CAPITAL MARKETS MORTGAGE:

 

Joseph Philip Forte

 

I.                   Introduction

 

            Historically, real estate finance business has been conducted ,within local markets. The traditional sources of real estate financing, whether for acquisition, development, or construction, have been the institutional lenders that do business in that local “Main Street” market–the commercial banks, thrifts, and insurance companies.  Until recently, primary market lenders generally did not approach the capital, or “Wall Street,” market for funding before or after loan origination. Likewise, with a few notable exceptions, Wall Street rarely made forays into the local real estate finance markets, and normally, it did so only to service an existing investment banking client with corporate real estate needs. Thus, while Main Street lenders focused primarily on the individual real estate project, Wall Street’s focus in real estate finance, for the most part, was limited to corporate client relationships. However, in recent years, Wall Street has expanded its real estate focus to become another source of real estate financing.

 

I.                   Background

 

A.                          Residential Mortgage‑Backed Securities (MBS)

 

            Wall Street’s orientation began to shift when Government Sponsored Entities (GSEs) entered the residential real estate finance markets nationwide in the 1970s.[1] Wall Street discovered and quickly exploited the opportunity to profit from the inefficiency of the fragmented residential real estate finance market.

 

            Although residential mortgage‑backed securities (MBS)[2] issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) were not backed by the full faith and credit of the United States, as GNMA’s MBS were, the government sponsorship of the GSEs created a capital markets perception of an implicit government guarantee.[3] This shadow guarantee, coupled with some Federal Housing Administration and Veteran’s Administration (FHA/VA) Loan pools, was the equivalent of a two‑tier credit enhancement. Without the usual capital markets credit concerns, the MBS issued by GSEs did not have to be structured to minimize the credit risks inherent in real estate finance transactions.

 

            The development of conventional or Private Label residential MBS transactions was, however, hampered by credit risk concerns. While some isolated Private Label MBS issuance occurred in the late 1970s, non‑GSE securitization of whole loans did not gain momentum until the thrift industry crises in the high interest rate environment of the early 1980s. Based on its good experience with GSE issued MBS, Wall Street saw a unique opportunity to profit from the thrift crisis by proffering the securitization exit strategy as the solution to the thrifts’ residential portfolio dilemma. Real estate assets, such as mortgages, are inherently illiquid and are not as freely transferable as securities. If the real estate assets, however, serve as a basis for the issuance of securities, greater liquidity can be attained through a vehicle separate and distinct from the real estate assets.

 

            Without a GSE issuer and the credit enhancement from a government guarantee, the Wall Street market would not consider a Private Label MBS to be equivalent to a GSE issued MBS. With a Private Label MBS, an investor would need to be concerned with the credit of the issuer as well as with the usual credit risks associated with real estate assets. To assure the market of timely payments on the securities, it became necessary to structure the Private Label transactions to provide credit support.[4]  This credit support can be provided by third party or issuer credit enhancement or by the structure of the transaction.[5] While mortgage loan sellers in the secondary market typically make representations and warranties concerning their mortgage loans and are generally obligated to repurchase the related mortgages in the event of a default, representations and warranties by a seller are not considered to be credit enhancement for a structured transaction in the capital markets.[6]

 

            In determining whether to purchase a particular class of securities, capital markets investors generally place enormous reliance upon the investment grade rating assigned to the issuance by one or more of the national credit rating agencies.[7] Credit enhancement makes the Private Label MBS more acceptable to capital markets investors and substantially increases the possible base of investors because it enables an issuer to obtain an investment grade credit rating for its MBS issuance. Investment grade ratings, therefore, become the key to success in the capital markets by allowing investors to dispense with the in‑depth review of the real estate that a primary market lender would undertake in its normal underwriting process.[8]

 

A.                          Commercial Mortgage‑Backed Securities (CMBS)

 

            Although the Wall Street investor (albeit wrongly) views the real estate collateral pooled for a residential MBS as homogeneous and similar in certain respects to corporate bonds, an investor cannot make the same assumptions in the face of the unique and diverse nature of commercial real estate.[9]  The securitization of commercial mortgages had a slower and more deliberate growth than the securitization of residential mortgages.[10]  Although several MBS transactions involving pools of commercial mortgages or a single large CMBS were closed from 1984 to 1985, the strong resurgence of interest by traditional Main Street lenders in commercial mortgages in the mid‑1980s stalled any further development of a CMBS market beyond some occasional isolated transactions.[11] The oversupply of traditional Main Street capital, unfettered by market restraints, crowded out the capital markets investors, but the cycle quickly ran its course. A series of events, including the savings and loan crisis and the stiffening commercial bank regulatory environment in the late 1980s, led to a national real estate depression in 1990 that effectively strangled the flow of Main Street capital to commercial real estate.  The credit crunch that followed severely impacted real estate and real estate investors, affecting lenders as well as owners.[12]

 

