once a mortgage, always a mortgage - the use (and misuse) of mezzanine loans and preferred equity...

7/31/2019 Once a Mortgage, Always a Mortgage - The Use (and Misuse) of Mezzanine Loans and Preferred Equity Investments

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New York Law SchoolPublic Law and Legal Theory

Research Paper Series 05/06 # 23

The Use (And Misuse) of Mezzanine Loans andPreferred Equity Investments

By: Andrew Berman,Professor, New York Law School

(http://www.nyls.edu/aberman

This paper can be downloaded free of charge from theSocial Science Research Network at:

http://ssrn.com/abstract= 902368New York Law Schools website can be accessed at

http://www.nyls.edu


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Once a Mortgage, Always a Mortgage --

The Use (and Misuse of) Mezzanine Loans

and Preferred Equity Investments

Andrew R. Berman*Since thebeginningsofEnglish common law,propertyownershaveused

themortgageastheprincipalinstrumenttofinancerealestateacquisitions,provide

liquidity,and raise additional capital.1And ifa firstmortgageproved insufficient,

theownersimplyborrowedadditionalfundssecuredbyasecondmortgageonthe

same property. Although the mortgage first developed in agrarian England to

financeacquisitionsoffarmland,2overthecenturiesithasprovedparticularlyadept

atsatisfyingthefinancialneedsofownerswithalltypesofrealproperty.

Tothisday,themortgageremainsoneofthemostcommonandsuccessful

techniquesto

finance

both

residential

and

commercial

real

estate

transactions

in

the

UnitedStates.3As themortgagemarket continued itsexponentialgrowthover the

*AssociateProfessorofLaw,NewYorkLawSchool,andformerRealEstatePartner,Sidley,Austin,Brown&Wood. Iwould like toacknowledge researchsupportprovidedbyNew York Law School and the helpful comments and encouragement of George Lefcoe,WilliamNelson, andmy NYLS colleagues, including Stephen Ellman, Karen Gross, SethHarris,KennethKettering,ArthurLeonard,andDavidShoenbrod.

1Inhisoftquoted treatise,COMMENTARIESONAMERICANLAW,JamesKentdefinesamortgageastheconveyanceofanestate,bywayofpledge for thesecurityofdebt,and tobecomevoidonpaymentofit.4JAMESKENT,COMMENTARIESONAMERICANLAW138139(JonRoland,ed.,O.Halstead15thed.2002)(1826).Asothershavenoted, thisdefinition isbroadenough to cover almost any form of mortgage but includes two essential elements:conveyance of land and security for a loan. LEONARDJONES, A TREATISE ON THE LAW OF

MORTGAGESOFREALPROPERTY,Ch.1,16,at21(7thed.1928).

24RICHARDR.POWELL,POWELLONREALPROPERTY37.05[1](MichaelAllanWolfed.,Matthew Bender 2004) (1949) (describing the historical development of themortgage as alocalizedtransactioninanagrariansetting).

3Residentialmortgage financingnowrepresentsamultitrilliondollarmarketwithbanksandotherfinancialinstitutionsmakingover$3.75trillionofresidentialmortgageloansin2003,compared to$1 trillion in2000,and$500billion in1995.According to theFederalHousingFinanceBoard,by the endof2003, residentialmortgagedebt increased40% since2000,jumping from $5.6 trillion in2000 tonearly$8 trillion in2003.MortgageandMarketData, 14 Family Mortgage Originations 19902002, available athttp://www.mortgagebankers.org/marketdata/index.cfm?STRING=http://www.mortgagebankers.org/marketdata/mortgage.html(lastvisitedSept.14,2004);FederalHousingFinanceBoard(Freddie Mac), U.S Housing & Mortgage Market Outlook , available athttp://www.taxadmin.org/fta/meet/re_pres04/notaft.pdf(lastvisitedSept.20,2004).


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last 25 years, however, a new (and soon to be powerful) real estate financing

technique also emerged.This technique first involved the active trading ofwhole

mortgage loans4on the secondarymortgagemarket5and later the securitizationof

largepoolsofmortgageloans.6Atfirstthesesecuritizationsconsistedalmostentirely

of residential mortgage loans (Residential Mortgage Backed Securitizations or

RMBS). 7 As the industry matured, however, mortgage securitizations also soon

included pools of commercial mortgage loans (Commercial MortgageBacked

Securitizations orCMBS).8Wall Street and other large scale financial institutions

underwrotethesesecuritizationsinanattempttoduplicatethesuccessofmortgage

lenders in the residentialmortgagemarket.With their aggressivemarketing and

Commercialpropertyownershavealsousedtraditionalmortgagefinancingtoraisecapitalsincetheyoftenlackaccesstootherfinancingsources.StevenSchwarcz,TheAlchemyofSecuritization, 1 STAN.J. L. BUS.& FIN. 133, 151152 (1994) [hereinafter Schwarcz,Alchemy](describing howmany companies do not have direct access to low cost capital marketfinancing because of their relatively small size, limited financing requirements andbecause they are generally unrated or rated less than investment grade). Consequently,commercialmortgage financings have also grown significantly. In 2003, lenders originatedalmost $200 billion of commercial mortgage loans, and the total amount of commercial

mortgagesoutstanding

at

the

end

of

2003

was

in

excess

of

$2.2

trillion.

When

residential

and

commercialmortgageloansarecombined,theaggregateofallmortgageloansoutstandingasof theendof2003exceeds$9.4 trillion.BoardofGovernorsof theFederalReserveSystem,Flow of Funds Accounts of the United States, Table F. 2 (Dec. 9, 2004), available athttp://www.federalreserve.gov/releases/z1/20041209(lastvisitedJuly11,2005);MortgageandMarket Data, Mortgage Loans Outstanding, available athttp://www.mortgagebankers.org/marketdata/index.cfm?STRING=http://www.mortgagebankers.org/marketdata/mortgage.html (last visited Sept. 14, 2004) (based on Federal ReserveBoardFlowofFundsAccountsoftheUnitedStates).

4Awholemortgageloanreferstotheinitialmortgageloanoriginatedbyalenderascompared to certificates, participations, tranches and other similar fractional interests in amortgageloan.

5The secondarymortgagemarket refers to the salebymortgageesofoneormorewholemortgageloanstootherfinancialinstitutionsorinvestors,butmostfrequentlyitrefers

to what is referred to as mortgage securitizations commercial mortgagebackedsecuritizations(CMBS)andresidentialmortgagebackedsecuritizations(RMBS).

6The securitizationmarket refers to theprocess inwhich entirepoolsofmortgageloansaresoldtypicallytoasecuritizationtrustorasimilartypeofspecialpurposeentity.Thistrustvehicle thenusuallysells to thepubliccertificatesorsecuritieswhicharesecured,andreceives the cash flow generated,by theunderlyingpool of commercial and/or residentialmortgages.Seealsoinfranote13.

7 Residential mortgagebacked securities (RMBS) typically refer to passthroughsecuritiesthatarebasedoncashflowsfromapoolofunderlyingresidentialhomeloans.Seealsoinfranote13.

8 Commercial mortgagebacked securities (CMBS) typically refer to passthroughsecuritiesthatarebasedoncashflowsfromapoolofunderlyingcommercialmortgageloans.Seealsoinfranote13.


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sales,theoutstandingamountandnewissuancesofbothresidentialandcommercial

mortgagebackedsecuritiesgrewatanastoundingrate.9

Theascendancyofmortgagesecuritizationshashadaprofound impacton

thefinancialmarketsfromMainStreettoWallStreet, changingtheverybasics

of realestate finance for first timehomebuyers,major financial institutions in the

UnitedStatesandeventheglobalmarkets.Theboominmortgagesecuritizationshas

alsoledtothedevelopmentofavastarrayofnewrealestatefinancingtechniques.

These financing techniques,which didnt even exist ten years ago, span abroad

spectrumof intricate legal structuresand theories, combineelementsofbothdebt

andequity financing,and fallat the intersectionof traditionalmortgage financing

and the capitalmarkets. This article focuses, in particular, on two of these new

financingtechniques:mezzanineloansandpreferredequityinvestments.10

9 Combined issuances of CMBS and RMBS grew from (a) $22.5 billion in 1978,WILLIAMW.BARTLETT,MORTGAGEBACKEDSECURITIESPRODUCTS,ANALYSIS,TRADING54(NewYorkInstituteofFinance1989)[hereinafterBARTLETT,MBS],to(b)$1.34trillionin1990,JosephShenker&AnthonyColetta,AssetSecuritization:Evolution,CurrentIssuesandNewFrontiers,69

TEX.L.

REV.

1369,

1372

(1991)

[hereinafter

Shenker,

Asset

Securitization],

and

(c)

$5.3

trillion

in

2003,Letter fromAmericanSecuritizationForum to theBoardofGovernorsof theFederalReserve System and the Office of the Comptroller of the Currency, Comment Letter Re:InteragencyStatementOnComplexStructuredFinanceActivities,reprintedinNEWDEVELOPMENTSINSECURITIZATION2004: PREPARING FORTHENEWREGULATORYREGIME (2004), availableat 871PLI/COMM345,348(Westlaw).Somehaveestimatedthat[s]ecuritizedlendingnowaccountsfor almost 20% of all outstanding commercial and multifamily mortgages in the UnitedStates. Joseph Forte, Wall Street Remains a Key Player in Commercial Real Estate FinancingDespiteCapitalMarketFluctuations,N.Y.ST.BARJOURNAL,JulyAug.2001,at34,38[hereinafterForte,WallStreetKeyPlayer].

When traditional senior and junior mortgage financings are combined with allresidential and commercialmortgage securitizations and other similar secondarymortgagemarketactivities,theaggregateofallmortgagerelatedfinancingsswellstoalmost$15trillion.U.S.CensusBureau,STATISTICALABSTRACTOFTHEUNITEDSTATES:20042005744(U.S.Dept.ofCommerce 2004).The securitizationand secondarymortgagemarketnotonly continues to

growhere,but ithas increasinglybecomeoneof themost importantsourcesoffinancing inthe international capital markets. In 2002, the aggregate of all nonUS CMBS issuancesexceeded $28.6 billion, an increase of almost $6 billion from 2001. Mortgage BankersAssociation, Issue Paper: Secondary Market for Mortgages 2 (July 2004), available athttp://www.mortgagebankers.org/library/isp/2004_7/Secondary%20Market%20for%20Commercial%20Mortgages.pdf(lastvisitedOctober4,2005);seealso,HowardEsaki,JapaneseCMBS:AJPY25TrillionMarket?,REALEST.FIN.,Feb.2003,at5(JapaneseCMBSmarkethaspotentialtogrowtoUS$200billionormore);GeorgettePoindexterandWendyVargasCartaya,EnRutaHaciaElDesarrollo:TheEmergingSecondaryMortgageMarket inLatinAmerica,34GEO.WASH.INTLL.REV.257(2002)(discussingtheexplosivegrowthofthesecondarymortgagemarketinLatinAmerica).

10RichardD.Jones&DanielW. Simcox, SixDegrees ofSubordination:TheDifferentTypes ofSubordinatedDebt inSecuritizedTransactions and theDevelopingViewswithRespect totheseProliferatingFormsofLoans,COMMERCIALSECURITIZATIONFORREALESTATELAWYERS(Mar.22,2001),availableatSF88ALIABA311(Westlaw).


