Doug Cornelius .com

Parke Chapman wrote a primer in the National Real Estate Investor on CMBS, CDO and the commercial debt markets.

Some highlights:

Q: What led to the formation of the first commercial real estate CDO in 1999?

A: Commercial real estate CDOs were a major innovation in part driven by the need to diversify risk after the 1998 Russian financial crisis sparked a global liquidity crunch. Unlike CMBS, which adhere to strict rules on the type and quality of collateral, the commercial real estate CDO market allowed lenders and investors to introduce a debt vehicle with more flexibility. What this means is that commercial real estate CDO managers can swap collateral out of the pool, making these highly managed pools of debt.

Q: What types of loans back CMBS and commercial real estate CDOs?

A: Two key differences center on the fixed- and floating-rate nature of the collateral. Commercial real estate CDOs are typically backed by floating-rate loans whereas CMBS collateral is backed by first-mortgage loans. A commercial real estate CDO can be backed by all sorts of collateral. CMBS, preferred equity and construction loans are commonly held by commercial real estate CDOs. REIT bonds and various other types of exotic debt such as second-lien loans and unsecured debt can get lumped into these pools.

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CDO

With mezzanine financing, there is a potential guarantee liability to the principals of the developer that they may not foresee. The issue arises in a financing that has a mortgage loan with springing guarantees combined with a mezzanine loan secured by a pledge of interests in the mortgage borrower.

Generally, the principals of a mortgage borrower give a bad boy springing guarantee to the mortgage lender. The principals agree to be personally liable for the mortgage loan if the borrower declares bankruptcy or does other “bad” things. Principals of the borrower give these guarantees because they control the borrower and have an economic interest in the borrower. They are essentially agreeing that in exchange for a non-recourse loan, they will not fight the lender’s efforts to take the collateral if the loan defaults.

The problem arises when the mezzanine lender forecloses on the pledge of interests in the mortgage borrower. After foreclosure, the mezzanine lender controls the mortgage borrower. Meanwhile, the springing guarantor has lost its economic interest in and management control of the mortgage borrower, but still has the liability under the guarantee for “bad acts” of the mortgage borrower.

If there is a mezzanine loan that goes into default, followed by a foreclosure by the mezzanine lender, the mezzanine lender controls the borrower, not the guarantor. The mezzanine lender can then threaten to bankrupt the mortgage borrower and trigger the personal liability for the mortgage debt. In the end, the guarantor may be forced to repay the mezzanine lender on its loan; in effect, the mezzanine loan had become a recourse obligation.

Mezzanine borrowers/bad boy guarantors should require the mezzanine lenders to obtain either (i) a release of the bad boy guarantor from the mortgage lender (usually by replacing the bad boy guarantee with one from the mezzanine lender) or (ii) an appropriate indemnity from the mezzanine lender for liability under the bad boy guarantee that the mezzanine lender creates post foreclosure. In each case, this should be a condition to permitting the foreclosure of the mezzanine position.

mezzanine loans
mortgage

When browsing through Massachusetts Lawyers Weekly, I came across Kowalczyk, et al. v. Estate of Smiarowski (Lawyers Weekly No. 14-087-07) (6 pages) (Sands, J.) (Land Court) (Misc. Case No. 245456) (July 31, 2007) (subscription required).

It cited M.G.L.c.240, section 15, which provides for a discharge of a mortgage that is 20 years past its expiration date. I had not run across this statute before, but it looks like a useful method to discharge old mortgages. The 20 years is a long time frame. With a typical 10 year commercial mortgage or 30 year residential mortgage, the old, undischarged mortgage would have to be very old to fall under the statute.

