressed assets which is already moving like molasses. Many of the properties which would be considered “distressed” are financed with CMBS loans and, to the extent that brokers were looking forward to selling these assets, we will have to wait even longer for these opportunities to present themselves.

Importantly, the guidance only applies to outstanding loans and only to servicers who believe a loan modification is in the best interest of all of the bondholders. The servicers are still bound by the terms of the pooling and servicing agreements and the servicing standards (which are not affected by the guidance) but at least the tax rules will not prevent dialogue among the parties.

Mr. Knakal is the Chairman and Founding Partner of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

16 Responses to “REMIC Modifications and Their Impact”

  1. 1 Erik Wallenius September 21, 2009 at 9:43 am

    Bob, very good article summarizing the facts and thoughts.
    I wonder whether AAA Noteholders will bring an action against the servicers as 1) they have significant amounts at stake, 2) a low coupon compared to funding costs for extended repayment and 3) hedge funds which bought or buy in far below par might want to realize profit as soon as possible in order to have a higher yield.
    As a servicer I would mostly argue that selling in such an environment (recession / credit crunch / foreclosure wave) does not make much sense, thereby qualifying nearly every loan for modification.

  2. 2 rknakal September 21, 2009 at 10:25 am

    Hi Erik, Thanks for the post. The AAA noteholders and others in senior positions are going to be very upset as they will be impacted in the same way as those in subordinate positions and litigation is sure to follow in many cases. With regard to the servicers taking the position that any sale now does not make sense, I think it depends on how realistic the turnaround of an asset might be given a realistic perspective on the market. This should be done on a case by case basis but I believe, as I mentioned in the story, that modifications will be the path of least resistance. It will be interesting to see how this actually plays out.

  3. 3 mike September 21, 2009 at 12:03 pm

    Bob, How do you see the never-ending leverage playing out in this? For instance, many buyers of AAA debt were using leverage to get some sort of reasonable yield. The smart ones set up their debt maturities to coincide with the maturity of the securities. So, as the tranche waterfalls play out, the AAA folks will continue to receive payments but may have a big balloon payment due, which means that extending the loan pushes them into default as well. Of course, this could happen at any level, but the AAA pieces are the biggest concern since the yields are so low it takes a lot of leverage to make sense out of them as investments. And, it’s possible that the folks that lent money to the buyer of the securities also borrowed their funds to juice the yield, and on and on down the capital stack.

  4. 4 rknakal September 21, 2009 at 9:13 pm

    Hi Mike, thanks for your post. Your points are very well made. With thin margins, even the smallest hiccup can create huge problems for the senior position. When you think you are in a safe senior position and you get crunched down to the same extent as everyone else in the capital stack, you can’t be happy (think of the Chrysler senior bondholders and how the government totally crunched them to a pulp in favor of the UAW). Look for the lawsuits to fly as this plays out.

  5. 5 brad greenblum September 22, 2009 at 9:35 am

    thanks this was very interesting. the big question is how long will it take for servicers to come up with their internal guidelines, deal with the various tranche holders and their issues, and the continued deterioration of the marketplace (contrary to the fed statements that the recession is over). We are in discussions with some of our debt holders and one group has gone from being cooperative to we need a solution now or we post the property. this lender is getting pressure from its investors to take action and get something done. will be interesting how it all plays out..

  6. 6 nathan isikoff September 23, 2009 at 10:24 am

    Great Article. This mess is going to take years to sort out.It will continue to be a drag on the property markets as well.

  7. 7 r lobel September 24, 2009 at 9:24 am

    As usual, clear, concise and both, to and on point.
    Unfortunately, the case-by-case approach will take donkey’s years to play out and without any substantial volume of transactions, the approach and systems necessary will be piecemeal, thereby further slowing down the process.

  8. 8 Steven Ancona September 24, 2009 at 12:10 pm

    Bob, great article, and cuts to the heart of the massive balloon problem our industry faces. While these types of measures will help, it’s seems akin to putting a bandaid on a massive hemmorhage. What we need is the CMBS industry back in play. I’m amazed that not one group has yet emerged to re-start a CMBS conduit (as far as I’m aware). It seems to me that spreads are as wide as they’ve ever been, allowing for significant profit, that the CMBS concept is a very sound one in principle, and so important for the future of our industry. The major problem with the old CMBS system was that you had originators selecting the rating agencies. If just that one element in the system were modified, so that rating agencies could do their work properly without having to worry about getting business from an unhappy originator, then I think confidence in the system could be restored. Perhaps a blind lottery selection system for rating agencies makes more sense.

  9. 9 rknakal September 24, 2009 at 12:48 pm

    Hi Brad, thanks for the post. Even the servicers and special servicers are curious as to how this will play out. Details are still being disucssed with Treasury as to how the implementation will work.

  10. 10 rknakal September 24, 2009 at 12:48 pm

    Hi Nathan, thanks for the post. Yes, it will be a drag (pun intended).

  11. 11 rknakal September 24, 2009 at 12:51 pm

    Hi Steven, thanks for your post. You are absolutely correct that we need access to public capital and CMBS would provide such access. While modifying the role of the rating agencies would help, originators need to keep a loss position in order to create confindence and some underwriting discipline. I wrote a piece on this called “CMBS Needs Some Skin in the Game”. If you scroll through the archives here, you will find it.

  12. 12 rknakal September 24, 2009 at 12:53 pm

    Hi Robert, thanks for your post. Forget about donkey’s years, it will take longer than it takes you and I to play a round of golf!

  13. 13 terrig October 2, 2009 at 7:30 am

    This is dead on. The master servicers, in many cases, have a vested interest both from a higher fee they received on defaulted assets (vis a vis performing assets) and the fact that many have “skin in the game,” a lower tranche debt which can be wiped out on liquidation.

    The special servicer is chosen by the “controlling class” of bondholders, based on “value”. Now we all know, value is a seemingly simple concept, which gets complicated pretty quickly (much like how many sf are in the space?) it depends on how fast do you need to sell, is there debt available, what is “market rent”, cap rates, etc. In this process “value” is determined by an appraisal (part art, part science) which means stay tuned to the latest legal updates – this should get interesting.

    The trust documents for the REMICs have written into them the old IRS guidelines, so the REMICs would need to be modified in order to take advantage of the new IRS guidelines.

  14. 14 REIT October 6, 2009 at 5:36 pm

    Hey, I found your blog while searching on Google your post looks very interesting to me. I will add a backlink and bookmark your site. Your perspective is very insightful. Keep up the good work!

  15. 15 Abe Hedaya October 8, 2009 at 2:38 pm

    It’s so easy to forget how far and wide the effects of a simple tax change can be. Another great article, Bob. This blog should be required reading for everyone interested in learning about what really happens behind the scenes.

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