            In the early 1990s Wall Street again seized the opportunity to provide a countercyclical funding source for commercial real estate finance transactions. However, the task of developing a CMBS market was eased by the Resolution Trust Corporation’s (RTC) mandated sell‑off of mortgages acquired in the liquidations of the failed savings and loan associations.[13]  The RTC’s activity had several profound effects on the CMBS market: it significantly increased investor awareness and knowledge of CMBS; it expanded the base of CMBS investors; and it legitimized the CMBS market. With the increased pressure on the management of traditional real estate lenders to tailor their investment portfolios for credit rating agencies, their government regulators, and the financial markets, CMBS began offering a viable solution for risk management and reallocation of institutional assets.[14]

 

I.                  THE CAPITAL CONSORTIUM

 

            The converging interests of Main Street and Wall Street lenders in the development of the CMBS market created a unique opportunity for the real estate industry to organize a unified effort to respond to the effects of the credit crunch. But to successfully join commercial real estate finance and capital markets, it was necessary for Main Street lenders to appreciate and respond to the specific concerns of Wall Street in the CMBS structures and for Wall Street to understand Main Street lender issues.  With the existing residential MBS market as a model of liquidity for single‑family properties, three national real estate trade associations joined forces, as the Capital Consortium, to pursue the common goal of fostering the development of a viable CMBS market to create a secondary market for commercial mortgages. The Capital Consortium is a confederation of the Mortgage Bankers Association of America (MBA), the National Association of Realtors® (NAR), and the National Realty Committee (NRC).[15]  To expedite and focus its efforts, the Consortium initially identified those primary obstacles to the CMBS market’s development which had not hampered development of residential MBS: lack of standard documentation, inconsistency in availability and scope of data on commercial mortgages, and a generally unfavorable regulatory and legislative environment for CMBS investment. The Consortium’s goals were to provide greater liquidity to the commercial secondary mortgage market, to bring enhanced market discipline and stability to the commercial mortgage market through efficient secondary market pricing, and to create known rating implications for commercial mortgage portfolios.

 

            Adhering to the Consortium’s objectives, the MBA‑sponsored Making the Market Working Group formulated data elements, which attempt to establish reporting guidelines for loans intended for securitization or for sale in the secondary market. To enhance market liquidity and to create efficient pricing, the Consortium promulgated the Data Elements Guidelines, that “aim at providing a comprehensive, uniform data framework for issuers, investment bankers, loan servicers and investors to better manage information at the security, class, pool, loan, property and tenant levels.”[16]

 

            The Clearing the Barriers Working Group, headed by the NAR, made tremendous progress toward removing regulatory and legislative barriers to commercial mortgage securitization. At the outset, the Consortium identified the following legislative and regulatory goals:  (1) to amend the “five or fewer” rule of the U.S. Tax Code governing real estate investment trusts (REITs); (2) to encourage federal preemption of state securities laws with regard to merit review and limitations on investment in CMBS; (3) to change the regulatory treatment of CMBS or portions of loan portfolios sold to others to avoid over‑reserving for federally regulated banks; and (4) to create a class exemption in the Employee Retirement Income Security Act’s (ERISA) “parties in interest” and prohibited transactions” limitations for CMBS.[17]

 

            The NRC’s Creating the Instrument Working Group was responsible for dealing with the lack of standard documentation for commercial mortgage transactions.[18]  The Working Group spent more than three years developing a mortgage template that was susceptible to being readily and predictably underwritten, originated, rated, and pooled for CMBS transactions.[19]  The Working Group chose a mortgage document developed by a New York law firm with a significant real estate finance and capital markets practice as its initial discussion draft for the ratable mortgage template.  The law firm’s mortgage template was created thirteen years ago for a national residential lender that regularly pooled its residential loans for securitization. The lender was contemplating a national commercial and multifamily lending program that failed to go forward. Since that time, the form has been used by numerous traditional real estate and Wall Street lenders in the primary and secondary markets including the first commercial mortgage conduit. Recently, the firm that developed the model substantially revised and expanded the form to reflect the current market issues and reorganized the mortgage from its historical accretion format into a corporate document format with the articles and sections grouped by subject matter. The revised form has been used for a number of years by several commercial mortgage conduit programs, which have since pooled and securitized the multifamily and commercial loans based on the revised mortgage document.[20]  The revised form has also been used in many large single or affiliated borrower pools and in many property specific single‑asset transactions.[21]  As a model, it, therefore, had the benefit of extensive primary market usage and capital markets exposure.

