The IRS announced on Sept 15 that servicers of securitized mortgages were empowered to modify the terms of loans to save the trusts/REMICs which own the troubled paper. I think this is a huge story that's gone unnoticed by any and all media.
Back on June 20, Partners Group put out a great research/opinion piece on the next market cycle in real estate, focusing on the effects on LPs & GPs. They looked back at the landscape during the S&L Crisis of 1990 and noted that only two of the top 15 real estate private equity firms survived through today. They pointed out that crises start a shuffling of the deck, wherein assets are devalued then transferred to the 'cream of the crop,' whilst the weak firms die off in a shakeout and are replaced by new blood.
Because of greater transparancy--they argued--and stricter disclosure regulations, public REIT performance leads the greater economy and markets, while private lags. Because of balance sheet actions like writedowns, public REITs often overshoot the downside, whereas PEs and hedge funds don't reflect poor performance until after recovery has set-in (far various ulterior motives). The latter issue proforma revisions after-the-fact, weathering crisis without stretching returns more than a standard deviation from their mean.
In the downturn du jour, another leg down in real estate would blow up so many of these private REITs on the spot. Heading into 2007 with portfolios leveraged as much as 70%, many of these private REITs have no equity left. A combination of creative accounting and the aforementioned proforma revisions, the wothless underlying investments maintain some nominal value.
That dangerous vulnerability of the private landscape puts the aforementioned IRS action into context:
Effective Wednesday, servicers can extend and change the interest rates and other payment terms on securitized mortgages more than a year in advance of their maturity dates, if they foresee that the loan will not be paid off at maturity.
The IRS revised a rule that had limited servicers from modifying loans that are performing even though the paralyzed debt markets would make it unlikely for the borrower to get the new financing needed to take out the loan at maturity. Doing so would have caused the trusts that own the loans to lose their real estate investment mortgage conduits, or Remic, status, which exempts their entity-level profits from taxes...
...In addition to the obvious benefit to the CMBS market, the IRS change is also a property-sales issue since the additional flexibility should help servicers avoid being forced to foreclose on loans and ultimately offer the loans or the properties backing them at discounted prices...
...The IRS revision does not address another Remic change sought by special servicers - the ability to originate loans from within existing trusts to facilitate the sale of foreclosed properties that had backed loans that were securitized through those deals.
This is kicking-the-can-down-the-road if I've ever seen it, but that’s good right now, I suppose. We build a bridge over CRE troubled waters to prevent an epic real estate explosion led by private REITs.
After public RE took write-downs and overshot the downside (as Partners Group noted), they got some nice snap back. Look at the puttering Maguire Properties REIT (MPG) which spiked up last week. MPG has been reviewing the non-recourse debt in its portfolio, weighing the consequences of forfeiting properties to the banks that originate their loans to save the cash burn. They're already surrendering seven properties as of their last 10-Q, but this IRS allowance saves them some asset hemorrhage. Citing Partners Group's analysis, MPG is a poorly managed firm with a non-geographically diversified portfolio that deserves to die on the vine. It's a Darwinian suggestion, but we all know the consequences of keeping zombies alive a la Japan. From a systemic, macro stance, the best outcome for MPG would probably be liquidation, in which their assets are sold at a discount into a more diversified buyer's portfolio.
The problem I see is in the compromise being made by the top CMBS tranches to save the mezz. (People have already been piling back into risk, this will accelerate it and risk arbs will make a killing.)While banks and public CMBS holders already took write downs, the U.S. government hasn’t. They’re holding onto most of the AAA paper through either outright ownership or as collateral at a high cost basis in these special vehicles and emergency programs.
What happens to derivatives and corresponding CDS contracts? We know how many banks have written those. These loan modifications will certainly perpetuate efforts to pin the front end of the yield curve. Principle forgiveness should also be a deflationary force, since I judge current market prices of AAA to BBB- MBS as having ignored the possibility of future troughs.
Disclosure: No holdings