New Deals Prompt Legacy CMBS Sales

Commercial MBS trading in the secondary market picked up sharply this week, as many investors sought to free up cash so they could bid on a wave of fresh paper.

More than $1 billion of bonds were put up for grabs on Monday and Tuesday alone, prompting dealers to speculate that the week’s bid-list volume might exceed $1.8 billion. That would mark a big jump from about $800 million last week and the recent average of roughly $1.2 billion per week, dealers said.

This week’s offerings consisted largely of long-term, super-senior bonds from the benchmark classes of multi-borrower transactions floated in 2006 and 2007. "The trading volume has definitely been elevated with a lot of short-duration paper that [typically] doesn’t move a lot," said one CMBS trader.

Several bid lists had aggregate balances topping $200 million each. The sellers were mostly insurers, asset managers and other buy-and-hold investors, who were expected to sink the proceeds into long-term, higher-yielding bonds from a flood of new issues. Just over $9 billion of CMBS offerings were priced or marketed this week, including $5.6 billion of conduit transactions.

"The ‘real money’ accounts are repositioning themselves and gravitating towards new issues," another trader said. Buysiders saw an opportunity to shift from bonds that are due to mature in two or three years into fresh, long-term paper carrying higher yields. And while new-issue volume is heavy right now, the annual total still isn’t keeping up with the runoff among transactions that priced in the go-go years before the crash, another trader noted.

Most of the offered bonds in the bid-list auctions conducted during the first half of the week did change hands. Word has it that Wall Street dealers submitted the winning bids on a healthy amount of that paper, in keeping with their role as CMBS market makers. There was little movement in benchmark spreads, which was about 60-80 bp over swaps, depending on collateral quality and the securities’ remaining terms.

New Risk Rules Add Hurdle for Project Loans

Impending changes in the risk-based capital rules for banks are starting to affect the terms and pricing of some high-leverage construction loans.

The U.S. version of the "Basel 3" guidelines, which take effect Jan. 1, sharply increases the amount of capital banks must hold in reserve against "acquisition, development or construction" loans unless the leverage is 80% or less and the borrower’s up-front capital contribution is at least 15% of the project’s value.

While most bank loans would fall well under the 80% leverage limit, the equity requirement is proving to be an obstacle for some deals — largely because the 15% threshold is based on the estimated value of a project "as completed," rather than the cost of construction.

As they start negotiating loans that may close after the first of the year, banks are informing borrowers that they’ll need to put up enough cash to meet the new requirement, or pay a higher interest rate to compensate for the cost of holding additional risk-based capital, according to industry pros.

Complicating the calculations are some gray areas in the new regulations, adopted last year by the

Comptroller of the Currency, the Federal Reserve and the FDIC to conform with the Basel 3 standards set by the Bank for International Settlements. The regulators haven’t spelled out just what "as completed" means, said George Green, associate vice president of commercial/multi-family policy at the Mortgage Bankers Association.

"Is that stabilized, is it non-stabilized?" Green said. "The value of an income-producing property is based on its leased income. Significantly different values are generated if a building is substantially leased versus minimally leased."

The higher the projected value of the completed property, the more cash the borrower would have to provide upfront to reach the 15% threshold. The rules also mandate that those funds remain committed to the project until the loan is retired or converted into permanent financing meaning the developer can’t draw out leftover cash as a project nears completion.

Construction loans that don’t meet the leverage and borrower-equity requirements must be treated as "higher volatility commercial real estate" under the Basel 3 rules. Loans in that category will be subject to a risk weighting of 150%, while most other commercial mortgages will be weighted at 100% and certain multi-family loans will qualify for a 50% weighting. Banks are generally required to hold capital against 8% of the balance of their loans, but the higher risk weighting will bump that up to 12%.

While many banks have already set new lending standards in response to the rules, others are still working out the details. "It seems more banks are just waking up to this new regulatory environment," said one originator.

Some banks are starting to put language into preliminary loan agreements stating that the proposed pricing can change if the estimate of the project’s "as completed" value comes back higher than expected and the borrower’s equity doesn’t reach 15% of that figure.

One broker said he was already seeing signs that some banks are cutting back on construction lending to avoid the new capital charges.

