Exploiting Loopholes

The golden rule with tennis, as with finance, is to always put your money on the Swiss. Tough luck on poor old Andy Roddick though, the guy was rightly gutted and is too good to only win a single major in his career so let's hope he comes back and wins another.

So the final legal submissions have now been made - this includes General Growth's post-hearing submissions against MetLife and against ING Clarion and Wells Fargo. The Committee of Unsecured Creditors, and the unsecured lenders ING Clarion, Helios AMC, and of course MetLife. They are really just summarising the arguments already put forwards, although additionally MetLife submitted a motion to dismiss evidence submitted by GGP because the "Movants [MetLife] were not provided with a copy to review."

The evidence itself is a summary of the MetLife Debtor groups that own the two malls in question in this appeal. Ultimately they were included to provide evidence of the consolidation benefit to GGP that would come about from their inclusion in Chapter 11. Again, whether this is accepted or rejected is arbitrary and will have little bearing on the overall decision.

Additionally I recommend reviewing two interesting analysis papers discussing the impact of the GGP bankruptcy on the CMBS industry. The first is entitled The GGP Bankruptcy So Far: Grounds for Concern, Sources for Hope, (thanks to GGP Freak for bringing that to my attention - you mentioned it is from a post on one of the boards so perhaps you could post the link). Either way, the article provides an interesting additional summary from legal experts.

It agrees that the notion of 'bad faith' is unlikely to stand up to analysis and sway the impending decision, although here the authors focus on the eleventh hour dismissal of independent directors as the other key factor instead of GGP's ability to prove its decentralised structure and hence requirement to include SPE's in Chapter 11 not directly in default. As I have said previously, many of the arguments being made in this case are being made for the cameras, and this view is clearly shared:

"in the GGP bankruptcy, it seems that the independent director issue may not be fully pursued because of the practicalities of the situation. In the view of some, even if the motions to dismiss are not granted, it is important that these arguments are made, if only to force a decision that will at least provide a benchmark against which lenders can attempt to structure and price transactions going forward."

Also interesting is this observation on the impact of the agreed DIP financing loan from Farallon Capital Management, part of which will be used to pay off the Goldman Sachs loan: "Using the $400 million DIP loan to retire the Goldman Sachs facility effectively increases the leverage on these assets by almost 100 percent."

The second article 'CMBS Bankruptcy Remote Structuring and the Recession: Revisiting the Benefits', was published last week by the Bureau of National Affairs. It provides a much more detailed analysis of CMBS structuring, and crucially an analysis on how the GGP rulings to date are impacting the industry. One telling remark is that the SPE bankruptcy remote structure has been "largely untested" to date, and only once these are resolved will the credit markets be able to move forwards with confidence and accurately rate and price risk into credit investments.

Where this article is useful is in summarising key ways in which SPE's "theoretically mitigates" risks:

1. Independent Directors to vote/approve the commencement of bankruptcy proceedings - the controversial one that we know about from its alleged 'misuse' during GGP's filing, which illustrated contractual holes.
2. Limits Debt that an entity can incur - both secured and unsecured, the court rulings have upheld this concept and ensured that GGP will not be able to load them up with additional debt as a result of their inclusion in Chapter 11.
3. Ensure that SPE assets/liabilities are not consolidated with those of a parent or affiliate that is involved in a bankruptcy - in reality this has not taken place in GGP's case from their inclusion in Chapter 11 either, although there would be a significant benefit from consolidation of net cash flows and of course negotiations.

As if anybody needed confirmation that the markets were being presumptuous about CMBS's, the article comments: "CMBS sponsors and lenders, supported by many of the credit rating agencies, relied heavily on the assumption that the remote bankruptcy provisions, specifically the independent director provisions, in the SPE’s governing documents would provide protection against an SPE borrower filing for voluntary bankruptcy."