 

            The Working Group delegated the drafting of the mortgage template to a Documents Task Force representing the diverse constituencies within the NRC. The Task Force included owners, advisors, builders, investors, lenders, and managers of commercial real estate investments. The Task Force decided to produce a complete form of a generic mortgage, rather than a mere skeletal template.[22]  Starting with the revised model, the Documents Task Force met on numerous occasions for more than two years to discuss, draft, and adopt substantive as well as technical changes to the initial model. After the Documents Task Force completed its final draft of the mortgage template, it was delivered to a Principal Working Group, comprised primarily of the nonlender constituency of the NRC, for its review and feedback. After nine months of negotiations, the Principal Working Group obtained certain concessions and modifications to the final work product of the Task Force.[23] The CMM was then submitted to the three trade association members of the Consortium for their review and approval. The Consortium approved the CMM and published it on June 25, 1996, as part of its Capital Markets Initiatives.[24]

 

IV.  The Capital Markets Mortgage (CMM)

 

            To ensure structural consistency and ease of use, the CMM contains a detailed table of contents, which enables a document draftsman or due diligence reviewer to locate specific provisions more easily.[25]  The CMM also incorporates a list of definitions for greater consistency in negotiating and documenting transactions and is organized by subject matter with numbered articles and sections that are captioned to proffer a more modem documentary presentation.[26]  Further, the CMM uses terms such as “borrower” instead of “mortgagor,” “lender” instead of “mortgagee,” and “security instrument” instead of “mortgage” to allow the use of consistent terms throughout various loan documents such as promissory notes or assignments of leases and rents.  Consistent terminology permits easier substitution of clauses between documents, especially between real estate security instruments in multistate transactions. The material provisions are outlined within the CMM and are in standard locations throughout the document for ease of drafting, modification, or due diligence review.[27]  It also contains certain legal and economic concepts universal to all real estate secured loans[28] and identifies certain substantive sections and clauses that may be added or deleted as appropriate in particular transactions, such as transactions based on property type or borrower entity.[29]  A Special Covenants article provides for the insertion of special transaction‑specific provisions without any disruption of the standard provisions’ placement,[30] and a separate Local Law article allows modification of the generic template for state‑specific law provisions.[31]

 

            Substantively, the Documents Task Force, in its development of the CMM, considered the recent experience of real estate lenders (from Main Street as well as Wall Street) in the primary and secondary mortgage markets; the current requirements of the various credit rating agencies in pool and as single asset CMBS transactions; and certain issues of particular importance to capital markets investors.

 

            To better appreciate the capital market related modifications to the CMM, it is helpful to understand that three elements are essential for any securitization structure to be ratable and, therefore, marketable: (1) the structure must not permit any interruption of the cash flow from the property to the ultimate investor; (2) all information regarding the borrower, principals of the borrower, the property, and the mortgage must be disclosed to the investors; and (3) the structure must disallow or must compensate for the repayment of any principal before its scheduled repayment, whether in installments or at maturity. These elementary principles drive many of the structural considerations that often baffle the Main Street lender, the lender’s counsel, the borrower, and the borrower’s counsel in looking at a commercial mortgage loan that is being originated for securitization. Knowledge of these basic principles of structured finance provides the real estate lawyer with a better grasp of the perspective of Wall Street, specifically investment bankers, credit rating agencies, and capital markets investors. This perspective has added certain significant nontraditional provisions to the CMM.

            The Wall Street perspective influenced the CMM’s provisions in a variety of ways, including financial reporting requirements and single‑purpose entity (SPE)/bankruptcy remote covenants. To avoid cash flow interruptions in a capital market transaction, an SPE is often required to be used by borrowers at the loan level[32] and by issuers at the securities level because of capital markets concerns that an entity (which may own other properties, assets, or businesses and incur other debt) is more susceptible to the risk of bankruptcy.[33]  The prohibition against any secondary financing in mortgage loan documents is similarly based on a concern that the junior mortgage lender might file for bankruptcy protection.[34]  A bankruptcy filing by or against a borrower, issuer, or junior mortgagee occasions, at a minimum, the imposition of an automatic stay of the lender’s enforcement rights against the property and a consequent temporary disruption of the cash flow. In addition, at the securitization level, a credit rating agency will look for third‑party confirmation that the transfer of pooled loans by the depositor to the CMBS issuer is characterized as a sale and not as a financing. In the event of an insolvency, if the transfer were characterized as a financing, an automatic stay would apply, delaying payments to investors.  The credit rating agencies may request that the transaction counsel provide a true sale opinion covering the sale from the transferor to the issuer. [35] The credit rating agency also may be concerned with the potential bankruptcy of the SPE issuer and may require assurance that the issuer would not be substantively consolidated in the bankruptcy proceedings of any affiliate of the transferor of the pooled loans. The credit rating agency may request the issuer’s counsel to render a nonconsolidation opinion to confirm the absence of this risk in the structure.[36]

 

            Addressing the specific requirements of the various credit rating agencies in drafting the CMM, the Consortium required the borrower, in certain cases, to make certain representations and warranties as well as specific covenants regarding its SPE/bankruptcy remote status.[37]  In certain other cases, the borrower may be required to make warranties and covenants promulgated by the various credit rating agencies with respect to its principal’s SPE/bankruptcy remote status, although the mortgage provision does not set forth any detailed representations and warranties beyond a mere cursory listing and intentionally does not set forth or sanction the credit rating agencies’ “wish list.”[38]  The CMM, however, does contain a specific default provision for the borrower’s failure to maintain its SPE status.[39]  In the same vein, the CMM provides that a lender’s consent to any transfer under the due‑on‑sale provisions may be conditioned upon, among other things, confirmation by the credit rating agency that “the transfer would not cause a downgrade, withdrawal or qualification of any Securities then rated.”[40]  The provision assumes that any permitted transferee would have to be an SPE entity similar to the borrower. Regarding secondary financing, the CMM reflects the current credit rating agency preference for an absolute prohibition against any secondary financing.[41]  The CMM also expressly provides more detailed and specific requirements for the borrower’s obligations to provide the lender with certain types of insurance regarding the property including minimum insurable amounts, limitations on deductibles, and special endorsements for such policies.[42]  Finally, the CMM imposes certain minimum credit rating agency standards for acceptable insurers.[43]

