NOVEMBER 10, 2010
Street Aims to Reboot CMBS
By KRIS HUDSON, Wall Street Journal
Wall Street has learned a lesson from the battles that have erupted for control of the bankruptcies of hotel owners Extended Stay Inc. and Innkeepers USA Trust: There has got to be a better way to build a commercial mortgage-backed security.
The strategies used by some investors to gain control of these failed companies has exposed flaws in the structures of CMBS, the commercial real-estate industry's favorite boom-time financing tool. But now, as investment banks revive the market for the securities, they are making structural changes designed to close these loopholes and curb these tactics.
CMBS, which were originated in the 1990s, had never been tested by a significant number of defaults until the current downturn. What investors and issuers realized was that the legal structure set up to deal with stress left a lot to be desired.Doing this will help determine how quickly the CMBS market can be fully restarted after its recession-induced hiatus, which many consider critical to restoring health to the commercial-property industry. CMBS, a market in which mortgages are chopped up and sold to thousands of investors as bonds, accounts for roughly $750 billion of mortgages now outstanding.
Under the terms of CMBS, when borrowers default the loan is turned over to a special servicer, which directs the loan's restructuring. Because the special servicer has so much power, there have been battles among investors within a given CMBS loan over who has the authority to hire or replace them.
In the restart of the CMBS market, which some are calling CMBS 2.0, securities are being structured so that the decision to select the special servicer is up to most, if not all, investors in the loan through a majority vote. For example, some new loans, including many originated by J.P. Morgan Chase & Co., require approval from 75% of a given loan's investors to replace the loan's special servicer.
Guidelines for hiring and replacing special servicers are "clearly changing so that it's not just in the hands of one [investor] class," said Anup Sathy, a partner specializing in corporate restructuring at law firm Kirkland & Ellis.
But it wasn't previously that way. In CMBS originated prior to the recent changes, the authority to pick the special servicer went to the "controlling stakeholder," defined as the junior-most investor whose claim still had value were the loan's collateral to be liquidated.
The trouble is, the controlling stakeholder's desired outcome might not match those of the rest of the investors in the loan. Investors with senior claims might favor immediate liquidation of the defaulted loan because they are guaranteed to be paid in full. In contrast, the controlling stakeholder often has a junior claim that would bring it only partial recoupment in liquidation. Therefore, that investor might push the special servicer to restructure the loan instead.
With so much at stake, the controlling-stakeholder structure spurred a lot of jockeying among investors in CMBS loans for the controlling position. Investors often bought slices of the debt in anticipation of their slice being deemed the controlling stake, thus granting them the right to name the special servicer. In some cases, special servicers themselves did so in a bid to guarantee they could appoint themselves the job of overseeing a loan's restructuring.
That type of gamesmanship is highlighted in two recent lawsuits related to the bankruptcies of Innkeepers and Extended Stay. In the Innkeepers case, LNR Partners Inc. alleges in a lawsuit filed Oct. 27 in New York state Supreme Court that another investor reneged on an agreement to name LNR the special servicer overseeing Innkeepers' $825 million CMBS loan.
LNR alleges that it had a pact with CRES Investment, a division of Presidio Holdings II LLC, stipulating that CRES would hire LNR as special servicer if CRES's slice of the mortgage was deemed the controlling stake. As a side bet, LNR bought slices of the mortgage on its own to better its chances of getting the designation.
However, LNR claims in its lawsuit that CRES, once it was named controlling stakeholder, didn't hire LNR, instead keeping Midland Loan Services as special servicer. "CRES' failure to comply with its contractual obligations is depriving LNR of its bargained-for right to control workout and resolution of the Innkeepers loan," the lawsuit reads.
CRES representatives didn't return calls seeking comment. LNR declined to comment.
A similar dispute emerged in the Extended Stay bankruptcy. Trimont Real Estate Advisors Inc. alleges in a lawsuit filed Sept. 21 in U.S. District Court in Washington, D.C., that rival special servicer CWCapital Asset Management LLC owes it a portion of a $19 million restructuring fee. CWCapital received the fee as special servicer of Extended Stay's $4.1 billion securitized mortgage.
However, Trimont said it is entitled to some of the fee because it was the special servicer in the case for roughly a year.
Prior to a bankruptcy auction that resulted in a sale of Extended Stay and its 680 hotels, Trimont was abruptly replaced as special servicer with CWCapital by investors Bank of America Corp., UBS Securities and Cerberus Capital Management LP.
CWCapital has asked a judge to dismiss the case, noting in its court filing that "during the nearly one year that Trimont was the special servicer, it had no success working out the loan or resolving the bankruptcy case."
CWCapital declined to comment. Trimont didn't respond to messages seeking comment.
Write to Kris Hudson at email@example.com