Rule Makers Remove CMBS Market's Accounting Linchpin

Until now, issuers of CMBS bonds would assemble a pool of mortgages and then create a Qualified Special Purpose Entity (QSPE), usually a trust, which would then issue bonds and sell them to investors in order to "buy" the loans from the issuer. The sub-institutional rated bonds and the first-loss position, or non-rated bonds, were sold to a "B-piece" buyer who typically acts as special servicer and has ultimate control of the disposition of the mortgages.

Qualifying special-purpose entities (QSPEs) generally are off-balance-sheet entities that are exempt from consolidation. The new standard eliminates that exemption from consolidation. Many qualifying special-purpose entities that currently are off balance sheet will become subject to the revised consolidation guidance in the proposal on consolidations of variable interest entities.

The new standard requires a company to provide additional disclosures about all of its continuing involvements with transferred financial assets. Continuing involvement can take many forms—for example, recourse or guarantee arrangements, servicing arrangements, and providing certain derivative instruments. The new standard also requires a company to provide expanded disclosures about its continuing involvement until it has no continuing involvement in the transferred financial assets. A company will also need to provide additional information about transaction gains and losses resulting from transfers of financial assets during a reporting period.

It is the B-piece buyer who is severaly impacted by this new accounting rule as they will now have to record the full face value of the mortgages and related bonds as assets and liabilities on their balance sheets which will make B-piece investing unattractive.

So, in the event of a CMBS issuance, who will now buy the B-piece? The bottom line: If there are no buyers, there can be no CMBS!

And because this affects all legacy deals, what happens to the existing pool of B-piece buyers?

Following is an artcle that appeared in this morning's CREDirect.com.....for your edification.

Rule Makers Remove CMBS Market's Accounting Linchpin

Thursday, 14 January 2010
By John Covaleski, Commercial Real Estate Direct Staff Writer

A new accounting rule that requires B-piece buyers of CMBS loans to record on their balance sheets the entire value of the bonds they handle has taken effect.

The Financial Accounting Standards Board, or FASB, has formally codified its FAS 167 standard, which eliminates qualifying special-purpose entities, or QSPEs, an accounting concept that's been the linchpin for CMBS.

The QSPEs allowed controlling-class investors to buy bonds from transactions without having to book the entire deals on their balance sheets. That in turn has enabled bond issuers to sell, for accounting purposes, the loans that they packaged into CMBS. They otherwise would have to carry the bonds' entire value on their books.

FAS 167, which also sets new reporting rules for the securitization of other types of assets, applies to existing CMBS as well as new issues. An overview of the rule is available on FASB's Web site.

It foists the responsibility to record CMBS bonds' total values on their controlling class investors or other entities that receive significant fees for managing the bonds' performance.

Both those definitions apply to B-piece buyers.

The codified version of FAS 167 is virtually identical to what FASB proposed last summer, stoking widespread fear that CMBS issuance and management would be severely crippled.

The new rule means that a B-piece buyer of a bond consisting of hundreds of millions or billions of dollars worth of loans would have to record the bond's entire value on its balance sheet, even though it may only own a stake worth say 2-3 percent of that value.

"This issue has not changed since last summer. QSPEs are gone," said Tom Barbieri, a partner in the assurance services practice of accounting firm PricewaterhouseCoopers.

FASB, the accounting rule maker for the United States, had been considering reining in CMBS issuers' user of QSPEs ever since the Enron accounting scandal. The credit crisis that began in 2007 heated regulatory interest in the issue this go-round.

The rule technically took effect Jan. 1 for companies that report by calendar years, and the first fiscal year beginning after Nov. 15, 2009, for all other companies.

"For the most part, issuers are in a discovery process to see what's going to have to go on their balance sheets. We have yet to see a lot of discussion of how they will deal with the rule," Barbieri said.

Loopholes could emerge from the rule's later interpretations. Barbieri said there could theoretically be cases in which a servicer's stake in a bond is too small and the performance-based component of its fees too small to consider it a controlling investor.

To be sure, he said those cases would be rare and that the SEC will closely monitor the management of CMBS deals for changes made to sidestep FAS 167.

The rule may also be modified somewhat in negotiations that FASB is having with the International Accounting Standards Board regarding converging their respective rules. FASB has deferred money market funds from having to meet the FAS 167 rules until after the convergence project is completed later this year.

