A primer: The commercial mortgage-backed security industry

GUILDERLAND — Tucked inside the $3.5 trillion commercial and multi-family real-estate financing sector, which is part of the broader $16 trillion commercial real-estate market of the United States, is the commercial mortgage-backed security industry.

The commercial mortgage-backed security (CMBS) began to take shape in the wake of the Savings and Loan Crisis of the late 198os, a time when hundreds of traditional savings and loan institutions, or thrifts, were closed.

In short, the deregulation of a Depression-era program allowed a certain type of bank that had been initially set up to handle little more than mortgages for working-class home buyers to among other things, speculate in commercial real estate and use federally-insured dollars to make risky loans — all of which led to the banks ultimately handing out more than they were taking in and then hiding the fact that they were insolvent.

 In response to the Savings and Loan Crisis, the federal government assumed  $113 billion worth of insolvent bank assets. Congress then created the Resolution Trust Corporation (RTC) to manage the real-estate loans held by insolvent banks. The RTC, in turn, took the loans, packaged them together, and sold them off as real-estate securities, worth an estimated $18 billion at the time.

The private-sector, taking note of how its breathtakingly-brainless billion-dollar botch-job could make private lenders a lot of money on the back-end of the Savings and Loan Crisis, created the modern CMBS market in the late 1990s — waiting just a decade to crater the entire CMBS sector during the Great Recession. 

In a commercial mortgage-backed security (CMBS), securitization means taking an illiquid asset, something that can’t be quickly or easily sold — a mall, for example — and transforming it into an easily bought and sold financial instrument like a stock or bond. 

A lender creates a commercial mortgage-backed security by taking a group of income-producing commercial-property loans (for example, mortgages held on hotels, warehouses, apartments, and retail property like a mall), bundling them together, and selling them as tranched — different “classes of certificates,” each with their own rate of return — securitized bonds.

“The typical CMBS [commercial mortgage-backed security] loan is a 10-year, non-recourse, fixed-rate loan,” according to the Federal Reserve. 

This means the typical CMBS loan is short-term in that the borrower has only a 10-year loan term; however, the monthly payments made by the borrower are set up as if he or she is paying off a standard 30-year loan.

So, for example, with a 10-year loan that is amortized, spread out equally, over 30 years, a borrower is doing little more than covering the interest on the loan and not putting a dent in the principal, leaving the borrower with a large balloon payment on the principal that comes due at the end of 10 years.  

Non-recourse means if a borrower defaults on a loan, his or her lender can’t try to take the property as collateral for the loss. 

If a loan in a commercial mortgage-backed security trust becomes “delinquent beyond [an] applicable grace period,” according to the Wharton School of the University of Pennsylvania, or the borrower has “defaulted [on] mortgage loans or [has] loans that are designated as ‘specially serviced’ as a result of credit events,” according to the Practising Law Institute, “the servicing of the loan will be transferred to the special servicer.”

In the CMBS industry, a special servicer assumes responsibility for a loan from its original administrator, known as a master servicer. And special servicers have a certain degree of autonomy after a delinquent or defaulted loan has been transferred to them — the special servicer can decide whether or not to foreclose on the loan, to negotiate with the borrower, or to modify the loan. 

But the inherent nature of commercial mortgage-backed securities — “limited flexibility,” according to the Federal Reserve — can cause a problem when a loan does need to be modified.

CMBSs are structured as Real Estate Investment Conduits (REMICs), which are set up to avoid attracting corporate-level taxes. But the same rules that allow for favorable tax treatment of REMICs “also require a rigid structure,” according to Cornell University, meaning adding new loans to the REMIC is “is generally prohibited.” 

And so, according to Cornell, “Prior to distress, there is little leeway for loan modification because what constitutes a ‘new’ loan is vaguely defined. Only when the loan is declared ‘distressed,’ can it be modified and restructured. Such bureaucracy and rigidity results in loan workouts being incredibly challenging and often not optimal for parties involved.”

Further, having a CMBS loan default or be “designated” to a special servicer means that, unlike in a traditional lender-borrower relationship, the special servicers’ concern does not lie with the borrower — the servicer acts on behalf of the bondholders.

In fact, the special servicer “may undertake actions that maximize the position of” investors with whom the servicer has monetarily-aligned in order to “guarantee the timely cash flow payments to [that investor].”

More News

The Altamont Enterprise is focused on hyper-local, high-quality journalism. We produce free election guides, curate readers' opinion pieces, and engage with important local issues. Subscriptions open full access to our work and make it possible.