Tag Archives: CMBS

The (R)evolution of Single-Family Rental Securitization

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Kroll Bond Rating Agency distributed its Single-Family Rental Securitization Methodology. Because this is a new asset class, it is interesting to watch how rating agency’s assess the risks inherent in it. And it will be interesting, of course, to evaluate down the road whether they got it right or not. The Methodology states that

Single-family Rental (SFR) securitizations are a new class of asset-backed securities with characteristics of both commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS). Like CMBS, the primary source of certificateholder distributions during the term of an SFR transaction are loan debt service payments that are generated by income producing real estate collateral. Also like CMBS, there is an element of balloon risk, as SFR loans do not fully amortize over their terms, and the repayment of ultimate principal on the certificates is dependent upon a successful refinance of the loan or loans that serve as trust collateral. However, there is a broader source of demand for the single-family homes underlying an SFR securitization, which can be sold into the vast market for owner-occupied homes, totaling approximately 79 million units. In the event that the pool of single-family homes backing an SFR securitization needs to be partially or entirely liquidated due to an event of default either during the loan’s term or at the loan’s maturity, the expected recovery from such a distressed sale of homes would be largely determined by the conditions in the larger market for single-family homes, which is a primary focus of RMBS analysis.

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the SFR securitization market is currently characterized by large institutional sponsors that have engaged in purchasing and refurbishing large numbers of single-family homes in distressed markets over relatively short periods of time.

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As this is an evolving asset class, we will modify or adjust our methodology to address new transaction features as they emerge. SFR securitizations to date have been collateralized by a single large loan that is in turn secured by mortgages on several thousand income producing single-family homes. While this methodology is designed for this structure, it is also applicable to securitizations secured by a few large loans. Structures featuring a larger number of loans to distinct borrowers, many of whom may be non-institutional in nature, pose additional credit considerations that are not addressed herein. (3)

This summary demonstrates that there are a lot of new characteristics for this asset-class that Kroll is trying to capture in its rating methodology. These include the hybrid nature of the security itself; the hybrid nature of the underlying collateral for the security; the innovative business model of institutional investors entering the single-family market in a big way; and the possible entry of new players in that market, such as non-institutional ones; and changes in the type of collateral underlying the securities.

The takeaway for readers: don’t mistake the apparent simplicity of a rating (AAA, Aaa) as a signal of the solidity of the reasoning that went into it. Ratings, particularly those for new types of securities, are constantly evolving. To think otherwise is to risk being left holding a bag filled with all of lemons that the market has to offer to unsuspecting investors.

Replacing Rating Agencies

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Although rating agencies have been the subject of much criticism, including much from yours truly, (here for instance) there is no clearly superior replacement for the existing business model.  Even worse, there is not even much theoretical work on alternatives. Thus, it is exciting to see that Becker and Opp have posted a new paper, Replacing Ratings, that at least considers a plausible alternative.

Their paper examines “a unique change in how capital requirements are assigned to insurance holdings of mortgage-backed securities. The change replaced credit ratings with regulator-paid risk assessments by Pimco and BlackRock.” (1) But their analysis did not “find evidence for more accurate inputs to regulation.” (3, emphasis removed) Indeed, their “empirical analysis reveals that the old system was better able to discriminate between risks. As a result, the old system based on ratings not only provided higher levels of capital, but also ensured that capital was more appropriately related to risks.” (3-4)

By the end of their analysis, they believe that “the new system only recognizes current (expected) losses, but does not provide any buffer against possible future losses. Our results are consistent with regulatory changes being largely driven by industry interests.” (21)

They find the new system is worse than the old system and that the new system benefits the industry.  So why should we care about this research at all?  For at least three reasons:

  1. it identified a change in the insurance industry that has implications way beyond that industry;
  2. it compared how two different MBS evaluation systems performed; and
  3. it identified the drawbacks of the new system.

This is how we begin to build a body of knowledge about “viable alternatives to ratings.” (2) But, of course, there is much more work to be done.

 

Cherryland, Very Strange

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I looked at the Cherryland decision yesterday. Law360 ran a story (behind a paywall) about it today, quoting me and others.  To recap, the original Cherryland case appeared to unexpectedly open up many commercial borrowers in Michigan to personal liability. The most recent Cherryland opinion reversed this result as a result of Michigan’s newly passed Nonrecourse Mortgage Loan Act.

The story reads in part:

Cherryland and Schostak reaped the benefits of the NMLA. But many CMBS loan documents are similarly written, and other borrowers and guarantors “may not have the saving grace of a politically connected developer getting a law passed very rapidly,” said Brooklyn Law School professor David Reiss.

