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ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW 21 ST ANNUAL SPRING SYMPOSIA

ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW 21 ST ANNUAL SPRING SYMPOSIA EMERGING FROM THE DARK? TRENDS AND RESPONSES TO THE CREDIT CRISIS PROGRAM CHAIR: - JOHN P. McNEARNEY, Husch Blackwell Sanders LLP

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ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW 21 ST ANNUAL SPRING SYMPOSIA

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  1. ABA SECTION OF REAL PROPERTY, TRUST & ESTATE LAW21ST ANNUAL SPRING SYMPOSIA EMERGING FROM THE DARK? TRENDS AND RESPONSES TO THE CREDIT CRISIS PROGRAM CHAIR: - JOHN P. McNEARNEY, Husch Blackwell Sanders LLP SPEAKERS: - Robert S. Chase II, Sutherland Asbill & Brennan LLP - Gregory A. Cross, Venable LLP - Christopher L. Peterson, University of Utah, S.J. Quinney College of Law

  2. Be Careful What You Wish For: The Cost of Clarification in the REMIC RulesRobert S. Chase II

  3. Background • REMICs Generally • A Real Estate Mortgage Investment Conduit (“REMIC”) is a securitization vehicle, generally a trust, that pools mortgages and pays interest and principal received on the mortgages to the trust investors. • REMICs are given special tax treatment under the Internal Revenue Code, but this tax treatment is contingent on the satisfaction of and continuing compliance with certain restrictions, including limitations on the non-mortgage assets held by the REMIC. • Servicing of loans in a REMIC is generally handled by a servicer, that operates under a pooling and servicing agreement. • Among other things, PSA requires servicer to act in a manner that preserves the tax status of the REMIC

  4. Background Preserving the Tax Status of the REMIC • A REMIC generally may not engage in certain “prohibited transactions” including the disposition of a “qualified mortgage.” • A “Qualified Mortgage” is a loan which is “principally secured by an interest in real property,” and that is transferred to the REMIC by the end of the third month following the REMIC’s startup day. • A mortgage transferred to a REMIC after the Contributions of assets to a REMIC made after the “startup day” is not a qualified mortgage, and the REMIC generally is subject to a 100% tax on the amount of the contribution. • If a mortgage held by a REMIC ceases to be a “qualified mortgage,” it can cause the REMIC to fail to qualify as a REMIC for tax purposes.

  5. Background “Significant Modifications” of REMIC Loans • REMICs are passive investment vehicles and it is relatively simple to ensure that new loans are not contributed to the REMIC, or that existing loans held by the REMIC are not sold—the potential issue arises when a loan held by a REMIC is modified. • Under the tax rules, if a loan is modified and that loan is a “significant modification” within the meaning of the Treasury Regulations, there is a deemed exchange of the original debt instrument for a new debt instrument that differs materially either in kind or extent. • If there is a deemed exchange of the original debt instrument, absent application of an exception: • The deemed sale of the original debt instrument is a prohibited transaction subject to tax; • The deemed contribution of the new debt instrument is a contribution of assets to the REMIC subject to a 100% tax (if made after the startup day); and • The “new” loan is not a “qualified mortgage for purposes of determining whether the REMIC qualifies as a REMIC for tax purposes

  6. Background What is a “Significant Modification”? • “Significant modification” requires that there be: • A modification of the loan; and • That modification must be “economically significant”. • Although economic significance is generally determined based on a facts and circumstances analysis, certain modifications are specifically considered to be significant, including, for example, • The substitution of an obligor on a recourse instrument; • Extension of maturity of an instrument beyond certain safe harbor periods; or • Certain additions, modifications or substitutions to collateral on a non-recourse loan.

  7. Background Additional REMIC Exceptions to “Significant Modifications” • Certain transactions that would constitute “significant modifications” for tax purposes generally, resulting in a deemed exchange for tax purposes, are not treated as exchanges for purposes of applying the REMIC rules • These transactions do not cause the adverse tax consequences or disqualification of the REMIC. • Exceptions include changes to the terms of an obligation that are due to default or reasonably foreseeable default are not significant modifications for purposes of the REMIC rules. • In September 2009, partly in response to industry concerns and the credit crisis, the IRS and the Department of Treasury issued additional guidance on modifying loans held by REMICs and also finalized modified REMIC regulations under section 1.860G-2.

