Armed with the go-ahead from two rating agencies, Donaldson, Lufkin & Jenrette this month is preparing to launch the first-ever small loan conduit CMBS program wrapped entirely by an environmental insurance policy, a deal that would help solidify this type of insurance as a valuable option for both issuers and investors.
After months of negotiations with insurer American International Group (AIG), both Moody's Investors Service and Fitch IBCA recently issued reports giving a thumbs-up to the use of environmental insurance in lieu of, or in addition to, standard environmental due diligence assessments for commercial mortgage securitizations. According to market players, the reports may foreshadow an upcoming trend toward environmental insurance and away from due diligence for upcoming CMBS deals.
"This is going to be very popular," said Jim Titus, director of real estate mortgage research at DLJ. "The reason we're doing this is that there is a definite cost advantage in going with insurance. There is also a speed advantage, in that the process is more timely and efficient when all is said and done."
Titus added that the real benefit with the insurance is that it lasts for the life of the loan plus five years. "We don't just have point-in-time coverage, which you get from Phase 1 [due diligence], but we get extended coverage, and I think most investors find that to be very attractive."
Though a CMBS deal by Goldman Sachs in January did include some loans protected by AIG, DLJ will be the first issuer to develop an across-the-board small loan program utilizing AIG's environmental policy. The investment bank plans to start off with loans under $3 million, a size the rating agencies were comfortable with, Titus said.
"I assume that over time this will probably gravitate up and we'll see larger loans also being insured, maybe with slightly different clauses on some of the policies," he added.
According to Titus, DLJ plans on signing its first environmental insurance policy within the next month or so, and loans that are wrapped with it would first appear in a September securitization.
The Advantages
To be sure, the practice of due diligence in CMBS deals isn't going away. Market players note that the law is well established and has been used in the real estate lending industry for almost 15 years.
Nonetheless, according to the reports, the use of environmental insurance has several advantages over the standard Phase 1 due diligence site assessments for mortgaged properties within a pool. These advantages include increased credit enhancements, longer-lasting coverage, a savings in both time and cost, and the ability to transfer the bulk of an issuer's environmental risk to a double- or triple-A rated insurer such as AIG.
A typical environmental policy covers not only conditions that are violations of environmental laws in existence at the time of the claim, but also future occurrences, changes in use and errors in due diligence. For this reason, Titus believes that the insurance route will continue to be perceived as valuable to investors across the credit spectrum.
"The high yield [subordinate] investors have got to like it especially, because they're the ones that are potentially going to be hurt by any environmental problems that crop up in the life of the loan," Titus said. "Five years into the loan, if something happens, the Phase 1 does nothing for you at that point; here we've got insurance to step in if there is a default, to remediate the environmental problems and pay off the loan."
Another reason investors would like this type of insurance is because, especially for those who lack the technical knowledge to effectively assess environmental risk in a CMBS pool, a policy from an established insurer would allay their concerns.
Though Phase 1 due diligence provides a detailed up-front review by an environmental professional, it assesses on a property-to-property basis, which is often more time-consuming and costly. Conversely, environmental insurance policies are tailor-made to the collateral pool, drawn up after the insurer has screened all the properties, done a statistical sampling of a pool and collected important information that might reveal which properties could turn out to be troublesome.
"CMBS is a natural candidate for something like AIG's plan," said Patrick Corcoran, a CMBS expert at J.P. Morgan. "Environmental insurance is such a specialized area...that a lot of investors don't want to be worried about, and if they can get a comfort level in the context of an insurance program where you get guys like AIG with specific expertise, it's a positive, for sure."
The coverage has some extensions that deal not only with the basics of paying off a loan balance and environmental conditions present, but also with a protection against third-party liability claims, such as if contamination or pollution on a particular site seeps into an adjoining site.
Due Diligence Not Dead Yet
Despite DLJ's upcoming use of the AIG policy and the positive reports from the rating agencies, sources indicate that due diligence still remains the primary process for evaluating properties in CMBS transactions, and few issuers have yet to explore the environmental insurance option.
Even the Fitch IBCA report, which concludes that lender environmental insurance may have positive credit implications for the issuer, acknowledges several caveats to the option. It notes that the likelihood of including properties with environmental concerns may be increased if insurance is used by itself, since "less due diligence is done up front to identify contaminated properties, and any existing problems would not be remediated prior to securitization."
However, the report adds that the increased risk of having environmental issues is largely offset by the fact that if there is an environmental problem on a defaulted loan, the insurer will pay off the mortgage obligation under the insurance plan.
"I think that what you would hear is that people have been pretty comfortable with past practices, and satisfied with that result," said Richard Calvert, assistant vice president of environmental programs for AIG. "But I think what we're trying to introduce here [with environmental insurance] is a new concept that can benefit a transaction."
But according to DLJ's Titus, the environmental insurance is most useful when used in conjunction with due diligence, not necessarily in place of it.
He pointed out that for the upcoming small loan program, DLJ has arranged with the rating agencies to hire experts to do "environmental screens" for smaller properties, which means somebody will assess the sites for asbestos, radon and lead paint risk - three risks not covered by the insurance policy.
"Everybody is still doing the same due diligence," Titus said. "We all want to know if there are environmental problems. AIG or any other insurer does not want to take on the risk if there is a problem. The amount they're getting paid to insure a $1 million mortgage loan is nowhere near the cost to clean up a dirty property. Everybody's got the same interest. AIG does not want to pay unnecessarily for clients."
What about cost savings? Instead of hiring a consulting company to do the entire due diligence - which is the traditional practice - a combination of the lender's own due diligence and the insurer's due diligence is employed to accomplish the same task. One main benefit to this strategy is an extra five years of coverage.
"What environmental insurance does is take the whole Phase 1 concept to a new level," Titus said. "That coverage lasts for the life of the loan and most loans today are 10-year loans, so we've got 15 years worth of coverage."
Indeed, if the insurance approach based on an insurer's expertise saves costs relative to a full universe investigation, then it is worth it, said J.P. Morgan's Corcoran. But that all depends on how the premium charged by the insurer compares with the cost for due diligence.
"This is all fairly new, and it may be a bit too early to tell which will be most cost effective," Corcoran said.
"If the rating agencies decide that it is a better deal for investors or possible risks to the pool of bonds, they may decide to favor one over the other, and if you get better subordination levels, that makes it a proceeds issue, and it becomes better economics for the deal generally."
- AT
