Economic Emergency Stabilization Act of 2008

The White House and Congressional Leaders finalized the Bailout Bill: Current draft of the Economic Emergency Stabilization Act of 2008. (from the Wall Street Journal) It will be interesting to see how it progresses through the House and Senate. I expect to see a lot of salesmanship as politicians try to weave into their current political campaigns.

What does it actually do?  Read this summary from the WSJ.com: Shape of Massive Bailout Bill Starts to Develop Definition. 

Disclaimers

Rev. Proc. 2008-28 and Foreclosure Relief for Securitizations

The Internal Revenue Service issued Revenue Procedure 2008-28 [.PDF ] which provides for the modification of certain mortgage loans will not jeopardize the favorable tax treatment of the capital structure for certain securitization capital structures.

One issue impacting the downturn in the real estate market is the inability of some lenders to revise the loan terms to avoid foreclosure. The packing of loans into a securitization structure was usually accomplished by using a REMIC or other tax-favorable structure. By adhering to the REMIC rules, the payments to the lender passed through the REMIC structure would not be taxed until received by the investors in the REMIC structure. REMICs are governed by Section 860A - 860G of the Internal Revenue Code.

One of the limitations in the REMIC structure is that the loans cannot be materially modified. If modified, the IRS imposes a hefty tax penalty. Section 860F(a)(1) imposes a tax on a REMIC equal to 100 percent of the net income derived from “prohibited transactions.” The disposition of a qualified mortgage is a prohibited transaction unless the disposition is pursuant to "(i) the substitution of a qualified replacement mortgage for a qualified mortgage; (ii) a disposition incident to the foreclosure, default, or imminent default of the mortgage; (iii) the bankruptcy or insolvency of the REMIC; or (iv) a qualified liquidation."860F(a)(2)

The IRS promulgated Rev. Proc. 2008-28 to give the servicers of residential mortgage loans some more flexibility in providing foreclosure relief, without jeopardizing the capital structure of the mortgage loan securitization. This revenue procedure applies to "a modification of a mortgage loan that is held by a REMIC, or by an investment trust, if all of the following conditions are satisfied:

1. The real property securing the mortgage loan is a residence that contains fewer than five dwelling units.
2. The real property securing the mortgage loan is owner-occupied.
3. (1) If a REMIC holds the mortgage loan, then as of either the startup day or the end of the 3–month period beginning on the startup day, no more than ten percent of the stated principal of the total assets of the REMIC was represented by loans the payments on which were then overdue by 30 days or more; or (2) If an investment trust holds the mortgage loan, then as of all dates when assets were contributed to the trust, no more than ten percent of the stated principal of all the debt instruments then held by the trust was represented by instruments the payments on which were then overdue by 30 days or more.
4. The holder or servicer reasonably believes that there is a significant risk of foreclosure of the original loan. This reasonable belief may be based on guidelines developed as part of a foreclosure prevention program similar to that described in Section 2 of this revenue procedure or may be based on any other credible systematic determination.
5. The terms of the modified loan are less favorable to the holder than were the unmodified terms of the original mortgage loan.
6. The holder or servicer reasonably believes that the modified loan presents a substantially reduced risk of foreclosure, as compared with the original loan."

If the modification meets those requirements, then

• The IRS will not challenge a securitization vehicle’s qualification as a REMIC on the grounds that the modifications are not among the exceptions listed in § 1.860G–2(b)(3);
• The IRS will not contend that the modifications are prohibited transactions under section 860F(a)(2) on the grounds that the modifications resulted in one more dispositions of qualified mortgages and that the dispositions are not among the exceptions listed in section 860F(a)(2)(A)(i)–(iv);
• The IRS will not challenge a securitization vehicle’s classification as a trust under section 301.7701-4(c) on the grounds that the modifications manifest a power to vary the investment of the certificate holders; and
• The IRS will not challenge a securitization vehicle’s qualification as a REMIC on the grounds that the modifications resulted in a deemed reissuance of the REMIC regular interests.

This revenue procedure governs determinations made by the Service on or after May 16, 2008, with respect to loan modifications that are effected on or before December 31, 2010.

Banks Are Keeping More Loans on Their Books

Mark Gongloff reports in WSJ.com that U.S. commercial banks are keeping more of the loans they make on their balance sheets.

Total assets at U.S. commercial banks swelled to $11.12 trillion in early April, up from $9.94 trillion a year ago, according to Federal Reserve data that are updated every Friday. Last month, the growth rate of bank assets hit its fastest growth pace in 28 years.

As Mark states, one of the problems that occurred in the CMBS market was that lenders were not keeping an interest in the loans they originated. They were just producing the paper to package into a stream of CMBS offerings. Banks forgot that they were making loans and that the loans would have to be managed.

Prior to the CMBS, when negotiating documents, the "no" response was that the change would reduce the value of the paper. I was not hearing that it would affect the lender's ability to manage the loan.

The Case for Exotic Notes in Commercial Real Estate Transactions

Fran Mastroianni of Goodwin Procter LLP, published a story in Real Estate Investment & Finance: The Case for Exotic Notes in Commercial Real Estate Transactions.

"PIK (payment-in-kind) Notes and Toggle Notes, which began as alternative debt instruments with safety valve features attractive to the real estate industry, became a life jacket keeping overly aggressive financially engineered deals afloat. Their use has temporarily retreated but their intrinsic value as sophisticated real estate finance tools almost guarantees that they will reemerge as the debt crisis subsides."

The CMBS Market has Re-Opened

According to Bloomberg, Morgan Stanley and Bear Stearns Cos. sold the first commercial mortgage backed security of the year: Morgan Stanley Sells First Commercial Mortgage Security of 2008.

It was a $1.2 billion dollar package of which $630 million was in the senior position. As you might expect the spreads were very high and the subordination was very high.

A CMBS and CDO Primer

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.

mortgage
CMBS
CDO