 

            Access to and disclosure of information in the capital markets is critical to the securitization process.[44]  A growing appetite for property and borrower‑specific information spawned by the losses accrued in the most recent national real estate depression, coupled with the continuing development of sophisticated computer data collection and retrieval systems in loan servicing, has fueled a feeding frenzy for information in commercial real estate finance.[45]

            The development of the CMBS market has further accelerated the process of modernizing the information infrastructure with respect to the quantity, quality, scope, and type of information requested.[46]  The increased availability of such information, has caused the number of parties gathering and reviewing information to grow. In addition to the traditional participants, credit rating agencies, secondary market investors (senior, mezzanine , and subordinate), trustees and custodians, due diligence contractors and their respective attorneys, accountants, and other agents are involved in various stages of the process, whether the transaction deals with a whole loan, bulk sale, or sale of CMBS in a public offering or a private placement.

 

            Noninvestment grade investors, especially holders of the first loss position (the “B” piece buyer[47]), will have an even greater need for critical information regarding borrowers and properties.[48]  Without the comfort of an investment grade rating, noninvestment grade investors or their due diligence agents are compelled to review the borrower’s credit and collateral to assure themselves of the prudence of their investments. Because of the inherent risk of the subordinate creditor position, the due diligence that they undertake may be greater than that of a primary mortgage market lender and similar to that of a junior mortgagee.  This need for information does not cease after the loan is initially underwritten, closed, and funded. A CMBS, by definition, is designed to trade both the senior (the “A” piece buyer) and the B piece buyer. Current information is critical for prudent trading to occur.

 

            To address the concerns of capital markets investors,[49] the CMM has significantly increased the scope and frequency of the delivery of financial information regarding the property, borrower, and any indemnitor. In addition, the borrower expressly covenants to obtain tenant estoppel certificates concerning leases on the property, as well as to provide estoppel certificates during the term of the loan.[50] Yet, market experience dictates that to better enforce borrower compliance with this information covenant, the mortgage should include some monetary or other penalty for the borrower’s failure to deliver its financial books and records that does not constitute an event of default and acceleration for the borrower’s failure to observe a covenant.[51]  Some lenders have also imposed a monetary charge for a borrower’s failure to deliver financial statements in a timely manner as required by the mortgage.[52]  Other lenders impose personal liability for the debt upon the borrower’s failure to deliver financial statements.  To encourage the liquidity of CMBS,[53] the mortgage template contains specific borrower covenants regarding its continuing disclosure obligations during the term of the loan.[54]  Further, the template contains an express provision for lender disclosure to any purchasers, transferees, assignees, servicers, participants, investors or their successors, or credit rating agencies of documents and information that the lender may obtain about the borrower, indemnitors, or property.[55]

 

            Because many different classes or “tranches” of loan pool cash flow may be created in a CMBS issuance,[56] any early return of loan principal prior to its scheduled repayment in whole or in part may severely disrupt the CMBS structure. Therefore, to facilitate the tranching of CMBS and protect the different interests of the respective classes of CMBS investors, article 9 of the CMM is dedicated to prepayments before default, after casualty/condemnation, and after default.[57] Article 9 does not specifically provide a particular yield maintenance formula, but rather allows the individual lender to determine the satisfactory yield maintenance computation based on the lender’s perception of current capital market acceptance. Because mortgage pool trustees are typically discretion‑adverse, the CMM mandates the use of insurance proceeds and condemnation awards,[58] subject to certain dollar thresholds and destruction/taking percentage limits,[59] for the restoration of the afflicted property upon compliance by the borrower and property with certain pre‑set conditions.

            Finally, the CMM establishes a relatively self‑executing mechanism for the disposition of casualty insurance proceeds, as well as condemnation awards, for use in the restoration of the property.[60] This last provision is quite unlike the usual Main Street lender’s requirement that the lender retain discretion concerning the application of any such proceeds or award to the restoration of the property or to the reduction of the principal.[61]

 

            Several of the new capital markets provisions, however, respond to neither credit rating agencies nor capital market investors. They respond to the method of operation of the marketplace. The borrower’s traditional warranty of title and authority has been expanded to encompass additional representations and warranties well beyond those found in a typical affidavit of title.[62]

 

            Regardless of whether commercial mortgages are sold as whole loans or publicly or privately as securitized pools, representations and warranties must be provided to potential investors; it is the custom of the marketplace. The nature and type of the representations and warranties may have an effect on the pricing of the transaction. For the average capital markets investor, the warranties may serve as an initial disclosure device or, in some cases, a substitute for due diligence. The CMM representations and warranties do not mirror the “wish list” of representations and warranties published by the credit rating agencies.[63]  However, the seller‑issuer into the capital market can ultimately look to the representations and warranties of the borrower contained in the mortgage and of any prior seller contained in the mortgage purchase and sale agreement,[64] as a backup to the representations and warranties it must make or pass through to the capital market.

