CMBS Losses Post-Coronavirus May Spark New Questions About Underwriting
The commercial mortgage-backed securities market continues to struggle, with Trepp Analytics reporting a 9.6% delinquency rate as of July, up from 2.62% a year ago.
The increase has sparked some fear in investors and other stakeholders that interested parties will begin probing CMBS deals with a heightened sense of diligence. They will be looking for underwriting errors that occurred at the time of issuance to justify a second wave of mortgage-backed securities litigation.
"To the extent that there is going to be potential litigation, it would not surprise me if attorneys started looking at [the disclosures in CMBS securitization prospectuses] to try and dig deeper to find out if [the representations made] are in fact true," attorney and Korein Tillery law firm partner Steve Berezney told Bisnow.
Berezney, who handled residential mortgage-backed securities litigation post-2008, says he has no knowledge of errors or falsehoods made in CMBS loan documents prior to the coronavirus crisis. But with investors losing their shirts on hotel and retail CMBS deals, now would be the time for key stakeholders to start looking for underwriting errors and omissions.
The lodging industry alone reported a recent delinquency rate of 23.79%, according to Trepp data, as hotels reel from closings and falling traffic in the wake of the coronavirus outbreak.
"As with the tragic events of 9/11, the recent drop-off in travel and lodging is not economically driven, but rather consumer-related fear of travel amid uncertain times," analysts with Kroll Bond Rating Agencies wrote in a recent report on CMBS.
The first wave of major U.S. MBS litigation involving securitized mortgages backed by properties occurred in the wake of the 2008 subprime housing crisis and well after 9/11.
The lawsuit epidemic began when falling U.S. home values prompted investors, banks and insurance companies to file billions of dollars worth of litigation over alleged misrepresentations made during the underwriting of home loans packed into home mortgage securitizations. JPMorgan alone agreed to pay $4.5B to settle losses tied to residential mortgage-backed securities, according to a Reuters report from 2013.
Many of those same securitized deals fell apart during the 2008 market downturn, attorney Berezney told Bisnow.
Berezney, who previously represented plaintiffs suing over losses tied to securitized home loans, says what is happening in today's CMBS market is not necessarily indicative of a slew of CMBS lawsuits to come. But he said he anticipates investors who lose big on CMBS deals will start to see if any of their losses can be tied to underwriting errors and misrepresentations made when the loans were first issued and securitized.
"The extent of the problems with RMBS were not realized until after the initial crash," Berezney said. "And it could be the same thing with CMBS. There is not as much incentive to dig deep into potential misconduct if CMBS are still paying and are not worthless."
The attorney says that in his opinion, the RMBS market of pre-2008 stayed afloat until a liquidity crunch forced investors to look at their original prospectuses and the unmet covenants made in RMBS underwriting documents.
"They are going to be asking questions," Berezney said. "They are going to be saying, 'How did this happen? Was it due to COVID? Was it just bad luck, or was it true that values were inflated or expenses were ignored and there were misrepresentations?"
An investor in Seattle raised similar concerns about CMBS deals a few months ago when he reported his concerns about reported property values to the Securities and Exchange Commission. ProPublica broke news of the Seattle CMBS adviser's complaint, reporting that John Flynn, an advocate for CMBS reform, studied CMBS data and alleged 14 lenders and CMBS servicers inflated property values tied to CMBS loans.
Those claims have been met with silence from the SEC and skepticism from the larger CMBS market, but the episode shows growing investor interest in how original CMBS deals were constructed. It also spotlighted how CMBS is now under the microscope in new way.
Other attorneys and analysts working in the CMBS space raised doubts about whether there was enough data analyzed by Flynn to draw definitive conclusions about the complaint either way.
With the nation in a financial downturn, asking questions about CMBS is an obvious next step for many investors.
"It's when CMBS aren't paying that people ask, 'What happened?' And they look to see if there are misrepresentations [in the] disclosures," Berezney said.
He added that CMBS has less room for error since three out of 30 loans packed inside a CMBS deal have a greater material effect financially on investors when compared to just several home loans out of thousands. One such example from Trepp Analytics is the "SASB CSMC 2014-USA" securitization, which includes one $1.39B loan tied to the Mall of America, which fell into special servicing earlier this year. This one loan, which remains in flux, comes with an incredible amount of value attached to it.
There are disparities between what caused the 2008 financial crisis and the recent coronavirus-induced market downturn, and these differences make the idea of blaming underwriting for recent CMBS losses much more difficult, analysts say.
"The differences between the causes of the financial crisis in 2008 and the global pandemic-induced economic downturn we are currently seeing are vastly different, so we don’t believe the effects of the 2008 crisis would be relevant to predicting potential long-term impacts of the current market," said Steve Jellinek, vice president for CMBS Credit Risk Services at Morningstar Credit Ratings.
"What we can say, however, is currently the shelter-in-place mandates put in place for the safety of our population are causing occupancy declines on hotels, bankrupting retailers, staving off apartment evictions and changing the office landscape. That is not something that could have been mitigated by insurers, investors, originators or securitizers."
Berezney agrees the pandemic could not have been predicted, but that won't prevent parties from evaluating the quality of the original underwriting on loan-to-value and debt-to-income ratios tied to struggling CMBS loans.
"Some of those events in 2008 exposed the underlying problems that had already been there," Berezney said of the RMBS market's fall. "It could be that COVID exposes underlying problems that were already there [in CMBS], like they were RMBS."
Contact Kerri Panchuk at firstname.lastname@example.org.
CORRECTION, AUG. 5, 11 A.M. CT: A previous version of this story misspelled the Korein Tillery law firm's name. The story has been updated.