In 2007, when the real estate market imploded, one of the many epicenters of the coast-to-coast quake resided in Miami, a city draped in lavish condominiums and skyscrapers. The city’s rapidly deteriorating housing industry gave birth to a training ground for companies to enroll in a real-world course to learn the soon-to-be-more-valuable skill of loan loss recovery. And since Miami is in Florida, a judicial foreclosure state, the business of collecting money on millions of distressed loans would be like enrolling in Harvard.
Sitting at the head of the class was Rialto Capital Management, a Miami-based real estate firm specializing in distressed assets. Founded in 2007 by the co-founders of LNR Corporation, a former subsidiary of Miami-based homebuilder Lennar, Rialto was hired by investment firms to liquidate foreclosures on distressed condos and other property and then collect as much money as possible.
“Rialto is just one of those companies that developed it early on more out of the circumstances that presented themselves,” says Rodney Carey, chief executive of Woodward Asset Capital. “They are an organization that developed a very specific niche skill and that’s how to collect on these debts. That’s something that not a lot of companies do well.”
And that skill of managing mountains of mortgage debt has given Rialto the confidence to issue a type of commercial mortgage-backed security in March that’s been extinct since the late 1990s, providing the mortgage industry a peak down a path that might help clean up the nation’s still-accumulating piles of bad commercial debt — and giving new incentives for buyers of that debt.
THE MECHANICS
Rialto’s old-world CMBS deal, titled Rialto Capital, 2012-LT1, is a meager $132 million of relatively low-cost financing allowing it to purchase a portfolio of 320 loans and properties. It’s comprised of a single class of bonds, rated BBB- by Fitch and Baa3 by Moody’s carrying a 4.75% coupon at 99.75 cents on the dollar and an average life of only nine months. J.P. Morgan Securities and Wells Fargo Securities are book-running the transaction.
The secondary mortgage market has existed for ages, but what makes this deal unique is that about 70% of the loans in the deal are in default or close to it, pooled from hotels, offices and retail properties in the Rialto real estate portfolio.
“That is almost a total inverse of what your normal security would look like,” Carey says. “The security is attractive because investors know as a bondholder they will be first in line as a creditor, and as long as there is enough cash flow in the deal, which there appears to be, it’s a pretty safe bet for them even though it’s a distressed asset.”
JPMorgan Chase for the past year has worked to structure such distressed bonds with a “fast pay” structure in which interest and principal pays out to investors and finally the issuer when the loan servicer sells the property or otherwise resolves the default. The faster the resolution of the loans, the faster the issuer gets proceeds and the higher the return on investment, which, of course is a call for excitement.
“The reason they get excited is because people made a lot of money in nonperforming loans in the last cycle, and they’re excited there’s an opportunity here,” says Fitch Ratings structured finance analyst Dan Chambers who expanded Fitch’s U.S. structured finance group. “On the flipside, I think banks are less likely to sell property on a fire sale basis for several reasons: They have less incentive, and they recognize that people made money on those transactions so they’re less inclined to throw the properties out to the market and basically give them away.”
And for Rialto and its bondholders to make that money, Rialto Capital, 2012-LT1, must be comprised of mortgages bought cheaply enough for the deal to pay off.
For instance, if Rialto pays a lender $50,000 for a commercial mortgage that still holds a $100,000 balance, Rialto can use its recovery expertise to sell the mortgage for an amount above the cost to acquire it. Another method is simply to work out a deal in which the distressed borrower’s balance is lowered, giving him a smaller unpaid balance and the investor a decent return.
Furthermore, Rialto could go after the borrowers’ deficiency judgment after a short sale and then classify it as revenue. “To me that’s the riskiest number you can bake in because there’s a lot of public sentiment against going after that deficiency,” Carey says. “There’s certainly a lot of government incentives and tax breaks to not go after that money from a guy who’s already lost his home and probably his job and everything else. It’s a ‘how many times can you kick a guy when he’s down’ type of thing.”
THE CLEANUP
More than 80% of the $205.4 million in nonperforming loans held at banks that failed in March was comprised of commercial real estate, according to commercial mortgage and CMBS data firm Trepp.
Analyst such as Joseph Baksic at Moody’s say the new Rialto CMBS is a single component of the overall cleanup process of the $75 to $100 billion of distressed commercial debt that occupies banks’ books today. Back during the downturn in the early 1990s, there was a major move to clean up balance sheets. But this time, banks may not be so careless.
“There was a sense that the banks gave a lot away to Wall Street,” Baksic says. “It’s taken a lot of years to get to this point about using securitization as a potential way to help clean up some of these nonperforming loans out there. I think it’s a piece of the puzzle. The indications we have are that there may be more of these to come.”
At least five funds have expressed interest in such deals to Moody’s Investors Service, as ratings are key to determining investor demand and bond pricing.