Meanwhile, the rule is expected to be a major and costly accounting headache for CMBS B-piece buyers. Rick Jones, chairman of the Commercial Mortgage Securities Association's political action committee, last summer noted, "It will be extremely expensive to meet these reporting standards and it will not make financial statements more understandable."

The FDIC last month issued its own rule that gives banks a year to phase in their implementation of FAS 167 so they can meet the agency's risk-based capital standards.

Fed: It's Time the Market Stands on its Own

It seems the fixed income securities arena as it relates to real estate needs to be through rehab by the end of the first quarter as the Fed is no longer going to be a crutch......I do not see how we will be ready but understand that it cannot last forever....The true test of the CMBS and RBS markets - especially the secondary market will occur once the Fed pulls out....Now is the time to adopt the Boy Scout credo and "Be prepared "

Fed: It's Time the Market Stands on its Own

April 1 will be the first day that the Federal Reserve will end its debt purchase program and allow the struggling U.S. mortgage market to operate unassisted. As a result, the Fed believes mortgage rates will rise about three-quarters of a percent to about 6 percent, Boston Fed President Eric Rosengren said Saturday.Fear of a worldwide perception that the U.S. government is simply printing money to use to purchase mortgage-related securities is a big reason the Fed has pulled back, analysts say. If that fear caused a sell-off of U.S. government bonds, it would push borrowing costs substantially higher and derail the economic recovery."We are still in uncharted waters," Fed Vice Chairman Donald Kohn said in an unrelated speech Saturday. "We will need to be flexible and adjust as we gain experience."Source: Reuters News, Pedro Nicolaci da Costa (01/08/2010)

Fed Reserve's TALF Program Backs First New Issue CMBS

The creation of CMBS 2.0 has not even begun but evidence that demand for the bonds exists was demonstrated this week as Developers Diversified and Goldman Sachs issued the first CMBS deal in over a year - of course it is backed by the TALF program which will have time limits. So, while this transaction brings hope, it is not a evidence that we have developed a panacea for the long-term....much like taking an aspirin to cure a head ache caused by a brain tumor....Below is a description of the transaction as provided by Co-Star on its Watch List eblast.

Developers Diversified, Goldman Sachs Put CMBS Deals Back in Action

By Mark Heschmeyer
November 18, 2009

Town Center Plaza in Leawood, KS, benefited from the first new CMBS deal in more than a yearThe first new-issue commercial mortgage backed securities (CMBS) supported by brick-and-mortar properties in nearly two years successfully sold this week.

DDR Depositor LLC Trust 2009 Commercial Mortgage Pass Through Certificates, series 2009-DDR1 represents the beneficial interests in a trust fund established by affiliates of Developers Diversified Realty Corp. The trust fund will consist primarily of a single promissory note secured by cross-collateralized and cross-defaulted first lien mortgages on 28 of Developers Diversified Realty's properties. Goldman Sachs Commercial Mortgage Capital originated the $400 million loan.

The deal sold at its asking price and saw strong investor demand. The word on the street was that the deal was up to five-times oversubscribed. The capital markets had been looking to this deal as a measure of investors' appetite for risk involving commercial real estate assets and, in some ways, as a sign of the potential strength of the recovery.

As sold, DDR's five-year loan would bear an interest rate of less than 6% after factoring in all fees and expenses. As a result, the strong demand for this deal could prompt other potential borrowers to pursue CMBS financing, according to Opin Partners LLC, an investment house in New York. In fact, DDR is said to have another upcoming securitization, and other REITs are also expected to come to the table including, Fortress Investment Group, which may have as much as $650 million in commercial mortgages to package into a new-issue CMBS eligible for TALF funding.

The Federal Reserve's TALF (Term Asset-Backed Securities Loan Facility) was key to the deal. The Federal Reserve created TALF to help market participants meet the credit needs of households and businesses by supporting the issuance of asset-backed securities collateralized by commercial mortgage loans, auto loans, student loans, credit card loans, equipment loans, floorplan loans, insurance premium finance loans, loans guaranteed by the Small Business Administration, or residential mortgage servicing advances.

Eligible borrowers on the DDR deal can borrow Fed funds for the five-year fixed period at a rate of 3.5427%. TALF funds can only be used for the purchase of AAA-rated class of securities. Of the $400 million DDR deal, Fitch Ratings rated $323.5 million as AAA ($41.5 million was rated AA and $35 million A). The DDR deal is expected to close officially next week at which time, the loans will also be funded.