Another industry pro said he knew of a few cases where banks walked away from potential deals when their calculations showed the loans would fall into the higher-volatility category.

 

Preferred Equity vs. Mezzanine Debt

An investor seeking a higher return than that available to a mezzanine lender, and not unduly concerned about exit strategies, can negotiate a senior equity position as a “preferred equity” holder. Preferred equity is most often used when a property is generating insufficient cash flow to service a junior or mezzanine loan, or where the senior lender prohibits subordinate financing. In some cases, a mezzanine lender may choose preferred equity because a debt position could have adverse tax consequences or in some way does not qualify under the lender's investment rules.

Enhanced Rights

While preferred equity clearly is subordinate to all debt, it does have some priority rights over other equity owners. The most important of these is the right to receive a preferred distribution, typically in the range of 12 to18 percent, on the invested amount. The actual rate will depend on a variety of factors. In addition, the preferred equity investor usually has the right to approve all major decisions of the general partner or managing member. Under certain circumstances, the preferred equity holder may become the general partner or managing member.

While the preferred equity holder has priority over other equity holders with respect to distributions, there is no assurance when payments will be made or indeed, if they ever will be made in the event the project fails. Finally, the preferred equity investment often has no maturity date.

Total Return

As noted above, the preferred equity has first claim on equity distributions equal to a designated percentage of its investment. In addition, the preferred equity will share in the capital appreciation of the venture. As a result, the preferred equity holder may receive a higher return than a mezzanine lender whose return is capped. The net effect is to raise the overall cost of capital to the common equity holders as compared to using mezzanine loans, but the benefit is that the carrying costs of the property are reduced.

Using Hurdle Levels

Preferred equity often is used in connection with new developments. Once the parties have agreed as to the amount, timing and form of the equity to be provided, they must agree about the division of returns to the developer and the equity party. The objective is to minimize the downside risk to the equity investor while providing a substantial incentive to the developer partner for the deal to perform in excess of expectations. This usually is accomplished by staging the returns to each party through so-called “hurdle” levels.

Example: Assume the equity partner puts up 90 percent and the developer puts up 10 percent. The initial split might be pari passu, until each party receives 12 to 15 percent of their investment. Additional cash flow would be distributed 80-20 between investor and developer until the investor has achieved a stipulated internal rate of return (say, 15 to 20 percent). Any additional cash flow would be split 60-70 percent to the investor and 40-30 percent to the developer. Since a construction project on an all-cash basis may return only 10 to 11 percent, the returns just described can be achieved only because of the upside leverage provided by the construction loan. A construction loan equal to 75 percent of cost at an interest rate of 8.5 percent increases the overall return to the 15 to 20 percent range.

Cashing Out

An important aspect to be negotiated between the developer and the equity investor is if and when the latter can exit from the investment. Under normal circumstances, the maximum value of the project is achieved only after the project is fully constructed and has been operating long enough to establish a stabilized net income. At that point, the construction lender will be taken out by a permanent loan, but any excess permanent loan proceeds are not likely to be sufficient to pay off the equity investor.

In devising an exit strategy during the initial negotiations, the developer and the equity partner can consider several alternatives. For example, the developer may be willing to sell the project. If the developer is not a merchant builder but wishes to hold the property in a portfolio, the developer may agree to take out a second mortgage or find a new equity partner.

Periodic Post Closing Follow Up on Borrower Environmental Obligations

Occasionally, a Lender has a borrower whose property, whether a new purchase or a refinance, has certain pre-existing environmental concerns. Perhaps the improvements were constructed prior to 1978, and there may be Asbestos Containing Materials (ACMs) or Lead based paint (LBP) concerns, or perhaps there are soil impacts resulting from periodic historical releases associated with normal agricultural uses of a property. In circumstances where pre-loan removal or remediation of the concern is not feasible, Lenders may address these concerns via an environmental indemnity, requiring borrowers to mitigate or properly manage any existing concerns to ensure that such concerns are not problematic during the term of the loan, either for human health and safety reasons, or for servicing the loan.

