Thompson & Knight’s William O’Connor Talks CMBS Credit Quality

Mr. O’Connor: A lot of people haven’t really dealt with the ruling in the Federal Housing Finance Agency v. Nomura Holding America Inc. case. The judge found that there’s a tension between how deals really close and the desire of the originators, depositors or issuers to reign in closing costs and also keep documents uniform. Oftentimes, when going through the due diligence and closing process, material items are waived, assets are put in or taken out of the pools and changes are made by the business people that are not necessarily reflected in the CMBS documents. What the Nomura case says is that if you don’t do that, there’s massive liability on behalf of the issuers and personal liability in some cases where it’s deemed to be securities fraud.

Why is this case so crucial to CMBS players?

This was a lawsuit by bondholders against Nomura and others saying that there were misrepresentations in the documents. The tension is that CMBS assets, if you’re talking about multiple assets in a portfolio and particularly larger number of assets in a portfolio, tend to have some hair on them. There is no vanilla asset and there is no vanilla legal document that will deal with all of these, so when going through the due diligence or negotiating what’s going in or out of a pool, oftentimes the communication to closing counsel is not as clear or transparent as it should be. Sometimes those changes take place after documents have been signed and before the deposit has been made into the trust. That’s a problem and apparently it happens often with some issuers.

What are some underwriting trends you’ve noticed in new issuances?

There have been a number of matters that we’ve been engaged on with respect to fairly recent CMBS transactions that crossed into special servicing where the reviews of the material commercial leases on the premises, particularly office buildings and retail, weren’t as sophisticated as perhaps they should have been. Underwriting didn’t focus on what was going on with a particular tenant in the market. For example, where a tenant had a cancellation right under the lease or where the rollovers for various tenants are timed as such that it could have a material affect on debt service, particularly where free rent periods are being negotiated. All of which makes it difficult for the single purpose entity to pay debt service in the event the reserves are near exhaustion. I think one of the trends in particular is a failure to really dig down into the lease stack on some of these buildings. 

What do all of these high-leverage deals indicate about where we are in the market?

Leverage is always an issue. There’s a direct correlation over time with how highly leveraged a deal is and how vulnerable it is to market changes or other uncontrollable events. There’s always been a correlation with the number of interest-only loans in the market and the default rate. It doesn’t take much with highly leveraged to cause a real problem with borrower economics.

Are you seeing anything interesting going on with haircuts and cash flow?

There’s a concern that cash flow, especially projections, is a bit optimistic, particularly in situations where the rents are somewhat controlled or in retail where there’s optimism about filling non-anchor space. I think the formulas that are being put out there by the borrower are kind of accepted on the credit side. When a deal does go into special servicing, those formulas prove to be optimistic.

Factors that aren’t being focused on are how taxes can increase when buildings are improved and how that works in certain jurisdictions. We’ve seen tax burdens underestimated in several cases and in certain parts of the country certain types of insurance obligations are underestimated. It really requires a deft knowledge of what the differences are jurisdiction by jurisdiction.

How does underwriting now compare to pre-crisis underwriting?

The documentation is better than 2005, 2006 and 2007. There’s more good behavior in the market than in the past, but there’s still enough to be concerned. You don’t need a high percentage of bad underwriting to cause a ripple in the market, at least that’s been my experience as a lawyer representing special servicers and opportunistic investors.

What do current delinquency rates tell us about where we are in the market?

They’re stable, at a rate that we’d expect in the industry. Part of that is because legacies have been refinanced or acquired out of the pool. If you were to put those legacies back in, I don’t think we would have a rosy picture at all. The way it’s reported is that once the note has been sold or refinanced, those assets are no longer tracked. Unless it comes back into a re-securitization, we don’t really understand what’s going on in the markets that are generally served by CMBS.