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In the real estate industry amezzanine financing refers to a loan secured

principallybytheborrowersequityinotherentities.Unlikeconventionalmortgage

financing where the borrower owns real estate, a mezzanine borrower doesnt

directlyownanyrealpropertynordoesitoperateanybusinessitactsmerelyasa

sort ofholding company.Amezzanineborrower typically only owns equity in a

family of other subsidiaries, and these other subsidiaries actually own the

underlying real property. 11 Therefore, the value of the mezzanine borrowers

collateral is derived solely from its indirect ownership of the underlying real

property.12Thecomplicatingfactor,however, isthatthissameunderlyingparcelof

landalso typicallyservesascollateral foramortgage loanbetweenaconventional

mortgage lenderand themortgageborrower thedirectownerof theproperty.13

Becauseof theunique structure ofmezzanine financing, therefore, themezzanine

loan isalways subordinate to the seniormortgage lenders collateral.At the same

time, however, the mezzanine loan remains senior to the borrowers equity

investmentintheunderlyingrealproperty.14

Unlike mezzanine financings, preferred equity transactions arent even

technicallyloans.Here,thelendertypicallymakesadirectinvestment(generallyin

the formofacapitalcontribution) inanentity.Typically, thisentitydirectlyowns

incomeproducing realproperty and is also amortgageborrowerwith a separate

mortgagelender.Inexchangeforitsinvestment,thefinancingsourcereceivesequity

in themortgageborrower.15Oftentimeshowever, the seniormortgageprohibitsor

otherwiserestrictsadirectinvestmentinthemortgagor.Insuchcases,thefinancing

11Theequityinterests typicallyconsistofmembership interests ina limited liabilitycompany, sometimes stock in a corporation, and rarely limited partnership interests in alimitedpartnership.

12Thetermmezzanineborrowerreferstotheborrowerunderthemezzanineloan,andthetermmortgageborrowerreferstotheseparatelegalentitythatownstheunderlyingincomeproducing real property. The mezzanine borrower typically owns directly or

indirectlyalloftheequityofthemortgageborrower,makingthemortgageborrower,ineffect,awhollyownedsubsidiaryofthemezzanineborrower.

13With amortgageborrower, the principal collateral for the secured loan is theborrowersdirectownershipofrealproperty.Themortgageborrowertypicallyownstherealpropertyoutrightinfeesimpleabsolute,althoughinsomecases,themortgageborrowerownsonlyalongtermleaseholdinterest.

14Joseph Forte,MezzanineFinance:ALegalBackground,COMMERCIALSECURITIZATIONFOR REAL ESTATE LAWYERS (Apr. 2004) at 442, available at SJ090 ALIABA 437 (Westlaw)[hereinafterForte,MezzanineFinance].

15The termPreferredMember refers to the financing sourceorlenderand thetermPreferredEquityBorrowerreferstotheentityinwhichthePreferredMembermakesits capital contribution or other investment.As discussedbelow, oftentimes the PreferredEquityBorrowerisalsothemortgageborrower.


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sourcemakesaninvestmentinanewlyformedentity,andthatnewentity(directly

orindirectly)ownsalloftheequityinterestsoftheunderlyingmortgageborrower.16

Unlikeotherequityinvestorsintheentity,however,thefinancingsourcehasspecial

rights: (i) the right to receive a special (orpreferred) rate of return on its capital

investment,17and (ii) the right to an accelerated repayment of its initial capital

contribution.18Ineffect,thepreferredrateofreturnreflectstheinterestcomponentof

a conventional loan, and the accelerated repayment of the investors capital is

analyticallysimilartotherepaymentofoutstandingprincipalinaloan.

The rapid success ofmezzanine loans and preferred equity investments

indicatesmore thanjustmarketdemand fornew andpopular financialproducts.

These new financings are quickly (and quietly) replacing conventional junior

mortgages as the principal means to provide property owners with additional

financing.Insodoing,thesenewfinancingtechniqueshavenotonlyfundamentally

transformed the real estate capitalmarketsbut alsomarked anew chapter in the

historyofrealestate finance.Theconventionalwisdomonrealestate finance isno

longer true: real estate finance is not limited simply to the many varieties of

mortgage products in the primary and secondary mortgage market. Now,

commercialpropertyownershaveanewarrayofnewfinancingtechniquessomeof

whichareneitherdirectlysecuredbyrealestatenorevendirectlyinvolveland.

No scholarlywriting has focused onmezzanine financings and preferred

equity investments. This article does so. Section I of this article describes the

developmentofmortgagelawasanewbodyoflawseparateanddistinctfromthen

existing contract law. Italsohighlightshow courtsused theirequitablepowers to

develop an arsenal of protections such as the equity of redemption to safeguard

borrowersfromoverreachinglenders.Byapplyingtheequityofredemption,courts

focused on the underlying substance of the transaction and the lenderborrower

relationshipratherthan the formalcontractsevidencingthe financing.ThisSection

alsodescribesthemanywaysinwhichlenderssoughttoundercutborrowersrights

by disguisingmortgage financings as other types of transactions. This historicalmaterial is particularly relevant for mezzanine loans and preferred equity

investmentssincecourtsmuststillwrestletofindtheproperbalancebetweenstrict

16Standard&Poors,CriteriaonA/BStructureinCMBSTransactions(Sept.25,2000),athttp://www2.standardandpoors.com/servlet/Satellite?pagename=sp/sp_article/ArticleTemplate&c=sp_article&cid=1031591714414&b=10&r=1&l=EN (last visitedNov. 7, 2005) [hereinafterCriteriaonA/BStructure].

17Theequityinvestorsrighttoapreferredorspecialrateofreturnexplainsinpartwhymany refer to the financing sourceas thePreferredMember.Forte,MezzanineFinance,supranote14,at442.

18CriteriaonA/BStructure,supranote16,at19.


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enforcementofthelenderscontractualrightsandremedieswithbasicpropertylaw

protectionsandequityconcernsforborrowers.

SectionIIdiscusses thebirthofmezzaninefinancingsandpreferredequity

investments.Inthissection,Ishowthattraditionalmortgagefinancingshelpedfuel

the development of the secondary mortgage market and commercial mortgage

backedsecuritizations.Thepowerandsignificanceofnational ratingagenciesalso

began to grow alongwithCMBS transactions, and theybecame heavily involved

withrealestatefinance.IargueinthisSectionthatthenationalratingagencieshave

caused the decline of traditionaljuniormortgages and inadvertently created the

dramatic expansion of mezzanine financings and preferred equity investments.

Section III describes in greater detailmezzanine financing and preferred equity

investmentsandthelegalstructureandbasicunderpinningsofthesenewfinancing

techniques.

Todate,courtshavenothadtheopportunitytoreviewthestructureofthese

new financing techniques and it remains unclearwhether courtswill respect the

craftylegalstructuresunderlyingmezzanineloansandpreferredequityfinancings.

These transaction documents raise certain fundamental issues and expose the

simmering tensionbetween contractandproperty law. InSection IV, I argue that

juniormortgages,mezzanine loansandpreferred equity financings alloccupy the

sameintermediatepositioninthecapitalstructureofapropertyowner(i.e.,theyare

allsubordinatetotheseniormortgage,butseniorinprioritytothepropertyowners

equity),mezzanine loans and preferred equity financings are in effectmortgage

substitutes, and lenders are simply attempting to avoid theborrowers equity of

redemption inorder tominimize thehazardsanddelayofmortgage foreclosures.

Based on the centuriesold property law adage once a mortgage, always a

mortgage I conclude that the law should treat all three types of financings

similarly and apply traditionalproperty theory to thesenew financing techniques

andtreatthemasmortgages.

I. HistoricalDevelopmentofMortgageFinancingandtheEquityof

Redemption

InthisSectionIdescribethedevelopmentoftheworldsmostsuccessfulreal

estate financing technique:mortgage lending.Byusing realestate as collateral for

financial transactions,propertyownershavebeen able to access financialmarkets

andraiseadditionalcapital.Atfirst,lendersstructuredthesetransactionstodisguise

the true nature of the lenderborrower relationship and to obtain extraordinary

rightstorealestatecollateral.Asaresult,lendersoftentimesdeprivedborrowersthe

right toreceiverentsandpossession from theirpropertyor torepay the loanafter

default.DuringtheearlycommonlawperiodinEngland,however,courtsbeganto

disregardthe

formal

structure

of

these

transactions

and

focus

instead

on

the

true


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substanceof the lenderborrowerrelationship.Theseequitycourtssoondeveloped

an array of rights for theseborrowers, including the equity of redemption the

borrowersrighttorepaythedebtatanytimepriortomortgageforeclosure.

As discussedbelow in Section IV, this historicalmaterial is particularly

relevant formezzanine loans and preferred equity transactions since these new

financing techniques are similar in many ways to early real estate financing

techniques used in common law England.Withmezzanine loans and preferred

equityfinancings,lendersalsoattempttodepriveborrowersofbasicpropertyrights

throughenforcementofcontractualrightsandremedies.Sincecourtshavenotyet

addressedtheenforceabilityofmanyofthecontractprovisionsfoundinmezzanine

financingsandpreferredequityfinancings,itisonlyaquestionoftimebeforecourts

willneedtoexaminetheverysameissuesthatcommon lawcourtsaddressedover

fivehundredyearsagoshouldthelawenforcethecontractdocumentsaswritten

orshouldthetransactionsbecharacterizedasamortgagesubstitute?

Since antiquity, property owners have used real estate as collateral for

borrowing.19LongbeforeitsfirstuseincommonlawEngland,landownerswereable

toborrowmoneybyusingtheirpropertyascollateralundertheearlylawsofancient

Egypt,20Rome,21Greece,22and India,23the French Code ofNapoleon,24and ancient

19There aremany excellent sources devoted to the historical development of themortgage.OneofthemostcitedanddefinitivetreatisesisGEORGEE.OSBORNE,HANDBOOKONTHELAWOFMORTGAGES(2ded.West1970)(1951)[hereinafterOSBORNEONMORTGAGES],uponwhich Ihavereliedextensively in thisSection.Othermajorbooksdevoted to thehistoryofmortgage law include LEONARD JONES, A TREATISE ON THE LAW OF MORTGAGES OF REALPROPERTY(1878)andRUDDENANDMOSELEY,ANOUTLINEONTHELAWOFMORTGAGES(1923).

Manyoftheclassictreatisesonpropertylawalsodiscussthehistoricaldevelopmentof themortgage.SeegenerallyPOWELL,supranote2;HERBERTTHORNDIKETIFFANY,TIFFANYONREALPROPERTY 13791382 (1903);WILLIAMF.WALSH,ATREATISEONMORTGAGES3 (1934);GEORGEW.THOMPSON,COMMENTARIESONTHEMODERNLAWOFREALPROPERTY101.01(1924).