Where the article becomes much more interesting is an examination of the circumstances in which GGP has been able to utilise cash flows as a collateral. Normally it would not be allowed, unless the lender consents, or the debtor convinces the court that "the lender’s interest in the cash collateral is ‘adequately protected.' "

This notion of 'adequate protection' means proving to the court that "the collateral is not being dissipated to the ultimate detriment of the lender. Typically this condition is satisfied if the property continues to generate cash flow and the lender is given a lien on post-petition income to replace the cash collateral that is expended." Despite the turbulence in commercial real estate valuations, it is fair to assume that the value of the assets exceeds debt in all cases before the court at present.

As such this is precisely what the Courts have awarded all of GGP's lenders who have appealed for their respective malls to be removed from Chapter 11. Despite a lien on cash collateral not being as appealing to lenders than instant access to the cash flows from the malls, income is safeguarded by the decisions made by Judge Gropper, by ensuring they are serviced and repaid in the event of liquidation.

The article concludes a summary of ways in which the GGP rulings to date are impacting the industry and a realistic assessment of the next steps relating to restructuring. Ultimately the ability of GGP to control the independent directors of its SPE's is seen as a key weakness in the current structure of SPE's. The legal authors point out that despite this it is very much legal, :

"Despite the fact that the removal and replacement of the independent directors may have violated the spirit of the original agreement with the lenders, GGP’s actions were permitted under state law and do not appear to have been prohibited by the organizational documents of the SPE borrowers."

In fact, the article even advises lenders able to who have the opportunity to "revisit the governance terms of borrower SPEs, would be well advised to consider modifying the 'remove and replace' provisions relating to the independent directors."

In many ways this suggests that GGP's bankruptcy is unique in another sense, due to timing and its ability to exploit weaknesses in the contracts that will be closed in the future. That being the case, any investors contemplating on taking positions in other REIT's in a similar position to GGP should exercise caution. It would be unwise to simplistically assume that other companies will necessarily be able to exploit this loophole for long, and so need to investigate the underlying SPE structures and contracts.

And finally:

"As the GGP bankruptcy progresses, given the uncertainties in the valuation of commercial real estate in the current markets, it will be interesting to see whether GGP attempts to reduce required interest payments based on the current market value of its properties and, if it does, how the bankruptcy court will determine the valuations of these properties and how reduced values will affect the commingled use of cash collateral."

Bear in mind how early into the bankruptcy process this all is - decisions made now can be amended throughout GGP's period in Chapter 11 on appeal. Meantime all of the information is before the court, suggesting a ruling is impending.

Addendum: just tidied up this post - you could tell I wrote and posted it during the Wimbledon Final, what a bloody mess it was...

Round 1 To GGP As CMBS Industry Overplays Its Hand

I will move off so many updates on GGP soon, not least as I am busy looking into other investment opportunities. However there was enough news late yesterday to warrant an update.

Firstly on DIP financing, after swinging between bidders (and worth noting that bidding for DIP financing is in itself a rarity), GGP turned down both Pershing Square and a consortium lead by Goldman Sachs, and instead opted for the group lead by hedge fund Farallon Capital Management.

Details seem largely unchanged from before at $400m of funding with a 12% interest rate and no warrants, apart from a lower exit fee and now a potential 8% equity repayment option - that is subject to GGP's equity value upon emerging from bankruptcy.

At present the exact details of the DIP financing are not available, although The Washington Post quotes Ackman as saying: "This is the best DIP loan that has been done since the beginning of the recession, and it could be the best DIP loan ever in terms of the structural features that are favorable to the company."

All indications had been that the Court hearing yesterday was going to rule in GGP's favour. So it proved, with both DIP Financing approved, and Judge Gropper, presiding over GGP's case, ruling for the SPE's inclusion in the Chapter 11 filing.

This brings the inital phase of proceedings to a conclusion, after much legal wrangling (and whinging) on both sides. Various lobby groups representing the CMBS industry, fearing the ramifications from investors if their products did not deliver on the promised bankruptcy protection, launched into the most hilarious claims.

The end result was that they stretched credibility and overplayed their hand.

"The GGP bankruptcy filing could - if passed - be disastrous for the CMBS [industry] in the US" warned Conor Downey, a partner at Paul Hastings. He then went on to claim that such a ruling would somehow lead to an enormous downgrade of CMBS debt and that none could attain triple-A rating again.

