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Fundamentals of commercial securitization.

At the risk of sounding like the boy who cried wolf, the era of commercial mortgage secufifization appears to have finally arrived. After nearly a decade of false starts, the current credit crunch has at last provided the fertile ground for this growth. Though the momentum has been primarily generated by the Resolution Trust Corporation (RTC), non-government commercial securitization activity is picking up and will likely sustain the market long-term.

Now is the time to consider the impact and opportunity of commercial mo rtgage securitization. Every aspect of commercial real estate finance, including mortgage banking, will be affected and involved. The purpose of this article is to provide a non-technical, management-oriented understanding of the fundamentals of commercial mortgage securitization. Beginning with a summary of the market's evolution, this article focuses on the securitization process and the strategic implications of this change.

Market evolution

The market for commercial mortgage securitization is rooted in the success of the securitization of residential mortgages. In the late 1970s and early 1980s, residential mortgage securitization first emerged as a major business on Wall Street. Ever searching for new areas of opportunity, investment bankers and others identified the estimated $800 billion pool of commercial mortgages as a likely next target.

However, the initial development of the market for commercial mortgage securities turned out to be more technically daunting than expected. Unlike residential mortgages, commercial mortgages are not generally guaranteed by the U.S. government, a circumstance that necessitates a detailed credit analysis to support the securitization process. The commercial mortgage market also lacks the standardization of underwriting and documentation common to residential mortgages. Moreover, these problems could not be overcome by various statistical means due to a dearth of dependable, long-term performance data.

Nonetheless, after an intensive 18-month study, Standard & Poor's Corporation, the New York-based rating agency, with the assistance of Kenneth Leventhal & Company, introduced the first rating models for commercial mortgage securities in November 1984. The initial rating models were applicable to single properties or to large pools and were hailed as a significant technical achievement. Initially, the market responded with a flurry of rated transactions and with the promise of growth similar to that of the residential market.

However, during the mid-1980s commercial real estate boom, the initial response to securitization was dampened due to some market-based difficulties. In particular, the rating models stipulated a strict, cumbersome and somewhat uncertain underwriting process, which conflicted witb the emerging market outlook of the time. Moreover, beginning with the entry of the S&Ls just a few years earlier, commercial banks, insurance companies, pension funds, foreign investors and credit companies all began to flood the market with capital for commercial real estate. As a result of the abundance of these relatively easy and inexpensive alternatives proactively urged on the market, commercial mortgage securitization was "crowded out" through the remainder of the decade.

With the advent of the credit crunch in 1989, the situation began to change drastically. Initially, the S&Ls and commercial banks driven by the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) retreated from commercial real estate lending. The banks were quickly followed by virtually every other lender that had participated in the frenzy of the 1980s.

Most traditional lenders are now preoccupied with their existing real estate problems. Moreover, the insurance sector is likely to encounter increasing regulatory scrutiny as these problems unfold. The prospects for any recovery in traditional lending activity appear virtually nil for the foreseeable future. As a result, commercial mortgage securitization has emerged not just as a viable source of financing, but in many cases the only one.

The prospects for commercial mortgage securitization are more promising now than ever before. RTC offering activity, beginning with multifamily properties, now includes more diverse commercial portfolios. Several significant portfolio refinancing transactions, including a deal done late last year by MLG Properties, based in New York, and another transaction by Southern Management Corporation (SMC), Silver Spring, Maryland, have been successfully completed with many more in the offing.

Restructuring financial institution portfolios using commercial mortgage securities, such as the Mellon/Grant St. transaction, are likely to become more prevalent. That transaction involving Mellon bank gave rise to the good bank/bad bank practice whereby certain troubled assets of a bank are carved out and put in an institution created solely to gradually liquidate those assets. Access to smaller borrowers will be provided by mortgage conduits, such as Multi-Family Capital Access, Richmond, Virginia, and others in the formation process. Overall, volume will increase substantially, which, in turn, should stimulate market development and efficiency.

Key concepts

Securitization is a term that is seldom fully understood. Essentially, securitization, whether for commercial real estate, single-family homes, credit cards or auto loans, is basically the same fundamental process. Securitization is the process of dividing or segmenting the cash flow associated with these discrete assets into new cash flow streams, or classes of particular interest to certain investors. So, whereas the initial collateral may only have appeal to a limited investor base, the new investment classes are designed to tap a wider base of investors with potentially diverse investment needs, thus establishing a broader and deeper capital base for investment.