Often times, a policy of “management in place” is sufficient to address the Lender’s concerns and help the borrower maintain best business practices. This frequently means that an Operations and Maintenance Plan (O&M Plan) would be put in place at the commencement of the loan, to run at least during the term of the loan, if not longer. The O&M Plan would require the borrower to properly manage the issues of concern, and not exacerbate the impacts or create any pathways of exposure which could negatively affect normal business operations or ability to service the loan. For ACM and LBP issues, this could mean only de minimus and non-intrusive maintenance and refurbishment of affected areas during the term of the loan, to reduce the likelihood of exposure to such concerns. Site (re)development that might mean material disturbance of affected areas could require consultation with and pre-approval of mitigation plans by the Lender, to ensure that the terms and conditions of the environmental indemnity were being met. Changes to the Approved Use of the property should also be subject to Lender consultation and pre-approval; since such a change could alter the identified pathways of exposure which the O&M Plan was supposed to address, and thereby increase the risk of environmental liability.

As a matter of compliance and monitoring, Lenders should consider requiring the borrower to provide, at least annually, a summary of borrower’s efforts and activities to “manage in place” any identified pre-existing environmental conditions, if periodic site visits are not feasible. By requiring borrower to provide the Lender with even a brief statement stating that the O&M Plan is being properly managed and that there has been no material change or exacerbation of the identified impacts, the Lender is compelling the borrower to pay at least periodic attention to the obligations that the borrower agreed to at the time of the closing of the loan. At the same time, the Lender can demonstrate that it was diligent in following up on its obligations to maintain a situational awareness concerning its collateral, by reviewing and notating where necessary such periodic borrower summaries.

This periodic follow up by borrowers and Lenders is cost effective and does not require much time or resources to implement, but serves to ensure that both borrower and Lender have a plan in place which provides periodic follow up on such pre-existing environmental conditions. If there is no change in circumstances, then no additional resources are required; if the review identifies a change, then both parties have the opportunity to correct the situation sooner, when the situation is more manageable, rather than later, when the fix may be more costly and time consuming. As the old adage says, “an ounce of prevention is with a pound of cure.”

Leased fee, fee simple. Who cares? Your regulator.

"Fee simple" and "leased fee"? What's that about and why does it matter?

Don't get distracted by the term "fee simple". It sounds strange because it's a vestige of middle-age, English common law. For purposes of illustrating the point, let's (over)simplify. Assume, for the sake of this conversation only, that fee simple is a rough translation for "ownership".

Example
Here's an example. Your borrower owns an office building. So, in other words, your borrower is the "landlord" to several office tenants under standard office leases. The tenants occupy the building. The landlord, in general, does not.

It might be common in real estate circles to say that your borrower owns the "fee", and that the handful of tenants that occupy the building own a "leasehold" interest -- a fancy way of saying they rent space.

Now assume that your bank is considering making a loan to this borrower. The loan will be secured by the borrower's interest in the office building. You are ordering the appraisal. What interest should you ask the appraiser to value?

What does it mean to appraise the "Fee Simple"?

It's a natural reaction to say "fee simple" -- after all, your borrower is not renting the property from someone else. They own it.

But here's what will happen if you do that. In valuing the property under the income approach, the appraiser will perform market research and use accepted methods and techniques to determine the appraiser's opinion of market rent. In other words, the appraiser will come up with an opinion as to the rent that your borrower could get if they leased space in the building today -- or, more precisely, as of the effective date of the appraiser's opinion of value. Then, the appraiser will use that opinion of market rent to value the building, more or less ignoring the current leases.

Below-market rents highlight the distinction

But what if some or all of the tenants in the building signed long-term leases 10 years ago, and still have 10 years left on their leases? What if those tenants are "credit" tenants (e.g., big, successful public companies with low risk of default) and as a result have sweetheart deals, even in light of today's real estate environment? Well, in that case, the appraiser's opinions about the "market rent" don't bear a resemblance to the cash flow that's actually coming in the door based on the specific terms of those leases. If you want the appraiser to dig through the terms of those leases, the rent roll, and other information and use the actual numbers in the income approach, then you need to order "leased fee".

What if I order it the "wrong" way?

