Commercial Foreclosure and the Commercial Mortgage Backed Security: Can improper procedures used in securitizing your commercial mortgage assist you in negotiations with your lender?

Across the United States today, commercial property owners are increasingly finding themselves struggling to pay their commercial mortgage loan, in default on their commercial mortgages, or facing foreclosure. Although the commercial mortgage foreclosure crisis is not as widely publicized, commercial property owners across the country are now facing situations akin to those experienced by residential property owners. Whether you own a shopping center, office building, retail store, mall, warehouse or any other commercial property it is important to know that there are defenses and strategies available to you, the commercial property owner, which can help you lower your mortgage payment or avoid foreclosure. Even if you are not currently in default or facing foreclosure, in some cases taking a proactive approach in investigating the status of your loan can assist you to negotiate a lower mortgage payment.

The Commercial Mortgage Delinquency Problem

As of September of this year, the credit rating firm Fitch Ratings reported there was $90.9 billion dollars worth of bad commercial loans backed by commercial mortgage backed securities. It should be no less shocking that the data provider Trepp has reported that in November 2010 there was $60.3 billion dollars worth of commercial loans backed by commercial mortgage backed securities that were either 30 days or more past due or in foreclosure. Although this shows an improvement in the amount of delinquent commercial loans, November’s rating was the second highest rating ever next to September 2010, proving that although there has been some drop in commercial mortgage delinquencies this problem very well still exists. Elizabeth Warren, chairman of the Congressional Oversight Panel, has stated that by the start of 2011 it is estimated that half of commercial mortgages will be underwater.

Despite the fact that the commercial foreclosure crisis plaguing commercial property owners is similar to the residential foreclosure crisis, there are differences between commercial and residential mortgage loans which make commercial loans more susceptible to delinquency and foreclosure, which could result in the commercial mortgage crisis becoming even more widespread and devastating than the residential foreclosure crisis. First, commercial mortgage loans do not offer incentives like guaranteed repayment of principal and interest by government or quasi-governmental agencies, such as Fannie Mae and Freddie Mac. Therefore, they are riskier to the bank and leave the bank in a position where the borrower, the commercial property owner, is the bank’s only chance of repayment. Additionally, commercial mortgage loans usually are for a greater dollar amount than residential mortgage loans as commercial properties are likely to cost more than residential properties. The high dollar amount of commercial loans in comparison to residential loans is then compounded by the fact that commercial loans mature at a faster rate than residential loans. While a residential loan is typically paid off over 30 years, commercial mortgages usually mature within five years and must be paid off or refinanced by that time. The high dollar amount of commercial loans and shorter loan term result in a higher monthly payment, making it harder for the borrower to continue to make payments in uncertain economic times and more likely that the borrower will find himself in default on his mortgage.

Another problem fueling the rise and continuance of commercial delinquencies is that many of these bad loans were originated during “the Boom” years. During “the Boom” years, property values were inflated and borrowers were not properly qualified by underwriters, resulting in a commercial mortgage loan debt which is higher than the value of the property. This makes it virtually impossible for commercial mortgage borrowers to obtain refinancing for their commercial loans, leaving them with no other option but to pay the loan off before the maturity date or go into default. According to Trepp data provider, it is estimated that $170 billion dollars worth of Commercial Mortgage Backed Securities loans will mature within the next three years. Commercial mortgage delinquencies will continue as more commercial loans taken out during “the boom” years will mature within the next few years and more and more borrowers will be unable to pay or refinance their commercial loans originated during “the Boom”.

Many commercial property owners are reluctant to investigate their loan status or challenge foreclosure because your commercial property is not your home, you may face little or no personal consequences from foreclosure and your loan amount may even be higher than the value of your property making it more sensible for you to walk away from your property. Many property owners assume their lender or servicer is correct in asserting their right to foreclose. However, property owners nationwide, residential and commercial alike, are finding that this is just not the case and that in these uncertain economic times you cannot just take someone else’s word for it. Lawyers and judges alike have begun to recognize a systematic practice of improper procedures used by major banks and their agents in the process of securitizing commercial mortgages. The consequences of such improper procedures are that many entities instituting foreclosure actions cannot prove that they own the loan in question and have standing to bring a foreclosure action. Investigating the status of your loan to determine whether any of these improper procedures were used in the process of securitizing your loan can help you challenge your foreclosure or negotiate a loan modification, sale of your property or assumption of your mortgage.

The Securitization of Commercial Mortgage Loans

In the 1980’s, the practice of securitizing mortgages began with the securitization of residential mortgages and then moved into the commercial mortgage market. Securitization is the process by which the cash flow associated with a group of assets is divided into new cash flow streams or classes of interests sold to investors. In a typical case, an investment firm will buy the mortgage loans and pool them together. The loans are packaged into pools, sometimes more than once, and are ultimately sold internationally to investors in the form of stocks and bonds. The pools of packaged, securitized loans are then transferred to a trust entity, which holds the loans in trust for the investors’ protection. During the securitization process, each loan is transferred several times before it is assigned into the trust. The securitization procedure requires the loan to be assigned and endorsed to the receiving party each time it is transferred.

