Commercial mortgage loans outstanding are estimated to be substantially in excess of $1 trillion and only 2% have been securitized. The fuse of commercial mortgage securitization has been sputtering since the process began in the late 1980s.
Recently, however, the fuse may have been lit for good.
Foch Capital Corp., the sponsor, with the assistance of UI USA Inc., the financial adviser, closed a private placement of commercial mortgage pass- through certificates on a "blind pool" basis. Significantly, the certificates were not rated by any of the rating agencies.
The Deal
The investors were given the opportunity to invest their funds in pass- through certificates representing an undivided interest in a pool of performing commercial mortgage loans. The loans were not identified in the offering.
Subject to the criteria established for the loans and the pool, the sponsor had discretion to determine the commercial mortgage loans to be acquired and deposited in the trust.
The trust issued several classes of certificates, which together represented the entire beneficial ownership interest in the trust. The loans in the trust constituted a Remic - a real estate mortgage investment conduit - under the Internal Revenue Code, thus ensuring that the payments under the terms of the certificates would receive "pass through" tax treatment - that is, they would not be taxed at the trust level.
The certificates issued by the trust were apportioned between the investors and the sponsor so that the sponsor would receive, in effect, a carried interest in the pool.
As such, the sponsor would receive payments on the certificates issued to it if, and only if, the certificates issued to the investors first yielded a specified hurdle rate of return. Thereafter, the yield on the pool would be apportioned between the investors and the sponsor. This arrangement resembles the structures used to compensate the general partners in an investment limited partnership.
Avoiding the Rating Agencies
The Foch transaction addressed one of the most significant obstacles to the issuance of commercial mortgage-backed securities - the notion that all or most of the classes, or tranches, of the securities must be rated "A" or better by one of the nationally recognized rating agencies in order to sell them in the market. The rating is largely a substitute for the buyer's due diligence.
Avoiding the Credit Enhancers
The Foch transaction also addressed the problem of incurring significant costs up front, such as the cost of credit enhancements. Regardless of the modeling approach used by the rating agencies, most private sector mortgage-backed securities - commercial or residential - will not achieve an "A" rating or better without some form of credit enhancement.
These enhancements and the rating process itself are costly because of the fees paid and because while the process is ongoing the mortgage loan sellers' or the sponsor's capital is tied up in the investment of the loans being pooled. In addition, not all the loans submitted to the rating agency and the credit enhancer may meet their criteria.
If certain loans are not included, the objective of the holder to sell the loan into the pool is frustrated. This cherry-picking approach has frustrated many originators of commercial mortgage loans.
Many commercial mortgage loan sellers and sponsors of commercial mortgage-backed securities have acknowledged that the result is not worth the amount of time, money, and energy. And those that have been successful haven't made much money. That is why there was a need for something different - for something that did not involve the rating agencies and the credit enhancers.
Transaction's Structure
The investors and the sponsor in the Foch transaction are assuming all of the risks customarily assumed by the credit enhancers and expect to derive substantial economic benefits for doing so. Moreover, as between the two, the sponsor is assuming the preponderance of these risks by being subordinate to the investors.
Therefore, the investors are relying on the sponsor's experience in the secondary commercial mortgage market and the sponsor's financial incentive to ensure that, after taking into account these risks and the payment priority to the investors, there will be a return to the investor.
In other words, instead of relying on the independence of the rating agencies, the investors are relying on the sponsor's desire to profit.
The "Blind Pool" Offering
The pool of commercial mortgage loans deposited in the pool for the Foch transaction is not as "blind" as many other "blind pool" or "black box" offerings. The criteria for inclusion of a loan in the pool are clearly identified and are common to most securitizations of commercial mortgage loans.
Therefore, the offering was not literally a "blind pool" offering like investment limited partnerships, hedge funds, and acquisition funds, where the sponsor is subject to virtually no restrictions on investment.
The Future
The Foch transaction provides an efficient means for commercial mortgage loan sellers to access the capital markets and provides an opportunity for investors to obtain the higher yields paid on commercial mortgage loans and greater diversity and liquidity than a direct investment in individual commercial mortgage loans.
Of course, the structure of the Foch transaction can be used for a pool of identified loans. The Foch transaction proved that nonrated, non-credit- enhanced commercial mortgage-backed securities can be sold. The key for the investors in the Foch transaction was the experience and savvy of the sponsor and the knowledge that the sponsor takes the first loss before the investors.
The Foch transaction does not spell the end of rated commercial mortgage-backed securities. Many investors will only buy rated securities and many sponsors and mortgage loan sellers will not or cannot accept the risk of first loss. The Foch transaction is the beginning of alternative structures to tap into the $1 trillion commercial mortgage market.
Mr. Schaefer is a corporate partner in the New York office of Loeb & Loeb and is co-chairman of its financial services group. He structured the Foch transaction.