In most cases, if this gets mixed up, it's just a misunderstanding. But getting this wrong can cost time and money. If you order a fee simple appraisal, the appraiser may not think to ask you about leases and rent rolls. He may assume there isn't a lease in place. Then, if you suddenly ask him why he didn't consider the lease, or if the appraiser runs into a tenant on his site visit, you could have an issue. The appraiser may have to go back and review leases and rework his income analysis. It pays to get this right up front.

(Aside from the regulatory issues discussed below, it's not "wrong" to order a fee simple appraisal for a building with tenants. There may be very legitimate reasons for wanting to know the market value of the building using the prevailing market rents and ignoring the specific leases in place. For example, it may be that the leases in place have above-market rent. In that case, a fee-simple appraisal may serve as a means of stress-testing value in the event those tenants were to default and the landlord was forced to re-rent the space. But you should understand what you're ordering. And the appraiser should take care to clearly explain in the report which interest he or she is valuing.)

Does my regulator care?

When you're dealing with a property with below-market rents, it might be tempting to view this distinction as an opportunity to influence value. You may be confident that your borrower's "good for it" and looking for a way to get the property to "appraise out". If you order a "fee simple" appraisal, you could take advantage of the market rents, even though your borrower's locked into below-market rents. But don't do it. Your regulator is paying attention.

Each of the prudential regulators requires that appraisers report appropriate deductions and discounts, and that includes, specifically, for properties with below-market rents. Refer to Appendix C in the December 2010 Interagency Appraisal and Evaluation Guidelines. There you'll read:

"For properties subject to leases with terms that do not reflect current market conditions, the appraisal must clearly state the ownership interest being appraised and provide a discussion of the leases that are in place. If the leased fee interest is being appraised and contract rent is less than market rent on one or more long term lease(s) to a highly rated tenant, the market value of the leased fee interest would be less than the market value of the unencumbered fee simple interest in the property. In these situations, the market value of the leased fee interest should be used."

Kroll Bond Rating Agency Releases Report Examining CMBS Equity Cashouts

Kroll Bond Rating Agency (“KBRA”) has released a research report delving into borrower equity cashouts in the commercial mortgage backed securities market. Given increased competition amongst lenders, we sought to quantify the impact that equity cashouts have had in driving our main stressed metrics into riskier territory.

Although slightly less than half of the loans in KBRA’s Top 20 rated universe have returned equity to the borrower, we also individually reviewed characteristics of the loans to gauge the story behind the numbers. After further review, it is evident that a majority of the cashouts have occurred in loans where the borrowers have had long operating histories of at least five years and where equity has built-up in the property either through equity investments and/or asset appreciation.

That said, the credit metrics of these loans weakened faster than the broader universe. As one would expect, stressed leverage for cashout loans deteriorated faster than the broader Top 20 universe, ending Q2 2014 at 104.3% compared to 101.4% for Top 20 loans.

Chicago: It's the hottest commercial property market since 2007

Sales of Chicago-area commercial properties are on pace for their best year since the crash amid an improving economy and low interest rates.

Investors acquired more than $9.15 billion in local apartments, hotels, retail, office and industrial properties through August, up 28 percent from the $7.14 billion spent through the first eight months of last year, according to New York-based Real Capital Analytics Inc.

Sales volume is on track for its highest annual level since its peak in 2007, when $22.5 billion in commercial property sold.

Investor demand for real estate continues to rise amid the slowly growing economy, which is pushing up occupancies and rents, and low interest rates, which has kept borrowing costs low and made it harder to find good returns on other investment types. At the same time, many landlords are capitalizing on soaring prices by putting their properties up for sale. And even higher prices in hot coastal markets are drawing more investors to Chicago.

“Nationally there's more being invested in commercial real estate, but I imagine Chicago is benefiting from the compression in yields and increase in prices in places like New York, San Francisco and Los Angeles,” said Ben Carlos Thypin, director of market analysis at Real Capital.

Nationally, prices for commercial real estate, except for office properties, have passed their 2007 peak, according to a report by Green Street Advisors Inc., a Newport, California-based research firm. A commercial-property price index calculated by Green Street has risen 7 percent in the past 12 months.

Sales of Chicago-area industrial properties have risen 55 percent, according to Real Capital, buoyed by renewed demand for “higher-grade” buildings by institutional investors, said Britt Casey, an executive director in the Rosemont office of real estate brokerage Cushman & Wakefield Inc. With 13.5 million square feet sold here in the first half of the year, Chicago was the most active industrial market in the nation, according to New York-based Cushman & Wakefield.