The highly impartial Mortgage Bankers Association also added their voice, stating grave concerns over the 'catastrophic' impact of such a precedent.

An official from the CMSA (Commercial Mortgage Securities Association) also over-exaggerated the situation by stating: "It is not an exaggeration to say that if a CMBS lender cannot get comfortable with the isolation of the real property asset to be financed and hence the cashflows derived from the operation of such asset, then no such financing will occur."

Yes, except that this does not mean CMBS lenders could not get comfortable with isolating the asset being financed. Fortunately the seasoned Judge Gropper was unimpressed with such overstatement. Even earlier in the week, such claims had been dismissed as "hyperbole".

Judge Gropper overruled the objections yesterday, rightly saying that lenders rights were protected and General Growth should have access to cash collected at its subsidiaries. The notion that commercial mortgage backed securites somehow mean lenders have a legal right to control the cashflow is clearly wrong. It would hinder a viable company, capable of fully servicing its debts to those creditors, from moving out of bankruptcy.

Where GGP had been out of line was an implicit suggestion in the bankruptcy loan that the underlying collateral for the existing CMBS loans (i.e. malls) could be used as collateral for the new DIP loan. That illustrates what CMBS do provide - a guarantee that the asset cannot be misused, and will always be there to enable repayment for the creditors, even in a bankruptcy.

Matt Reid, a senior financial analyst at DBRS made a telling observation, by stating that "the GGP bankruptcy is unique in that most of its CMBS loans are performing reasonably well with strong debt service coverage and likely equity value above the mortgage debt."

Additionally Reid concurs with my previous analysis into the motives for including SPE's: "After reviewing the bankruptcy filing documents, we think the motivation for the filing of the SPEs is to generate better negotiating leverage with the special servicer to extract the value above the CMBS mortgages, while keeping such debt current. The plan is to use this cashflow as working capital during the reorganisation process, which could be several years. Such a ruling would be positive for unsecured creditors."

Round 1 to GGP and unsecured creditors then. It will be interesting how (or if) this impacts the share price later today upon opening.

How Much Extra To Move Jobs?

That's the conundrum I have been faced with this morning, following another headhunter call. Of course, the salary levels they claim are usually best-case and designed to hook you into taking it further. This one dangled the prospect of an extra £50,000 increase in my base salary if I moved.

However after about 5mins deliberation, the answer is going to be 'no'. It is certainly tempting from one perspective, but one problem is that the bank in question is terrible: without naming names, one of those suffering from merger pains, combined with being incompetently run for years - hence is on government life support and has made huge losses.

Most of all though, there is more to this than just money. Let me just reassure you that there is no loyalty for the bank, or love for the 'unique team culture' - every bank spouts waffle about it being a giant family and that they are the best. Unfortunately the brutal culling of staff in the last year merely illustrated the fallacy to those corporate clones too stupid to see it before.

Working for yourself is the only place to aim for in life. So yes, an extra £50k now would be nice, but the cost is all of the hassle and risk of a new job. When I factor in work on my business ahead of the launch later this year, I realised what is much more important to me. At present I have got time to work on this almost daily, but that could easily change with a new boss on my shoulder, and needing to forge a reputation at a new place.

Anyway it's an interesting question, and highlights to me how my priorities have changed so significantly since I mentally made the jump towards my aspirations being out of the sector.

Although not yet announced, Pershing Square are about to submit a counter-offer on the DIP financing. It is unsurprising because without the innovative equity conversion option they had included as the DIP financier, they lose a valuable hedge against their significant existing holdings. This will be good news for GGP again, as any competition around terms of financing benefits the firm - I am just hoping to see the equity conversion option dropped, but matching the other loan terms with a lower interest rate is a more likely sweetener.

Otherwise Reuters reported last week that Simon Property Group have raised more capital in another significant stock offering. They cite the reason being for "general corporate purposes", but pointedly there is no longer a denial of interest in future acquisitions, just citing timing.

