Tranche warfare
(Otherwise known as ‘fight among yourselves, I’m feeling verklempt.’)
Securitization, that creature of the early 1990’s, has wrought new changes in our marketplace, none more timely now than the discovery that when a loan goes upside down, the untangling of securitized positions is hideously more difficult than before.
I can’t see any alternatives
In fact, because the financing quilt is so patchwork, we have the remarkable spectacle of the creditors fighting not with the borrower but among themselves –
So often am I overcome by emotion
– as illustrated in this Wall Street Journal article whose title is so inescapably obvious that I stole and replicated it for this post:
Hancock at Center of ‘Tranche Warfare’
In
Supporting a capital stack that reaches to the sky?
Earlier this month, a Broadway fund defaulted on $700 million of debt tied to the Hancock tower and other buildings.
Default is the starting bell.
Time to fight about control!
Until there is a default – technically, until a default is declared – then the sponsor has control of the property’s operating and financial decisions. That’s optionality – the power to make choices that will influence a valuable asset. Sponsors have the optionality because their hard equity puts them in the position of taking first loss.
When the sponsor defaults, however, it means that the equity is gone – at least potentially all gone – and therefore that somebody in the capital stack is exposed to loss.
I’m feeling both exposed and chicken …
That sets off a food fight:
Who’s in charge here?
The default triggered a scramble among investors holding debt tied to the acquisition, with some pushing for immediate foreclosure and others pushing to extend the loan in hopes of a real-estate rebound.
Who’s most stubborn?
Why would some want foreclosure, others want delay? Very simply, because some think they’re in the lifeboat (fully collateralized) and others behind them in the queue think they’re headed for the icy waters:
Some of you will be left out of the money
The commercial real-estate sector has endured plenty of previous busts. But the fallout is likely to be different this time because of all the debt structures developed in the past decade that have never had to ride out a downturn.
The Journal is right; this time is different.
This time it’s personal
Some $700 billion in debt was carved up into commercial mortgage-backed securities, or CMBS, and sold to investors. Another $50 billion to $75 billion of loans were sold as mezzanine debt, which fills the gap between the mortgage and a borrower’s equity. Like CMBS, mezzanine debt was often sliced and diced into many pieces with varying degrees of risks.
The legal system that governs default-enforcement imagines that capital sits in a simple vertical stack where each layer (from lowest and most senior to highest and most junior) is distinct from the one below and held by an individual counterparty (investing lender).
In the middle column, the senior lender is the ‘hard’ debt, and the junior is behind and ahead of the equity
Our lender-protection contractual standards (and our bankruptcy jurisprudence) divide debt holders into two groups: those (called ‘money-good’ in the parlance) whose loan can be fully repaid on a sale at the property’s value, and those (’out of the money’) who will suffer a partial or complete loss upon immediate sale. (A primer on who’s-who is here.)
This system, developed over several generations of previous credit crunches, works well when each tranche of debt is a unitary counterparty – a single holder who can act or not.
Today’s tranches, though, are not unitary counterparties – the tranche may be pledged or sliced into pieces each of which is held by a different and divergent entity. (Imagine our horizontal layer of debt being sliced vertically into several pieces side by side.)
“Tranche warfare is starting,” said John Zizzo, a real-estate lawyer at Cadwalader, Wickersham & Taft LLP, referring to the loan “tranches,” or slices, that investors own.
Zizzo, ready to fight in the tranches
Indeed, in today’s world almost every horizontal level of debt has been so sliced, either directly or indirectly (via CDO’s and so on). That slicing is securitization, and it’s the new element introduced since the last major credit crunch, in 1990.
“It has never been tested before this current market meltdown.”
With securitized debt, the counterparty is not unitary but fragmentary, even atomized – it’s scattered to the four winds (literally; many securities are owned by offshore investors) and some elements may even have been lost.
So who’s in charge?
We wanna know but we’re not happy about it
The disputed $700 million of debt in the Hancock battle is mezzanine debt that was divided up among nine investors. With real-estate values declining, not all of the investors would be paid off in a liquidation.
As a result, investors who believe they would be in the money are pressing for an immediate foreclosure, according to people familiar with the matter.
What a surprise! Those who could be fully paid want to be fully paid now.