“There’s got be a way to shake it loose,” says Carey of the herculean task of chipping away at the nation’s stockpile of commercial mortgage debt. Carey is pessimistic about principal forgiveness as a reduction tool. At the time of publication, the Federal Housing Finance Agency had just delayed its decision to allow principal reduction on Fannie Mae and Freddie Mac mortgages, with Acting Director Edward Demarco entangled in a dispute with lawmakers who say that his opinion on the matter is based on ideology and not analytics.
Sean Brannan, president of Los Angeles-based Capital Funding Corp. of America, says Rialto’s influx of capital, which otherwise would sit and prolong the stagnating commercial real estate cycle, will provide energy to frozen markets. He adds that it might “relieve borrowers in the form of discounted payoffs, thus reducing mortgage payments and putting dollars back in the pockets of business-owners whom can successfully restructure their debt.”
The assets backing the deal have a principal balance of $526.1 million, with Rialto buying them for $224.15 million. It expects to recover roughly $350 million from the pool. So the $132 million bonds financing the deal represent only 38% of expected recoveries. The thinking is that the Rialto portfolio will generate about $116 million in the first year and another $134.3 million in the second for investors. Rialto wouldn’t receive anything until after the $132 million of bonds is retired.
Fitch says the debt represents about 54% of Fitch’s recovery value. In other words, values would have to drop 46% from what the ratings firm estimates in order for investors to not get their entire principal back. “That’s a fairly significant decline,” Chambers says. “Because cash flow from resolving the collateral is paid first to the note holders, Rialto has an incentive to maximize quick resolutions — the faster they get more money back, the better they do.”
Ron D’Vari, chief executive of New York-based NewOak Capital Advisors, says transactions such as Rialto’s on the margin help to transfer assets to the hands of experienced workout entities, but that they lack the size to meaningfully clear troubled assets in the market like the Resolution Trust Corporation did in the early 1990s.
The RTC is a U.S. government-owned asset management company charged with liquidating mortgage loans belonging to savings and loan associations declared insolvent by the Office of Thrift Supervision as a consequence of the S & L crisis of the 1980s.
Between 1989 and 1995, the RTC closed or resolved 747 thrifts with total assets of $394 billion, according to the Federal Deposit Insurance Corp. Its funding was provided by the Resolution Funding Corp., or REFCORP, which still supports the debt obligations it created for these functions.
And if Rialto’s collection efforts fall short of expectations or if the economy continues to tank or if the government implements another foreclosure moratorium or more costly regulation — which, based on recent history, are all real possibilities — expected rates of return will erode.
“If the business behind the mortgages continue to decline, eventually this will affect these trades because defaults will rise,” Brannan says. “Essentially, the successful exit of the Rialto portfolio will require the banks (such as JPMorgan and Well Fargo) to re-emerge and refinance the mortgages and effectively provide an exit for the CMBS bondholders. If the market does not improve there will be a glut of these assets, which will further create declines in the values, making it a nonviable business model for CMBS holders,” Brannan says.
However, if this type of financing proves out and the market is accepting, purchase prices for distressed portfolios of small loans will rise and there’ll be an avalanche of portfolio sales. That might help break the logjam and speed the recovery in commercial real estate.
THE BENCHMARK
The extent to which deals such as Rialto Capital, 2012-LT1, revive the housing economy depends on their success in purchasing loans at a significant discount. The deal, Carey says, is made in the buy and not necessarily the sell. “That’s the role they’re going to fill, they’re going to get that bottom tranche of business moving again — stuff nobody else wants,” he said.
“The biggest thing you have to worry about when you get into commercial properties is whether you have recourse on the individual,” Carey says. “Are you in a recourse or nonrecourse state?”
According to Moody’s, 90.2% of the underlying loans in the pool, excluding REO assets, represent full-recourse financing. Recourse to the borrower typically results in a lower loss given default, as it is an effective negotiating tool for quicker and fuller resolutions.
“I think everybody’s looking at it like a good deal on the surface just because the deal is getting done,” Carey says. “I think it’ll take another 18 to 24 months to tell if it was a good deal or not. Rialto is going off assumptions based on the book of business they’ve managed over the past two to three years for their private clients, and once you put those assumptions on a larger scale, they should make sense. However, there is no long term history to say this is how the market performs. We’re in unchartered territory.”
And part of it is just the uncertainty of where it’s going to price and the economics of the deal. “Competitors will say, ‘OK, now that there’s a benchmark deal out there, we have an idea of how our collateral will compare, how our bonds might compare to make a determination as to whether this securitization makes sense for us,’ ” Chambers says.
There’s a sense in the CMBS market that Rialto-type securitizations in which a significant portion of the pooled loans are nonperforming could become a popular way for investors to finance purchases of loans from banks and servicers saddled with the responsibility of distressed loans.
“Until we can figure how to get that part of the market moving again, the overall housing market will struggle,” Carey says. “What Rialto is doing is getting distressed assets moving — (it) is absolutely a first very needed step in the overall housing recovery.”