Therehavealsobeenmanyexcellentlawreviewarticlesexaminingthehistoryofthemortgage. SeeH.W.Chaplin,The Story ofMortgageLaw, 4HARV.L.REV. 1 (1890);JohnH.Wigmore,ThePledgeIdea,10HARV.L.REV.321(1897);HaroldD.Hazeltine,TheGageofLandinMedievalEngland,17HARV.L.REV.549 (1904).More recently,AnnM.Burkharthaswrittenextensively on the development of themodern daymortgage. See, e.g.,AnnM. Burkhart,Freeing Mortgages of Merger, 40 VAND. L. REV. 283 (1987) [hereinafter Burhkart, FreeingMortgages];AnnM.Burkhart,LendersandLand,64MO.L.REV.249(1999)[hereinafterBurkhart,LendersandLand].

20InancientEgypt,propertywasusedas security formaritalobligations.Chaplin,supranote19,at12.

21Roman civil lawpermitted theuse ofproperty as collateral for loansunder thepignusandthehypotheca.Underthepignus,theborrowerpledgeditspropertytothelenderascollateralfortheloan.Thelenderthentookpossessionofthepropertysubjecttotheexpressconditionthatitwouldtransferpossessionbacktotheborrowerwhentheborrowerfullypaidofftheloan.Underthehypotheca,theborrowerpledgeditspropertytothelenderascollateral


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Israel.25Property owners in England were no exception. They too used land as

collateralasearlyastheAngloSaxonperiod.26

Althoughnodetailedevidenceisavailable,historiansagreethattheearliest

instanceinEnglishlawofanownerusinglandascollateralforaloanisthegage27of

Glanvilles time in the late 12th century.28UnderGlanvilles gage,29the gagor (the

pledgorandborrower) transferredpossessionof its land to thegagee (thepledgee

but,unlike thepignus, theborrower retainedpossessionof theproperty.Theborroweralsohadtherighttopayoffthedebtandredeemitscollateralbeforethelenderextinguishedtheborrowersrights in thehypothecatedcollateral.4JAMESKENT,COMMENTARIESONAMERICANLAW136137&n.(a)(1884);seealsoJONES,supranote1,at2;2STORY,COMMENTARIESONEQUITYJURISPRUDENCE 1005 (1886); Handler Constr. v.Corestates Bank, 633A.2d 356 (Del. 1993 )(discussingthehistoricaldevelopmentoftheequitablemortgage).

22 In Ancient Greece, a pillar or tablet set up on the land, inscribed with thecreditors name and the amount of the debt indicated that the owner had pledged thepropertytothecreditor.Chaplin,supranote19,at5.

23Id.The entire system of the hypothecation of land as collateralwas common toIndoEuropeansandwasfullyelaboratedintheearlylawsofIndia.

24Anearlyvariationofwhatwenowrefertoas themortgagewascomparabletoasimilarinstrumentundertheCodeNapoleon.OSBORNEONMORTGAGES,supranote19,1.

25JONES,supranote1,at1(discussingreferencesintheOldTestamenttomortgagesand that ancient Jews certainly used, if not, originated, the practice of mortgaging realproperty);seealsoWigmore,supranote19,at401406(discussingthehistoricaldevelopmentofpledgingcollateral tosecurea loanunderJewish law, including thePentateuch, theMishnaand theGhemera);JacobRabinowitz,TheStory of theMortgageRetold, 94U.PA.L.REV. 94(1946)(discussingtheinfluenceofJewishpracticesandlegalformsonEnglishmedieval lawandthedevelopmentofthemortgage);MichaelS.Knoll,TheAncientRootsofModernFinancialInnovation: The Early History of Regulatory Arbitrage, 1922 (June 8, 2004), available athttp://papers.ssrn.com/paper.taf?abstract_id=555972 (last visited July 22, 2005) (discussingmany types of loan transactions that violate the Talmuds prohibition on usury and theequivalencebetweenanimpermissible[usurious]loanandapermissiblesalefollowedbyaredemption).

26RUDDEN&MOSELEY,supranote19,at3(describinghistoricalrecordsofmortgagesinearlyAngloSaxontimesandintheperiodimmediatelyaftertheNormanConquestwhentheDoomsdayBookwasbeingwritten); seealsoJONES, supranote1,at1a,3;OSBORNEONMORTGAGES,supranote19,at4;Hazeltine,supranote27,at552;.

27InNormanFrench,gagemeanspledge.

28OSBORNEONMORTGAGES,supranote19,at2.

29RanulphDeGlanville,ChiefJusticiarunderHenry II,wroteTractatusdeLegibusAngliinabout1190.Glanvillestext,inwhichhedescribedthevifgageandthemortgage,isperhapstheoldestbookdescribingthelawsandcustomsofEngland.See1JAMESKENT,LectureXXII:OfthePrincipalPublicationsontheCommonLaw,inCOMMENTARIESONAMERICANLAW(JonRolanded.,15thed.19972002)(1826),;seealsoPOWELL,supranote2,37.02;Burkhart,FreeingMortgages,supranote19,at305n.71.


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andlender)untilfullrepaymentofthedebt.30Themostpopulargagewasthemort

gageormortuumvadium(deadpledge);thecreditorkepttherentsandprofitsof

thelanduntilthedebtwasrepaidinfull.31Notsurprisingly,lendersoverwhelmingly

preferredtousethemortgagesincetheyretainedtherents,profitsandpossessionof

the landwhile remainingentitled to repaymentofprincipaland interest. It is that

namemortgageormortgagethathasremained.32

Becausethegagewasbasicallyunfairtoborrowers,theBractonianmortgage

soonbegan to replaceGlanvilles gage in the thirteenth century.33Although there

werevariations,theBractonianmortgagebasicallyrequiredtheborrowertotransfer

anestateforyearsandlegalpossessiontothelender.Typically,theborrowerhadthe

righttorecoverthepropertyuponpaymentofthedebt,butiftheborrowerfailedto

repay the debt the lenders title automatically converted itself into a fee simple

absolute.34While theBractonianmortgagewas clearlyan advanceoverGlanvilles

gageforbothlendersandborrowers,lendersstillremaineddissatisfiedsincethelaw

required lenders toproveboth the existence of thedebt and the validity of their

title.35

Asaresult,byapproximatelytheendofthe15thcentury,Littletonsgage

thedirectforerunnerofwhatwenowrefertoasthecommonlawmortgage soon

began to displace the Bractonianmortgage.36Under this type of arrangement, the

30OSBORNEONMORTGAGES,supranote19,1at23.

31Id.;seealsoSIRFREDERICKPOLLOCK,THELANDLAWS132134(FredB.Rothman&Co.1979)(1883);RUDDENANDMOSELEY,supranote19,at4;

32 Morris G. Shanker, WillMortgage Law Survive?:A Commentary and Critique onMortgageLawsBirth,LongLife,andCurrentProposalsforItsDemise,54CASEW.RES.L.REV.69,7172(2003);seealsoBurkhart,LendersandLand,supranote27,at252;Chaplin,supranote27,at8.

33OSBORNEONMORTGAGES,supranote19,4.

34Chaplin,supranote19,at8;Hazeltine,supranote19,at556.

35Chaplin,supranote19,at9;OSBORNEONMORTGAGES,supranote19,at78.

36ThereisnoclearconsensusonexactlywhenLittletonsgagebecamethedominantform ofmortgage,but the dates range from the thirteenth century to the early sixteenthcentury.OSBORNEONMORTGAGES,supranote19,5at8(arguingthatinthefourteenthcenturythe conveyance of the fee upon condition subsequent emerged as the dominant form ofmortgage);POWELL,supranote19,37.02(notingthatin1475,Littletondescribedamortgageasaconveyanceuponcondition that if thedebtorpaidupon theduedate . . .hemight reenter);RUDDEN&MOSELEY,supranote19,at4([B]ytheendofthe15thcentury,mostlendersinsistthatthelandbeconveyedtotheminfeesimplesubjecttoaconditionthattheborrowermayreenterthelanduponsatisfactionofthedebt.);Chaplin,supranote19,at9(findingthattheoutrightconveyanceofthefeeconditionedupon thesubsequentconditionofborrowersrepaymentof thedebtappears in the legalrecords in the thirteenthcentury);Cf.Hazeltine,


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borrowerconveyedadeterminablefeetothelenderretainingareversionaryinterest;

upontheborrowersrepaymentofthedebt,thelendersestateautomaticallyended

and theborrowercouldexercise its rightofreentryandrecover the land from the

lender.37Furthermore,iftheborrowerbreachedtheconditionbyfailingtorepaythe

debtontheduedate(oftenreferredtoasthelawday),absolutetitleautomatically

vestedwiththelenderandtheborrowerforeverlostitsland.38

In some ways, Littletons gage was a peculiar structure for securing a

financingtransactionsincethelenderobtainedlegaltitleimmediatelyuponmaking

the loan.Although theessenceof the relationshipbetween theborrowerand the

lenderwasmerelyadebtrelationship,thelawcloseditseyestothetruecharacterof

the transaction and accorded the lender all the rights of fee ownership.39Under

Littletonsgage, the lenderreceived the legalbenefitsof feeownershipof the land

eventhoughtheparties intendedonly tosecuretheborrowersobligationtorepay

the lender. 40 Perhaps most important, the lender also had the legal right to

immediatepossessionofthelandevenpriortotheborrowersdefault.41

From the first use of Glanvilles gage to Bractons mortgage and then

Littletonsgage, the lender increasinglyobtained stronger rights in themortgaged

land.The culminationof this trendwasLittletonsgagewhere the lenderactually

obtained fee title to the mortgaged land with almost all the rights incident to

absolute ownership, including the right to possession and collection of rents and

profits.42Althoughthe legalstructuresofGlanvillesgage,Bractonsmortgage,and

Littletonsgagediffered,inmanywaystheyweresimilar.Eachintendedtousethe

borrowersrealpropertyascollateral fora loaneven thoughon its faceeach legal

structurepurportedtodosomethingentirelydifferent.Aswithmezzanineloansand

preferredequityinvestmentsthenewrealestatefinancingtechniquesofthetwenty

supranote19,at557(suggestingthatthecommonlawmortgagecanbefoundinthesourcesofthelawlongbeforethetimeofLittletoninthetwelfthandthirteenthcenturies).

37SeeOSBORNEONMORTGAGES,supranote19,5,at9;POWELL,supranote2,at37.02;RUDDEN&MOSELEY, supranote19,at4;Burkhart,FreeingMortgages, supranote19,at31213;Chaplin,supranote19,at9;Hazeltine,supranote19,at55657.

38OSBORNEONMORTGAGES,supranote19,5,at9;POWELL,supranote2,37.02.

39Burkhart,LendersandLand,supranote19,at255.

40OSBORNEONMORTGAGES,supranote19,5,at9;Burkhart,LendersandLand,supranote19,at25556.

41OSBORNEONMORTGAGES, supranote19, 5, at1011;Burkhart,LendersandLand,supranote19,at25556.

42Burkhart,LendersandLand,supranote19,at25556.


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firstcenturydiscussedinSectionIIItherewasagrowingchasmbetweenthelegal

structuresusedbylendersandborrowersandthetrueunderlyingpurposeofthese

transactionswherelandwasbasicallyservingascollateralsecurityforaloan.