The recovering economy should help boost demand for commercial space, and support sales and prices in turn, Mr. Thypin said.

“Whether (the economy) continues to grow at the pace it seems to be growing this year remains to be seen, but the bottom falling out anytime soon is pretty unlikely,” he said.

Expecting a typical increase in activity in the fourth quarter, Mr. Thypin expects Chicago-area commercial property sales to exceed last year's total of nearly $14.6 billion.

Significant sales so far this year include the record $850 million paid for the office tower at 300 N. LaSalle St. and the $85 million deal for the 1.6-million-square-foot Solo Cup warehouse in the south suburbs. Other deals include the $60 million sale of the Golf Mill Shopping Center in Niles and the $132 million sale of a Gold Coast apartment building.

Most-Active Special Servicers - Aug. 2014

CMBS Special Servicing Volume Dips in August

The volume of loans in the hands of the CMBS industry’s 17 special servicers declined last month, after increasing for two straight months, and now stands at $40.6 billion, according to Morningstar Credit Ratings.

The decline was driven by the $994 million of liquidations that took place during the month. According to the Horsham, Pa., rating agency, 2,246 loans are now in special servicing. That compares with 2,288 loans, with a balance of $41.1 billion, that were in special servicing in July.

Because the universe of CMBS tracked by Morningstar declined to $621.5 billion from $627.8 billion, the percentage of loans in special servicing remained flat in August, at 6.54 percent.

CWCapital Asset Management, the most-active special servicer, saw the volume of loans it handles shrink by some $340 million, while LNR Partners saw its volume shrink by $230 million. And C-III Asset Management saw a $90 million increase. Most other servicers saw much smaller changes in the volume of loans they handle.

While loans continued to get pushed to special servicing, most had balances of less than $75 million. The biggest to transfer last month was the $69.7 million mortgage against the Indian River Mall & Commons, a 434,577-square-foot retail property in Vero Beach, Fla., that’s owned by an affiliate of Simon Property Group. The loan is securitized through Banc of America Commercial Mortgage Trust, 2005-1, and was transferred to C-III because it’s expected to default upon its November maturity.

C-III also is handling the biggest large-balance loan to be transferred to special servicing in recent weeks: a $122.6 million mortgage against a portfolio of 936,320 sf of office space owned by Investors Real Estate Trust. The Minot, N.D., REIT said it was considering surrendering the portfolio in a deed-inlieu of foreclosure because it’s not likely to be able to refinance the loan when it matures in 2016. The loan, commonly referred to as the IRET Portfolio, was transferred to C-III in late July.

First Deal of Conduit Flurry Prices

The first of six scheduled CMBS conduit transactions priced late last week at levels that were substantially tighter than the last conduit, which priced three weeks earlier.

The benchmark AAA class of the latest deal, WFRBS Commercial Mortgage Trust, 2014-C22, priced at 84 basis points more than swaps, 6 bp tighter than the 90-bp spread for the last conduit, COMM, 2014-CCRE19, which priced on Aug. 13. And the BBB- class of the WFRBS 2014-C22 deal priced at 345 bp more than swaps, in 25 bp from the COMM deal.

What’s more, the latest conduit deal’s A-S class, which typically carries the highest ratings, was rated Aa1 by Moody’s Investors Service. That is the equivalent of a rating of AA+ from Fitch Ratings and Kroll Bond Ratings, the other two agencies that rated the WFRBS deal. It marks the first time that a conduit deal’s junior class has received split ratings. But the class still priced tighter than the previous conduit, at 115 bp more than swaps versus 118 bp. Said one investor: “There’s money out there that needs to be put to work.”

The A-S class of the WFRBS deal has 23 percent of credit support, meaning that 23 percent of the transaction would have to be wiped out before it would be impacted. For it to have won Moody’s Aaa rating, the thinking is that the bond class would need to have 25 percent of subordination.

WFRBS deal were somewhat of a surprise to some investors, given that five other conduit deals are in the wings and expected to price before the month is out. That volume ought to give investors the ability to be extremely selective, so they would demand greater yields from certain deals.

