FEATURE: The whistle blower

Despite inherent conflicts of interests at special servicers, there is next to no regulation to protect bondholders according to Jack Rose, chief strategist at San Diego-based real estate consultant, Breakwater Equity Partners. Here, he explains the issues

PERE: Jack, what is your assessment of conflicts of interests concerning special servicers of commercial backed mortgage securities (CMBS)?

Rose: They have a series of blatant conflicts of interest between their duties to the bondholders in the real estate mortgage investment conduit (REMIC) trusts and their interest in buying the (same) properties as cheaply as possible.

PERE: Can you spell out the issue?

Rose: From the bondholder perspective, special servicers have a duty to maximize value, but as an investor, the special servicer wants to get the asset at cheaply as possible. It is simply an insurmountable conflict of interest. It is repeated constantly in the space and it is really obscene what has gone on. The bondholders really don’t understand how badly they are being treated in all of this.

PERE: Yet bondholders are sophisticated investors, so surely they know what is happening?

Rose: Not at all. Here is what happens in a lot of these deals: we go to the bondholders and explain to them what is going on – some of the bondholders include the likes of TIAA CREF and the Los Angeles Water and Power Employees’ Retirement Plan. We have explained to them that the special servicer is gaming the system and that they are being shortchanged. We explained it to them and they just don’t seem to get it, so we put it in writing and they still don’t get it.

PERE: What is the typical structure you witness?

Rose: As you know, effectively the junior tranche bondholders – which in a REMIC trust are typically referred to as certificate holders or note holders – control the REMIC trust and special servicer.  There are a couple of major conflicts. What we see is that the controlling class has an incentive to play, “heads I win, tails you lose.” They want to avoid cashing out. Even if it makes sense to sell a property and dispose of it, they will hold onto it so that they can continue to get fees as a special servicer and so that they don’t lose control to the next most senior class of bondholders. Special servicers are jockeying for position and buying up these bonds and controlling the rights class. What that leads to is to make inefficient decisions. So in other words if they play ‘extend and pretend’, if it turns out that the market cooperates, they end up making money, but if it turns out the other way, someone else bears the costs. That is one conflict.

PERE: There are other more egregious conflicts, aren’t there?

Rose: Well, there are more. The second is they are constantly going out and cutting deals on the discounted loan pay-offs (DPOs) that allow them to make extraordinary fees at the cost of the bondholders. Let’s say you have a property under water, for example with a $100 million loan. The value of that property might be $60 million. That is what they can sell it for on the open market. Well, if they can sell it for $58 million and get someone to pay them a $2 million fee to take it over, then effectively the bondholder has been short changed by $2 million.

PERE: Is there a third conflict?

Rose: The last area and the coup de grâce for bondholders, and this is probably the biggest one of all and is a little complicated. This is the problem – it is so complicated only insiders are able to take advantage of it. When these loans were first made, they had to go through an underwriting so there was an originator, say Wells Fargo. They had to underwrite the loans and go through their due diligence and they put the assets into a REMIC trust which is a pool of lots of different mortgages. When they did that, they put a provision in the trust that basically called for a ‘flip back’ if there were any material omissions or material misstatements of fact. Well, the underwriting standards of 2006 and 2007 were very poor and these REMIC deals had many instances of either omissions or misrepresentations. To give you an example – we had a property in New Jersey. It was a redevelopment play and it was underwritten as if the owner paid zero property tax. In fact, in the second year the tax paid would be 20 percent, in the third year 30 percent, then 40 percent in the fourth year up to full taxes. In this case, they underwrote it, but in their projections they did not note that the property taxes were going to be going up.

PERE: What is the issue? 