Therewas adisconnectbetween the legal structure andpurpose of these

earlymortgagetransactions.Forexample,iftheborrowerfailedtorepaythedebtin

the exact amountonprecisely theday set, the legal structureof the common law

mortgagedictateda severe result in the courtsof law since the lender technically

heldadeterminablefee.Accordingly,iftheborrowerfailedtorepaytheloanonthe

maturitydate,theborrowerirrevocablyforfeiteditslandtothelender.43Thisresult,

however, ignored the true nature of the lenderborrower relationship. By the late

sixteenthandearlyseventeenthcenturies,theequitycourtsattemptedtoaddressthe

harsheffectsofforfeiture.44

The equity courts allowed aborrower to avoid strict enforcement of the

forfeitureprovisionsbydeveloping(andthelawcourtslaterfollowedbyenforcing)

theborrowers equity of redemption.45By characterizing the determinable fee for

what itreallywasamortgagetheequitycourtspermittedtheborrowertorecover

itspropertyuponpaymentofthedebtwithinareasonabletimeevenafterthe law

day.46At first the equity of redemptionwas limited to individualborrowers only

where there was fraud, accident, mistake, excusable error, impossibility,

oppression,orsomesimilarfamiliargroundofgeneralequityjurisdiction.47Butby

43OSBORNEONMORTGAGES,supranote19,5at12.

44OSBORNEONMORTGAGES,supranote19,6;Burkhart,LendersandLand,supranote19,at264.

45OSBORNEONMORTGAGES,supranote19,6,at12.

Manyexcellentbooksandarticlesdiscuss theequityof redemption.SeegenerallyR.W.TURNER,THEEQUITYOFREDEMPTION:ITSNATURE,HISTORYANDCONNECTIONWITHEQUITABLE

ESTATESGENERALLY(1931);JeffreyL.Licht,TheClogontheEquityofRedemptionandItsEffectonModernRealEstateFinance,60ST.JOHNSL.REV.452(198586);MarshallE.Tracht,Renegotiationand SecuredCredit: Explaining the Equity ofRedemption, 52 VAND. L.REV. 599 (1999); C. C.Williams,Jr.,CloggingtheEquityofRedemption,40W.VA.L.Q.31(193334);BruceWyman,TheClogontheEquityofRedemption,21HARV.L.REV.459(1908).

46OSBORNEONMORTGAGES,supranote19,6at12;Burkhart,LendersandLand,supranote19,at264.

47OSBORNEONMORTGAGES,supranote19,6,at1213;seealsoPOWELL,supranote2,at37.02; TURNER, supranote 45, at 21, 25.According to Turner, the first instance of a courtorderingwhatwenowrefertoastheequityofredemptiondatesto1456inacaseinvolvinghighlyunusual circumstances: excessiveprofit, imprisonment of themortgagor in debtorsprison,and the lendersgross fraudandoppression. Id.at21.Thereweresoonothercasessuggesting the courts power andjurisdiction to order equitable relief. But the equity ofredemptiondidnotdevelopallatonce.Itdevelopedoveraperiodof timeandonlyas theresultofaverylongsuccessionofdecisions.Chaplin,supranote19,at10.


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theearlypartoftheseventeenthcentury,thecourtsrecognizedtheborrowersright

ofredemptionasageneralrule.48

Facedwithlendersattemptstoundercutborrowersrighttoredeem,courts

continued to enforce strictly theborrowers equity of redemption and refused to

enforceanypurportedwaiverorcontractuallimitationoftheborrowersrightsasan

unlawfulclogontheequityofredemption.49Inanattempt toavoidtheborrowers

equityofredemptionlendersoftenstructuredthemortgagetransactiontoappearas

another type of conveyance. Lenders structured these financing transactions as a

conditional sale or lease with right of early termination,50an outright salewith

another contractwhere thebuyerlender promises to resell the land at a higher

price,51or a conveyance to a thirdparty tohold the land in trust for the lenders

benefitiftheborrowerfailedtorepaythedebt.52Notwithstandinglendersattempts

todisguisewhatwas inessenceamortgagetransactionortoforcetheborrowerto

agree contractually towaive or limit its right of redemption, the law prevented

lenders from circumventing or otherwise clogging the equity of redemption. In

lookingbeyondthelegalstructureoftherelationshiptothetrueunderlyingnature

of the transaction, the courts declared one of themost important and longheld

48See,e.g.,Burkhart,LendersandLand, supranote19,at264,n.93(citingHamiltonv.Dirlton, 1 Ch. Rep. 165 (1654));OSBORNE ONMORTGAGES, supra note 19, 6, at 13 (citingEmanuelCollegev.Evans,1Ch.Rep.18 (1625); TURNER,supranote45,at2627 (explainingthatequityofredemptionwasgivenasamatterofcourseandtherelieforiginallygiveninexceptional circumstances hadbecome the rule, and the cases where no relief wouldbeaffordedhadbecomerareexceptions);Chaplin,supranote19,at10.

49OSBORNEONMORTGAGES,supranote19,97;Licht,supranote45.

50Thisisatypeoffinancingwherethesellerhelpsthebuyerfinanceaportionofthepurchaseprice for the landbeing sold.Thedevice is similar to the lease for salewhere therentpaymentsarereallyinstallmentsofthepurchaseprice.Althoughtenantbuyerobtainspossession, landlordseller retains legal title until payment in full of all the installments.

Typically, the contract includes a time of the essence provision and provides that upondefaultlandlordsellercanrecoverpossessionandstillretainallofthepriorpaymentsmadebyborrowertenant.OSBORNEONMORTGAGES,supranote27,21.

51Thisisatypeoffinancingwhereintheinitialsale,theborroweristhesellerandthe lender is thebuyer.The statedpurchasepriceof the initial sale is in reality the loanamount,andtheborrowerseller transfers legaltitletothelenderbuyerascollateralsecurityfortheloan.Iftheborrowerrepaystheloaninfull,inthesubsequenttransaction,thelenderisnowtheseller,theborrower isnow thebuyer,andtheresalepricerepresents theborrowerbuyers repaymentofprincipalandall accrued interest.Upon timelypayment, the lendersellerreconveystitletotheborrower.Aswithmostmortgagesubstitutes,thereistypicallyatime limiton theborrowers right to repurchase souponadefault title irrevocablyremainswiththelender.OSBORNEONMORTGAGES,supranote19,at31.

52ThistypeofstructureissometimesreferredtoasaTrustDeedMortgage.OSBORNEONMORTGAGES,supranote19,21.


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doctrines in real estate law: once amortgage, always amortgage. The courts

amplified thisdoctrinewithoftrepeatedpronouncementssuchas[t]hereshallbe

noclogonequityofredemptionand[t]helandshallbereturnedtothemortgagor

exactlyashepartedwithit.53Ifthetruenatureofthetransactionwasamortgage,

thelawwouldtreatitasamortgage.54AsMarshallTrachthasobserved,thecourts

regardtherightofredemptionasessential,immutable,andunwaivable,andevery

effortbylenderstoundercuttheborrowersequityofredemption:howeveringenious,hasbeenmetbytheunyieldingresistanceofthecourts:onemaynotclogtheequityofredemption.The ideathatthe equity of redemption is an inherent and inseparable part ofeverymortgage isnowsocommonplace,soaccepted, that itelicitsrelativelylittlecommentorquestion.55

Althoughtherearemanyexplanationsfortheemergenceoftheborrowers

equityof redemption,mostagree that it signaled the courtsgeneral reluctance to

enforceforfeitureprovisions.Especiallywherethevalueofthelandgreatlyexceeded

theamountowedtothelender,theforfeitureprovisionseemedparticularlylikean

otherwise unenforceable penalty. 56 By refusing to enforce the harsh forfeiture

provisionscontainedinthetransactiondocuments,thecourtssimultaneouslyeroded

thethenexistingfreedomofcontractrulesandbegantodevelopmortgagelawas

a unique and separate body of equity law. 57 Prior to that time, the general

principlesofconveyanceandcontract lawgovernedthe lenderdebtorrelationship.

Sincefreedomofcontractwasparamountand[t]hepartieshadagreedtotheir

bargain, courts generally enforced the precise terms of the documents.58But the

equitycourtslookedbeyondthemerewordsofthecontractandinsteaddevelopeda

setofequitableprinciples thatbetter servedwhat theyobservedwas inessencea

debtorcreditorrelationship.

The emergence of the borrowers equity of redemption indicated the

willingness of the courts to look at the true substance of the underlying debt

transaction rather than focusing solely on the formalistic structure of the secured

loan.By lookingat the intentrather than the form, thecourtprotected theparties

53TURNER,supranote45,at62;Shanker,supranote32,at77(referringtothecommonstatementamortgagebyanyothernameisstillamortgage).

54 JONES, supra note 1, 7, at 10;; Chaplin, supra note 19, at 1112.

55Tracht,supranote45,at600601.

56JONES, supra note 1, at 810; OSBORNE ONMORTGAGES, supra note 19, 6, at 14;RUDDEN&MOSELEY,supranote19,at57;.

57Shanker,supranote32,at7374.

58Shanker,supranote32,at73.


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reasonable expectations. If theparties truly intended to enter into a secured loan

thenequitywouldprotectthepartiesexpectations.Thelenderexpectedtoberepaid

thedebtwithinterestinareasonablytimelymanner,andtheborrowerexpectedto

recoveritsmortgagedpropertyuponpaymentoftheoutstandingdebt.59Thecourts

recognized that after the borrower paid the lender, the basic debtorcreditor

relationshipended,andthelendernolongerhadanyrightstothelandoragainstthe

borrower.60

Notwithstanding some inherent limitations of the common lawmortgage

andthedevelopmentoftheborrowersequityofredemptioninEngland,allofthe

BritishNorthAmericancoloniesthatlaterbecamestatesadoptedthewholesaleuse

ofmortgagesandbasedtheirmortgagelawonthecommonlawofEngland.61With

thefurtherrefinementofmortgage lawintheUnitedStates, ithasprovedadeptat

satisfying the financialneeds ofproperty owners, and remains themost common

andsuccessfultechniquetofinancerealestatetransactionsintheUnitedStates.62The

mortgagehasprovedespeciallydurable,inpart,sinceapropertyownercouldeasily

satisfy its financing needsby simply granting amortgage on its land.With this

relativelysimpletransaction,theborrowerreceivedtheloanproceedsandthelender

typically received collateral worth much more than the loan. However, the

mortgagorstillretained,inlawandequity,legaltitletothemortgagedpropertyfor

thepurposeofsecurityandgeneralownership.Sincethelawrecognizedthedebtors

59 JONES, supra note 1, at 810; OSBORNE ONMORTGAGES, supra note 19,6, at 12;RUDDEN&MOSELEY,supranote19,at57.

60Shanker, supra note 32, at 74.Theborrowers right to redeemwas not limitless,however. Lenders soon obtained amechanism to endborrowers equitable rights in theirmortgagedproperty.Uponapplication to the court,a lender couldobtainajudicialdecreeorderingtheborrowertoredeemthepropertywithinareasonabletime.Iftheborrowerfailedto repay the debtprior to the end of the redemption period, hewas foreverbarred fromredeeming.OSBORNEONMORTGAGES, supra note 19, 6, at 12; POWELL supranote2,37.02;;Shanker,supranote32,at76.Theeffectofthisproceedingnowknownasstrictforeclosure

would leave the lenderwithgood title in themortgagedproperty.OSBORNEONMORTGAGES,supranote19,10.Ifthevalueofthe landgreatlyexceededtheamountowedtothe lender,however,thelenderobtainedawindfall.Realizingthebasicunfairnesstotheborrower,equitycourtssoonrequiredthatthemortgagedpropertybesoldatforeclosure; theproceedsof theforeclosuresalewouldbeusedfirsttopaythedebtoritsoutstandingdebt;andthebalanceofthesaleproceeds, ifany,wouldbedistributed to theborrower.Thismethodforeclosurebysaleorjudicialforeclosureprotectsboththeborrowersequityinthemortgagedpropertyandthelendersrighttoberepaidtheoutstandingdebt,andisnowthemostfrequentmethodofforeclosure.Shanker,supranote32,at76(notingthatsomejurisdictionsstillpermitthelimiteduseofstrictforeclosure);seealsoOSBORNEONMORTGAGES,supranote19,10.