Indeed, the benchmark AAA class of COMM, 2014-UBS5, priced on Tuesday at a spread of 88 bp more than swaps. Its A-S class, which has a balance of $100.9 million and carries an Aa1 rating from Moody’s, but AAA ratings from Kroll and Morningstar, priced at 123 bp more than swaps and its BBBclass priced at 370 bp more than swaps.

The deal’s underwritten leverage level is 66.8 percent and it lacks the multifamily concentration of the WFRBS deal. Only 6.7 percent of its $1.4 billion collateral pool is backed by loans against apartment properties, which are considered less volatile than other property types. But the benchmark class of GS Mortgage Securities Trust, 2014-GC24, was being shopped at a level of roughly 87 bp more than swaps. The deal’s A-S class was being shopped in the area of 110 bp more than swaps.

Meanwhile, some investors still require a Moody’s rating, so the split rating could have excluded them, or forced them to price the class wide of where it printed.

The WFRBS deal benefited from its 16.8 percent concentration of loans against apartment properties, which included $65.5 million of residential cooperative properties, which have relatively low leverage. While the transaction’s underwritten loan-to-value ratio was 64.6 percent, Moody’s stressed LTV was 110.1 percent. That increases to 114.3 percent if the co-op loans are excluded.

Also helping was the fact that Moody’s rated bond classes down to the deal’s class C, which it rated A3. It hasn’t been asked to give its ratings for classes below the most senior in a number of previous deals. The rating agency often requires greater levels of credit support than other agencies for certain bond classes before it gives comparable ratings.

Meanwhile, the CMBS market was bound to see an improvement in spreads.Other fixed-income securities had tightened, so the expectation was that CMBS would as well. Spreads on the secondary market had tightened by a couple of basis points last week.

Investors expect at least two other conduits to price when all is said and done. Those would be led by Deutsche Bank and JPMorgan Securities, respectively.

Bank Lending Through August: Commercial Real Estate Lending At Smaller Banks Continues To Thrive

Summary

• Commercial real estate lending continues to grow rapidly and the smaller banks further underwrite the construction industry.
• Business loans at the largest banks in US continue to rise but support M&A activity, stock buy backs, and hedge fund and private equity transactions.
• Foreign-related institutions are reducing the US cash being taken off shore.

Three areas I would like to focus on today: commercial real estate lending at the smaller banks; business lending at the largest banks; and the reduction in cash assets at foreign-related institutions in the United States.

First, let's look at commercial real estate lending. Over all, commercial real estate loans at all commercial banks in the United States rose at a 7.2 percent, year-over-year rate in July 2014. This amounted to an increase of about $105.0 billion. In the four weeks ending on August 27, 2014, they increased another $7.9 billion.

The largest portion of this increase came at the smaller, domestically chartered banks. Almost two-thirds of the commercial real estate loans in the domestically chartered banks come from the smaller commercial banks, a total of almost $1.0 trillion.

Over the past 52-week period, the smaller banks increased their loan portfolio by 11.0 percent, or about $95.0 billion.

The smaller banks have almost 37.0 percent of their loan portfolios in commercial real estate loans - 24.0 percent of their total assets.

One of the major concerns of the Great Recession was the fear that commercial real estate loans were going to result in a lot more bank failures than actually occurred. The commercial real estate loans were five- to seven-year loans and were to be paid off at maturity. The loans did not turn up on the bad loan lists of the banks because in 2010 or 2011 or 2012 they had not matured yet and hence there was no pressure on the banks to write them down…or off. The hope was that the recovery would allow them to be paid off…or refinanced.

The recovery did its job. The banks were able to refinance the loans…with the consent of the regulators - and, because of the delays in finishing the projects, construction firm's required additional funds to pick up on where they left off during the recession - and these new funds were approved.

One of the major reasons for the increase in the loan balances at these banks is not because of new loans coming on the balance sheets of the banks, but because of the new money given to the borrowers so that they could complete their projects.

The health of these smaller banks is becoming more and more dependent on the ultimate payoff of these commercial real estate loans. My concerns are with the concentration of bank assets in these loans; the shakiness of the economic recovery so dependent on these commercial real estate developments; and the continued shrinkage of the banking system, especially in the number of small banks in existence.