Rose: You have a firm like Wells Fargo as the as originator of the loan, which then securitizes it. Wells Fargo in a different division is the trustee, and Wells is also the master servicer, so the master servicer collects the rents. If it goes into default it goes to the special servicer.  We go in and point out that, ‘You didn’t disclose something to the bondholders. It was a material omission.’ Now, the bondholders have the right to put back the loan to the underwriter and the originator if they misrepresented it or if there was securities fraud. Indeed, they have a duty to put it back to them. Taking the earlier example, if it was a $100 million loan and the property is now valued at $60 million, the originator and the underwriter have to write a cheque for $100 million. They have to give it back to them at face value. But you have a situation where a trustee has a duty to put the loan back and basically sue the originator, which is part of the same company. How many times in the history of the US CMBS market do you think that has ever happened? Zero.

PERE: What regulations are in place to protect bondholders?

Rose: There is really no regulatory framework to speak of – that’s the problem. It is the Wild West. You can do whatever you want. The only oversight if you can even call it that is from the ratings agencies. They have to rate these REMIC pools, they also have to rate the special servicers. But they really do not do much because they are paid by the underwriters, which is a common problem in this space and they are not aggressive. We have brought to them black and white examples of wrongdoing on the part of special servicers. They will make a few phone calls and pretend to investigate but basically do nothing. It is a scandal.

PERE: How did you become involved?

Rose: We represent clients in this space. For example a client that owns a piece of property or properties. Many of our clients are tenants in common, and some of them are mom and pop investors.

PERE: Have you any other examples of malpractice?

Rose: Many. As we got into it, we realized not only was there securities fraud on behalf of the sponsor, but also, as we dug further and further we realized that the bondholders were also victims of the same misrepresentation. In another example, a property was bought from a Ponzi scheme. Properties that have been sold as part of Ponzi scheme can be pulled back into the litigation. It resulted that the lender knew about this Ponzi scheme because there was a reported list of the property and they never disclosed it to the bondholders and it ended up losing millions of dollars. Right now they are in the process of foreclosing on it. It is a $28.6 million loan and the bondholders are probably going to get back $12 million. Those bondholders should be reimbursed the full $28.6 million. 

PERE: Who is ultimately suffering? 

Rose: There are so many bondholders out there that are not paying attention and are taking a hit. If it is a retirement fund, their retirees are taking a hit. Or if it is a municipal pension fund, their taxpayers are putting in the extra money to their retirees and they are completely oblivious to all of this. This is a black and white case and the servicer in this case has completely gotten away with their actions because the trustee refuses to do anything. We have put this in writing repeatedly and they are doing nothing about it.

PERE: How many special servicers are blameworthy and who is the worst?

Rose: CW Financial is the worst by far of any of the players out there. The others are bad, CW is horrible. You also have CIII-Capital Partners, LNR Partners, and ORIX Capital Markets. You have really one special servicer that is pretty small and plays it on the up and up. They don’t go after these deals themselves and that is Midland. They are not trying to submarine the bondholders to make extra money.

PERE: CW Financial is owned by Fortress Investment Group. It is not uncommon for a special servicer to be owned by a private equity group. How aware are they of these practices?

Rose: I am not even sure of how aware Fortress is of what is going on. I think if they knew what was happening they would be appalled. It is just not sustainable. It is one of those scandals that kind of bubbles below the surface. And eventually somebody understands it and it becomes a multi-billion dollar liability. If the Department of Justice were to go after this, I am telling you there is multi-billion dollar settlement to be had in all of this.

PERE: Why aren’t there such cases?

Rose: There are bigger, sexier problems particularly with the residential sector where you have seen all the settlements there and activity concerning RMBS. This issue just hasn’t had the same play. It is a big market, but smaller than RMBS and it has largely gone unnoticed.

PERE: Have you not had any success raising this issue?

Rose: It is a very incestuous relationship between all of these parties. It is an amazing scandal and nobody seems to be paying any attention to it. The bondholder maybe large institutions, but they are not that sophisticated in this area. Believe me, we have written the rating agencies letters – every one of them – Moody’s, S&P, Fitch – and they are aware of the situation and they have done nothing to resolve it. There are no federal agencies that have oversight here. There are incredible conflict of interests, and we have been waiting for some plaintiff’s attorney group to come in and sue. I am surprised it hasn’t happened yet.