61RobertH.Skilton,DevelopmentsinMortgageLawandPractice,17TEMP.L.REV.315,316(1943).

62Seesupranotes3,5,6andaccompanyingtext.


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continued legal interest in its real property, the property owner was now also

capable of granting additional liens in the retained legal interests to otherjunior

lenders;anditwasalsolegallypossiblefortheverysameparcelofrealpropertyto

serveascollateralfortwodifferentmortgageloans,eachheldbyseparatelenders.63

As a result, theborrower could easily raise additional capitalby simply granting

anotherlenderajuniormortgageonitsproperty.

Inpart,thesuccessofmortgagefinancing isduetoa legalsystem thathas

developedaclearsetofrulesgoverning therightsand liabilitiesofmortgagorand

mortgagee and the relative priorities among competing mortgagees all holding

mortgages on the same parcel of land.64Althoughboth senior andjunior lenders

heldmortgageson thesameproperty, theirrelativerightsdifferedsignificantlyby

virtueofthecommonlawruleoffirstintime,firstinright65andlaterbecauseof

the recording statutes.66In thisway, the lowlymortgage proved quite flexible in

providing financing, liquidityand capital formost realestateownerswhileat the

sametimeprotectingthecollateralandsecurityinterestsformortgagelenders.

Until recently,mortgage financing proved satisfactory formost property

owners to fulfilltheir financingneeds. Itwas flexible,simple,cheap,andprovided

theborrowerwithstrongprotectionsagainstanoverlyaggressiveoroverreaching

lender.Perhapsmost important,however,because the financialmarketssoreadily

acceptedjuniormortgage financing, property owners could easily and efficiently

raisecapitaloverandbeyondtheamountfinancedsolelyfromtheseniormortgage

lender.67Although this relatively simplemodelof real estate financinghas served

63CharlesJ.Reid,Jr.,TheSeventeenthCenturyRevolution in theEnglishLandLaw,43CLEV.ST.L.REV.221(1995).

64Chaplin, supra note 19, at 12 (stating thatby early colonial times, around 1600,mortgagelawwasalreadyperfectlywellsettledinEngland);seealsoPOWELLsupranote2,at3739(bythemiddleoftheeighteenthcentury,whenBlackstonewrote,thebasicfeaturesofthemodernmortgage had crystallized and although there have sincebeen additions and

adaptations,thebasic featureshave remainedunchanged);GeorgeLeeFlint,Jr.&MarieJulietAlfaro,SecuredTransactionsHistory:TheFirstChattelMortgageActsintheAngloAmericanWorld, 30WM.MITCHELLL.REV.1403 (2004) (discussing thedevelopmentof the legal rulesapplicable to multiple lenders holding chattel mortgages in the same nonpossessorycollateral).

65 See Richard A. Epstein, Past and Future: The Temporal Dimension in the Law ofProperty,64WASH.U.L.Q.667 (1986).SeealsoJESSEDUKEMINIER&JAMESE.KRIER,PROPERTY(5thed.2002)(citingmaximofRomanLawQuipriorest temporepotoirestjure (Who isfirstinpointoftimeisstrongerinright)).

66Thefirst(recorded)mortgagewouldbeseniorinprioritytothesecondmortgage,andconversely,thesecondmortgagewouldbesubordinatedandjuniortothefirstmortgage.

67StevenHorowitz&LisaMorrow,MezzanineFinancing, inREALESTATEFINANCINGDOCUMENTATION:STRATEGIESFORCHANGINGTIMES (2004),availableatSJ005ALIABA 541, 544(Westlaw)(ithasbeenfairlycommonuntilrecentyearsfortheMortgageBorrowertoobtain


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propertyownerswell forcenturies, Iconclude that in the last tenyears realestate

financehas fundamentally changed, andproperty ownersnow increasingly avoid

(or are prohibited from incurring)juniormortgage debt.68The following section

describesthespectaculargrowthofmortgagebackedsecuritizationsalongwiththe

risingpowerofthenationalratingagencies,andalsohelpsexplainwhycommercial

property owners now increasingly rely onmezzanine loans and preferred equity

investmentsinsteadofjuniormortgagefinancings.

II. FromDirttoSecuritiestoEquity:TheDevelopmentofNonTraditional

FinancingTechniques

In this Section I discuss the development of two new real estate finance

techniquesmezzanine financings andpreferred equity investments. In Subsection

A,Idiscussthedevelopmentofthesecondarymortgagemarket,and,inparticular,

thespectaculargrowthofcommercialmortgagebackedsecuritizations(CMBS).69In

SubsectionB,Idiscussthegrowthandrisingpowerofthenationalratingagencies

andtheirspecializedroleandincreasinginvolvementwithrealestatefinance.And,

in subsectionC, I demonstrate that the national rating agencies have caused the

decline of traditional junior mortgages and inadvertently created the dramatic

expansion of new nontraditional financing techniques inparticular,mezzanine

financingsandpreferredequityinvestments.

A. FromDirttoSecurities TheGrowthoftheSecondaryMortgageMarket

higher loanproceedsby alsogranting a secondmortgageon itsproperty to a subordinatelender); see alsoDianeHess,WhenYouBorrowAgainst theHouse, REALESTATEJOURNAL athttp://www.realestatejournal.com/buysell/mortgages/20050621hess.html (lastvisitedJuly12,2005).

68Seeinfranotes15357andaccompanyingtext.

69There aremany excellent sources devoted to the historical development of thesecondarymortgagemarketandmortgage securitizations, including the following (listed inchronologicalorder):RichardBartke,FannieMaeandtheSecondaryMortgageMarket,66NW.U.L.REV.1(1971)[hereinafterBartke,FNMA];RobinMalloy,TheSecondaryMortgageMarket:ACatalystforChangeinRealEstateTransactions,39SW.L.J.991(1986)[hereinafterMalloy,CatalystforChange];DavidRichards,GradableandTradable:TheSecuritizationofCommercialRealEstateMortgages,16REALEST.L.J.99 (1987) [hereinafterRichards,GradableandTradable];BARTLETT,MBS,supranote9;Shenker,AssetSecuritization,supranote9;Forte,WallStreetKeyPlayer,supranote9.

Inaddition,thewebsitesforGinnieMae,FreddieMacandFannieMaeeachprovide an easy to understand overview of their respective legislative and programmatichistories. Information for Ginnie Mae, available at www.ginniemae.gov; Information forFreddie Mac, available at www.freddiemac.com; Information for Fannie Mae, available atwww.fanniemae.com.


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The advent of the secondarymortgagemarket and the securitization of

mortgagesbegan inearnestwith theeconomicdepressionof the1930swhen large

scaledefaultsbyconsumersontheirhomemortgagesledmanybankstowithdraw

from lending in the residentialmortgagemarket.70In response to the depressed

residential mortgage market and increasing withdrawals of consumer deposits,

Congress intervened in the housing finance system with a variety of legislative

initiatives,includingnewprogramsandadministrativeagenciesdevotedexclusively

toimprovingtheresidentialmortgageloanmarket.71Thesenewprogramsincluded:

(i)FederalHomeLoanBankSystem (FHLBS), (ii)FederalHousingAdministration

(FHA),(iii)FederalNationalMortgageAssociation(affectionallyknownasFannie

MaeandmoreprosaicallyasFNMA), the firstgovernmentalagency tomakea

secondarymarket in residentialmortgagesbypurchasing insuredmortgage loans,

and(iv)by1944,anewinsuranceprogramattheVeteransAdministration(VA)to

guaranteecertainmortgageloansmadetoveterans.72

Even with these programs, however, there was little new housing

constructionfrom1926through1946duemostlytotheDepressionandWorldWar

II.Additionally,withtheexceptionofFannieMaespurchasesofFHAinsuredand

VAinsuredresidentialmortgages,thesecondarymortgagemarketremainedlargely

inactive during the 1950s and most of the 1960s.73 But that changed when the

governmentonceagainsoughttoincreasesignificantlytheavailabilityofcapitalto

financehomeownership. In a spurtof legislative activitybeginning around 1968,

Congressmade FannieMae quasiprivate, expanded its permitted activities, and

continueditsauthoritytoborrowdirectlyfromtheTreasuryatbelowmarketinterest

rates.ItalsoseparatedFannieMaeintotwodistinctentities74andcreatedtwoother

70Manymortgages loansduring thisperiodhadvery low loantovalue ratios ofabout 40%,were short term, [requiredborrowers to pay] . . . interest semiannually, andinvolved aballoonpayment, often as short as three or five years. Inpart itwas the non

amortizingfeatureoftheseballoonmortgagesthatcontributedtothehighdefaultratesoftheDepressionyears.BARTLETT,MBS,supranote9,at45.

71Carrie Lavargna,GovernmentSponsoredEnterprises areTooBig toFail:BalancingPublicandPrivateInterests,44HASTINGSL.J.992,100002(1993).

72SeeBartke,FNMA,supranote69,at1418;Malloy,CatalystforChange,supranote69,at99295.

73Shenker,AssetSecuritization,supranote9,at138182.

74Section302(c)(2)ofTitle IIof theNationalHousingAct states:OnSeptember1,1968, thebody corporatedescribed in the foregoingparagraph [FannieMae] shall cease toexist in that formand isherebypartitionedinto twoseparateanddistinctbodiescorporate,eachofwhich shallhave continuityand corporate successionasa separatedportionof thepreviouslyexistingbodycorporate.12U.S.C.1716b(1968).


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entitiestheGovernmentNationalMortgageAssociation(GinnieMaeorGNMA)75

andtheFederalHomeLoanMortgageCorporation(FreddieMacorFHLMC).76

Duringthe1970sandearly1980s,therewasaslowandsteadydevelopment

of various residential mortgagebacked securities (RMBS). In 1970, Ginnie Mae

issuedpassthroughcertificatesbackedbyFHAinsuredandVAinsuredmortgages.