  8. Background Recent REMIC Guidance • Prior to 2008, the existing rules relating to modifications of REMIC loans had been unchanged for almost 20 years and therefore it was perceived by many that they did not properly take into account industry practice. • IRS in a pilot program worked with CMBS industry to provide guidance to address industry concerns not clearly addressed in the existing regulations. • Final regulations were issued in September 2009, concurrently with Revenue Procedure 2009-45, which provides additional guidance on modifying loans held by REMICs, partly in response to industry concerns and the credit crisis.

  9. Revenue Procedure 2009-45 Overview • Revenue Procedure 2009-45 was issued on September 15, 2009. • Most directly targeted at the credit crisis. • The Revenue Procedure clarifies when a loan is considered to be in default or when default is reasonably foreseeable. • It specifically was not intended to change what types of modifications were allowed prior to its release or are allowed going forward. • The Revenue Procedure was retroactive and applies to modifications occurring on or after January 1, 2008.

  10. Revenue Procedure 2009-45 Reasonably Foreseeable Default Factors • The Revenue Procedure sets out circumstance under which a loan modifications generally will not result in adverse REMIC consequences. There are four factors: • The property securing the pre-modification loan is not a residence with fewer than five units and is not the issuer’s principal residence. • At the end of the three month period beginning with the startup day of the REMIC, no more than 10% of the stated principal of the REMIC’s assets was attributable to loans where payments were overdue by 30 days or where default was reasonably foreseeable at the time they were contributed to the REMIC.

  11. Revenue Procedure 2009-45 Reasonably Foreseeable Default Factors (continued) • The holder or servicer reasonably believes, based on all of the facts and circumstances, that there is a significant risk of default of the pre-modification loan; and • The holder or servicer reasonably believes, based on all of the facts and circumstances, that the modified loan has a substantially lower risk of default that the pre-modified loan.

  12. Revenue Procedure 2009-45 Application • In applying these factors, whether there is a “significant risk” of default is based on a diligent and contemporaneous analysis by the holder or servicer. • It can be based on a credible, written factual determination of the issuer if the holder or servicer does not know or have reason to know that the issuer’s representations are false. • The risk of default does not have to be immediate and specifically can be more than one year in the future. • Past performance can be indicative of future performance, but a performing loan can also be found to have a significant risk of default. • This is particularly relevant in situations where the borrower is current but will have difficulties refinancing on maturity.

  13. Revenue Procedure 2009-45 Practical Implications – Was Rev. Proc. 2009-45 Necessary? • Under REMIC rules, modifications made in anticipation of foreseeable default are already exempt—just provides guidance for when default is reasonably foreseeable. • Moreover, many debt modifications including maturity extensions and certain changes in interest rates are exempt from treatment as a “significant modification” under the existing regulations. • Although applauded as a welcome relief for borrowers and servicers, not clear that in application it achieved the desired result.

  14. The New Regulations Overview • At the same time the Rev. Proc. 2009-45 was issued, regulations that were developed to address industry concerns with the application of outdated REMIC rules also were finalized. • The final regulations adopt, with some modifications, proposed regulations issued on November 9, 2007. • The new regulations generally expand the types of modifications that can be made to mortgages held by a REMIC without negative tax implications. • However, the new regulations also require a valuation test for all releases of property and for certain other modifications, which is generally more onerous than the prior regulations. • The final regulations are effective for modifications to loans made on or after September 16, 2009.

  15. The New Regulations Permitted Modifications • The new regulations permit the release, substitution, addition, or other alteration to the collateral for, guarantee on, or other form of credit enhancement for a mortgage held by a REMIC, as long as the mortgage remains principally secured by an interest in real property following the modification. • The new regulations also allow a change in the recourse nature of an obligation as long as the loan remains principally secured by an interest in real property.

  16. The New Regulations Application • Under either the 80% Test or the Fair Market Value Test, the regulations require that the fair market value of the real property securing the loan be determined by: • A current appraisal; • An appraisal conducted at the time of the loan’s origination that has been updated as necessary; • A sales price in a substantially contemporaneous assumption transaction; or • Any “commercially reasonable” valuation method. • The IRS has not provided guidance on either when an updated appraisal is necessary or what constitutes a commercially reasonable valuation method.

  17. The New Regulations Significant Changes • Elimination of “Substantial Amount” Exception • Under the prior regulations, a change to a non-substantial amount of the collateral, guarantee, or credit enhancement was not a significant modification under section 1001 and did not implicate the REMIC rules. • Under the construct of the new regulations, even though such a change would not be a “significant modification”, it nonetheless requires testing whether the loan will be principally secured by an interest in real property after the change.