 

            Because the Documents Task Force sought to appeal to the widest possible user audience for its CMM and to establish its qualifications by demonstrating its expertise and experience in the real estate finance markets, the CMM contains many new nontraditional provisions that are based on recent developments in case law,[65] statutory law,[66] and the bitter lessons of the last real estate downcycle.

 

            Lender underwriting practices, having become more stringent as a result of the lien enforcement and collateral recovery problems of the last national commercial real estate crisis,[67] have had a significant impact on the legal documentation requirements for the commercial real estate financing of many traditional lenders. In the CMM, the carveouts to exculpation impose personal liability on the borrower for the lender’s losses due to fraud or intentional misrepresentation, or misappropriation of rents after default, security deposits, rents paid in advance, and insurance or condemnation proceeds. However, the borrower’s liabilities have been expanded to include the payment of fees or commissions to affiliates or principals after default in violation of the mortgage and for any criminal acts perpetrated regarding the property.[68] Although the CMM has incorporated a springing personal liability for the debt provision negating exculpation, this provision has been limited to the borrower’s voluntary bankruptcy or involuntary bankruptcy commenced by an affiliate.[69]

 

            In addition to the usual default article,[70] a generic rights and remedies article contains all of the traditional disparate remedies available to a lender as well as other lender rights that are normally dispersed but well hidden throughout a more traditional mortgage.[71] Although it does not grant any new or unique remedies, the CMM does gather all of the remedies in one central location and sets forth generic remedies ordinarily deemed implicit in the mortgage or incorporated by reference to local case or statutory law. It includes, among other rights, the right to obtain the books and records,[72] the right of entry,[73] the right to release of property,[74] and the application of proceeds.[75]

 

            Other than new provisions occasioned by changes in federal flood insurance law, the property insurance provision of the CMM has been significantly expanded to set forth expressly the required types of insurance coverage[76] and includes a detailed outline of the types of policies and insurance carriers that are acceptable.[77]  With respect to other recent federal legislation, entirely new provisions relating to criminal activity,[78] and pension plans[79] have been added because they directly affect the commercial real estate that serves as collateral security for the loan, as well as the financial capacity of the borrower who owns the property and the indemnitor or guarantor of the loan.  Other provisions have been considered and rejected, such as a provision relating to access laws,[80] which was considered to be covered by the general Compliance with Laws section.[81]  Unless and until the U.S. Department of Labor grants a class exemption from ERISA for investment grade CMBS,[82] the ERISA representations and warranties, as well as the covenants, are important because the pool of potential CMBS investors continues to grow to include more private pension fund investment.[83]

 

            Of course, numerous other provisions of the CMM may be modified to conform to a particular lender’s assessment of its appetite for commercial real estate risk. For example, the exculpation carveouts, may be expanded to incorporate a variety of additional risk factors or limited as the borrower and lender may resolve in their negotiations in a particular transaction.[84]  The default section[85] can be expanded from its short version with a catch‑all covenant clause to a more traditional laundry list of defaults, allowing the lender to limit the defaults to which the notice and cure requirements would apply.[86] The lender may also consider expanding the springing liability provision[87] for greater conformity with the new FNMA/FHLMC Mortgage document that imposes personal liability on the borrower for the debt incurred by violation of SPE status, due‑on‑sale violation, fraud, or misrepresentation.[88]

 

            Despite the capital markets and the lender reactive features, the CMM may also be viewed as generally favorable to borrowers. For example, a substantial amount of the unfettered lender discretion common to traditional mortgage documents has been eliminated from the document. In lieu of lender discretion, the potentially lenderless loan has preset requirements and thresholds incorporated into the mortgage document at its origination stage. In addition, the CMM’s provisions have been intentionally drafted to be susceptible to modification or deletion as required by a particular transaction. For example, the casualty, as well as condemnation, restoration provisions may be modified to reduce the conditions precedent to the use of casualty proceeds to rebuild as the borrower and lender may agree in a particular circumstance.[89] The leasing provision may be modified to incorporate into the mortgage standards for leasing a particular property to tenants, benchmarks for lenders granting nondisturbance, conditions of termination, or conditions of acceptance of the voluntary surrender of leases.[90]  To assure compliance with the leasing standard, the lender may require the borrower to deliver an annual leasing certificate to the lender certifying that the borrower has leased property space for not less than the then current market rental rate and term. Further, the borrower should certify that the lease does not contain concessions in excess of the market, but does include other provisions for similar properties in that particular submarket.