FreddieMacin1971issuedguaranteedmortgageparticipationcertificatesbackedby

conventionalmortgages.And, in1981,FannieMae introduced itsguaranteedMBS

program for conventionalmortgages.77During this earlyperiod, the securitization

marketdevelopedatanastoundingrateatfirstforGNMA,FNMA,andFHLBand

laterforprivatecorporationsandinvestmentbanks.Thetotalissuanceofsecurities

byGinnieMae,FreddieMacandFannieMaewentfromjust$0.5billionin1970,to

$8billionin1975,to$23.1billionin1980,andto$108.2billionin1985.Justtwoyears

later in 1987, their combined issuance of mortgagebacked securities more than

doubledto$225billion.78By2003,itexceeded$432billion.79

Many factorshelped the rapidgrowthof the residentialMBSmarket: loan

documentation for residential mortgages was relatively homogeneous and

standardized; the landservingascollateralwas fairlycomparable;andsincemany

residentialmortgageshadsimilarmaturitiesand interestrates, itwasofteneasyto

assemblepoolsofloanswithsimilarunderlyingfinancialattributes.Inaddition,as

discussed above, many residential loans were insured or guaranteed either by

75CongresscreatedGinnieMaeonSeptember1,1968pursuanttoSection302(c)(2)(A)ofTitle IIIof theNationalHousingAct,12USC1716.Section302(c)(2)(A)states:Oneofsuch separated portions [of the formerly existing FannieMae] shallbe abody corporatewithoutcapitalstocktobeknownasGovernmentNationalMortgageAssociation . . .whichshallbeintheDepartmentofHousingandUrbanDevelopment.12USC1716(1968).

76See FederalHome LoanMortgage Corporation Act, Title III of the EmergencyHomeFinanceActof1970,Pub.L.No.91351,303(a),84Stat.450,452(codifiedasamendedat12U.S.C.1452(a) (1994)); seealsoJohnC.Cody,TheDysfunctional FamilyResemblance

Test:AfterRevesv.Ernst&Young,WhenareMortgageNotes Securities?,42BUFF.L.REV.761,767 (1994);LisaM. Fairfax,WhenYouWishUponAStar:ExplainingTheCautiousGrowthOfRoyaltyBackedSecuritization,1999COLUM.BUS.L.REV.441,447(1999);

77BARTLETT,MBS,supranote9,at89;Shenker,AssetSecuritization,supranote 9,at1384.

78BARTLETT,MBS,supranote9,at19.

79Incalendaryear2003,therewere$92.3billionand$303billionofhomemortgagesmadeby government sponsored enterprises andGSEbackedmortgagepools, respectively.And, there were $10.9 and $26.6 billion of multifamily residential mortgages made bygovernment sponsored enterprises andGSEbackedmortgagepools, respectively.Board ofGovernorsof theFederalReserveSystem,FlowofFundsAccountsof theUnitedStates,TablesF.218andF.219(Dec.9,2004),availableathttp://www.federalreserve.gov/releases/z1/20041209(lastvisitedJuly11,2005).


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federal instrumentalitiesorquasipublic entities likeFannieMae,GinnieMae and

Freddie Mac or by private mortgage insurance making them almost riskfree

investments.80The tremendousaccelerationofprivate labelRMBSwas alsodue in

parttothehighinterestratesinthelate1970sand1980sandtheensuingSavingsand

Loan(S&L)insolvencycrisis.

In short, the S&L crisis, as it has since come tobe known, refers to the

massive insolvencies of hundreds of savings and loan associations, their forced

liquidations,and theselloffof their inventoryofmortgage loanstheprimeassets

ownedbytheS&Ls.81Althoughthefactorsthatleduptoandcausedthedebacleare

numerousandvaried(andbeyondthescopeofthisarticle),itresultedinthecreation

ofanewentity,theResolutionTrustCorporation(RTC),todisposeoftheinsolvent

thriftsprincipalassetsbillionsofdollarsofmortgageloans.82Toacceleratethesell

offof themortgageportfolios,theRTCbeganto issueresidentialmortgagebacked

securities(MBS)backedbypoolsofmortgageloansformerlyheldbytheS&Ls.With

theRTCs issuanceof residentialMBS, investor awareness andmarket acceptance

increased,andthemarketexpandedevenmore.83

80Richards,GradableandTradable,supranote69,at111.

81 LAWRENCEWHITE, THE S&LDEBACLE PUBLIC POLICY LESSONS FOR A BANK ANDTHRIFTREGULATION3(1991)[hereinafterWHITE,S&LDEBACLE].

82Id.at176,178.

83JosephForte,RatableModelforMainStreetandWallStreet,31REALPROP.PROB.&TR.J. 489, 495 (1996) [hereinafter Forte,RatableModel] (citing statistics generatedby The E&YLeventhalRealEstateGroup,1995/1996COMMERCIALBACKEDSECURITIZATIONSURVEY,TrendsandDevelopments,1996,at1).


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Atthesametime,theS&LcrisisparticularlyaffectedthedevelopingCMBS

market since the failed S&Ls owned notjust residentialmortgagesbut also large

portfoliosofcommercialmortgages.Aswiththeresidentialmortgagesformerlyheld

by the failed savings and loan associations, the RTC alsobegan selling off their

commercialmortgages.84TheRTCdiscoveredthatthesecuritizationmarketwasan

efficientandfastmethodtoselllargeinventoriesofcommercialmortgageloans.As

Joe Forte, a leading CMBS practitioner, has observed, the RTCs activity had

profoundeffectsonthemortgagesecuritizationmarket,includingincreasedinvestor

awareness, an expanded base of investors, and cost efficiencies. Perhaps, most

important, theRTC legitimized theCMBSmarket, therebymaking itan attractive

option todisposeof commercialmortgages in the secondarymarket.85Asa result,

thepaceofCMBSissuanceshasbeensimplystaggering:$1.6billionin1990(before

theRTC issuedanyCMBS), to$30billion issued in1996withover$100billion in

CMBSoutstanding thatyear.86More recently,FitchRatings recentlyestimated that

therewasapproximately$572billioninCMBSoutstandingasof2004.87

B. TheNationalRatingAgenciesandCMBS

TheCMBSindustryhasimpactedtherealestatecapitalmarketsfromMain

StreettoWallStreet,affectingmortgageborrowers,majorfinancialinstitutions,and

other commercial lenders, both in the United States and the overseas financial

markets.88ThissectiondescribesanunderexaminedeffectoftheriseofCMBS: the

concomitantinvolvementofnationalratingagenciesintheCMBSmarketalongwith

theirincreasedcontrolovertheactualpracticeofrealestatefinance.Inparticular,the

rating agencies have inadvertently stifledjuniormortgage financingwhile at the

same time contributing to the rapid rise of two new types of nontraditional

financingtechniques:mezzaninefinancingsandpreferredequityinvestments.

84 Georgette C. Poindexter, Subordinated Rolling Equity:Analyzing Real Estate LoanDefaultintheEraofSecuritization,50EMORYL.J.519,528(2001).

85Forte,WallStreetKeyPlayer,supranote9,at35.

86Id.at3435 (citing statisticsgeneratedbyTheE&YLeventhalRealEstateGroup,1995/1996COMMERCIALBACKEDSECURITIZATIONSURVEY,1996,at1).

87MBAStaff,PositiveRealEstateOutlook,ExpertsSay,MBACOMMERCIAL/MULTIFAMILYNEWSLINK, May, 5, 2005, available atwww.mortgagebankers.org/cmnewslink/issues/2005/05/05.asp(lastvisitedJuly18,2005).

88See,e.g.,MichaelSchill,TheImpactofCapitalMarketsonRealEstateLawandPractice,32 J. MARSHALL L. REV. 269 (1999) [hereinafter Schill, Impact of Capital Markets]; KingslyGreenland, Why Liquidity ShouldHelpYou Sleep Better,NATLREAL EST. INV.,June 1, 2005,available at 2005 WLNR 9459228 (Westlaw).

Comment]FJB1:[I could not find thedata from Moodys in 2000, but I d id find

more recent data with a larger number. Is

this ok?


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Therearecurrentlyfourratingagenciesthatarenationallyrecognizedinthe

United States: Moodys Investors Services, Standard & Poors, Fitch, Inc., and

Dominion Bond Rating Service Limited.89Of the four,Moodys and Standard &

Poorsbyfardominatetheindustrywithacombinedmarketshareinexcessof80%.

Fitchsmarketshareconstitutesapproximatelyanother15%.90Asaresult,thesethree

ratingagencieseffectivelycontrolover95%of themarket.91Since the formationof

these rating agencies, the financial markets have relied upon their opinions

regarding the creditworthiness of publicly traded companies and the issuance of

debtandsecuritiesobligations.92

89TheSecuritiesandExchangeCommissionrecognizesonly thesefourcreditratingagencies asNationallyRecognized StatisticalRatingOrganizations (NRSRO). See infra note205andaccompanyingtext.Itwasonlyrecently,onFebruary24,2003,thattheSECapprovedDominionBondRatingServiceLimitedasthefourthNRSRO.DominionBondRatingServiceLtd., SEC NoAction Letter, Feb. 24, 2003, available athttp://www.sec.gov/divisions/marketreg/mrnoaction/dominionbond022403 out.pdf (lastvisited Nov. 7, 2005); Credit Rating AgenciesNRSROs, athttp://www.sec.gov/answers/nrsro.htm(lastvisitedNov.7,2005).

90ClaireHill,RegulatingtheRatingAgencies,82WASH.U.L.Q.43,59(2004).

91RichardShelby,Senator,U.S.SenateCommitteeonBanking,Housing,andUrbanAffairs,Statement:Examining theRoleofCreditRatingAgencies in theCapitalMarkets,(Feb. 8, 2005) athttp://banking.senate.gov/index.cfm?Fuseaction=Hearings.Testimony&TestimonyID=743&HearingID=136(lastvisitedJuly22,2005)(Moodys,S&PandFitchrepresent95%ofthemarketshare).

92Inaddition,since1975, theSECandCongresshaveusedcreditratings issuedbycertain approved rating agencies (defined as Nationally Recognized Statistical RatingOrganizations (NRSROs))undervarious federal securities laws to augment and sometimesevensubstitute for itsownreviewofcomplex financialmatters.The termNRSROwas firstadopted in 1975withRule15c31 (the socalled NetCapitalRule) foruse in conjunctionwith determining the net capital requirements ofbrokerdealerswho held certain typesof

proprietary securities. Since then, however, the SEC has incorporated the definition ofNRSROsinmanydifferentregulationsissuedundertheSecuritiesActof1933,theExchangeActof1934,andtheInvestmentCompanyActof1940.Forexample,undertheSecuritiesActof1933,certainassetbackedandothersecuritiesmayberegisteredwithFormS3theshortform registration statement if at least oneNRSRO rates the securitiesbeing offered asinvestment grade. SEC.ANDEXCH.COMMN,REPORTON THEROLEANDFUNCTIONOFCREDITRATINGAGENCIES IN THEOPERATION OF THE SECURITIESMARKETS 56 (Jan. 2003), available athttp://www.sec.gov/news/studies/credratingreport0103.pdf(lastvisitedJuly22,2005).