The second area is the growth of business lending, commercial and industrial loans, at the largest banks in the United States. From July 2013 through July 2014, C&I loans in the whole banking system rose by about 11.0 percent, a good healthy number. In the past four weeks, ending August 27, C&I loans rose by another $15.5 billion.

Of this increase, 44.0 percent of the increase came at the 25 largest domestically chartered banks in the United States and another 27.0 percent came from foreign-related institutions.

These organizations primarily lend to larger corporate organizations.

It seems as if the largest proportion of these loans have been going to large corporations - to help them pay dividends, to buy back stock, and to engage in mergers and acquisitions - and to hedge funds and private equity funds to help them finance their current transactions.

Note, that almost all of these uses of funds are not for current productive purposes, either the production of consumption goods or for producing investment in plant or equipment. The money is being used in the financial circuit of the economy to support financial transactions.

This is, of course, evidence of why the efforts of the Federal Reserve are flooding into areas of the economy that do not result in more robust economic growth.

Finally, I would like to call attention to the fact that foreign-related institutions, in the past four weeks or so, have actually been reducing the amount of funds they are taking off shore. I have focused on the behavior of these foreign-related institutions almost every month in my review of the banking system for the past four or five years.

Over the last four weeks, the foreign-related institutions have reduced their "Net deposits to related foreign offices" by almost $80.0 billion. Over the past several years as the financial situation in Europe grew, these deposits grew from a negative amount of around $150.0 billion to a positive amount of about $650.0 billion, a swing of about $800 billion dollars. Not an insignificant amount of the Fed's money to be taken off shore.

We will have to watch this further to really understand what is taking place. The decline could be the result of the actions of the European Central Bank and the efforts of the ECB to lower the value of the euro. We will see.

 

Overall, the commercial banking system seems to be doing all right and surviving. It is just not contributing much towards further economic expansion.

Carve-outs: Bad-boy Guarantees Have Borrowers Getting Spanked

So-called bad-boy guarantees have recently created headaches for borrowers when CMBS loans go bad, industry experts told Mortgage Observer. A number of recent cases across the nation have interpreted the guarantees, which prohibit certain borrower activity, like “indebtedness,” and “insolvency,” to mean that the principals of a borrowing entity are personally liable for losses in the event of default—a shocking development for CMBS borrowers and lenders alike.

It began with a 2011 case, Wells Fargo vs. Cherryland Mall, which rose to the highest court in Michigan. A provision that the borrower would “not become insolvent” was found to constitute a personal guarantee by the principal of the development company, which had defaulted on a CMBS loan, said Sam Lee of Duval & Stachenfeld. “It created a ripple effect,” in the industry, he said, because that “innocuous phrase,” one type of bad-boy clause, was boilerplate in many CMBS loan documents at the time. (The ruling by the Michigan court was actually later overturned by the state legislature, in an unprecedented move).

The Michigan ruling “meant, in effect, that a non-recourse loan—a loan that is asset-based, where you’re only looking at the property—all of the sudden became a recourse loan,” said Jonathan Mechanic, head of real estate at Fried, Frank, Harris, Shriver & Jacobson LLP. Cherryland was followed by a similar case in Georgia, in 2012, where the court followed the Cherryland court’s precedent (and Wells Fargo was also the plaintiff ), and later by CP III Rincon Towers vs. Richard Cohen, filed this year in New York’s Southern District.

Many in the industry agree that the Cherryland case was not in line with industry expectations, or with the intentions of borrowers when they signed. In fact, the court did not look at intention in Cherryland, said Janice Mac Avoy, a partner in Fried, Frank’s real estate group.

Even lenders do not universally want the guarantees interpreted this way, a source told MO, because they could discourage borrowers from from taking out CMBS loans in the future. (Bad-boy guarantees have largely been removed from loan documents now, that attorney said, though legacy CMBS could continue to spur suits for the next couple of years).