“If I was an existing borrower [or borrower’s counsel], I would look at this very carefully,” Reiss told Law360. “And new borrowers should try to negotiate new language that protects for this, saying that becoming insolvent is not something that is going to trigger the bad boy guarantee.”

After the initial decision was handed down last year, attorneys say they and their colleagues all took a hard look at the language in their clients’ nonrecourse loan documents to be sure that if they found themselves in a similar situation they would be protected without the cover of a law like Michigan’s NMLA or Ohio’s Legacy Trust Act, which followed shortly thereafter.

In fact, experts say they don’t believe many other states will likely follow suit with their own guarantor-protecting statutes. So even though Wells Fargo lost out in the Cherryland row, lenders will likely keep the case in mind when considering deals.

Although “most people believe that the [pre-NMLA] decision in Cherryland was not what was intended by virtue of the documents,” said Schulte Roth & Zabel LLP real estate partner Jeff Lenobel, the solvency covenant was drafted in a way that allowed it to be read as a bad boy trigger.

This has led many who represent borrowers and guarantors to seek more due diligence and spend more time making sure loan language is just right.

More than $1 trillion in CMBS loans are coming due over the next several years, and Lenobel said he wouldn’t be surprised to see the issue come up again in a different court.

While the Cherryland case is all but over, another similar suit — Gratiot Avenue Holdings LLC v. Chesterfield Development Co. LLC — is making its way through Michigan’s federal courts. And attorneys aren’t ruling out the possibility of an appeal to the U.S. Supreme Court to ultimately determine the responsibilities of a guarantor in a nonrecourse loan.

“It may be a very smart move by the lending industry to appeal to the Supreme Court,” Reiss said.

Cherry Bombs in Michigan

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An ongoing Michigan state case, Wells Fargo Bank, N.A. v. Cherryland Mall L.P. et al.,  has been generating a lot of heat over an obscure but important issue for commercial mortgage borrowers, the scope of carveouts from standard nonrecourse provisions in loan documents.  And now the most recent opinion issued in the case raises important constitutional issues as well.

This case (as well as the similar Chesterfield case (a federal court case also in Michigan)) took many in the real estate industry by surprise by reading language in the loan documents at issue in those cases so as to gut their nonrecourse provisions.  Michigan (as well as neighboring Ohio) quickly passed legislation to return the nonrecourse language to how it was commonly understood.

The Michigan courts’ interpretations of the language in the loan documents was inconsistent with how such provisions were typically understood in the industry.  While the new statutes returned things to how they were commonly understood to be before the cases were decided, they did so in a way that raises more fundamental issues.  Most importantly, such statutes potentially violate the Contracts Clause of the United States Constitution which bars the “impairing” of “the Obligation of Contracts.”

The most recent Cherryland opinion upheld the constitutionality of the new Michigan statute and rightly notes that the Contracts Clause is not read literally. This has been true at least since the Depression era U.S. Supreme Court case of Home Building & Loan Association v. Blaisdell did not invalidate Minnesota’s mortgage moratorium.  The U.S. Supreme Court had thereby given states some leeway pursuant to their police power to remedy social and economic problems, notwithstanding the text of the Contracts Clause.   The situation in the Cherryland case is less sympathetic than that in Depression-era Blaisdell, where many, many homeowners were being foreclosed upon.  The Cherryland borrower, in contrast, is a politically-connected real estate developer. But the point remains that the Contracts Clause is not an absolute bar to legislative revision of privately negotiated contracts.  How politically connected, you might ask.  The court indicates that

defendant [David] Schostak is co-chief executive officer of defendant Schostak Brothers & Company, Inc., and that Robert Schostak is co-chairman and co-chief executive officer.  . . . Robert Schostak is “a high ranking Republican Party leader in Michigan, with many years of involvement in assisting the party’s candidates to gain election in the legislature.” We note that Robert Schostak has been chairman of the Michigan Republican Party since January 2011, was finance chairman through the 2010 election cycle, and had served on campaign fundraising teams for prominent Republicans. (8, note 3)

The borrowers here are as well positioned to get helpful legislation passed as anyone. There is much to chew over here, not the least of which is the Court’s finding that the statute was not “intended to benefit special interests.” (8)

There are also important practical aspects to the case. For instance, it is quite possible that courts in other jurisdictions will read the typical CMBS nonrecourse language similarly to how the Michigan courts read it.  Lenders will want to take a look at their loan documents to determine whether they mean what they say and say what they mean. And borrowers should read the language in their loan documents carefully before signing on the dotted line. They have been warned.