According to the SEC, since 1975 four additional rating agencies have beenrecognizedasNRSROs.However,eachofthesefirmshassincemergedwithorbeenacquiredby other NRSROs. These four additional rating agencies were Duff and Phelps, Inc.,McCarthy,Crisanti&Maffei,Inc.,IBCALimitedanditssubsidiary,IBCA,Inc.,andThomsonBankWatch,Inc.RatingAgenciesand theUseofCreditRatingsundertheFederalSecuritiesLaws,SecuritiesActReleaseNo.8236,ExchangeActReleaseNo.47972,InvestmentCompanyAct Release No. 26066, 80 SEC Docket 1003 (June 12, 2003), available athttp://www.sec.gov/rules/concept/338236.htm#P25_3179 ; seealso,RichardSylla,AHistorical

Comment]FJB2:[See comment

FJB2


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Although there is a long history of rating agencies reviewing public

companies and various debt and securities offerings, until themid 1980s rating

agencieswere seldom involvedwith the commercial real estatemarket, let alone

withCMBS.Duetotheabsenceofnationalcreditratingsandtheresultinglackofa

standardmeans to evaluate real estate investments,major investors like pension

funds,otherfinancialinstitutionsandforeigninvestorsavoidedCMBS.93Inorderto

gainmarketacceptanceandtomakeiteasierforpotentialinvestorstoevaluatenew

CMBSproducts, the issuersof theseCMBSproductssought ratingagency review.

Accordingly,inthemid1980s,themajorratingagenciesbegantorankvariousdebt

and securities offerings secured by commercial real estate.94 At first, the rating

agencies only evaluated debt securedby single commercial officebuildings and

multifamily properties, 95 but soon the agencies also rated securities and debt

securedbyothertypesofcommercial,industrialandretailproperties.96

From those earlybeginnings, the agenciesnow rate offerings ofdebt and

securities thatare securedbyavastarrayof commercial realestateandmortgage

loanswithexceedinglycomplexandindividualizedloanprovisions,includingboth

fixedrateandfloatingrateinterestloans.97Forexample,Fitchnowhasunderwriting

criteria andpublished reports and studies ondiverse transactions such as single

borrowerloans,distressedrealestateloans,loanssecuredbyleaseswithAAAcredit

Primer on the Business of Credit Ratings, in RATINGS, RATING AGENCIES AND THE GLOBALFINANCIALSYSTEM23(RichardM.Levichetal.ed.,2001).

93 Andrea R. Priest, New Rating System at S&P SeenAiding: Commercial MortgageSecondaryMarket,BONDBUYER,Nov.27,1984,at4.

94In1984,Standard&Poors firstbeganratingCMBS.See id. Duff&Phelps (nowknown as Fitch) and Moodys followed shortly thereafter with ratings of commercialproperties inOctober, 1986 andDecember, 1986, respectively. See Richard Ringer,Duff&PhelpsExpandsRatingsListByEvaluatingMortgageSecurities,AM.BANKER,Oct.23,1986,at8;

EvelynWallace,Moodys toBeginRatingSecuritiesBackedbyCommercialPropertyLoans,BONDBUYER,Dec.29,1986,at3.

95Richards,GradableandTradable,supranote69,at114.

96CarlKane&StanRoss,RevisionsinBondRatingSystemtoAllowCashFlowUsefromRealEstateLoans,AM.BANKER,Jan.25,1985at20;Richards,GradableandTradable,supranote69,at114 (although the agencies all initially refrained from ratingdebt securedbyhotels,gasstations,movietheatersandotherserviceorientedproperties).

97 Fitch rates all types of mortgagebacked fixed income securities in the U.S.,includingmultipleborrowermultiple asset, singleborrowermultiple asset, nonperformingassets,singleborrowersingleasset,credittenantleasebacked,andrealestaterelatedCDOs.Fitch Ratings, Coverage, athttp://www.fitchratings.com/corporate/sectors/sector.cfm?sector_flag=2&marketsector=2&body_content=about(lastvisitedJuly15,2005).


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tenants, and floatingrate commercial mortgages.98Similarly, S&P has published

underwritingguidelines foran increasinglyvastarrayofmortgageloansincluding

singleproperty,multiplepropertyandlargeloantransactions;oneS&Ppublication

alone contains almost 250pagesofdetailed analysis and legal criteria forvarious

typesofCMBS transactions.99And,ofcourse,Moodysalsohas itsownguidelines

thatarejustasextensiveanddemandingasthoseofitspeers.100

InevaluatingCMBS transactions, the ratingagenciesassessamultitudeof

factorsinanattempttoevaluatetheoverallcreditworthinessofdebtobligationsor

securities. 101 Based on their respective underwriting criteria and individualized

rating systems, each rating agency, after an exhaustive analysis of the various

98 Fitch Ratings, RATING SINGLEBORROWER COMMERCIALMORTGAGE TRANSACTIONS,available athttp://www.fitchratings.com/corporate/reports/report_frame.cfm?rpt_id=225816&sector_flag=2&marketsector=2&detail= (Nov. 11, 2004) (last visitedNov. 7, 2005); FitchRatings,CREDITTENANT LEASE LOANS, available athttp://www.fitchratings.com/corporate/reports/report_frame.cfm?rpt_id=48513&sector_flag=2&marketsector=2&detail= (Apr. 22, 1999) (last visited Nov. 7, 2005); Fitch Ratings,

SECURITIZINGDISTRESSED

REAL

ESTATE

(Apr.

9,

1999)

(on

file

with

author);

Fitch

Ratings,

RATING

FLOATINGRATECOMMERCIALMORTGAGETRANSACTIONS(Dec.1,1999)(onfilewithauthor).

99StandardandPoors,U.S.CMBSLEGALANDSTRUCTUREDFINANCECRITERIA(May1,2003), available athttp://www2.standardandpoors.com/spf/pdf/fixedincome/040103_cmbslegalcriteria14.pdf(lastvisitedJan.25,2004)[hereinafterS&PCriteria].

100MoodysInvestorServices,STRENGTHINSTRUCTURE:MOODYSAPPROACHTORATINGSINGLEFAMILY HOUSING BONDS SECURED BY MORTGAGEBACKED SECURITIES (Oct. 23, 1998),availableat

http://www.moodys.com/moodys/cust/research/MDCdocs/18/10146.pdf (last visitedJuly 12, 2005);Moodys Investor Services,USCMBS:MOODYSAPPROACHTORATINGFUSIONTRANSACTIONS (Apr. 19, 2005), available athttp://www.moodys.com/moodys/cust/research/MDCdocs/19/2003300000429425.pdf (lastvisitedJuly12,2005).

101 The rating agencies examine (i) the reliability and amount of the cash flowgeneratedby thepoolofunderlyingmortgages; (ii) the liquidationvalueof theunderlyingrealestateuponforeclosureoftheunderlyingcollateral;(iii)thecreditsupportorotherthirdpartyguaranteesoftheobligations;(iv)thelikelihoodthatanyothercreditorwillhaveclaimstotheunderlyingcollateralortootherassetsoftheissuer;(v)certainbankruptcyrelatedriskssuch as the possibility of substantive consolidation, insolvency andbankruptcy; (vi) stresstestswhichanalyzetheeconomiceffects,ifany,iftheunderlyingmortgagesareprepaid;(vii)thediversityoftheunderlyingpoolofmortgageswithrespectto location,typeofcollateral,and interest rate; (viii) the amount of overcollateralization; (ix) the structure of the entityholding the underlying collateral (which is typically structured as a singlepurposebankruptcyremoteentity);(x) loantovalueanddebtservicecoverageratios;(xi)interviewswith issuers; and (xii)whether themortgages in the collateral package permit additionalsecuredorunsecuredindebtedness.JenniferGoldblatt,LoansBehindMortgageBackedsDueforTest,AM.BANKER,Feb.19,1998,at16,;FitchAltersCMBSRatingModel,COM.MORTGAGEALERT,Oct.9,2000,at3;RatingsBoostMBSMarket,NATLMORTGAGENEWS,Nov.7,1988,at5.


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factors, assigns a rating or grade to the various tranches 102 of the CMBS

transaction.103Standard&Poors,forexample,mightratethefirstandsafesttranche

of aCMBS, AAA, the second tranche, AA, the third tranche, BBB, and the

riskiest tranche,B.104Theassignedcreditrating is theunderpinningof theentire

CMBS transactionsince itdirectlyaffectspricingand thereforealsothe investment

decisions ofpurchasers.105Although eachpotentialpurchasermight assess its risk

tolerance differently when making personal investment decisions, there are still

fairlyuniform economiceffectson securitization transactions.Asdescribedabove,

lower ratings signify higher risk; the market demands higher interest yields to

compensateforthehigherrisk;andhigherinterestyieldscosttheissuermoneyasa

resultofhigherinterestcostsand/orlowercashproceedsrealizedupontheissuance

oftheCMBS.106

The rating agencies have also developedunderwriting guidelines to help

market participants understand the ratings process. As discussed below, the

guidelines cover almost every aspect of the CMBS transaction and even include

detailed criteria for eachof theunderlyingmortgage loans comprising thepooled

collateral.107By seeking the highest possible rating for each tranche of theCMBS

transaction, market participants become acutely sensitive and responsive to the

underwritingcriteriaoftheratingagencies.Itisnotdifficulttoascertaintherating

agencies criteria and theirparticular likesanddislikes sinceeachdisseminates its

guidelinesbroadlyontheirwebsites,inpublishedarticlesandinpublicspeechesof

itsstaff.108

102The term tranche refers to oneormore related securitiesoffered at the sametime and securedby the same pool of underlying securities. Typically, each tranche hasdifferentcharacteristicsregardingrisksandbenefits.

103SeePoindexter,supranote84,at537 (underwriterand sellerdesign securities inresponse to the assigned ratingsbyvarying for each tranche factor, including interest rate,expectedmaturity,yield,andcashflow).

104ThetrancheratedBisreferredtoastheBpiece.AtS&P,aBratingmeansthatthere isagreatervulnerability todefaultbut that there is current capacity tomeet its loanobligations,althoughadverseeconomicandfinancialconditionswilllikelyimpairtheabilityto repay interestandprincipal.SteveBergsman,ExaminingtheRatingAgencies:HowWellDoTheyFareUnderGlass?,NATLREALEST.INV.,Aug.1,1996,at8,availableat8/1/96NATLREALEST.INV.48(Westlaw).

105Bergsman,supranote104(ratingagenciesarecriticaltotheCMBSprocesssincetheratingseffectivelydetermineprice).

106Schwarcz,Alchemy,supranote3,at136137.

107Seeinfranotes108and113.

108See,e.g.,CharlesCitro,CMBS:MoodysApproachToRatingLoansSecuredByGroundLeasehold Interests,COMMERCIALREALEST.FIN.2003:WHATBORROWERSANDLENDERSNEEDTO


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Theratingsprocess isan integralcomponentof thesuccessandcontinued

growth of CMBS. Initially, national credit ratings helped make commercial

mortgagebackedsecuritiesattractive formanynew typesofcommercial investors.

Someregulated industriessuchaspensionfundsand life insurancecompanies,for

example, can onlybuy investments that are rated investment grade or higher.109

Furthermore, since the ratings are consistently applied and are national in scope,

investmentmanagersarebetterabletocompareCMBStootherpossibleinvestments

such as corporate andmunicipalbonds.110An investor could therefore compare a

AAACMBSinvestmenttoaAAAcorporatebond.111Accordingtomanymarket

participants,theratingagenciesdetailedanalysisalsohasincreasedtheavailability

ofpublic informationconcerningrealestate.112Asmorecommercial investorsenter

into theCMBSmarket, itbecomes safer,more liquid, andmore like other capital

marketinvestments,allofwhichfurtherfuelsthegrowthofCMBS.