 

            The CMM is a ratable mortgage, which allows the lender and the borrower to weigh the cost and the benefit of each variation of a transaction provision from the ratable template. Lender and borrower knowledge of the cost of a variation from the ratable template should enhance the lender’s understanding of its pricing and the capital markets value of the loan asset it is creating and improve the borrower’s understanding of the rate and proceeds offered to it by the lender.

 

            The CMM is not intended as a standard mortgage for use in all transactions.[91] The CMM may be modified based on differences in property type, lender requirements, borrower characteristics, market considerations, and other factors. It is an evolving document that will be modified occasionally by the Consortium to reflect its acceptance and usage in the market and in response to developments in the CMBS markets generally.[92]

 

V. CONCLUSION

 

                        The effects of the development of a CMBS market on the primary mortgage market will be considerable.[93]  The benefits should include increased liquidity; avoidance of cyclical credit crunches; increased geographic, borrower, and collateral diversification; evolving market standardization of underwriting; servicing and documentation; and the resulting stabilization of commercial property values. The disadvantages could include the risk that lenders may leave the real estate finance market or consolidate, the risk of poor underwriting and servicing, the loss of portfolio lender discipline, the loss of the personal lender/borrower relationship, the unresponsiveness of investors, and the risk of governmental intervention in the market.[94]

 

            As the lingering spectre of the recent real estate credit crunch recedes from the institutional memory of the Main Street lenders, the early reports of the demise of Main Street real estate finance and the triumph of Wall Street CMBS may have been greatly exaggerated.   With the return of the Main Street lender to real estate finance,[95] the increased competition for a limited number of financing opportunities may wreak havoc on Wall Street’s plans to have conduits[96] replace traditional lenders as the principal source of real estate capital.[97]  Nonetheless, with the actual decrease in the number of traditional real estate lenders in the Main Street market through liquidation and consolidation and the periodic reduction in appetite of Main Street lenders for commercial mortgages in real estate downcycles, Wall Street and the CMBS market will have a legitimate place in the commercial real estate market as a countercyclical source of real estate finance and as an exit strategy for primary market lenders, as well as for commercial mortgage portfolio investors.[98]

 

            Wall Street and Main Street can coexist and mutually profit from real estate finance and the real estate industry may be the primary beneficiary with access to a larger source of financing than has been tapped before.[99] The mutual education of the markets to the critical issues confronting them will help assure the successful development of a CMBS market. The Capital Markets Initiatives and especially the CMM will assist Wall Street and Main Street in understanding each other’s concerns in the financing of commercial real estate.

VI.  Representations and Warranties -     

the Capital Markets Context

 

 

            When traditional “Main Street” lenders initially approach the commercial secondary mortgage market to sell their commercial mortgage loans, they are often unpleasantly surprised by the additional capital markets obligations and requirements which the typical “Wall Street” investor imposes in any transaction. For example, it is a well established secondary market requirement that the mortgage loan seller provide any purchaser (and pass‑through to the ultimate investor in the mortgage loans) with certain representations and warranties with respect to the mortgage loans being sold.

 

Main Street Market

 

            In the Main Street market, a seller would ordinarily transfer the mortgage loan to a purchaser “without recourse, representation or warranty”. However, a purchaser in the Main Street market would ordinarily conduct its own due diligence of the mortgage loan and condition its obligation to purchase on its satisfactory re‑underwriting of the credit and collateral for the mortgage loan. Thus, a purchaser would investigate and rely on its own independent risk assessment of the borrower and property for each individual mortgage loan.

 

Secondary Market

 

            As the residential secondary mortgage market developed, Wall Street purchasers quickly determined that the Main Street due diligence traditionally conducted for individual mortgage loans was clearly neither cost effective nor efficient for bulk pool sales. Soon Wall Street began to develop its own methodology for selective due diligence sampling of mortgage loans when purchasing a large portfolio. Each investment house crafted its own “proprietary” program for due diligence sampling of mortgage loans. Yet the limited due diligence undertaken by purchasers in the secondary mortgage market did not satisfy the needs of the capital markets investors or the credit rating agencies. Obviously, this limited investigation did not provide the capital markets purchaser with sufficient information to properly conduct its full risk analysis of the credit and collateral for the mortgage loans in a pool. Similarly, the credit rating agencies would be unable to evaluate a mortgage loan pool for eventual rating purposes. To accommodate such investors in the bulk sale of mortgage loans in large pools (as well as the credit rating agencies), the practice of requiring detailed representations and warranties from a mortgage loan seller developed quickly as the market expanded. To bolster their own analysis of the mortgage loans in a pool, Wall Street investors began to rely heavily on very detailed seller representations and warranties for the disclosure of basic mortgage loan information needed for their investment decisions.

