A capital markets mortgage: A ratable model for Main Street and Wall Street

Real Property, Probate and Trust Journal, Fall 1996 by Joseph Philip Forte

Editors' Synopsis: The author discusses the increased importance of the national financial market in local real estate financing. He looks at Wall Street's role in the commercial real estate markets and discusses a project by three national real estate trade associations to create a new document the Capital Markets Mortgage (CMM), which is a template for commercial mortgages Lastly, he discusses various sections of the CMM in detail. A draft of the CMM follows this Article.

I. INTRODUCTION

II. BACKGROUND

A Residential Mortgage-Backed Securities (MBS)

B. Commercial Mortgage-Backed Securities (CMBS)

III. THE CAPITAL CONSORTIUM

A. The Working Groups

B. The Finished Product: The Capital Markets Mortgage (CMM)

IV. CONCLUSION

I. INTRODUCTION

Historically, real estate finance business has been conducted within local markets. The traditional sources of real estate financing, whether for acquisition, development, or construction, have been the institutional lenders that do business in that local "Main Street" market-the commercial banks, thrifts, and insurance companies. Until recently, primary market lenders generally did not approach the capital, or "Wall Street," market for funding before or after loan origination. Likewise, with a few notable exceptions, Wall Street rarely made forays into the local real estate finance markets, and normally, it did so only to service an existing investment banking client with corporate real estate needs. Thus, while Main Street lenders focused primarily on the individual real estate project, Wall Street's focus in real estate finance, for the most part, was limited to corporate client relationships. However, in recent years, Wall Street has expanded its real estate focus to become another source of real estate financing.

II. BACKGROUND

A Residential Mortgage-Backed Securities (MBS)

Wall Street's orientation began to shift when Government Sponsored Entities (GSEs) entered the residential real estate finance markets nationwide in the 1970s.1 Wall Street discovered and quickly exploited the opportunity to profit from the inefficiency of the fragmented residential real estate finance market.

Although residential mortgage-backed securities (MBS)2 issued by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) were not backed by the full faith and credit of the United States, as GNMA's MBS were, the government sponsorship of the GSEs created a capital markets perception of an implicit government guarantee.3 This shadow guarantee, coupled with some Federal Housing Administration and Veteran's Administration (FHA/VA) Loan pools, was the equivalent of a two-tier credit enhancement. Without the usual capital markets credit concerns, the MBS issued by GSEs did not have to be structured to minimize the credit risks inherent in real estate finance transactions.

The development of conventional or Private Label residential MBS transactions was, however, hampered by credit risk concerns. While some isolated Private Label MBS issuance occurred in the late 1970s, non-GSE securitization of whole loans did not gain momentum until the thrift industry crises in the high interest rate environment of the early 1980s. Based on its good experience with GSE issued MBS, Wall Street saw a unique opportunity to profit from the thrift crisis by proffering the securitization exit strategy as the solution to the thrifts' residential portfolio dilemma. Real estate assets, such as mortgages, are inherently illiquid and are not as freely transferable as securities. If the real estate assets, however, serve as a basis for the issuance of securities, greater liquidity can be attained through a vehicle separate and distinct from the real estate assets.

Without a GSE issuer and the credit enhancement from a government guarantee, the Wall Street market would not consider a Private Label MBS to be equivalent to a GSE issued MBS. With a Private Label MBS, an investor would need to be concerned with the credit of the issuer as well as with the usual credit risks associated with real estate assets. To assure the market of timely payments on the securities, it became necessary to structure the Private Label transactions to provide credit support.4 This credit support can be provided by third party or issuer credit enhancement or by the structure of the transaction.5 While mortgage loan sellers in the secondary market typically make representations and warranties concerning their mortgage loans and are generally obligated to repurchase the related mortgages in the event of a default, representations and warranties by a seller are not considered to be credit enhancement for a structured transaction in the capital markets.6

In determining whether to purchase a particular class of securities, capital markets investors generally place enormous reliance upon the investment grade rating assigned to the issuance by one or more of the national credit rating agencies.7 Credit enhancement makes the Private Label MBS more acceptable to capital markets investors and substantially increases the possible base of investors because it enables an issuer to obtain an investment grade credit rating for its MBS issuance. Investment grade ratings, therefore, become the key to success in the capital markets by allowing investors to dispense with the in-depth review of the real estate that a primary market lender would undertake in its normal underwriting process.8