C. NationalRatingAgenciesImpactonCommercialRealEstateFinance

Theratingsprocesshasdrasticallyinfluencedtheoriginationofcommercial

mortgage loans and the growth of the CMBSmarket. The rating agencies have

changed some of the basic fundamentals of real estate finance, affecting the

relationshipsamongmarketparticipants,thebasiclegalstructureoftheunderlying

mortgageloansincludedinCMBStransactions,andthecontractualarrangementsof

otherlendersprovidingfundsdirectlyorindirectlytothemortgageborrower.

The rating agencies achieved these dramatic results through the use of

underwriting guidelines; these guidelines are extensive, demanding, and

KNOWNOW(2003),availableat489PLI/REAL413(Westlaw);DanielB.Rubock,CMBS:MoodysApproach To Terrorism InsuranceAfter the Federal Backstop, COMMERCIAL REAL EST.FIN. 2003:WHAT BORROWERS AND LENDERSNEED TOKNOWNOW (2003), available at 500 PLI/REAL 335(Westlaw);ClaireHill,Securitization:ALowCostSweetenerforLemons,74WASH.U.L.Q.1061,

1071 (1996) (rating agencies dictate a significant amount of the structure of securitizationtransactions);seealsosupranotes98100, infranote113.ButseeFrankPartnoy,TheSiskelandEbertoftheFinancialMarkets?:TwoThumbsDownfortheCreditRatingAgencies,77WASH.U.L.Q.619,651(1999)(describinghow the internalprocessbywhichagenciesactuallydetermineaparticularratingissecretandproprietary).

109Shenker,AssetSecuritization,supranote9,at1398n.137.

110Kane&Ross,supranote96,at20;seealsoPriest,supranote93,at4.

111SeeAlanKronovet,AnOverviewofCommercialMortgageBackedSecuritization:TheDevilisintheDetails,1N.C.BANKINGINST.288,308(1997).

112Goldblatt,supranote101,at16;seealsoWhite,S&LDebacle,supranote81(discussinghowthegrowthofpubliccapitalmarketsinrealestatehascausedanexplosionofinformationaboutrealestate.).


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surprisinglyuniform in scope and coverage.113For example, injustonedocument

alone,Standard&Poorshasassembledalmost250pagesofextensivelegalcriteria

forcommercialmortgagebackedsecuritizations.Thepublishedcriteriacoveralmost

everyconceivabletopicaffectingnotjustthelegalstructureoftheCMBStransaction

butalsotheunderlyingmortgageloansinthepoolofloansservingascollateralfor

theCMBStransaction,includingtheacceptabilityofcertaintypesofcollateral(single

property,multipleproperty,andlargeloantransactions),transferofmortgageloans,

environmental criteria, due diligence, servicing issues, substitution of property,

appraisalmethods,titleinsuranceandmortgagerecordingtaxes.

Thecriteriaare soextensive that theyevenaddress theactual legal terms,

provisionsandstructureoftheunderlyingmortgageloanscontainedinthepoolof

collateral for CMBS transactions.114In its published guidelines, for example, S&P

opines on most every aspect of these underlying mortgage loans, including

representationsandwarranties,theformationofspecialpurposebankruptcyremote

entities, acceptable intercreditor agreements, guarantees, legal opinions, cash

collateral and lockboxes, and permissible alterations to themortgaged property.

Moreover,asdiscussedbelow, therearealsoextensive criteriagoverning the type

andamountofadditionalindebtednessthatanunderlyingmortgageborrowermay

incur.115

Because of theuniformity and strictness of rating agency guidelines, and

sincealendercannottypicallychangetheprovisionsofaloanonceitismade,many

mortgagelendersnowfrequentlyrequirethatallnewmortgagescomplywithmost

oftheguidelines.Suchrequirementsrepresentattemptstoensurethatnewmortgage

loans are acceptable to the rating agencies for inclusion in an investment grade

securitization and the secondarymortgagemarket. Thus, even if a lender has no

present intentionof transferringaparticularmortgage intoasecuritizationor later

selling in thesecondarymarket, inorder tomaintain its liquidityandpreservethe

113 S&P Criteria, supra note 106; Fitch Ratings, EVALUATING ADDITIONAL DEBT INCOMMERCIAL MORTGAGE TRANSACTIONS (Dec. 19, 2001), available athttp://www.fitchrisk.com/corporate/sectors/criteria_rpt.cfm?sector_flag=2&marketsector=2&detail=&body_content=crit_rpt) (last visited January 20, 2005) [hereinafter Fitch, EvaluatingAdditionalDebt];Moodys, CMBS:MOODYSAPPROACH TOABNOTESANDOTHER FORMS OFSUBORDINATE DEBT (February 4, 2000), available atwww.moodys.com/moodys/cust/content/loadcontent.asp?c=sri_s (last visitedNovember, 30,2004)[hereinafterMoodys,ABNotes];seealsoHill,supranote108,at1071;Cf.Bergsman,supranote104,at48.

114Horowitz&Morrow,supranote67,at546(ratingagencieshaveplayedagreaterroleindetermining thestructureofthesubordinatefinancingand inencouragingtheuseofmezzaninefinancingasopposedtosubordinatemortgagefinancing).

115S&PCriteria,supranote99.


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value of the mortgage loan asset, a prudent lender still ensures that all new

mortgage loans satisfymostof the ratingagencies requirements.Sinceall lenders

are trying tocomplywiththesameguidelines, therehasbeenuniformity inmany

aspectsofcommercialmortgageloans.116

Theratingagencieshavesignificantlyalteredthelandscapeforsubordinated

debt because their underwriting criteria all require strict prohibitions on such

subordinate financings.At theirmostbasic, theratingagenciesseek toensure that

themortgagescontainedintheCMBSpoolofcollateralremainseniorliensandthat

theywill have firstpriority to theunderlying collateralthe land and the flow of

rental incomeincaseofdefault.117FromFitchsviewpoint,additionaldebt inany

formputsgreaterstressonthecashflowofapropertyandincreasedlossesinthe

eventofdefault.118Similarly,Moodystakesthepositionthat[a]sageneralrule,all

subordinate debt has some adverse effect on the credit of the senior debt since

juniordebtincreasesthelikelihoodofdefaultontheseniordebtand,insomecases,

increasestheseverityoflossontheseniorpiecewhenadefaultdoesoccur.119

Rating agencies particularly abhor junior mortgage debt because of the

unique risks it imposes.120Since thejuniormortgage is a direct obligation of the

underlyingmortgageborrower, theratingagenciesbelieve that itadverselyaffects

theseniormortgageesrightsandthelikelihoodofrecovery.121Fortheseniorlender,

themere existenceof ajuniormortgagemightdelay and complicate itsmortgage

foreclosure proceedings, necessitate obtaining the junior lenders consent to a

workoutorotherconsensualmodification,affecttheseniorlienpriorityofthesenior

mortgageoranyfutureadvances,andgivethejuniorlendersubrogationrightsifthe

junior lendermakes payments to a third party or claims the senior lender acted

improperly.122Theserisksareparticularly likelysincejuniormortgagees frequently

116Schill,ImpactoftheCapitalMarkets,supranote88,at284(therequirementsoftheratingagenciesaredictatingtheformandcontentofcommercialmortgages).

117S&PCriteria,supranote99,at18.

118Fitch,EvaluatingAdditionalDebt,supranote113,at1.

119Moodys,ABNotes,supranote113,at1.

120Jones&Simcox, supranote10at328 (least favoritemodel forallof theRatingAgencies is the second mortgage); Horowitz & Morrow, supra note 67, at 545; Forte,MezzanineFinance,supranote14,at440(sincethemid1990s,thenationalratingagencieshavebeen less amenable tojuniormortgage financing and therehasbeen a growingprejudiceagainstsecondmortgages).

121Moodys,ABNotes,supranote113,at7.

122Forte,MezzanineFinance,supranote14,at441.

Deleted:


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have the financial resources and incentive to interfere with the senior lenders

exerciseofitsrightsandremedies..123

The seniormortgagee alsohas significant risk sincemostjuniormortgage

debt isrecourseto theborrower.Asaresult,aborrowerwillhavestrongfinancial

incentives todivert the reduced cash flow to the secondmortgage, insteadof the

seniormortgage, to avoidpersonal liabilityunder the recoursejuniormortgage.124

Thejuniormortgagedebtaddsincreasedriskespeciallyintheeventofaneconomic

downturn since the reduced cash flowsmightjustbe insufficient topayboth the

seniorandjuniormortgages.125Insuchacase,themortgageborrowermightdefault

onthejuniormortgageandseekbankruptcyprotection,therebyhurtingthesenior

lender.126In case of adefaultunder thejuniormortgage, ajuniormortgageemay

seektoexerciseitsrightsandremediesandforecloseitsmortgage,appointareceiver

for the rents from the tenants, and terminate leases. 127 The junior mortgagees

exercise of any of these remedies necessarily increases the likelihood of default

undertheseniormortgageandincreasesrisktotheseniorlender.128

Inaddition,becauseoftheincreasedriskofdefault,anytypeofsubordinate

financing also necessarily increases certainbankruptcy risks. For example, in any

bankruptcywithbothseniorandjuniormortgagelenders,thereisariskofacram

down129ajuniorcreditorforcingabankruptcyreorganizationplanonthesenior

mortgagelender.130Theseniorlenderwouldalsobesubjecttotheautomaticstayof

the Bankruptcy Code, 131 possible claims by the junior lender of equitable

subordination,132orclaimsbyothercreditorsofsubstantiveconsolidation.133

123Horowitz&Morrow,supranote67,at545.






129Acramdownisthecommonparlanceusedbyjudgesandpractitionerswhenreferring to the forcing of modifications down the throat of an unwilling party. JackFriedman,WhatCourtsDoToSecuredCreditorsInChapter11CramDown,14CARDOZOL.REV.1495,1496(1993).

130S&PCriteria,supranote99,at18.

13111U.S.C.362(2005).

132Forte,MezzanineFinance,supranote14,at441.Under theequitablesubordinationdoctrine,abankruptcycourthas thepower toequitablysubordinateaclaimor interestofalenderor toavoid thelenderslien.Whileaclaimmaynormallybesubordinatedonlyif the

Comment]3259393:[Prof. Berman:Perhaps it would be better to paraphrase

this more and remove the quotation

marks in order to make this better fit the

language that you have been using.


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Therestrictionsimposedbytheratingagencies,therefore,attempttoreduce

the likelihood and ability of another creditor filing an involuntary bankruptcy

petition against the underlyingmortgage debtor or themortgageborrower itself

initiatingavoluntarybankruptcypetition.Asaresult, it isnow increasingly likely

that any commercialmortgage included in a securitizationprohibits theborrower

from incurring any additional junior mortgage financing as well as any other

significantdebtevenifthejuniormortgageisasoftsecond134orotherwise deeply

subordinated totheseniormortgage.135

Theratingagenciestypicallyonlypermittheseniormortgagedebtitself,contractual

obligations of themortgageborrower to tenantsunder leases, and certain limited

types of trade debt and equipment financing. 136 These broad limitations on

additionaldebtsignificantlylimittheabilityoftheunderlyingmortgageborrowerto

incuradditionaldebt.

once a mortgage, always a mortgage - the use (and misuse) of mezzanine loans and preferred equity...

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