In the Rincon case, a fund named Carmel Partners bought the debt after Bear Stearns went belly up, said Ms. Mac Avoy, who represented borrower Mr. Cohen. Carmel argued that clauses prohibiting “unpermitted” indebtedness and transfers triggered full recourse when the borrower was slapped with a mechanic’s lien. Carmel sought to take control of the property, a San Francisco condominium conversion, by way of a non-judicial foreclosure. But the fact that in draft documents with the original lender the borrower deleted a clause that would have triggered loss recourse in the event of a mechanic’s lien supported Mr. Cohen’s argument this instance should not trigger full recourse, and the court found in favor of Mr. Cohen.

Carmel is appealing, however, and, if successful, the outcome would alarm many CMBS borrowers, sources said. It would also potentially open the door for a bevy of litigation, since so many CMBS loans would fall under the same New York jurisdiction.

The industry is keeping a watchful eye on the case. The appeal should be decided early next year, Ms. Mac Avoy said.

“Some people are outraged that [bad boy clauses] are getting enforced,” said Chris Delson, a partner in the real estate group at Morrison & Foerster LLP.

And the Georgia and Cherryland rulings run contrary to industry understanding of CMBS loans and their risks, Ms. Mac Avoy asserted. “The issuer is saying ‘we are not making individual credit decisions,’” when originating a CMBS loan, she said. Rather, they are lending based on property fundamentals.

Still, many believe the courts in New York will take the side of CMBS borrowers. Such a ruling would be in line with the sentiment of past, similar cases brought and decided here, sources said.

“We had a case at 610 Lexington Avenue about a year and a half ago where a lender tried to take the position that it was recourse,” said Mr. Mechanic. “The court sided with us and said, ‘no, that doesn’t make sense.’”

Private Equity: When Lenders Question Funds on Their Guarantees

Concerns over the net worth and liquidity of private equity funds are increasingly causing disputes and delays in commercial real estate transactions, Schulte, Roth & Zabel’s Jeffrey Lenobel told Mortgage Observer.

“I represent a lot of private equity and disputes and extensive negotiations happen on virtually every deal where a guarantee from a private equity fund is involved,” said Mr. Lenobel, head of the of the New York-based law firm’s real estate group.

With private equity investors now playing such a pivotal role in commercial real estate deals, those investors are now asked to sign guarantees ranging from non-recourse carve-out guarantees to environmental indemnity agreements to completion guarantees in construction deals. A leading cause of friction is unmanaged expectations, wherein lenders expect a consistent and concrete proof of income and liquidity, according to Mr. Lenobel.

“The first and threshold issue is that just because a private equity firm has a series of funds doesn’t mean that fund II can guarantee the obligations of fund I,” he said. “These funds, for the purposes of guarantees, are separate entities and I don’t think the investors in one fund would have any interest in guaranteeing the real estate held by investors in a different fund,” he added.

The concerns are multilayered. During the investment period of a given fund, there is little if any liquidity, Mr. Lenobel said. Instead, the value of that fund comes from uncalled capital commitments made by various investors and is, essentially, theoretical.

“At the point, if a lender says, ‘O.K. private equity fund, you need to guarantee the obligations, what’s your net worth?’, you are going to look at the fund’s financial statement during this investment period and see that it virtually has no assets and virtually no equity,” he explained. In those situations, disputes often arise between lenders and private equity investors over whether uncalled capital commitments count as assets.

After the investment period, when all of the capital has been called and a private equity fund owns several assets, a different issue arises. Since the average lifespan of a private equity fund is relatively short compared to most real estate companies, REITs and pension funds—in many cases between seven and 10 years after the investment period—the sale of a private equity fund’s assets may raise new concerns about its net worth. As a fund sells off its assets, the liquidity and net worth tests often imposed by lenders can yield unsatisfying results, making it more difficult for that fund to prove its solvency.

“Everybody has to look at the timing of the tests imposed by lenders on private equity funds,” the real estate attorney said. “This will avoid unexpected problems.”

In order to comply with customary net worth and liquidity covenants, private equity funds can mitigate guarantee concerns by holding onto a percentage of their assets to establish reserves and also by establishing third party lines of credit, among other measures, he said.

In most cases, lenders just need to manage their expectations, he added.

“Lenders are starting to understand how funds work and that is paramount to these issues, since private equity funds are among thebiggest players in the real estate industry today,” Mr. Lenobel told MO.