MBA NEWSLINK: It is more technical than this, but the Financial Accounting Standards Board generally proposed a major accounting rule forcing lenders to keep CMBS loans on their balance sheets rather than allowing them to place the loans in qualified special purpose entities, or QSPEs. What impact will this have on the CMBS market?

JOE FRANZETTI: Let's think about the CMBS market. Right now, it's dead.

If [a lender] had a loan on their balance sheet that they could not put into CMBS, and the reason they could not do it was because there was no market for the bonds, they were forced to hang on to the origination with the hope they can sell it.

Most of the money-center banks were essentially using CMBS as a big trade. They took the loans in, packaged them up and sold them out. It was a long-term trade, but they never retained risk--that was the banking model.

If, in fact, they now have to keep those loans on their balance sheet--even if they sell bonds against them--I don't believe it gives the same borrower effect.

For one, it balloons the bank's balance sheet and creates all sorts of regulatory issues. In fact, if they are forced to keep the loans on their balance sheets, I'm not quite sure a money-center bank wants to be in that business anymore.

The question is--if the market is already effectively dead on the issuance side, what does it take to get it started again?

The hope was that the money-centered banks would come back to the market when there is a bond market to sell into. Are those hopes dashed on the accounting side?  They could be, which means [the industry] is going to have to reinvent itself because there are going to have to be, essentially, issuers that are non money-center bank issuers yet sell through money-center banks.

Here is an example. Any one of these special servicers were taking a risk in the pool. If, in fact, a new entity was created that wants to be a b-piece buyer, they will need to originate loans, create bonds and sell those bonds. But, they will need a line to make money to lend to the borrowers. As a first-risk player, they can hopefully obtain a line-of-credit from, perhaps, a money-center bank. In the class of repo-financing, they can make their loans and the money-center bank will not be holding loans for CMBS. They will be holding a repo agreement.

As the originator--this new b-piece buyer--once they aggregated all these loans, they can turn to a money-center bank to sell bonds for them. The money-center bank never takes ownership of the loans on their balance sheets so this accounting treatment does not take effect. The [b-piece originator] takes off  the repo when [the money-center bank] sells bonds for them.

These classic investment banks are going to go back to doing what they do best--sell bonds and not be loan originators. Loan originators will want to be the ones who retain the risk.

When this market does come back, that's the way it is going to come back. Start with the person who will take the first-loss risk, he is going to have to get the warehouse line from a money-center bank and the investment bank, which can also be the money-center bank, will sell the bonds. This way, the investment banks never really get in the lending business anymore. They are a bond seller and a warehouse provider.

NEWSLINK: There is now tension between AAA bondholders and lower-rated bondholders on timing for special servicers to foreclose--or extend--loans in default. The Wall Street Journal reported the possibility that Treasury could relax the real estate mortgage investment conduit rules [REMIC rules] to allow special servicers some flexibility to modify and/or negotiate with borrowers. Are bondholders going to be all right with this or will it lead to deterioration in confidence among CMBS investors?

FRANZETTI: Any time there is a game changer in the rules, there is a potential to lose confidence.

However, when all the noise and the name-calling settles, senior investors are going to say to b-piece buyers, 'Your job was to maximize the return to the trust. Do your job.'

Whether that means talking to the borrower earlier rather than later--the reason they talk later rather than earlier is because of these REMIC provisions--but if they talk to them early, then fine. They still have to do their job, which is to maximize proceeds to the trust. So I believe senior bondholders are not going to really care about whether Treasury allows modification to REMIC that will let special servicers modify loans early.

What [senior bondholders] are going to do is keep their eye on it and try to figure out whether b-piece [buyers] were self-serving or whether they were doing what they were supposed to be doing, which is maximize return to the trust.

Does it undermine confidence? I don't think it does until somebody can definitively point to a b-piece buyer and say, 'You were self-dealing on this issue. You weren't looking out for our best interest. And now, we're going to have to go through disciplining a special servicer and b-piece buyer.'

If that's the case, then we start to see market confidence eroded.

NEWSLINK: What property types are in most distress right now?

FRANZETTI: The hotel and retail sectors. What happens is, the ones that feel most distressed are the ones that return faster. We are going to see an impact on hotel/retail and then it will move to warehouse with shorter leases, then office and then whenever we have a recovery, we will start to see those day-rate properties [recover].

More people will start to show up to spend some money at the shopping centers. You might see them there first as a recovery or business activity means more people travel, which will have an impact on hotels. That will happen before people start committing to office space again.

NEWSLINK: In day-to-day operations, what's keeping you awake at night?

FRANZETTI: I struggle the most with making sure people see the current situation the same way.

In my job, I'm trying to bring the borrowers and lenders together to find an amicable solution because that will maximize value to everybody and, hopefully, a solution that helps the industry.

Everybody believes the other person is trying to take advantage of them. We try to get a borrower and lender at a table and figure out if the borrower should stay in the property to manage it for the lender or if the lender needs to provide some debt service relief for the borrower to put some money into the property and restore it in some way.

But everyone thinks that the other person is trying to take advantage--lenders thinking borrowers are putting off the day of reckoning and borrowers thinking lenders are just trying to squeeze them out of their properties. If people have those things so entrenched in their minds, then it is really hard to get some kind of solution.

In this market, it's never a win-win. The question is how bad is the lose-lose. I try to mitigate that. That's what troubles me the most--trying to get perceptions in line and focused on the reality of the situation.

Borrowers obviously see the impact first because it is their tenancy that feels the impact. Lenders--not that they cannot accept it--are shocked to see how quickly values have eroded.

What keep me up at night and what might be an impediment to really getting through this is trying to get everybody's perceptions in line.

The whole relationship with special servicers and perceptions is a system that is not working. I think it is working and people are trying to do their jobs, but we are seeing some [special servicers] overwhelmed from just a time point-of-view.

If [borrowers] have a credible argument, discussion and thesis about what needs to be done, the special servicers are listening. They are obviously constrained by pooling and servicing agreement and REMIC issues, but they are listening and trying to figure out how to do their job the best way they can. They may not be staffed properly right now.

There is frustration and borrower complaints but it is a matter of resource allocation. Once they sit at the table, special servicers are being reasonable and they are doing their jobs.

NEWSLINK: Is the current situation getting larger than previous expectations?

FRANZETTI: [Special servicers] are seeing a lot more than they expected and quicker than they thought would be there. Also, they are getting the message that values have gone down more dramatically than they thought.

There is not an easy answer as taking [the asset] and selling it because the market is pretty bad to sell into. There is a level of humility that these special servicers have had to face up to in making them determine the best way to deal with [the situation]. 

The numbers will suggest this is worse [than 1998 and 2001] and just everything on the horizon tells us it is going to be awhile before [the market] returns. It's a classic case of never being as good as it seems, and it is certainly never as bad. Going back to the late 1980's, people were saying we had 15 years of office supply. That was not the case, but everyone was marching around saying there would never be another office building built.

This is pretty bad, but people are not necessarily going into the bunker. We are just going to have a couple years of pain.