M.G.L.c.240, section 15 states:
(b) If the record title of land or of easements or rights in land is encumbered by an undischarged mortgage or a mortgage not properly or legally discharged of record, and the mortgagor or the mortgagor’s heirs, successors or assigns do not have actual or direct evidence of full payment or satisfaction of the mortgage but the mortgagor, or the mortgagor’s heirs, successors or assigns have been in uninterrupted possession of the land or exercising the rights in easements or other rights in the land, either: (1) in the case of a successor or assign who is a bona fide purchaser for value or who is an heir, successor or assign of the bona fide purchaser for value, for any period of 20 years after the recording of a deed from the mortgagor or his heirs or devisees to the bona fide purchaser, which deed did not evidence that title was taken subject to the mortgage or that the purchaser assumed or agreed to pay the mortgage; or (2) in the case of the mortgagor, or the mortgagor’s heirs, devisees or successors by operation of law, for any period of 1 year after the expiration of the time limited in the mortgage for the full performance of the condition thereof, or for any period of 20 years after the date of a mortgage not given to secure the payment of money or a debt but to secure the mortgagee against a contingent liability which has so ceased to exist that no person will be prejudiced by the discharge thereof, the mortgagor, or the mortgagor’s heirs, successors or assigns, or any person exercising the rights in easements or any person described in section 11, may file a petition in the land court or, except in the case of registered land, in the superior court for the county in which the land is located; and if, after such notice by publication or otherwise as the court orders, no evidence is offered of a payment on account of the debt secured by the mortgage within the relevant period of uninterrupted possession or of any other act within the time in recognition of its existence as a valid mortgage, or if the court finds that the contingent liability has ceased to exist and that the mortgage ought to be discharged, it may enter a decree discharging the mortgage, which decree, when duly recorded in the registry of deeds for the county or district where the land lies or, in the case of registered land, when duly noted on the memorandum of encumbrances of the relevant certificate of title, shall operate as a discharge of the mortgage and no action to enforce a title under the mortgage shall thereafter be maintained.

I will speaking as part of the seminar: Real Estate Development From Beginning to End in Massachusetts in Dedham on November 16, 2007.

Agenda

construction mortgage

The Attorney General is proposing new regulations under the Consumer Protection Act (M.G.L. 93A). The new regulations add new prohibited activities as provisions (15), (16), (17) and (18) under 940 C.M.R 8.06.

The new prohibited activity in item (18) of the proposed regulations prohibits a lender from discriminating among similar borrowers. “It is an unfair or deceptive act or practice for a lender (a) to use a pricing model for its mortgage loans which treats borrowers with similar credit criteria and bona fide qualification criteria differently; or (b) to make a mortgage loan when any or all of the cost features of the mortgage loan are based on criteria other than the borrower’s credit and other bona fide qualification criteria.”

Although this regulation has a good purpose in preventing lenders from discriminating among borrowers, no two borrowers or properties are the same. The regulation gives no safe harbor for a lender to show that it is not discriminating.

The Attorney General is proposing new regulations under the Consumer Protection Act (M.G.L. 93A). The new regulations add new prohibited activities as provisions (15), (16), (17) and (18) under 940 C.M.R 8.06.

The new prohibited activity under item (17) makes it a “deceptive act or practice for a mortgage broker to process, make or arrange a loan that is not in the borrower’s interest.” It goes on to require the broker to disclose when the financial interest of the broker conflicts with the financial interest of the borrower. If the broker is going to get paid more if the borrower gets a loan with a higher interest rate, the broker needs to disclose the conflict and not help with the loan. The regulation further provides that the broker cannot disclaim a fiduciary duty to the borrower.

I surprised that the regulation requires the mortgage broker to have a fiduciary for the borrower. I think the mortgage broker is acting as an agent for their lenders, not as an agent of the borrower.

I think this regulation, if enacted, will leave mortgage brokers scratching their head as to how to operate. How can they determine if a loan is in a borrower’s interest?

The Attorney General is proposing new regulations under the Consumer Protection Act (M.G.L. 93A). The new regulations add new prohibited activities as provisions (15), (16), (17) and (18) under 940 C.M.R 8.06.

The proposed prohibited activity in (16) limits the mortgage lender’s ability to make no-documentation or limited documentation loans. These types of loans were targeted at borrowers who had trouble documenting all of their income. Typically this type of borrower would be an independent contractor or small business owner. [CNN.Money background article]

On the dark side, I believe these borrowers were typically a contractor or business owner who did not do a good job tracking all of the cash they received and was hiding income from the taxman. I also think these loans were used for a borrower trying to get more of a mortgage than they would ordinarily be able to get using typical underwriting standards. The borrower would state that they had more income than they actually did. I never saw a good reason for this type of loan to exist other than to cheat the lender or the taxman.

