Tom Acitelli Oct. 8, 2009, 5:49 p.m.
Rising delinquency and default rates of multifamily and commercial mortgages have paved the way for our sector’s entry into the popular and policy discourse. From a barely discernible count of nonperforming loans a year ago, default rates for securitized mortgages have climbed precipitously as the credit crisis has evolved and matured.
The performance of bank-held loans has deteriorated as well, though the critical differences between portfolio and securitized mortgages have received little analytical attention to date. Similarly, the most observable policy interventions have focused thus far on the commercial-mortgage-backed securities (CMBS) market. The expansion of the term asset-backed securities loan facility (TALF) to CMBS, announced earlier this year and implemented in June, is intended to trigger new activity in the otherwise moribund securitization market. Likewise, the further expansion of the program to legacy CMBS is intended to enhance the liquidity of existing securities. And while the TALF program was warmly received upon its announcement, its practical offset to the market’s broader illiquidity has been insubstantial at best.
To stem the rising tide of defaults of securitized commercial mortgages, the Treasury Department moved last month to ease tax rules governing the modification of loans included in real estate mortgage investment conduits (REMICs). The policy change follows months of lobbying by the industry’s eminently capable Washington representatives and has been lauded as a significant step forward in the effort to contain the commercial mortgage debt crisis.
BUT JUST HOW BIG a step is it?
Up until the adoption of the new rules, significant modifications to a securitization vehicle’s loans risked triggering tax penalties except when “occasioned by default or a reasonably foreseeable default” [Treasury Regulations, Subchapter A, Section 1.860G-2(b)(3)(i)]. Abstracting from the complexities of the tax code, modified loans risk being treated as newly issued obligations that have been exchanged for the original, pre-modification obligations.
The prevailing view holds that the possible tax consequences of Treasury regulation have limited interaction between strained borrowers and their servicers. Proponents of the new procedure contend that serious discussion of mortgage modification does not take place until too late because the Treasury’s standard is not viewed as being met until “the loan is not performing or default is imminent.”
The Internal Revenue Service’s new revenue procedure seeks to clarify the conditions under which the tax status of the structure will not be challenged (the new procedure appears in the Oct. 5 Internal Revenue Bulletin No. 2009-40, Pages 471-474). It also limits which loans will qualify for modification, principally as a function of value tests. Under the new regime, the servicer is held to a reasonable belief standard that there is a “significant” risk of default. To be sure, the reasonable belief “must be based on a diligent contemporaneous determination of that risk.”
Critical to encouraging the proactive identification and management of problematic loans, a determination can be made that the loan is at significant risk of default “even if the loan is performing.” It would seem that borrowers and servicers are now free to negotiate modifications even if the problematic maturity is a ways off, provided that the change substantially reduces the risk of default and that the fiduciary and economic justification obligations placed on the special servicer in the Pooling and Servicing agreement are fully satisfied. Among the remedies for loans that pass these filters, changes to interest rates, principal write-downs and extensions of amortization schedules may stave off an otherwise inevitable deterioration in mortgage performance.
WILL THE NEW RULES MAKE A difference? In spite of the complex relationships and conflicting incentives of the stakeholders, the change does remove a disincentive—whether real or perceived—for the revision of commercial mortgages otherwise at risk of default. By mitigating concerns about the potential cost of managing distress in securitized mortgage portfolios, and in spite of the inevitable moral hazard and scalability problems that will arise, the adjustment has the potential to ameliorate outcomes for legacy CMBS.
But the change is hardly a panacea for the commercial mortgage market. To the extent that it mollifies concerns with regard to the challenges facing the commercial mortgage marketplace, the new procedure may even prove counterproductive.
After all, the majority of commercial mortgages in the United States are held on the balance sheets of banks. The current paralysis in the CMBS marketplace—except under the auspices of the Federal Reserve Bank and with the lubrication of low-cost credit—exacerbates the challenges faced by bank lenders in managing their legacy portfolios. Efforts to reignite securitization while managing the consequences of its previous excesses will undoubtedly benefit traditional lenders as well.
But that benefit is unlikely to be so far-reaching that it will obviate the need for direct and timely intervention in support of the keystone of sustainable, long-term credit availability.
Sam Chandan, Ph.D., is president and chief economist of Real Estate Econometrics and an adjunct professor of real estate at Wharton.