Due to "transfer-restriction" clauses found in the prospectuses of seasoned bonds, the transition to the new rules outlined in the long-anticipated Erisa guidelines - due to be released today by the Department of Labor - might prove to be as controversial and confusing as last week's presidential election.
According to Erisa lawyers, analysts and market pundits monitoring the development, many of the pooling and servicing agreements of CMBS and ABS dated before August 23 contain clauses that specifically forbid certain subordinate bonds to be transferred to Erisa-restricted accounts.
Even the upcoming new rules - which ironically were meant to open up such securities to Erisa plans - cannot supercede the clauses, meaning that Erisa plans will not be able to invest in any of the older deals unless underwriters go back and amend the language of the prospectuses - a very work-intensive and expensive process.
More importantly, some sources indicate that there will be a much larger investor base for newer deals, since all deals issued after August 23 took these clauses out, in anticipation of the release of the new guidelines. This might very well cause a "tiering effect" in the CMBS and ABS markets, sources say, since there will be a far larger number of Erisa plans investing in the newest deals versus the older ones.
"It is tough for plans to buy the older deals, even under the new exemptions, unless they amend the underlying pooling and servicing agreements," said Bruce Gallant, an attorney at J.P. Morgan Investment Management Inc. "My guess is that, in most cases, issuers are not going to go through the effort to do that. There will be a tiering between those plans that can buy those deals and those that can't. This will create confusion in the market."
"To the extent that the older documents are not changed, there could be some sort of tiering in lower-rated CMBS," noted Brian Lancaster, a CMBS researcher at Bear Stearns. "There will be a class of investor who is not able to buy older ones, and a whole big class that could buy newer ones."
"The question is, is it worth it to [underwriters] economically to go back and change the clauses? The underwriter picking up the security in the secondary market might not even be the underwriter who originally did the deal," added Barbara Klippert, an Erisa attorney at Stroock & Stroock & Lavan. "Furthermore, the wording is different in different bonds, and for some of them, you actually need permission to amend the language, or you outrightly are not allowed to amend it."
A Solvable Problem?
The majority of pre-existing deals contain language in the pooling and servicing agreements or other governing deal documentation that outrightly restricts or inhibits the trustees or transfer agents from selling a non-Erisa-eligible security to an Erisa plan, according to George Miller, senior vice president and deputy general counsel of The Bond Market Association.
However, this particular obstacle will be unrelated to Erisa eligibility. "This is a problem that can be solved," Miller said. "If an amendment to a prospectus is required, these can be unilateral amendments. No certificate holder consent would be required and that is reasonable, because these are changes that would not affect negatively the interest of any existing class of bond holders, and that is usually the threshold you need to meet."
Additionally, it is unlikely that Erisa-eligible investors are a big enough force to really engender a tiering effect, sources say.
"I am very skeptical that it would have that sort of effect, because of the types of investors out there," said Patrick Corcoran, head of CMBS research at J.P. Morgan & Co. "There are two types of CMBS investors: those that are limited to the triple-A part of CMBS, or sophisticated analysts who put B-piece money to outside managers, and they already take advantage of the relative value of CMBS.
"Ask yourself: Are either one of these investors likely to initiate a buying spree where they distinguish sharply between deals to give you a tier in spreads? These investors either barely have a toe in the water or are in there with a wet suit and tanks."
A Case-by-Case Basis
Still, others disagree, saying that all home-equity, manufactured housing, multifamily, residential, CMBS and prime mortgage products will be significantly affected by this, mainly because the pension plans who seek these older subordinate securities will have to spend a lot of money.
"There are many technical details involved," Klippert said. "You have to be sure that the only reason the security can't be transferred is because of a rating or subordination. Furthermore, you have to get opinion of counsel to prove that it is not a prohibited transaction. And to go back and amend the agreements, there is a huge cost involved."
Therefore, it seems, a lot hinges on the demand for these seasoned securities. That is why this issue will be addressed on a case-by-case basis: "It all depends on where demand is coming from," the BMA's Miller said. "If there is a lot of interest for a particular deal that contains this restriction clause, that will create motivation to amend the document, if necessary."
Additionally, there will be a learning curve involved here, mainly because Erisa plans will have to learn the risks involved for these new investments, and that doesn't happen overnight.
A Larger Problem...
Regardless of these technical issues associated with the new Erisa guidelines, some market observers say that there is a larger issue here that is repeatedly ignored: Erisa accounts do not have as much of a demand for single-A and lower-rated asset-backed securities as people think.
The flood of Erisa money that was predicted to go into CMBS and ABS is just not there, says Michael Youngblood, managing director of real estate at Banc of America Securities.
"Erisa plans have not shown any historic interest in mortgages," Youngblood said. "The language of the indentures doesn't matter, because the question is whether mortgages are attractive on a risk-reward basis to Erisa accounts."
For the first quarter of 2000, Erisa accounts held $30.5 billion in all forms of mortgages out of a whopping $5.1 trillion in total assets. Back in 1970's first quarter, Erisa accounts held $4.2 billion in mortgages out of $114.7 billion in total assets.
Moreover, the pension plans have not shown any particular liking for GSE mortgage debt, which certainly has far better liquidity and risk protections than single-A-rated CMBS or ABS.
"There has been exponential growth in Erisa assets, but only tiny relative growth in their mortgages," Youngblood said. "The Street has not effectively sold to Erisa accounts on the virtues mortgages as an asset class.
"Until that argument is made, none of the minutiae of these new guidelines will matter." -