Mortgage Backed Securities and Personal Bankruptcy

At long last, the end of the series!

Personal bankruptcy is usually filed by an individual for very different reasons than corporate bankruptcies. Whereas the primary motivation behind filing a business bankruptcy may be protection of the business or satisfaction of debts, personal bankruptcies are frequently filed for asset protection, in addition to satisfaction of debts.

The two sections of the bankruptcy code that apply to personal bankruptcies are chapter 7 and chapter 13. As with business bankruptcies, chapter 7 for personal bankruptcies is a process of liquidation and seeks include all non-exempt assets of the petitioner in the bankruptcy estate in order to liquidate them to pay off debts. Chapter 13, on the other hand, seeks to reorganize the debt of a petitioner pursuant to a payment plan, which typically last from 3 to 5 years.

Special Purpose Entity Bankruptcy Concerns for Mortgage-Backed Securities

Let us continue the bankruptcy theme begun in my last post and discuss the effects of Special Purpose Entity (SPE) bankruptcies and their effect on mortgage-backed securities. Obviously, most bond covenants designate the bankruptcy of a SPE an event of default and restrict the likelihood of its happening. In the unlikely event that such a bankruptcy does happen however, here is an overview of the process.

As a quick review, I would like to restate that mortgage-backed securities are the result of a process of securitization that takes place when a real estate lender sells a package of its loans to an entity, called and SPE. The SPE receives the money to purchase the loans from the sale of either securities, beneficial interests in the entity or trust certificates from a trust set-up to hold the loans. If securities or trust certificates are sold, they are called mortgage-backed securities (MBS). Through the securitization process, real estate lenders are provided with cash to originate more loans and investors are able to purchase MBS and invest in the real estate market without having to hold real property. If you question why one would want to invest in the real estate market at all, please see my earlier post, “Why I Choose Real Estate.”

Why I Choose Real Estate

A number of times throughout my career, I have been asked a very poignant question—why real estate? Admittedly, other asset classes do carry a certain level of prestige, which is typically more associated with the asset’s mystique, yet I find that real estate can be as involved and complex as any other asset class. Although the mathematics for risk curves and certain derivative transactions may be more intricate than those used in a typical commercial real estate property acquisition, such transactions and risk analysis can be structured around real estate financing structures. In fact, the mathematical aspects of some of the more “complex” investment vehicles are not as esoteric as they seem and most can be understood, given enough time and exposure to them. The legal issues specific to each class of investment can also be considered complex, but not beyond the comprehension of most competent lawyers. Ultimately, the decision to prefer one asset class over another boils down to a matter of preference.

So, why do I so closely follow real estate? The reason is that underlying any real estate-related transaction is a relationship to a tangible hard asset. A tangible hard asset that has a value influenced by easily understood factors. Real estate markets for every property class are motivated by the economy, real estate demand and the market for the business that the property serves. The real estate market is also relatively stable and changes over the course of years, not months or weeks. Finally, real estate is one of the few assets that lends itself to owner-operation in a way that a company or payment stream may not.

Second Mortgages: Why They Are Less Prevalent In Commercial Real Estate Than In Residential Real Estate

Early in my whole loan trading career, an investor once offered to fund a partnership that would purchase second position liens, also known as second mortgages, secured by commercial real estate. The investor promised to pledge a substantial amount of capital, if I was able to assemble a portfolio of target assets. Understanding the risk/reward profile of such an investment and desiring to deliver for what seemed to be a potential source of new business, I quickly began to work on finding commercial seconds to underwrite and select. After a few days on the phone with a number of commercial lenders, real estate debt funds and large financial institutions, I began to realize that commercial real estate second mortgages were not easy to find. Finally, after a few weeks of searching, I informed the investor that I was unable to find any asset worth purchasing that met his mandate.

Nearly ten years later, I now understand why the second mortgage, an established method of financing in the world of residential finance, is so infrequently used in commercial real estate. To state it plainly, the property-income focus of commercial real estate, makes commercial seconds more of a liability than an asset. It is this income focus that leads most commercial lenders to emphasize property performance over the qualifications of the borrower. As a result, most commercial financing is offered with no recourse to the buyer upon default, giving the lender as much control over a distressed asset as possible and incentivizing the owner of a distressed property to “walk away” when there are no more options. In order to maintain as much control over the property as possible, most commercial real estate lenders will insist that they be on the only creditor of the property and that the property be structured in such a way that it is remote from the bankruptcy of the borrower. These goals are typically accomplished by establishing a holding entity for the property to be financed, placing the borrower in the equity position of the entity and making the lender a creditor of the entity, secured by its largest asset.