We’re tired to waiting to get out of this financial vehicle
Such investors include Five Mile Capital Partners, led by former real-estate financier Steven Baum, and Normandy Real Estate Partners, founded by property investor Finn Wentworth. Mr. Wentworth also is a founder of the New York Yankees’ YES Network.
Investors likely to lose out in foreclosure want to give Broadway more time to repay the loan.
What a shock! Those who would lose money want everybody to take more risks to increase the property’s value.
Among those investors is a BlackRock Inc. fund run for outside investors. That fund owns the riskiest slice of the loan.
What makes this delicious, at least to an innocent bystander, is that the warring factions are conceptually on the same side of the table. They’re all capital providers, not capital consumers, and they all want to be paid, even as none of them wants to drive the bus.
Also involved in the scrum are
We’re prepared to throw mud to get what we want
Mr. Buck is perhaps the cat among the pigeons. While all the others see the building only as a source of headaches to be endured on the way to money, he sees it as an opportunity to build his business. Nobody forecloses with quite the relish of a real estate entrepreneur who bought the debt at a discount.
Tastes better because it was bought at a discount
Complicating things further, State Street Corp. inherited stakes in two tranches from Lehman Brothers, according to a person familiar with the situation.
Translation: I’ve arrived late and don’t know anything, but I think you need my consent, don’t you?
I may look diffident but I’m hard to expel
The failed investment bank had pledged the loans to
Remember Hank Paulson’s joke about himself being the dog that didn’t know what to do after it caught the bus? Hel-lo,
These investors had hoped to make fast money on debt tied to the $3.3 billion acquisition, which included the John Hancock Tower and six other properties.
The mezzanine debt essentially was a one-year bridge loan with two six-month extensions that Broadway planned to pay off with new debt or additional equity.
Short-term loans without a long-term takeout are called bullet loans, bullet as in brain.
In finance, if the borrower makes interest payments, and then the whole sum becomes due and payable at once (a balloon), it’s called a bullet loan.
This is your equity brain after a bullet loan
When I describe such a loan to neophytes, I bring my finger up to my temple, to show where a bullet points.
Now the thing you have to understand, finance Neo, is how to dodge the bullet.
Bullet loans depend on there being ample liquidity.
The credit crunch and recession have prevented Broadway from raising capital.
Our position is impregnable, sir
My problems come not in spies but in battalions, so even if the credit markets were oopen for business, there’s another problem:
Meanwhile, cash flow from properties has fallen too low to service the mezzanine debt, according to people familiar with the matter.
Uh oh.
When the buildings were purchased, Broadway assumed it would be able to fill the space with tenants paying more rent. But the vacancy rate in the John Hancock Tower has risen from practically zero to 15%.
Double oops.
You can see why a global de-leveraging is like a pileup in slow motion. Each contraction in money circulating money squeezes down another part of the financial ecosystem, which in turn shrinks the money circulating to buy or rent or finance or invest in things.
The mezzanine debt was supposed to deal with such a scenario.
Under bankruptcy law, a money-good lender can be compelled to stand still, so as to prevent that lender from inflicting collateral damages on those junior security holders. That principle – wait if you’ve covered, gain rights if you’re exposed – works well when the capital is in single layers, so we can determine precisely who stands where.
In case of default, creditors would conduct an appraisal to determine who was in the money and who wasn’t. Terms of the agreement call for the most junior creditor still in the money to be the “controlling holder.” That creditor gets to decide whether or not to foreclose.
Who’s the controlling holder?
Nice idea, but …
According to people familiar with the matter, Five Mile and Normandy believe that they are the controlling holder and are moving to hire a special servicer that would launch a foreclosure proceeding. That move is expected this week. A joint venture led by the two firms bought the debt in mid-2008 at a discount from Lehman and RBS with seller financing.
When the counterparty is dispersed, the multiplicity of holders means that no one is in charge, leaving the loan servicer compelled to do what the documents say. And the documents say enforce all your rights, waive none of them.
So somebody is likely to start foreclosing on the sponsor, and somebody else is likely to sue to enjoin the foreclosure.
But other creditors are arguing over the appraised value and who is in control, according to these people. They may go to court to try to block the foreclosure action.
Meanwhile, the lawyer’s meters turn …
They call it a bank of electric meters because there’s one fast-turning meter for every bank!
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