The Mess at Extended Stay

Includes: BAC, JPM, USB, WFC
by: Felix Salmon

Are you confused by the WSJ article about the Federal Reserve and Extended Stay? If so, then this story, filed in June by Tom Hals of Reuters, might help give some much-needed background. Even then, though, this is a very complicated and messy bankruptcy, so I just phoned Tom to get things clearer still. Here’s how I understand the situation — with the caveat that, as I say, it’s very complicated and messy, and I’m not an expert on this by any means.

First, the fact that Maiden Lane owns a large chunk of Extended Stay debt is not really news: the Maiden Lane lawyer was extremely vocal in the public bankruptcy hearing that Tom attended. (This bankruptcy is being litigated in the Southern District of New York, not in Delaware, which is a good indication of how big and important it is.)

Secondly, if you look at Extended Stay’s bankruptcy filing, something very interesting pops out: there’s substantially only one creditor. M&T Trust Co is owed $8.5 billion by Extended Stay, and that’s basically all of Extended Stay’s debt. M&T Trust Co, of course, doesn’t own all that debt: it was poured into a special-purpose entity, tranched up, and sold off to a large number of real-money creditors. It’s those creditors who are now fighting and suing each other over what happens to Extended Stay.

The senior creditors — Cerberus and Centerbridge Partners, as well as Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), and US Bancorp (NYSE:USB) — control a majority of the debt and have come to an agreement with Extended Stay’s CEO, David Lichtenstein whereby they essentially take over the company, leaving the junior creditors (including Maiden Lane) with nothing. Already, at least one junior creditor has written its holding down to zero.

If this were a normal bankruptcy, a majority of the creditors (the senior creditors own about 60% of the debt) might well be able to push that kind of a deal through. But this isn’t a normal bankruptcy, because technically you can’t have a majority of the creditors when there is only one creditor and that creditor is a special-purpose entity.

If the rules for special-purpose entities apply here, then the holders of the various tranches would need near-unanimous agreement, and the senior creditors couldn’t push through their deal.

The Federal Reserve does have a conflict here. As a regulator, it wants to help set ground rules which make CMBS workouts as predictable and transparent as possible. As a creditor, however, it is very much on the side of the junior creditors. To some degree it helps that the management of the Maiden Lane portfolio has been outsourced to Blackrock (NYSE:BX). And I doubt that Fed policymakers would let one $900 million note affect their prescriptions for systemic change overmuch — especially when JP Morgan (NYSE:JPM) has promised to eat the first $1 billion of losses on the Maiden Lane portfolio. But if you’re confused what the nub of the WSJ story is, that’s it.

There’s a subplot, too, concerning a “bad boy” clause in the Extended Stay debt, under which Lichtenstein should by rights be on the hook for $100 million now the company has declared bankruptcy. If the senior creditors get their way and manage to take over the company, however, it seems that they’ve promised to cover all such expenses — rendering the clause largely moot as far as Lichtenstein’s net worth is concerned. As the Fed looks at this case, it’ll not only be thinking about how the rules governing special-purpose entities affect property-company bankruptcies; it’ll also be thinking about whether and how bad-boy clauses should be enforced.

So you can reasonably expect this one to drag on for a while.