The classes of a commercial mortgage security are based on two key variables of interest to capital market investors: maturity and credit risk, as shown in Figure 1. Maturity distinguishes investments by their terms, which typically run from one or two years for short-term investments to twelve to fifteen years for long-term assets in today's market.

In a normal yield environment, the shorter the maturity, the lower the cost-of-funds. Credit is differentiated by the typical rating grades ranging from "AAA" through junk, with the cost-of-funds inversely proportional to the risk. Accordingly, the structuring objective in securitization is to take a single asset or pool and create new classes with as much high quality and/or short-term concentration as possible, to both increase the availability and reduce the cost-of-funds.

Securitization process overview

The process of securitization represents a fundamental shift not only in the sources of capital but in the mechanics of lending activity. In contrast to the traditional two-party lending relationship, securitization of commercial real estate typically involves multiple parties each with highly specialized roles and responsibilities. In addition, securitization gives rise to some new or significantly altered tasks, such as structuring of the mortgage securities, which tend to differ from the traditional lending activities.

Overall, the securitization process involves a highly differentiated sequence of tasks linking the borrower and the investor, as depicted in Figure 2. The sequence of steps from origination to ongoing service and placement are typically carried out in the order indicated. These tasks are usually conducted by multiple participants although some tasks may be grouped together.

The key points in the process are outlined as follows:

Borrower - The borrower may be a developer/owner or a financial institution. In some cases, multiple borrowers may act in concert. While developer/owners seek an alternative to traditional lenders, financial institufions may want to restructure their existing portfolios or create new funding mechanisms.

Mortgage/property - The collateral to be securitized may be mortgages or properties. In most cases, the product would have to be seasoned and/or stabilized. Securitization of properties or new mortgages on properties is referred to as primary securitization or new originations, while transactions involving existing mortgages are termed secondary securitization.

Origination - Origination can be separate from underwriting and typically involves a contact or brokerage relationship with a borrower. The originator can also be expected to have a basic understanding of the securitization process and screen and/or assist in underwriting potential deals.

Underwriting - The underwriting function for securitized transactions combines various specialized due diligence tasks, such as engineering, toxic wastes, appraisals, cash flow projections and so forth. These due diligence tasks must comply with the guidelines of the rating agencies and are typically significantly more rigorous than traditional lending practice.

Structuring - Structuring is the central link between borrower and investor and is the area where both sets of objectives must be balanced. Consideration must be given to cash flow and value, as well as accounting, tax and legal issues.

Closing - Following the structuring process, the closing involves preparation and processing of the required documentation. In a securitized transaction, this usually involves both mortgages and securities. Documentation must comply with various securities laws and local real estate statutes.

Warehousing - Warehousing activity involves traditional funding prior to receiving securities proceeds. In some cases, funding may be simultaneous with closing. The warehousing function could be expanded to encompass packaging or controlling/buying collateral to be securitized.

Rating - This involves assigning a credit rating to the security structure. The rating process is typically performed by one of the four national rating agencies: Standard and Poor's, Moody's Investors Service Duff & Phelps Inc. and Fitch Investors Services. Rating criteria include economics and legal considerations, with some variations among the various rating agencies.

Credit enhancement - Most transactions require some level of credit enhancement. Credit enhancements, such as subordination or reserves, may be provided in the structure or supplied through other means by a highly rated third party.

Issuer - The legal entity owning the assets to be securitized. Rated transactions require the issuer to be a single purpose, bankruptcy-remote entity. Also, most issuer entities are Real Estate Mortgage Investment Conduits (REMICs) or may elect the REMIC option in order to qualify for federal tax pass-through status.

Distribution - Distribution or placement is the sales activity to the investors. In some cases, a seller may "go firm" or underwrite the security in advance of sales. Distribution to certain classes or select investors may also be very specialized.

Servicing - Mortgages must be serviced in the traditional sense, but the servicing standards may be higher for securitized transactions in which the servicer is providing a critical component Organization, systems and procedures, as wer as the rating of the servicing entity, may be significant factors for servicing in a securitized transaction.

