It Seemed Like a Good Idea at the Time: Current Issues with Alternative Financing Vehicles Timothy J. Boyce August 2, ABA Section of Real Property, Trust & Estate Law 2009 Annual Meeting

2 Summary of CMBS Issuance Source: Commercial Mortgage Alert

3 Holders of Commercial & Multifamily Mortgage Loans Source: CMSA, Flow of Funds Accounts of the United States Federal Reserve Release Z.1

4 CMBS Loans in Special Servicing Balance as percentage of all U.S. CMBS loans 12/98 12/00 12/02 12/04 12/06 12/08 Source: Fitch

5 CMBS Loans in Special Servicing Balance as percentage of all U.S. CMBS loans 12/98 12/00 12/02 12/04 12/06 12/08 Source: Fitch

6 Overview of a Securitization

7 Modifications, Waivers, Amendments and Consents What modifications, waivers, amendments and consents (a “modification”) can the Master Servicer agree to without the consent of any of the Special Servicer, the Trustee or any Certificateholder? –The Master Servicer can agree to modifications so long as all of the following conditions are met: 1)The loan must be a non-Specially Serviced loan 2)All modifications must be in writing 3)The modification does not violate the REMIC rules 4)All modifications must comply with the Servicing Standard

8 Understanding REMICs Real Estate Mortgage Investment Conduits The purpose of a REMIC is to create multiple interests in a pool of mortgages without adding an additional layer of tax on the overall transaction (a “pass-through” entity) Substantially all of REMIC’s assets must be a static pool of qualified mortgages

9 Modification: any alteration of a legal right or obligation of the issuer or a holder of a debt instrument Significant Modification: generally any change in the terms of an obligation that would be treated as an exchange of obligations under IRC § 1001 Consequences of Loan Modification

10 Consequences of Loan Modification (cont’d) If a loan is “significantly modified,” the REMIC is treated as though the unmodified loan were paid off and a “new” modified loan were made as a replacement If a significant modification occurs after the obligation has been contributed to the REMIC, the modified obligation will not be a qualified mortgage Other rules apply if the loan is in default or in imminent danger of defaulting –REMIC allows any kind of modification (no restrictions)

11 Understanding Servicing The Master Servicer handles all day-to-day maintenance of a performing loan The Special Servicer handles day-to-day operations of all loans in default/reasonably foreseeable default Although specially serviced loans are no longer governed by REMIC, all loans are governed by the Pooling and Servicing Agreement (PSA) Each PSA is different All PSAs requires that Master Servicer/Special Servicer take all actions concerning loans (including modifications) in accordance with the “Servicing Standard”

12 Understanding Servicing The Servicing Standard: Servicing loans for the benefit of the certificateholders with the same care, skill, prudence and diligence with which the servicer services its own loans, or third party loans, whichever is higher, giving due consideration to the maximization of the recovery of the loan on a net present basis, without regard to: relations the servicer has with the borrower or certificateholders, or the impact on compensation, servicing advances, or possible indemnities.

13 Scenario I A Loan That Needs To Be Modified But Is Not Yet An Imminent Default Borrower takes advantage of dot com boom and high rents and uses a CMBS loan to refinance an office building to cash out its initial equity contribution Dot com bust occurs, market rents drop in half, and a significant number of leases will rollover in the next several years Borrower anticipates that it will (i) need to significantly reduce rent to keep tenants or (ii) face increasing vacancy, either of which will affect Borrower's ability to pay the debt service payments in the future Borrower tries to be proactive and immediately notifies the lender of its need to modify the loan documents in order to avoid a future default Borrower tries several times to contact Lender, but Lender does not respond

14 Scenario II A Loan In Danger of An Imminent Default Borrower owns a shopping center and a major tenant has missed its current rent payment Borrower has learned or suspects that the tenant is in serious financial trouble The tenant constitutes a significant percentage of Borrower's rent Borrower has no reserve funds to carry the project and no income other than rent revenue it can use to make debt service payments

15 Scenario III A Loan That Is In Default Either of the above scenarios ultimately results in a mortgage default; or In the case of Scenario I above, Borrower intentionally triggers a default by withholding a payment in order to get the Lender's attention (the loan would not otherwise be in default yet)

16 There are about 25 types of modifications to loans that typically do not present a problem –The “original terms” exception (discussed below) –Most assumptions –Non material modifications: Changes in the terms of a loan due to default (or reasonably foreseeable default) Waivers of “due-on-sale” clauses Waivers of “due-on-encumbrance” clauses Lender’s stay or temporary waiver (up to 2 years) Substitution of substantially similar credit enhancement contracts Amendments to the financial covenants Subdivision of parcel without changing total collateral Most changes to a lease Loan Modification

17 Modifications That Do Not Pose a Problem A small change in yield: the yield must not vary from the annual yield on the unmodified instrument by more than the greater of-- –1/4 of one percent (25 basis points); or –5 percent of the annual yield of the unmodified instrument (.05 x annual yield) Substitution of new obligor: for non-recourse debt, such substitution does not constitute a significant modification Certain changes in timing of payments: must not result in a material deferral of scheduled payments. Addition/deletion of co-obligor: must not result in a change in payment expectations –If the addition/deletion is part of a transaction that results in the substitution of a new obligor, the transaction is treated as a substitution of a new obligor, rather than as an addition/deletion of a co-obligor A minor change in security or credit enhancement: must not release, substitute, add, or alter a substantial amount of collateral on a non-recourse debt instrument Defeasance: If already permitted by the loan documents (can’t add the provision later)

18 Modifications That Do Not Pose a Problem (cont’d) Original Terms Exception: an alteration of a legal right or obligation that occurs by operation of the original terms of a debt instrument is not a “modification” –Can occur automatically (e.g., an annual resetting of the interest rate based on the value of an index); or Alteration due to the exercise of an option is a modification unless-- –The option is “unilateral”; and –The holder’s exercise does not result in a deferral of, or a reduction in, any scheduled payment of interest or principal

19 Modifications That Do Not Pose a Problem (cont’d) An option is unilateral only if-- –The other party does not have a right to alter or terminate the instrument or put the instrument to a related person –Exercise of the option does not require the consent of the other party, a related party, or a court or arbiter –Exercise does not require consideration, unless the consideration is a de minimis amount, a specified amount, or an amount based on objective financial information

20 Examples of Significant Modifications Substantial Change in Security or Credit Enhancement: if modification releases, substitutes, adds, or alters a substantial amount of collateral on a non-recourse debt instrument, it is a significant modification Change in Priority of Debt: is a significant modification if it results in a change in payment expectations Modification Changing Status as Debt: if modification results in an investment that is not debt for federal income tax purposes, it is a significant modification Change in Recourse Nature: if modification changes the debt from recourse (or substantially all recourse) to non-recourse (or substantially all non-recourse), or vice versa, it is a significant modification

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