  18. The New Regulations Significant Changes • Expansion (in some cases) of Permissible Releases • Under the prior regulations, an argument could be made that releases of real property securing a loan could only be made through a defeasance. • The new regulations specifically permit a release that is not in connection with a defeasance as long as the obligation remains principally secured by an interest in real property. • The new regulations also impose a valuation requirement that had not been necessary in the past and that has been criticized as being overly restrictive. • Previously, the regulations only required valuation at the time of origination or contribution.

  19. The New Regulations Significant Changes • Contraction (in some cases) of Permissible Releases • Under the prior regulations, a release of property pursuant to the terms of a contract is not a “modification” and therefore would not be a “significant modification” • The new regulations require that the “principally secured” test be satisfied, notwithstanding that the release would not be a significant modification of the loan. • In order to satisfy principally secured test, a valuation of the property is generally required.

  20. The New Regulations Other Practical Considerations • Condemnations - The new regulations also call into question whether a valuation is required if there is a condemnation or taking of property subject to a mortgage. • Under the new rules, the condemnation of even a small piece of land could cause the disqualification of the REMIC (if the 80% Test cannot be satisfied) through no voluntary action of the borrower. • Valuation Costs - The principally secured test requires a “commercially reasonable” valuation, which may require borrowers that are financially strapped to incur excess cost.

  21. The New Regulations Other Practical Considerations • Releases in Connection with Defa ult -Previously, modifications to loans caused by default or reasonably foreseeable default were not significant modifications. • Under the new regulations, modifications where a portion of the property is sold and the proceeds used to pay down a defaulted loan would not be permitted, unless the Principally Secured Test is satisfied.

  22. The New Regulations What’s Next? • The IRS is aware of concerns with respect to the practical application of the new regulations and has indicated that it will issue clarifying guidance. • Until then, borrowers and servicers are faced with the burden of complying with the often increased burdens of compliance with the new regulations.

  23. “INTO THE COAL MINE” Gregory A. Cross Venable LLP

  24. WHERE WE ARE?U.S. MARKET AS WHOLE • $3.5 trillion commercial real estate market is experiencing serious financial stress • By 2014, an additional $1.4 trillion is expected to mature • Property values have reportedly declined by 40% • Pooled loans in excess of $200 million are extremely rare • Defaults doubled in 2009 and are not expected to peak until 2011

  25. WHERE WE ARE?CMBS MARKET • CMBS loans represent approximately 20% of commercial property debt • At the end of February 2010, 10% of CMBS loans were in special servicing - $76.6 billion • During 2009, CMBS special servicers resolved $8.7 billion of the defaulted loans – just 11% of the loans in special servicing • There were virtually no new securitizations in 2009 and uncertainty remains in 2010 • Maturities significantly increase in 2011 and 2012 • Credit Suisse recently estimated that it would take special servicers 5.5 years to resolve the current backlog

  26. UNIQUE CHARACTERISTICS OF CMBS • Cannot re-lend against REO • Cannot effectively distribute interest rate increases • Cannot extend beyond term of PSA or contractually permitted period • Must sell within six years after REO • Cannot advance funds for construction • Generally cannot take equity as part of restructure • Controlling class representatives instruct special servicers even though ultimately out of money

  27. IMMEDIATE MARKET REACTIONS • “A rolling loan gathers no loss” • “Hold and hope” • Short term extensions • Full cash sweep • 12 months • Receiverships with no intent to foreclose • Consensual longer term extensions in bankruptcy – GGP

  28. WHAT HAPPENS NEXT? INVESTORS/BORROWERS • Aggressive senior investors jumping trust structures • Investors shopping for maturing defaults “loan to own” • Bankruptcy cram down • Low interest rates – Till • Low valuations • Bankrupt guarantors • Bankruptcy sales • No credit bid • Large case bankruptcy filings • Corporate Family Doctrine – GGP

  29. WHAT HAPPENS NEXT?SPECIAL SERVICERS • Delayed response time • Investor litigation to preserve trust structure • Foreclosures with corresponding REO build-up • Loan sales • Split A/B structures reflecting value realities of the market • REMIC reform

  30. SOURCE MATERIALS • Maureen Milford, Next Bubble: Commercial Real Estate, The News Journal, March 14, 2010 • Commercial Mortgage Alert, February 5, 2010 • February 22, 2010 Credit Suisse First Bank Analysis Report on the CMBS Market

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