Ronald Borod and Jonathan Black, who were recently hired as structured finance partners in DLA Piper's corporate and finance practice, are proposing a program that could supplement the governments Public Private Investment Program (PPIP).
Aside from this, both Borod and Black have worked together in engineering a vehicle for providing leverage for buyers in the distressed debt markets. Through this vehicle, they are bringing together market participants to elevate bid prices on distressed assets. Although specifically applied to the CMBS market currently, Borod and Black said that this technology could have some use for the CLO market as well.
When we began conceptualizing these programs, we looked at the marketplace and saw that the buyers and sellers are separated by a wide bid-ask gap, and that is causing the market to remain largely frozen, Borod said. He added that sellers are further divided into regulated institutions like banks and securitized structures such as CDOs and CMBS.
The problem currently is that equity buyers have no leverage and are required to have an internal rate of return of 20% to 30%. In buying assets, they would have to value the collateral at very low prices to achieve these returns.
The issue here is price discovery, Black said. This process is not helped by rating agencies rerating bonds so market players dont trust the valuations on the underlying assets in securitized deals. Borod and Black concluded that different solutions are needed for the toxic asset problems of regulated financial institutions, with their regulatory capital constraints, on the one hand, and securitized pools of defaulted assets, on the other.
Borod said that there are some limitations inherent in the asset sale model under the current version of the PPIP.
The PPIP Legacy Loans Program, before the government announced it would apply only to assets of banks in receivership, faced the challenge of being between the rock and the hard place. On the one hand, by selling assets at distressed prices, banks participating in PPIP would be undermining their regulatory capital; but on the other hand, if this problem was cured by artificially inflating prices which private investors are willing to bid on toxic assets through government subsidy in the form of non-recourse leverage guaranteed by the Federal Deposit Insurance Corp. (FDIC) and 50% of the equity required to buy the assets the government ran the risk of being criticized for using taxpayer money to create windfalls for banks and private investment groups.
As an alternative to the asset sale model for banks with toxic assets, Borod and Black , working with an outside group of distressed debt and structured finance specialists, are proposing another approach, known as the Distressed Asset Restructuring Trust (DART).
DART would have the banks retain their toxic assets inside wholly owned special purpose trusts and would rely on valuation of the intrinsic value of the assets on the assumption that they will be held to final maturity.
Through the DART program, as proposed, the FDIC would, if the program receives federal approval, guarantee for a fee the aggregate principal recovery projected for the entire portfolio of a bank's nonperforming assets under the intrinsic value model. This guarantee would be attached to certificates received by a participating bank from the trust on the transfer of the assets and would effectively convert the 100% to 200% risk-weighted assets transferred to the trust into 20% risk-weighted assets that the certificates would represent.
This would not only improve the Tier 1 capital of these financial institutions but would also define the bottom of the banks balance sheet, Black said. The problem with the current situation is two things are happening: the shrinkage of the Tier 1 capital for financial institutions and a deflation of asset value. By using this model, it would stop the market from bleeding and allow the banks to start making loans again.
The intrinsic value model would allow a bank to automatically improve its capital ratios by removing the distressed assets from its balance sheet and replacing them with trust certificates with a final-maturity guarantee determined according to the held-to-maturity or intrinsic value of the distressed assets.
The model used to determine the assets intrinsic value will focus on loss frequency and severity and would have to be thoroughly vetted and approved by the federal guarantor. Once the assets have all run off, it can be determined whether the portfolio as a whole achieved the projected principal recovery.
If it does, then nothing will be owed on the federal guarantee. If it does not, then the federal guarantor will owe the difference between the total principal recovery and the recovery projected under the intrinsic value model.
This would not only help in pricing distressed assets but also help these institutions rework their balance sheet, Borod said, "and all at little or no actual cost to the federal government or the FDIC's insurance fund."
Bridging the Bid-Ask Spread
Borod and Black are also, as stated above, working on the architecture of a vehicle that would provide leverage to the buyside to be applied to defaulted assets in existing CMBS pools. You have to use leveraged programs to improve the economics of what youre doing, Black said.
Private equity firms would like to buy assets at 25 cents on the dollar because they are fully funding their acquisitions with equity," he added.
The constraint on the sell side specifically the special servicers who are responsible for servicing defaulted mortgage loans in CMBS pools is not regulatory capital standards but servicing standards.
Special servicers have to be comfortable that they are maximizing values for CMBS securities holders in a manner consistent with the Pooling and Servicing Agreements under which they perform their functions. All-equity funded offers, to date at least, are not hitting the prices that will permit the special servicers to sell.
"Our goal is to devise structures that permit the buy side to increase their offer prices sufficiently to bridge enough of the bid-ask gap to make deals happen, without compromising the buyers' yield requirements or the sellers' servicing standards, said Borod.
Both Borod and Black are holding conversations with various industry players, including private equity firms or opportunity funds, special servicers, who are disposing of these assets, and the various sources of debt capital.
The goal is to use leverage responsibly and elevate bid prices, Black said. You need new leverage to bring the economy back on its feet, although the use of leverage is clearly going to be constrained.
He added that they both are also speaking closely with special servicers to establish protocols for making these assets available for inspection.
Its like a three-dimensional connect-the-dots exercise, he added. They are currently establishing procedures to give special servicers a certainty of execution while making sure that the equity and the leverage pieces are brought into the equation efficiently.