The world’s largest microprocessor maker may have a thing or two to teach commercial mortgage lenders about loan sales. Andy Grove, the colorful management guru of Intel in its formative years who died earlier this year, once described the secret to the company’s success as more than just taking the ball and running with it. “At Intel,” he explained, “you take the ball, let the air out, fold it up and put it in your pocket. Then you take another ball and run with it. When you’ve crossed the goal you take the first ball out of your pocket, re-inflate it and score two touchdowns instead of one.”
In the secondary market game, loan sales have been largely reserved for failed banks and non-performing loans or as an end-of-the-bench substitute for securitization. Facing formidable macroeconomic and regulatory defenses as the current real estate cycle ages, however, lenders are increasingly learning that loan sales offer additional scoring opportunities.
The market dislocation beginning in late 2015 and early 2016 caused, according to Gerard Sansosti and Daniel O’Donnell of the debt placement and loan sale advisory groups at HFF, “an uptick in the sale of performing loans, particularly floating rate, as portfolio lenders prune their loan holdings for exposure issues, scratch and dent sales, and attractive pricing.” Unacceptable concentrations of loans to one sponsor, in limited or challenged geographic areas or asset types, or with similar loan maturities, are among the exposure issues motivating loan sales.
Portfolio lenders have not been the only loan sellers running with the ball. Confronted with widening spreads and less frequent securitizations, CMBS lenders too are pursuing loan sales as a cost-effective alternative. Private equity lenders, for example, often face both the holding and opportunity cost of having capital tied up in loans subject to increased warehouse interest charges and uncertain exits. Regulatory requirements such as risk retention and increased capital reserves offer additional motivation for banks and CMBS lenders to consider loan sale exits.
Loan purchasers include CMBS issuers seeking to more quickly fill out loan pools with desirable loans, debt funds, and vertically integrated shops with loan servicing arms targeting bridge loans in order to establish borrower relationships for future takeout financing.
There are obviously other loan structures and loan sale categories that address senior lender exposure at origination or post-default. Mezzanine debt, preferred equity, syndication/participation and note splits, for example, reduce senior lender loan amount risk. Non-performing loan sales have their own protocols, with prevalent use of loan auction shops and, for CMBS loans, pooling and servicing agreement constraints.
Whether to sell, hold or securitize a mortgage loan, and similarly whether to originate or purchase, involves the interplay of a comparative matrix of factors. Transaction costs, retained liability, speed and certainty of exit, and pricing (and whether premium or discount to par) may vary significantly between a securitization and a loan sale exit. The roster of CMBS issuers is substantially smaller than that of potential loan purchase investors, and each has different tolerances for cash flow, location and stabilization of properties, and loan terms. Among investors, institutional purchasers may have more rigorous requirements than high yield investors. And depending on business objectives, each player may read the macroeconomic tea leaves differently. To maximize exit options, loan originators must also consider whether and how to tailor loan terms and underwriting to match the demands of these different purchasers. Non-institutional investors must evaluate whether they have the expertise (and stomach) for hands-on asset management, a cost that also impacts pricing.
Whatever the game plan or the player, whole loan sellers and purchasers must address numerous documentation and legal issues.
Sale Agreement. Loan sales have historically been documented like real estate transactions, with agreements requiring earnest money, a defined diligence period, some negotiated level of loan and property representations, physical delivery of loan documents generally via escrow closings with a title company and damages as remedy for termination and breach. While many transactions still employ this documentation approach, CMBS technology has refined the loan sale process. Industry-accepted representations and warranties and remedies, standard mortgage file documentation, advanced loan data capture and presentation, and custodial possession of documents have streamlined transactions. The loan sale agreement may mirror the terms of a mortgage loan purchase agreement (MLPA) executed in connection with a securitization, but increasingly transactions are documented as simply as a trade confirmation, going directly to an assignment and assumption agreement executed on the date of closing. Additional terms can mimic the scope of an MLPA, including for loans intended for securitization, post-closing securitization cooperation covenants.
Identity of Loan Seller. Purchasers will insist on a parent company as loan seller to backstop loan representations and warranties. If loans have been assigned to affiliates, for example in connection with a loan warehouse financing, the loans will need to be reassigned as of the closing date. Warehouse financing, however, creates additional closing issues.
Representations and Warranties. Securitization reps and warranties represent the standard for loan and property diligence and are obviously the expectation for CMBS loans, so dialing back could impact pricing. More conservatively, representations can be subject to post-closing adjustment to pick up any variation in those actually required for the securitization. In CMBS securitizations, SEC regulations require a certification of loan information by, and imposition of personal liability on, the chief executive officer of the issuer, which is often in turn required from each loan seller. In loan sale agreements, on the other hand, reps and warranties are made by the loan seller only, with no officer-level certification or liability.