A security which is backed by a pool of securitized commercial mortgage loans is called a Commercial Mortgage Backed Security (CMBS). Securitized commercial mortgage loans are owned by investors, rather than the lender who originated the mortgage. Since the loans are not owned by the originating lender, master servicers are hired to collect the mortgage payments and deliver the income to the investors. In the event of a default on the loan, the loans are then transferred to a special servicer who can modify the loan, sell the promissory note, or proceed with foreclosure.

“The BOOM”

Around 2004, the volume of mortgage securitization transactions began to increase vastly continuing through the height of the market in 2005, 2006, and 2007. Commercial Mortgage Backed Securities were extremely popular during this time because they offered higher returns than other investments. As the demand for this type of investment was high, the issuance of Commercial Mortgage Backed Securities contributed steadily to the real estate boom. In order to take advantage of the high demand for CMBS, lenders rushed to issue loans without concern for quality since they intended to immediately securitize them. Furthermore, in their rush to securitize the loans, evidence indicates that paperwork was improperly filled out and securitization procedures were not properly followed. In turn, we are only first realizing the depth of what seems to be a regular process employed by banks and their agents to save money while increasing profits by ignoring traditional mortgage protections and securitization procedural requirements.

Improper Procedures in the Securitization Process

Mortgage securitization procedures require compliance with various laws and regulations which govern the securitization process. Each state’s Uniform Commercial Code includes regulations which govern “secured transactions” involving the transfer of loans encumbering real property. Moreover, state trust law governs the trusts which hold the securitized loans and these trusts must comply with any applicable state trust law. The procedures for securitization must also comply with federal regulations enacted by the Internal Revenue Service, as many trusts elect tax breaks under the Internal Revenue Code, and those enacted by the Securities and Exchange Commission, which govern the sale of any type of securities. Additionally, procedures used in the process of securitizing the loan must comply with any specific steps outlined in the pooling and servicing agreement governing the securitization process for the specific pool of loans.

In the rush to securitize loans, it is beginning to be recognized that many notes and mortgages were improperly transferred between the different required entities during the securitization process in violation of the UCC and state trust law. An integral part of the securitization process is the transfer of the loans from the originator, to the intermediary parties and eventually to the trust. As part of the securitization process, the transfer of the loans to the trust must be done properly through an endorsement of the loan by the transferring party to the receiving party. Furthermore, each time the loan is transferred it must be validly assigned from the assignor to the assignee, as evidenced by a recorded assignment in the county where the property is located. One technique which was commonly used by banks in order to facilitate multiple transfers throughout the securitization process was to use a “blank assignment”, which does not name the true owner and endorses the loan in blank. Banks challenged on the basis that this is an improper transfer have defended this practice claiming that the true owner does not need to be named in the assignment as long as the loan itself is transferred. The jury is still out on whether a blank assignment is considered a proper transfer.

If there is an improper transfer or invalid assignment during the securitization process of your loan, the true owner of your loan may be unknown and the entity seeking to foreclose or enforce the note may not have authority to do so. A problem in the documentation required to transfer ownership of the loans at any stage of the securitization process puts ownership of the pooled mortgages into question. In order to have standing to bring a foreclosure action, the plaintiff must prove that it is the owner of the note and mortgage in question. If it cannot prove it is in fact the owner of the note and mortgage due to a problem in the documentation required to transfer the note and mortgage, then it is without authority to foreclose. Judges have increasingly found that many banks claiming to own mortgages which were pooled and turned into securities do not have standing to foreclose on the properties or enforce the notes. In many cases, these foreclosures are not further prosecuted or re-filed, indicating that the problem standing in their way is not easily fixable. Moreover, improper transfers during the securitization process may lead to the disqualification of the entire investment from a tax exempt status elected under the Internal Revenue Code and imposition of any corresponding penalties under IRS regulations.

Remedies Available to Commercial Property Owners with CMBS loans

Equipped with knowledge of the improper procedures systematically used by banks during the securitization process, the commercial mortgage backed securities loan borrower may be able to challenge foreclosure or negotiate a loan modification, sale of the property, or assumption of mortgage with the special servicer and lower his payments. In an effort to avoid foreclosure many special servicers have been modifying loans to extend the repayment term until a specified date in the future, in the hopes that the market will improve and the borrower will be able to refinance the loan at that time. Special servicers are realizing quickly that it pays to recover as much as they can from the borrower and cut their losses by working with the borrower and modifying his loan, rather than foreclosing. Additionally, special servicers have begun to actually rewrite loans for certain borrowers to allow them to continue making payments, rather than merely extending the maturity date of the loan.

An additional option for borrowers who can no longer afford to make payments on their commercial mortgage backed securities loans is to negotiate a sale or assumption of mortgage with the special servicer. Under this option, the seller and bondholders agree to sell the property to a buyer who will assume the seller’s mortgage and continue making payments on the loan. In addition, the borrower avoids foreclosure and the special servicer avoids the costs of the foreclosure process and delays associated with a foreclosure sale of the property.

In the end, there is light at the end of the tunnel for commercial property owners with commercial mortgage backed securities loans. Fitch reports that while only 8.9 billion dollars worth of bad commercial mortgage backed securities loans were recovered by special servicers in the first quarter, 27.9 billion dollars has been recovered from bad loans by special servicers in the third quarter. This indicates that special servicers in charge of loans backed by commercial mortgage backed securities have begun to work with borrowers in an effort to prevent foreclosure and avoid fueling the impending commercial foreclosure crisis.