Investigations into the Orb Group's dealings (see ASR 3/3/02) involve only two CMBS transactions, but for the young and promising European CMBS market, these latest missteps could prove to be valuable cautionary examples.

"We expect one of the growth sectors this year in European structured credit to be CMBS due mainly to the difficulties faced by many banks that have traditionally lent aggressively to the commercial real estate sector," reported analysts at BNP Paribas.

A number of investment banks are in the process of setting up conduit programs in London similar to Morgan Stanley's European Loan Conduit program (ELOC). These conduits function much like U.S.-style CMBS conduits that acquire assets and finance through the securitization market. Morgan Stanley is currently working on Gorgons ELOC 12, which priced earlier this year.

Most transactions launched under the ELOC program are performing well; in some instances, however, things have gotten tricky. Investors have learned to be wary of overexposure to supporting parties because a downgrade or default can possibly affect the credit quality of a transaction.

According to BNP, CMBS rents are typically paid by tenants directly into accounts called lock boxes. These "lock boxes" are specifically designed to service the debt of the borrowers and thereby reduce exposure to the borrower. Though other loans in the portfolio backing ELOC 8 included this mitigatory feature, the loans made to the Orb group did not.

"Orb only had an obligation to pay a calculated rent amount five days prior to bond payment dates," explained BNP. "This presumably means that rents paid by Orb tenants go directly to Orb or to an associated company, and then Orb is obligated to pay the amount into the CMBS transaction accounts on the specified day. On the most recent payment date, Orb did not make its required payments."

Orb's failure to pay was covered up by a withdrawal from an escrow account that has since not been replenished; according to analysts, this means that the group has failed to pay anything at all. If vacancy rates had risen, Orb would have still been able to fulfill their obligation at least in part. By paying nothing, however, the group triggered red flags throughout the market. Adding more fuel to the situation is the fact that Orb affiliates account for over half of the total rent from the Orb portfolio.

The loan is now one payment behind schedule, but reserve funds are in place to mitigate the risk for two interest periods. Morgan Stanley, the servicer of the loan, recently named GVA Grimleys as the managing agent of rent collections and cash flows.

So far, only the class E and class F notes of the transaction stand to be affected. All other transactions from the ELOC program are currently performing well, and Fitch Ratings recently upgraded the ELOC 7 transaction.


Orb Group had its foot not only in the ELOC conduit, but in Morgan Stanley's Hoteloc transaction as well. Ernst &Young has been appointed to review the cash flows received by Hotel Portfolio II, and the firm's preliminary findings indicate that funds may have been inappropriately transferred to and from the agency account within the Hoteloc structure, which is controlled by Hotel Portfolio II. The security trustee has taken control as a result, and all accounts have been transferred to another bank, market analysts said.

Orb Group announced its plans to exit the hotel business, which means that it would be selling its properties under the portfolio. Moody's Investors Service, in its advanced rating of the class D and E notes, considered high-end real-estate conversions of these properties. The question now is whether the new equity holder will move ahead with these plans.

"Given that the estimated uplift in value is around [$321 million equivalent] we remain convinced that any potential purchaser is likely to redevelop the properties," explained Morgan Stanley. Even if the purchaser doesn't redevelop, the bank said, the structure is not likely to be overstretched - $852 million equivalent of debt outstanding against a $1.26 billion equivalent valuation of the assets translates, based on current use, into a 67% loan-to-value ratio.

However, according to BNP, Orb had guaranteed the loans currently in default using a portion of its ownership shares in the of the hotel portfolio as backing. This could complicate Orb Group's plan to sell its hotel portfolio in the Hoteloc transaction, and could also potentially interrelate bondholders to both transactions. "Whatever the outcome, it is another lesson for investors that they should be fully aware when unrated, little-known companies are placed in a position within a securitization structure where their performance can affect bondholders."

Copyright 2003 Thomson Media Inc. All Rights Reserved.


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