Due to the market saturation (in the US) of mall owners, all of the REIT's need to expand their market shares through acquisitions. As such, and despite denials, Westfield are also lining up to compete with Simon and Vornado (who have openly admitted interest) for any asset sales that GGP decide to put out there.

As with DIP financing, it is much better to have competition in a sale like this. On an unrelated rumour, the Court will reconvene tomorrow to review the DIP financing options and progress further. For now this is a side show to the bigger issue relating to creditors and the SPE inclusions discussed in my last post.

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'...

Analysis: GGP Declares Chapter 11

Well, the loss of my lunchtime bolt hole has proved a bit of a problem for me in finding time to post in the last couple of weeks. To be fair, I have been working on (and completed) a draft of the business plan, and have also selected a group of vendors to approach in the coming weeks for a build estimate.

Meantime my next major task is completing a functional spec for the site, as there's no way I trust the average coding monkey with the all-important design and usability. Overall it is going very well, and I am feeling really positive that I can create something unique, useful and commercially viable.

Of course the big news of the last fortnight was GGP finally filing for Chapter 11 bankruptcy protection.

The final straw was the combination of the bond solicitation process failing to persuade sufficient Rouse bondholders to extend, and the threat of action from disgruntled creditors ready to file a claim on certain malls - that meant GGP had little choice but to seek to protect its assets from being effectively raided.

GGP filed with $27.3 bln debt and $29.6 bln assets - figures that are of course disputed - and obtained $375 million in debtor-in-possession financing courtesy of Pershing Square.

Bill Ackman is a canny operator, and clearly used this to hedge Pershing's existing position (at 25% they are the third largest shareholder in GGP currently). By providing DIP financing, Pershing yields a healthy 12% annual return on the debt. Additionally Pershing gain warrants to buy 4.9% of the new equity when it emerges from bankruptcy, and most interestingly the potential to convert the $375m DIP into equity.

The latter option has to be admired, as it ensures Pershing Square will be guaranteed equity whichever way the firm emerges from bankruptcy. I am confident however that it remains strongly in Ackman's interests to maintain common shareholder value, although this does now raise the spectre of dilution. I have analysed this in some detail, and believe that dilution risk is a minimal factor: if the event occurs, that means GGP will have successfully restructured, emerged from bankruptcy and the huge upside potential to the shares will offset and limit any impact.

GGP President, Tom Nolan, gave several interviews subsequently, and placed the blame squarely on the frozen credit markets as the primary cause of GGP's current problems. It will clearly form the central crux when outlining the company's argument as to why a loan extension agreement is justified, and increases the likelihood of approval by the courts.

Certainly the fact that no major rivals who wanted to buy some of the best, revenue-generating properties put up for sale could secure funding is a powerful illustration of the wider market problems, and in favour of GGP.

Nolan also stated that GGP does not see an immediate need to tap DIP financing for 8 weeks, due to cash flow business running costs illustrates the relatively healthy position of the business model. Once again, GGP stands out as an unusual case. Bill Ackman also immediately went to the press to rubbish assumptions by many that GGP's weakness would be to the gain of rivals, by effectively meaning Chapter 11 meant liquidation and an eventual firesale of assets.

Today Fitch downgraded some of GGP's CMBS debt, citing that:

"If the properties remain in bankruptcy, General Growth could seek to load up the properties with additional debt to help repay their corporate unsecured debt."

So far, everything has progressed exactly as I had hoped with regards to the Chapter 11 filing, with the exception of Pershing's DIP equity conversion option. Liquidation and/or widescale share dilution remain the only scenarios in which being long in GGP would not produce significant returns.

It will be interesting finding out what the restructuring proposal submitted to the court contains.  The above illustrates another mechanism by which GGP could pay off unsecured lenders and/or the bondholders without necessarily needing to sell properties.  A key point mentioned here but not considered is that GGP are completing a strategic review, with a specific aim of only offering to liquidate lesser malls as part of the court proposal.

A combination of financial re-engineering, some limited asset sales, and a wider extension request for loans until the credit markets recover sufficiently to enable normal refinancing is the most likely right now.