Master servicing - While traditional servicers typically operate at the collateral level, master servicers perform similar functions at the security level. The master servicing is often carried out in concert with security administration.

Administrator/trustee - The securities must be administered throughout their term. This typically involves monitoring distributions to investors, tax reporting and other trustee functions.

Trading - Commercial mortgage securities are tradable instruments. After-market trading, a function often assumed by the same investment bank responsible for the initial placement, is an important factor in structuring and pricing subsequent issues.

Investor - Investors in commercial mortgage securities are differentiated by a number of factors, including risk, term, fixed or floating instruments, and the like. Typically, risks are stratified into A, B and C investors for high investment grade, low investment grade, and high risk, respectively.

Strategic implications

The long-term changes precipitated by commercial mortgage securitization represent a fundamental shift in the sources and methods of capital access for income real estate. This shift parallels the development of the residential mortgage securities market where two out of three, new, singlefamily mortgages are now securitized. As with the residential market, the changes in the commercial mortgage securities market are likely to become permanent, even if traditional lending activity eventually resumes.

Unlike the residential market, the commercial mortgage securities market, though nearly a decade old, is still in an early stage of growth - a time when the greatest opportunities can be found.

The potential opportunities afforded by commercial mortgage securitization are defined by the process pipeline outlined earlier.

Basic opportunities for mortgage bankers include establishing new financing sources, developing new fee-based services, such as underwriting and expanding servicing portfolios, among others. More broadly, opportunities include restructuring and refinancing existing portfolios, creation of mortgage conduits and developing and managing investment funds. These are but a few examples with many variations and niches to be explored within the pipeline model.

Essentially, the process of identifying specific opportunities in commercial mortgage securitization is based on the discipline of strategic planning or defining what business to be in. Strategic planning involves an intensive evaluation of strengths and weaknesses and opportunities, to determine the areas of greatest potential. Determining potential involvement in the emerging market for commercial mortgage securities should be considered as a fundamental business decision not an afterthought.

Key areas to be considered in this context are identified in Figure 3 and listed as follows:

* Contacts/relationships with potential borrowers, brokers, financial institutions, investment banks, investors, other mortgage bankers and so forth;

* Technical skills, such as market analysis, environmental assessment, financial modeling, structuring and workouts, among others;

* Product and/or geographic knowledge based on property types, such as hotels or public storage, regional market expertise or data bases;

* Operational and systems capabilities for origination, servicing, asset management, fund management, and the like;

* Real estate/assets including property, mortgages, servicing rights and other assets either directly or indirectly controlled or accessible;

* Capital to invest in establishing and sustaining new business opportunities or ventures, as well as to take positions in mortgage securities as investments.

The process of strategic planning only begins with identifying specific securitization opportunities to be pursued. Other fundamental business elements must be comprehensively examined and planned to support the commercial mortgage securitization business strategy. The hierarchical planning process shown in Figure 4 systematically addresses the elements that need to be considered as the business plan takes shape. Some examples of specific issues include:

Capital structure - How much capital is required for various purposes and what capital structure should be used?

Organization - What should the organizational structure be and what specific skills are needed?

Compensation - Given a revised organization and definition of responsibilities, how should key positions be compensated?

Operations - How should the flow of work be designed and controlled given the heightened scrutiny and needs of the capital markets?

Systems/procedures - What new systems and procedures are required to support the operations or how should existing systems and procedures be modified?


The technical underpinnings for commercial mortgage securitization have been in place for some time now. As a result of the current credit crunch, the market for commercial mortgage securities is gaining momentum and will likely broaden and deepen as time goes on.

The securitization of commercial mortgages entails a fundamental shift not only in the sources of capital but in the mechanics of the lending process. This process is complex and highly differentiated offering a wide variety of potential business opportunities. Now is the time to evaluate and plan for these opportunities while the market is in an early growth stage.

Commercial mortgage securitization is not just another transaction but a permanent change in the overall business environment. Accordingly, each potential competitor needs to develop an appropriate strategy and business plan based on its unique strengths and capabilities. There are many opportunities to be examined and the most successful participants will get there by design not by default.

Carl Kane is managing director of management advisory services for Kenneth Leventhal & Company in New York.
COPYRIGHT 1992 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Kane, Carl
Publication:Mortgage Banking
Date:Jul 1, 1992
Previous Article:Breaking new ground.
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