 

 

 

Purpose of Representations/Warranties

 

            To assure that the Main Street lender fully appreciates the reliance that Wall Street investors place on representations and warranties as an initial disclosure device and, in many cases, a substitute for due diligence, the secondary market requires that the mortgage loan seller also contractually bind itself to either cure or repurchase (or indemnify the investor with respect to) any mortgage loan which is the subject of a breach of the representations and warranties. This is an added incentive for the seller to fully investigate and carefully review the mortgage loans in its pool in conjunction with the information it discloses with the delivery of its representations and warranties. The seller continuing to bear the risk of loss for its misrepresentation or non‑disclosure should encourage the seller to exclude mortgage loans which do not conform to the representations and warranties or to fully disclose such exceptions.

 

Repurchase Obligation

 

            To be a truly reliable and effective remedy for the capital markets investor, however, the cure or repurchase obligation must be provided by a seller that is financially capable of curing the breach or repurchasing the mortgage loan. Otherwise, any perceived market value that the seller’s cure or repurchase obligation added to the transaction would be illusory. If the seller of the mortgage loans is not a financially responsible party there is no market incentive to exclude non‑conforming mortgage loans. Therefore, Wall Street investors (as well as the credit rating agencies) will require another creditworthy party to guaranty or otherwise assure the purchaser (and any ultimate investor) of the performance of the cure or repurchase obligation by the seller. This could be, and often is, a financially responsible subsidiary or affiliate of the seller. Representations and warranties are integral to commercial secondary mortgage market transactions but investors and the credit rating agencies do not consider them to be a credit enhancement or support for a transaction.

 

Record/Contract Conflict

 

            In the secondary mortgage market, while the mortgage loans are assigned without recourse of record, the typical capital markets mortgage purchase and sale agreement contains seller representations and warranties that constitute a contractual derogation of the “non‑recourse” endorsement and assignment of the mortgage loans transferred under the agreement. The typical mortgage loan and purchase and sale agreement contains substantially the following provision:

 

“The representations and warranties and warranties set forth in [the Agreement] shall survive the sale of the Mortgage loans to Purchaser and shall inure to the benefit of Purchaser and its successors and assigns, notwithstanding any restrictive or qualified endorsement on any Mortgage Note or Assignment of Mortgage or Purchaser’s examination of any Mortgage File.”

 

Commercial Mortgages

 

                        Evolving almost as a due diligence substitute, the original representations and warranties developed in the residential secondary mortgage market were (aside from covering some basic seller issues) a broad based sweep of the legal, economic and physical characteristics of the mortgage loans that a purchaser would (or should) discover in a full due diligence of the mortgage loan files, payment records and servicing files of the seller as well as by a site inspection of the property and a title search update. But the average capital markets investor (albeit wrongly) views residential mortgage loans as homogenous and in some ways similar to corporate bonds. Commercial mortgage loans (and in most cases multifamily mortgage loans) have very different characteristics than residential mortgage loans. Commercial mortgage loans involve income property underwriting and approval; lack standard underwriting and mortgage loan documents; lack FNMA/FHLMC mortgage loan programs and market guidance; involve different legal and regulatory issues of investment authority, borrower structure and credit, and property zoning; depend on income producing leases and tenants as well as other interested third parties; and have differing insurance requirements and a variety of permissible prepayment riders. To compensate for this vast array of differences, Wall Street developed representations and warranties for commercial mortgage loans that were more extensive as well as different from the market representations and warranties for residential mortgage loans.

 

Representations and Warranties

 

            Although several of the credit rating agencies have recently published “suggested” representation and warranty templates which they require for commercial mortgage loan transactions, the representations and warranties current in the secondary market are neither static nor fixed but can vary with the seller, the mortgage loans, the properties, the transaction and, at times, the risk appetite of the purchaser. Yet a core set of representations and warranties can be discerned from most transactions and may be categorized into three distinct types: basic, mortgage loan and collateral. The basic representations and warranties encompass such fundamental issues as the seller’s authority and mortgage loan ownership, its compliance with law in mortgage loan origination and servicing, and the mortgage loans being whole mortgage loans and not participations. The mortgage loan representations and warranties address economic issues such as the payment terms, history and delinquency; lien priority; the existence of waivers, modifications, releases, extensions, counterclaims or setoffs; obligations for future advances or liability for reserves, holdbacks and escrows; the maturity date; and whether the mortgage loans are cross‑defaulted or cross‑collateralized or contain collateral outside the pool. Finally, the collateral representations and warranties cover physical condition, title and other legal issues surrounding the encumbered properties such as real estate tax status, physical damage and condemnation, encroachments and other title issues, environmental condition and compliance, building, zoning and other legal use or occupancy compliance, mortgage loan title insurance coverage and the status of any ground lease.

 

Permissible Modification

 

            The nature, type and scope of the representations and warranties provided by the seller will probably directly affect the pricing of the transaction with the investors as well as the rating levels accorded by the credit rating agencies. While the credit rating agencies like to see their “work list” of representations and warranties in transactions, which they rate, capital markets investors are often willing to negotiate the scope and substance of deal specific representations and warranties***************. However, a person must be certain that taking lesser representations and warranties from a seller will not result on its incurring sandwich liability for greater representations and warranties required of it by the credit rating agency. Sellers also frequently request that the life‑of‑transaction survival of the representations and warranties be limited to a shorter period of time. Again, certain investors may agree to foreshorten the survival of the representations and warranties although the credit rating agencies are prone to require a life‑of‑transaction term.