Portfolio, bridge and seasoned loan sales typically do not include such rigorous reps and warranties. Such loan sellers take the position that no rep or warranty should be provided to the extent a loan or property feature can be determined by due diligence review and that representations should be limited to seller’s knowledge or lack of receipt of written notice of an event and subject to all matters contained in the diligence file. The promulgated FDIC loan sale agreement, for example, conveys loans “as-is” with no reps and warranties, but provides for seller repurchase of a loan for certain specified material issues.
Robust diligence information is the best answer for limited reps and warranties and enhances loan pricing. Prudent lenders are scrubbing loans as they close in order to ensure compliance with the most stringent reps and warranties and to anticipate either loan sale or securitization exit so that curative items such as missing documents or documentation errors can be corrected and loan and property level information and disclosures can be compiled in advance.
Survival Period. The survival period of reps and warranties is negotiable. For a non-securitized pool of loans with pricing discount, a survival period of three to six months would be customary. Sales of loans intended for securitization often have a survival period of 18–24 months. As a reference point, absent parties’ contractual agreement otherwise, New York law, the typical governing law for loan sale transactions, applies a six-year statute of limitation on alleged breaches of reps and warranties that accrue from the date made (i.e., the date of loan sale closing).
Purchasers may start with a “life-of-loan” ask, but that’s not market. Property-related conditions that existed at the time of sale can generally be determined within a short period of time, and causation for loan loss lessens with passage of time anyway. Loan document defects can often be determined by pre-closing diligence or during post-closing servicing (though of course the ultimate test for document defects is when remedies are exercised). Leverage in times of volatility may favor CMBS loan purchasers who insist on aligning reps and warranty survivability with their securitization exposure.
Loan Document Schedule. Completeness of the loan document schedule in a loan sale agreement is important and should reference any sourcing/servicing interest strips or rights that may have been previously assigned by separate agreements and survive the sale. If documents are held by a custodian, the custodial receipt and loan document schedule should conform. Generally the transfer of a “mortgage file,” unless all such items are held by a custodian, is contemplated promptly after the closing. It is typical for CMBS loans to use an industry-standard mortgage file definition; for other loans, either a list of loan-specific mortgage file contents or a generic definition of items in the seller’s possession or control is used.
Remedies. The typical CMBS loan sale remedial formula is a cure period and, if not cured, either an agreed-value settlement or a repurchase obligation. A cure period and cause of action for damages (actual damages, not speculative, punitive, or contingent) in lieu of repurchase obligations is also seen. Market volatility may dictate that the loan sale be documented more conservatively and aligned with securitization risks: the purchase price could be subject to reduction based on a recalculation of value at the purchaser’s ultimate securitization to take into account the pricing exposure an actual loan seller faces in the securitization, such as price concessions demanded by a B-piece buyer, allocable securitization transaction expenses and any subordination level required by rating agencies generally or for the specific loan. The repurchase remedy could apply also if, through no fault of the purchaser, the loan is kicked out of the purchaser’s intended securitization or if the securitization has not occurred by a specified date. The parties might include a negotiated right for the seller to substitute a separate loan if the purchased loan is deemed defective or kicked out of the securitization.
Closing. Loan sale closings are simplest if loan documents are held by a custodian, in which case only original assignment documents need to be physically delivered at closing. This is particularly true when the seller, purchaser, or both have obtained warehouse/purchase financing secured by pledged loans. Rather than physical review and delivery of original documents at closing, custodians provide trust receipts and exception reports confirming the documents held, status of whether original or copy/recorded or unrecorded, and any exceptions noted in their review for approval or curative repair. The loan document transfer can be achieved by delivery of transfer documents to the custodian and simple bailee or escrow letters by which the custodian holds the documents for each party pending the closing. If one or more transaction parties have warehouse/purchase financing, a multiparty escrow agreement among loan facility lender(s), custodian(s), seller, purchaser, and escrow agent(s) will be needed to accommodate the assignment and purchase price payment and/or loan facility payoff, which will require lead time due to multiparty signoff.
Assignment Documents. It is important to agree upon the form of assignment documents early in the process, particularly if multiple states and mortgages are involved (which is magnified in single-family rental loans) and/or one or more parties has a loan purchase facility. With loan facility parties as seller and/or purchaser, tiers of assignments to SPE affiliates may be required. This is one of the most time-consuming parts of the loan sale process, so planning and lead time is required.
Whether performing loan sales are just a late-game Hail Mary pass or a permanent addition to a sophisticated secondary market playbook remains to be seen. Several factors may provide the answer: the increasing number of yield-chasing debt funds, with nimble, opportunistic business models, filling the capital gap in commercial real estate financing; the cresting wave of maturing loans originated at the peak of the prior real estate cycle; and streamlining of loan sale transactions with broadly accepted information gathering and legal process technologies developed for CMBS transactions. Just as single-family rental loans emerged as a new asset class in response to the Great Recession, performing loan sales may emerge from the current market volatility and regulation as a vital business option available throughout the game.
Reinflating the ball and scoring with performing loan sales has never been easier, or more timely.
Charles T. Marshall is a partner in Alston & Bird’s finance practice group.