The Internal Revenue Service's update on REMIC rules that will now allow for more commercial loan modifications is welcomed by the industry. However, the 80% property valuation test required at the time of the modification could bring punitive consequences.
The first ruling is the final implementation of Notice 2007-17, which allows additional types of modifications to occur in connection with commercial mortgage loans held by REMICs. The first notice discussing these changes was issued in March, with industry requests for amendments to the REMIC rules coming for years before that.
The changes were meant to amend the rules to make them conform to and accommodate commercial mortgage industry practices. The document, released in September, contains the final regulations that became effective Sept. 16.
"The reason the rules are important is that, with a few specific exceptions, a significant modification of an obligation held by a REMIC will generally cause it to fail to be a 'qualified mortgage,'" JPMorgan Securities analysts said. "If this were to happen, the REMIC that holds the loan could lose its tax-exempt status."
Under the new rule, the substitution is possible as long as once the swap process is in place, borrowers can prove that they are at least 80% principally secured by real estate that is verified by a valuation test at the time the modification is executed.
That means that for loans that are deep underwater, the new guidelines are not likely to help.
"Loans where the borrower is already turning over the keys and not even attempting to initiate discussions with the servicers come to mind," Bank of America Merrill Lynch analysts said. "We also think it will be hard for the recent guideline changes to affect loans that are backed by properties being valued at a fraction of the original loan amount."
Before the new regulations took effect, the 80% valuation test was applied alternatively at the time of origination of the mortgage loan or at the time the loan was contributed to the REMIC, and there was no ongoing requirement that the 80% test be satisfied.
The 80% test is deemed to be met where the servicer reasonably believes as of the date of the modification that the test is met based upon a current appraisal; an appraisal obtained when the loan was originated that has been appropriately updated; the sale price of the property where there is a contemporaneous sale with an assumption of the mortgage loan; or some other commercially reasonable valuation method.
Michael Rufkahr, a partner in the international and domestic tax group at Dechert, explained that a partial release of collateral permitted as a unilateral option under loan documents drawn when the REMIC rules did not require any loan-to-value retest could mean that the new retesting requirement would cause the modified loan to fail to satisfy the principally-secured-by-real-property test. Thus, it would cease to be a qualified mortgage, with potentially adverse tax consequences for the REMIC, even though the borrower has a contractual right to the collateral release.
"The 80% value test was always required, but it was applied only at the outset, at the time the loan was originated or contributed to the REMIC," Rufkahr said. "It was never an ongoing test, so if your real property collateral declined in value, that wouldn't cause a REMIC problem. But, under the amendment, where there is any release of real property collateral, borrowers and servicers now have to think about what's happened to the value of that collateral because they now have to satisfy that 80% value test immediately after the release."
He added that, aside from the releases under the terms of the loan documents, many industry participants thought that a release of a lien connected with an actual default or a reasonably foreseeable default would not cause a loan to cease to be a qualified mortgage. However, the new retesting requirement will also restrict releases in those instances.
The concern is that the established practice of permitting partial releases of real property collateral might be curtailed where property values have declined below the required 80% of the loan amount.
"The IRS said in a letter ruling it was okay to give a partial release and permit a sale of a collateral parcel so long as the proceeds were applied to reduce the amount of the loan, but there was never a requirement to retest the value at that time," he said. "Servicers thought that the qualified mortgage loan status generally would be safe if the proceeds garnered from the release were applied to reduce the loan balance, since this resulted in a similar LTV before and after the release - perhaps not exactly the same, but similar."
The Servicer Juggle
For servicers, the amendment represents a significant relaxation of the appraisal requirement. The change will give them more options in how they service a problem loan because the servicer will no longer have to wait for the loan to be in default to proceed with modification discussions.
On paper, the revenue procedure looks like it will give greater flexibility to modify loans."The range of modifications permissible under the revenue procedure is substantially greater than those permitted under the new regulations where the servicer determines that there is a significant risk of default, but actual default has not occurred and is not yet reasonably foreseeable within the meaning of the regulations, and includes, for example, significant changes in interest rates and maturity extensions," Rufkahr said. "The revenue procedure explicitly states that there is no maximum period after which default is per se not foreseeable and states that, in appropriate circumstances, a holder or servicer may reasonably believe that there is a significant risk of default even though the foreseen default is more than one year in the future."
BofA Merrill Lynch analysts said that although this guideline could lower the overall CMBS delinquency rate, it could also raise the number of loans in special servicing, which would lead to an increase in special servicing fees to the trust. The concern is that this could cause shortfalls to the lower-rated tranches.
The practical outcome may be that borrowers will not be able to get any significant relief under the revenue procedure.Rufkahr said that because servicers continue to be bound by the terms of pooling and servicing agreements (PSAs), it is likely that in many situations servicers will not have authority to make changes now permitted under the relaxed tax rules.
"Master servicers often will not have authority to make significant changes to interest rates or loan maturities; that authority will lie with special servicers, but loans ordinarily will not be transferred to a special servicer before default becomes imminent," he said. "Thus, because the revenue procedure permits modifications once the servicer determines that there is a significant risk of default, but a significant risk of default is generally not sufficient for a transfer of a loan into special servicing when the default is not imminent, the relaxed tax rules permit modifications at times when the servicer of the loan does not have authority under the PSA to modify the loan."
The new guidelines discussed above affect REMICs but were not extended to commercial mortgage loans held by investment trusts. The last piece released is a request for comment regarding modifications of commercial loans held by investment trusts.
Although the REMIC rules have relaxed, it won't give the servicers free latitude. They still must abide by the documents and agreements of the securitization, such as the servicing standard laid out in the pooling and servicing agreement.
"Servicers have now been handed a difficult task," he said. "More borrowers will request extensions of loans that aren't due for another 12 to 18 months, but the servicer won't have the authority under the pooling and servicing agreements to make those changes."
Even if servicers do have apparent authority under a PSA to modify a loan that far in advance of maturity, they will still have a duty to protect all classes of investors, Rukahr said. "The more senior noteholders ordinarily will not want the maturity extended, and certainly not that far in advance," he added. "Thus, the servicer will continue to have his hands tied and will likely have to say 'no' to some very unhappy borrowers."
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