Some of key ratings drivers cited by Fitch Ratings included:

Loan-to-Value Ratio (62.4%): The Fitch stressed value is $641 million, based on a Fitch weighted average cap rate of 8.7%.

Debt Service Coverage (1.44x): The Fitch-adjusted cash flow for the 28 properties was $55.6 million, approximately 16.% less than the trailing 12 months net operating income.

Strong Tenancy and Mix: A majority of the portfolio is anchored by national or large regional tenants, with Wal-Mart representing the largest tenant exposure at 10.3% of the total square footage and 5.4% of base rent. The top five tenant concentrations, which represent 23.2% of total square footage (and 15.2% of base rent) are all investment-grade rated. Other top tenant concentrations include TJX Cos., Lowes, Home Depot, and Bed Bath & Beyond.

The 10 largest properties backing the deal and their allocated loan amount are listed as follows:

Town Center Plaza, Leawood, KS; 649,696 square feet; $54.3 million; Hamilton Marketplace, Hamilton, NJ; 956,920 sf; $44.4 million; Plaza at Sunset Hills, Sunset Hills, MO; 450,938 sf; $30 million; Brook Highland Plaza, Birmingham, AL; 551,277 sf; $26.4 million; Crossroads Center, Gulfport, MS; 545,820 sf; $26.4 million; Mooresville Consumer Square, Mooresville, NC; 472,182 sf; $19.5 million; Deer Valley Towne Center, Phoenix, AZ; 453,815 sf; $18.9 million; Downtown Short Pump, Richmond, VA; 239,873 sf; $13.4 million; Abernathy Square, Atlanta, GA; 129,771 sf; $13 million; and Wando Crossing, Mt. Pleasant, SC; 325,907 sf; $12.8 million.

Open Letter to the CMBS Industry

We are all looking for solutions: Solutions to the economic situation, solutions to the investment equation, solutions to our personal financial condition, solutions to problems we never knew we had.

The loss of jobs together with household wealth and income that has occurred over the past two years has only one precedent in our country’s history: The Great Depression.

The government reaction with regard to the commercial mortgage market has been underwhelming. With over $290 billion of commercial mortgages maturing in 2009 and 2010, the credit crunch is real and is forcing banks, special servicers and insurance companies to extend and amend….pretending that capital will return to the marketplace by the time these loans come due again – as well as the deluge of loan maturities already scheduled to occur over the next three years – which will not happen without the revitalization of the CMBS market.

It is clear that the banks and insurance companies cannot replace the capital lost when the CMBS market collapsed. Everyone in commercial real estate has a vested interest in the creation of a new and improved structure for mortgage-backed securities which uses the tremendous infrastructure that has been developed and provides appropriate safeguards in order to make CMBS attractive to investors, profitable for the participants and practical for the borrower.

Many of our industry organizations like the CMSA, the MBA, the Real Estate Roundtable and others are weighing in on these matters but the bondholders, the B-piece buyers, the servicers (primary, master and special), the rating agencies, the SEC, the IRS and the FASB are all working in a crisis mode – and buried under legacy asset issues….such that it is difficult for them to look into the future without a jaundiced eye.

We all recognize that the mechanisms put in place to prevent a meltdown did not work so we have to start with a clean slate. The following issues all need to be addressed:

Ø Creation of Generally Accepted Rating Principles including standardized underwriting standards and an industry oversight mechanism which could be modeled after the accounting profession;;
Ø A bond structure whereby loan originators and investment banks retain an interest in the bond pool to prevent aggressive and sloppy underwriting and execution;
Ø Imprudent loan structures that do not provide for future cash needs, like leasing reserves, or aggressive underwriting or sizing should result in the need for increased subordination levels over deals that do not provide these protections;
Ø REMIC rules and Pooling and Servicing Agreements need to be written to enable timely portfolio and asset management when loans become troubled.
Ø Bond pools and loan structures need to be simpler whereby conflicts of interest are eliminated;
If we are to resurrect the CMBS market, these issues and many more must be addressed. We need to start a dialogue to bring out the best and brightest ideas to establish a workable structure to revitalize the Commercial Mortgage Backed Securities market. With hundreds of billions of loans maturing in the next five years, this is one of the most critical projects we can execute to provide an exit for the legacy assets on the books today.

I implore our industry organizations and government regulators to start an open dialogue with all industry professionals – through blogs, conferences, meetings and any other way for us to get the great CMBS financial engine running again.

Please let me know your thoughts