The Internal Revenue Service's proposed changes to commercial real estate mortgage investment conduits will offer more flexibility for borrowers looking to modify their loans and bring the regulations up to date with today's market, according to proponents of the adjustments.
The current regulations addressing REMICs, adopted in 1992, allow for only limited modifications. The IRS and Department of Treasury have proposed exceptions that would allow for modifications that substitute, add or alter a substantial amount of the collateral for a guarantee or other credit enhancement on the loan. Those allowances would remain as long as the obligation continues to be principally secured by an interest in real property. It will also permit a change in the nature of the obligation from recourse to nonrecourse, if the obligation is still secured by an interest in real property.
Some market players believe the current regulations are outdated and do not take into account the complexities of the modern securitized commercial loan industry. "The regulations were adopted in 1992, and the securitization industry was primarily just a residential loan market," said Charles Adelman, a senior partner at Cadwalader, Wickersham & Taft. "It was only in that year that the commercial mortgage loan securitizations began to grow in volume, so the IRS could not really foresee at that time what the issues might be with the administration of loans."
George Howell, a partner and head of the tax and ERISA practice at Hunton & Williams, said that one of the biggest issues for borrowers and servicers has been the difficulty for borrowers to substitute one property for another property within its pool of loans, even when the new property makes the loan even more secure than before. "The problem was that under the old regulations [a property substitution] could have resulted in a qualification problem for the REMIC," he said. "The modification might be enough to call this a deemed exchange of the old mortgage loan for the new one with the new collateral."
Lenders have traditionally offered two programs: REMIC loan programs where they can offer a great rate but very little flexibility, or a non-REMIC program which is more flexible, but has a higher rate because the lender cannot finance it as efficiently.
Adelman, who also serves as the chair of the tax subcommittee for the American Securitization Forum, noted that commercial loans are fundamentally serviced differently than residential loans. Residential mortgage servicing is really a collection function and if something goes wrong with the loan, the servicer is responsible for collecting the loan, Adelman said.
Commercial mortgage loans, on the other hand, "are much more dynamic" because they represent functioning businesses, and there are a variety of ways in which borrowers are actively administering their properties. "The properties change over time," said Adelman. "The tenants change, the business earns more or less over time. The properties tend to be transferred from one owner to another while the loan is still outstanding."
In other words, the servicing of commercial loans requires some degree of flexibility beyond those of residential mortgage loans. "The REMIC rules provide some flexibility for this, but there is a general rule that says if the loan held by the REMIC is modified in a significant way then it is as if the loan were refinanced," said Adelman. "That would cause a valuation of a fixed-pool requirement for REMICs, and it would cause the modified loan to be disqualified and potentially the whole REMIC."
Tom Deutsch, deputy executive director of the ASF, said the organization has a few concerns about the proposal. One regards the requirement of an independent third-party appraisal to be prepared, which the ASF believes could be too costly. "The appraisal for commercial mortgages is a much more detailed and intensive process [than that for a residential property], which can be very expensive and have some real money impacts on the trust or servicer," he said. "In these kinds of cases you really have to weigh the costs and benefits associated with it. This is a case where it's not clear at this point that the costs of those third parties are really justified by the benefits they would create."
Although investors could be wary that looser regulations will mean a flood of modifications, Howell does not think this will be a problem. "I guess it all depends on whether you trust the rating agencies," he said. "Today some people have skepticism about the rating agencies, but in the real world that's what you rely on, and usually in order to do one of these modifications you have to have the sign-off from the rating agency saying that it's not going to affect the rating of the bond. I think that is really the built-in protection for the investors."
(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.