The Washington Post does not paint a pretty picture on the use of these loans: The Lowdown on Low-Doc Loans.

Although the new regulation does not prohibit this type of loan, the regulation makes them very unappealing to lenders. The lender must deliver a statement with the borrower’s income and a disclosure that the loan will be at a higher interest rate because of the “no-doc” option. Also, the lender needs to verify the employment and income when the stated income is “not reasonable for the occupation or experience of the borrower.. . .”

I do not know how a lender is supposed to determine what a reasonable income is for a person in a particular occupation with a particular level of experience. Effectively, a lender is leaving itself wide open for a claim under 93A if makes no-doc or limited doc loans in Massachusetts.

The Attorney General is proposing new regulations under the Consumer Protection Act (M.G.L. 93A). The new regulations add new prohibited activities as provisions (15), (16), (17) and (18) under 940 C.M.R 8.06.

The new (15) provides in part: “It is an unfair or deceptive act or practice for a . . . lender to . . . make a mortgage loan unless the . . . lender . . . reasonably believes at the time the loan is expected to be made that the borrower will be able to repay the loan based upon a consideration of the borrower’s income, assets, obligations, employment status, credit history, and financial resources, not limited to the borrower’s equity in the dwelling which secures repayment of the loan. . . .”

The problem with this new prohibited activity is the lack of a benchmark for a lender to rely on. The challenge from the borrower under (15) will almost always come after the person has gone into default and is scrambling to prevent foreclosure. How can the lender prove that they reasonably believed the borrower could repay the loan when it turns out that the borrower could not.

How much of their income should a borrower reasonably be expected to expend on their mortgage and still be expected to be able to repay the loan? Certainly a loan with monthly payments in excess of 100% of a borrowers net monthly income would be a violation of this new provision. But I am not sure where the percentage hits the tipping point to become reasonably expected to be able to repay. 90%? 75%? 50%? 25%?

I think the borrower should be the party that determines if they will be able to repay the loan.

The Attorney General is proposing new regulations under the Consumer Protection Act (M.G.L. 93A).

The Attorney General summarized wants to enact the new regulations to:

· Prohibit mortgage brokers or lenders from making a loan if they do not have a
reasonable belief that the borrower is able to repay the loan.
· Restrict the abuse of no-documentation or “stated income” loans by requiring that the mortgage broker or lender disclose how the interest rates or other charges will increase under a “no-doc” loan, and obtain the borrower’s signed statement of income in order to process those types of loans.
· Prohibit mortgage brokers from arranging or processing loans that are not in the borrower’s interest, and prohibit brokers from brokering loans if their financial interests conflict with the borrower’s.
· Prohibit mortgage lenders from steering borrowers to loan products that are more costly than those that the borrower qualifies for, and prohibits lenders from discriminating between similarly qualified borrowers.

These new regulations are an update of regulations from 1992 when the last big mortgage crisis affected the Commonwealth. The regulations apply to all residential mortgages, except open end home equity lines of credit.

The update adds new prohibited activities as provisions (15), (16), (17) and (18) under 940 C.M.R 8.06.

I have a lot of concern about knee-jerk reactions to mortgage crisis. One person’s predatory lending is another person’s provider of an opportunity to invest in real estate.

The Massachusetts Attorney General is reacting to the current sub-prime mortgage lending situation by proposing several new regulations under M.G.L. 93A

A copy of the proposed regulations can be found here.

The hearing schedule for the proposed regulations is as follows:

Monday, September, 17, 2007, 11:00 a.m.
Worcester Regional Chamber of Commerce
339 Main Street
Worcester, MA 01608

Tuesday, September 18, 2007, 11:00 a.m.
Brockton District Court, Rotunda Hearing Room
215 Main Street
Brockton, MA 02301

Wednesday, September 19, 2007, 10:00 a.m.
Office of the Attorney General
1350 Main Street, 3rd Floor Conference Room
Springfield, MA 01103

Thursday, September 20, 2007, 10:00 a.m.
The State House – Gardner Auditorium
Boston, MA 02108