 

            In either case, the investor must be satisfied That it has conducted sufficient due diligence to fully investigate the mortgage loan characteristics of the pool which would traditionally be encompassed within the representations and warranties current in the marketplace. While some agree that securities law liability should allow for a shortened survival term, transactions often extend beyond the applicable statute of limitations and breaches are often discovered during a foreclosure or workout of the mortgage loan much later in the term.

 

            The credit rating agencies do acknowledge that with appropriate due diligence and investigation of the mortgage loan pool some limited modification of the representations and warranties is acceptable and transactions are often rated and sold in the capital markets with much lesser representations and warranties than the credit agencies purportedly require for a rating.

 

            The depositor‑issuer into any capital market or transaction can ultimately look to the representations and warranties of the borrower, if any, contained in a mortgage and of any prior seller contained in a mortgage purchase and sale agreement, to support for the representations and warranties it must make or pass through to the capital market.

 

Capital Markets Mortgage

 

            To bolster the lender/seller’s representations and warranties, the Capital Markets Mortgage, recently published by the Capital Consortium*************** as a “template” for commercial mortgage loans that can be readily and predictably rated to allow the pooling of multiple mortgage loans for secondary market transactions, expanded the borrower’s traditional warranty of title and authority to encompass additional representations and warranties well beyond those found in a typical borrower affidavit of title at closing. But the representations and warranties do not mirror the “wish list” of representations and warranties published by the credit rating agencies. These warranties cover the legal status and authority of the borrower, the validity of the mortgage loan documents, anticipated litigation, the status of the property (akin to a title insurance company’s affidavit of title but more expansive in its coverage), the borrower’s status as a non-­foreign person, separate tax lot assessment, ERISA compliance, status of leases, financial condition, business purpose of the mortgage loan, filing of tax returns, change of facts from the mortgage loan application, full disclosure, third party representations, and illegal activity. Capital Markets Mortgage Article 5***************.

 

Conclusion

 

            Regardless of whether commercial mortgage loans are sold in the capital markets as whole mortgage loans or participations or publicly or privately as securitized pools, representations and warranties must be provided to potential investors in such transactions; it has become the custom and practice of the marketplace.

 

 

 

 

VII.  AVAILABILITY VS. CONFIDENTIALITY:

LOAN INFORMATION IN THE CAPITAL MARKETS

 

 

The development of a commercial mortgage backed securities (“CMBS”) market has allowed the traditional real estate borrower access to the capital markets. Yet together with its benefits, it has also burdened real estate borrowers with certain capital markets requirements more stringent than, or unknown to, the primary real estate market.

 

In traditional real estate finance transactions, the borrower provides the primary market lender with requested information concerning the borrower, its principals, any guarantor and the property as well as its occupants in order to obtain the loan. This loan specific information is necessary for the credit and collateral underwriting process and is a prerequisite to making a loan secured by commercial real property. A typical portfolio lender would review and retain in its loan files the organizational documents, financial statements, rent rolls, leases, estoppels, etc., that it received from the borrower and the environmental, appraisal and building condition reports prepared for it by third parties in its loan origination process. Unfortunately, this data has ordinarily been obtained only as a condition of making the loan and no contractual obligation to update the data has customarily been obtained. Therefore, during the administration of the loan such information is often neither updated nor updatable. When new or updated data becomes critically necessary, such as in the event of a loan default or upon the disposition of the mortgage loan, the lender often has only limited rights to obtain such data.

 

Before the advent of the secondary market for commercial loans developed, commercial mortgages were transferred as whole loans in limited cases and only between two primary market lenders but often with borrower acquiescence (or transferred as loan participation interests without borrower knowledge). In such cases, the loan was traditionally re‑underwritten by the buyer prior to purchase based on the contents of the loan file made available and transferred to the buyer. New information from the borrower was rarely available and, unless volunteered, not contractually obtainable. Little thought, if any, was given to issues of confidentiality or liability in the dissemination of such information to potential investors or loan participants.

 

A growing appetitue for property and borrower‑specific information spawned by the losses of the most recent national real estate depression, coupled with continuing development of sophisticated computer data collection and retrieval systems in loan servicing has fueled a feeding frenzy for information in commercial real estate finance.

 

With development of the CMBS market, this entire process has further accelerated with the quantity, quality, scope and type of information requested. With the growing availability of such information, the number of players involved in gathering and reviewing information has proliferated. In addition to the traditional players, there now are credit rating agencies, secondary market investors (senior, mezzanine and subordinate), trustees and custodians, (master, primary, sub‑ and special servicers), due diligence contractors and their respective agents involved in various stages of the process, whether it is a whole loan or bulk sale or sale of CMBS in a public offering or a private placement.