CMBS Industry Gets A Wake Up Call

I have been following recent events in the commercial mortgage backed security market with interest since General Growth Properties filed for Chapter 11 on April 16.

The headlines have recently been around an alternative DIP financier being announced.  This is good news for GGP, because it has improved terms - in particular relating to potential equity dilution, which is the primary threat to common shareholders. Pershing Square had both a 4.9% warrant and a 5% equity conversion clause linked to the DIP repayment.

By contrast the new DIP terms removes the warrant, although replaces the 5% equity conversion with 6% (and demotes DIP financing to a junior lien on cash collateral - in effect making repayment less prioritised versus other secure debt to appease creditors). The equity conversion is considerably less than previously however, and as I said before ought to have minimal impact on the firm, as this could only be exercised upon successful emergence from bankruptcy. By which time the firm capitalisation should be hugely higher.

Of more interest were the recent details around the degree of investigation and preparation that GGP put into their bankruptcy filing, designed to ensure they maximise leverage when negotiating with creditors further down the line.

Firstly, it should be said that the issue here all comes down to one of expectations. Those lenders who entered into the various credit products being sold by the banks over the last 5 years, such as commercial mortgage backed securites, were reassured during the sales pitch by the way they were structured.

I know because I work with credit sales people at the banks, and their oily schmooze would be enough to convince me that they know what they are talking about, were I not familiar with the legal grey area in the detail beneath the surface.  In the event, salesmen just regurgitate a well-honed sales pitch, whether they're selling CMBS's or used cars.

"Debt is tiered by risk and reward, so if you take out the higher grade debt in this product, you will be first in line for repayment in the event of a default" schmoozes the salesman.

"But what about if they go bankrupt, and take the whole thing down with them?" asks the nervous-but-greedy investor. "Surely then being first in line isn't going to be any use."

"Ah but that is all factored into the inherent design of this product", reassures the schmoozy salesman. "Commercial mortgage backed securities from DodgyBank Inc are structured with the issuer to be held through a 'special purpose vehicle'."

"What the hell is that?" asks the nervous-but-curious greedy investor.

"It's a clever legal structuring of the debt, that provides additional insurance. The holder of the security and underlying collateral is not the company that owns the malls, it's an independent legal entity which is bankruptcy remote. That means if they go under, your asset does not, so you are guaranteed to be first in line if they default as all the cash flows towards repaying you."

"Wow, that's awesome - I can't lose! Put me down for $10 million on one of the really big REIT's.. hmm, that fast growing one 'General Growth Properties' looks good."

Of course, had these idiots bothered to do some due diligence, they would have read the finer print and worked out that the companies had far more control over those special purpose vehicles (aka 'special purpose entities' or SPE's) than they realised.

In GGP's case, they had the power to hire or fire the directors of the SPE's for the underlying assets (malls) as they so chose. As such, they did just that in the weeks leading up to bankruptcy. Unsurprisingly all 166 SPE boards then subsequently backed having their malls enter Chapter 11 with GGP, so this was firstly quite legal.

In papers filed Wednesday in U.S. bankruptcy court in New York, General Growth argued the CMBS investors' objections to including the SPEs "appear grounded in the misperception that 'bankruptcy remote' means 'bankruptcy proof'."

Now the battle ground is set between GGP, which wants to strengthen its position, and outraged creditors that wish to prevent the malls which their loans are secured against being included in bankruptcy (and the cashflows going to elsewhere in the business).

Unfortunately for the creditors, as the Wall Street Journal reports yesterday, GGP have prepared a significant argument to the court by pledging "to continue paying interest on its mortgages, possibly making it more difficult for CMBS holders to argue they should be allowed to foreclose. It also pledged to provide its mortgage lenders 'adequate protection,' meaning they will have an administrative claim in any liquidation scenario to cash flow drawn from their properties by the parent company."

Whatever the court decides will have far-reaching implications for the wider credit markets, but the odds are strongly in favour of GGP persuading the courts to go ahead with this, as it is very difficult to argue this is not in the wider interest of the market and commercial real estate industry to allow this to happen.

Otherwise the only news today is that I snapped after nearly 5 hours of wedding related shopping on the Kings Road earlier.  After a row with L about how all she seems to want to do with time off is go shopping, and how I have better things to do (such as finish the functional spec), she has gone off for a hair appointment, and I'm contemplating whether this is what married life is going to be like.

Perhaps I ought to Google 'marriage pre-nup'...