CMBS Part III: Incentives and Conflicts of Interest

The theory behind CMBS is one thing, but reality is often something else. In this final part of our three part series, we’ll discuss three primary issues of concern with how things often play out in the real world.

This article will make more sense if you’ve already read Part I: Basic Structure that explains what a CMBS is and Part II: Opportunities through Tranching. These earlier articles introduce an example that will be expanded upon below.

1. Originator Incentives

In our example, Max is the creator of each mortgage loan. Max makes his money by originating new loans and charging fees. Thus, the more loans he creates, the more fees he can collect. Further, the faster he originates a new loan and sells it to Mateo, the quicker he’ll end up with more cash that can be used to create the next loan. This incentivizes Max to create as many loans as he possibly can and to do so as quickly as he can.

This can tempt Max to get sloppy with his underwriting. Remember that once Max sells the loan, he no longer has to worry about whether or not the borrower makes their payments. The default risk has been passed on to someone else. Max has little motivation to make sure that Julie, or any other borrower, is actually in a position to make their monthly loan payments. Max is instead motivated to originate as many loans as possible to whoever happens to come it to his office.

This was a major contributing factor to the crash in residential mortgage backed securities (RMBS), leading up to the Great Recession. RMBS are very similar to the commercial version we’ve been discussing, with the primary difference being that the mortgage loans are associated with houses instead of commercial buildings like offices, production facilities, and retail centers.

The phrase “subprime mortgages” refers to loans that were made to borrowers who shouldn’t have qualified for loans in the first place. But because the originators had no intention of holding on to the loans, they didn’t worry about whether or not borrowers were capable of paying back the loans. As already mentioned, loan originators were passing the risk off on someone else, while making their money on origination fees.

2. Senior and Junior Tranches Have Different Interests

Recall that when Julie was only able to make a partial payment it was the investor in the lowest level tranche that took the hit. While Amar received his usual payment, Zoe only got what was left. Let’s pretend that instead of making a partial payment, Julie stopped making payments all together. In fact, let’s say that things got really bad for her business and she was threatened with a possible foreclosure.

If foreclosed on, Julie would lose the building she bought. The building would be sold to someone else and the proceeds from that sale would go towards paying back investors like Amar and Zoe. But in most cases, foreclosure proceeds do not cover the entire balance due on a loan.

Investors like Amar who invested in the higher level tranches would likely receive a portion of what they were owed from Julie. However, investors in the lowest level tranches, may very well receive nothing at all. Thus, those investors at the bottom would rather not see Julie foreclosed on. They would prefer that she be given a chance to rebound and get back on track.

At the same time, the investors in the highest level tranches would see foreclosure as a way of speeding up the payments due. Instead of having to wait several years for Julie to pay off the loan, they’re happy to get paid more quickly. Depending on the specifics and how much cash is recovered, those high level tranche investors may receive a partial payment or they may even be paid the entire principal owed them by Julie.

But Julie’s loan doesn’t belong to any one investor or any one tranche. Along with other loans, Julie’s loan was put into a trust, a legal entity that is supposed to act on behalf of all the investors. The trust then has to make a decision about whether to foreclosure on Julie knowing that lower tranche investors will likely get burned, or giving Julie a break, something that the higher level tranche investors likely wouldn’t like. So, what should the trust do?

Normally, a third-party company is hired, a specialist of sorts, to handle delinquent loans. This third party, known as a “special servicer” basically has to pick a side to align with: the higher level or lower level tranche investors. In order to attract people to the lower level tranches, sometimes the lower level tranche investors are allowed to pick the special servicer. Other times, the special servicer is a sister company of another party, maybe a company affiliated with Max or Mateo. As you can imagine, these conflicts of interest can cause problems and complicate matters.

In theory, the special servicer should equally represent all tranches, and act in the best interest of everyone. But when faced with a situation where only side can get what they want, how does the special servicer decide? Well, if one of those sides hired them and is responsible for their getting paid (as is often the case), then it shouldn’t be too hard to predict where their loyalty would lie.

3. Credit Rating Agencies are Hired by Issuers

CMBS are complicated and even experienced investors have a hard time understanding them. When CMBS were brand new many people avoided them for this very reason. To encourage more investors to get involved, issuers (someone in Mateo’s position) would hire credit rating agencies to rate the different tranches. For example, the very top, senior most tranche might have a AAA-rating. These are the same type of ratings that bonds receive.

A bond investor often looks at a credit rating agency to determine how safe or how risky a particular bond is. The idea here was to make that same kind of rating available to someone considering a CMBS investment. If you saw one tranche with a C-rating and the other rated AAA, it’s simple to quickly determine which one is safer, and how much safer. Plus, you could, at least in theory, put your faith in the credit rating agency to presumably understand something better than you might understand it.

There are at least two problems with this. The first, is that the bond rating agencies didn’t really understand CMBS as well as many investors assumed they did. The CMBS market was new and the rating agencies were not as familiar with real estate as they were with corporations that issue bonds. As a result, their ratings weren’t always as accurate as they should have been.

Secondly, the credit rating agencies were hired by the CMBS issuers. Imagine if Mateo came to you and said that he wants to sell an investment to someone and would like you to rate the quality of that investment. He goes on to explain that if you’re willing to provide the rating that he wants, you’ll get his business. Otherwise, he’ll find someone else to provide the rating.

Even without explicitly lying about the quality of a tranche, the credit rating agencies would tell an issuer, like Mateo, what minimum criteria they need in order to get a B-rating, a AA-rating, or a AAA-rating, allowing issuers to play the system. This leads to a conflict of interest in which the ratings marketed as being aids to investors may carry little to no meaning. In essence, people thought they were investing in something much safer than they actually were.

Conclusion

The CMBS market began with the intention of creating something where all parties involved could benefit. But in practice, human nature took over and conflicts of interest arose. This caused problems and many people got hurt.

Borrowers were given loans that they should never have been given and ended up ruining their credit, losing their homes, and dealing with a lot of unnecessary stress. End investors (people in the position of Zoe and Amar) lost money and lost their faith in the system. Lenders like Max, issuers like Mateo, and credit rating agencies all lost credibility. Instead of everyone benefiting, it felt like everyone got burned.

Although some of the issues have been fixed over time, not all have been, and the emotional impact persists. There is still a stigma associated with mortgage backed securities (both residential and commercial) that will continue for decades to come, as investors and the public alike remember the events leading up to the Great Recession. That stigma, that trauma, those memories… cannot be escaped. They will still be there whenever someone talks about a mortgage backed security. Trust is easily lost, but difficult to regain.

At the same time, over time new investors will enter the market, including those who were too young to have experienced the Great Recession or understand what led up to it. Thus, it’s possible that history could repeat itself if society doesn’t learn from it.