Sunday, September 20, 2009

The GGP case changed the rules of engagement for securitization

A recent ruling in the case of the defaulted General Growth Properties (GGP) has sent shock waves through the securitization markets. The ruling placed into question the strength of what's called "bankruptcy remote" entities. These entities are set up to ring fence the assets that represent the collateral pool for structured debt. One key reason for this requirement is to protect the debt holders' collateral from being dragged into bankruptcy if the equity holder defaults.

For example, consider a hedge fund that wants to leverage some assets. It would create a Special Purpose Entity (SPE) to purchase assets (loans, bonds, etc.) The hedge fund then contributes equity to the SPE. The leverage would come from senior lenders who are comfortable with the pool of assets in the SPE as collateral, but want nothing to do with the hedge fund. Their concern obviously is that if the hedge fund blows up, the fund's creditors will go after the assets in the SPE, even if the SPE itself has not defaulted and has plenty of asset coverage.

Using Delaware law allowed structured finance gurus to ring fence the SPE. A bank structuring the deal would work with the equity holders (in this case the hedge fund) to appoint independent directors and a trustee. If the hedge fund defaults, the structured senior debt holders and the trustee would make sure nobody can touch the collateral (including cash) in the SPE.

The GGP case seems to have changed the rules of engagement with respect to Delaware SPEs. In this particular case, the SPEs in question were GGP's property holdings that used CMBS financing. First let's take a quick look at a typical CMBS structure with respect to the equity holders and the SPEs:

Usually each property is held in an SPE which gets a mortgage on the property from the CMBS pool. These SPEs have independent directors and have been viewed as "bankruptcy remote". The mortgage provider is the CMBS SPE (a separete entity), which holds a pool of such mortgages on multiple properties (usually geographically diversified). To finance these mortgages, it issues structured notes that are tranched based on seniority. Cash flows (mortgage payments) generally follow a "waterfall" prescribed by the CMBS indenture, with senior notes getting priority to these cash flows.

In many cases a credit worthy equity owner will provide some form of a limited non-recourse guarantee to the mortgage lender. That creates additional credit support to the CMBS structure, reducing the financing cost to the property owner. This credit support however was a negative when the judge was considering the issue of "bankruptcy remoteness". The ruling allowed the bankrupt GGP to go after the properties and cash held in these SPEs, exposing the weakness in the Delaware SPE structure. The paper below discusses the weaknesses of the Delaware SPEs, particularly as it relates to CMBS.

The key issue was that the independent directors of the SPEs as well as the management (which now were the direct creditors of GGP) were allowed to consider not just the interests of the creditors, but of the equity holders when deciding about the fate of the SPEs. GGP creditors wanted to drag the SPEs into bankruptcy and they got the directors to vote their way. Interestingly enough GGP fired existing SPE directors and appointed new ones (that would be more cooperative) shortly before they filed for Chapter 11. The explanation was that the new directors knew more about commercial real estate.

But how can you force an entity into bankruptcy if it is current on its debt and doesn’t have to refinance for up to three years, as was the case with these SPEs? GGP argued that these entities will be bankrupt anyway when they have to refinance their balloon mortgages. This argument is in fact valid because of the wall of commercial real estate debt maturing in a few years (see looming balloon risk).

In addition, the argument was that the current state of GGP (as the SPEs’ affiliate), should be considered. In order to preserve value, the SPEs need to file now, rather than wait until their debt matures. The judge accepted this argument and allowed to have the SPEs file for Chapter 11.

That of course was a shocker to the CMBS debt holders, because their collateral was now compromised. Some legal scholars have argued that GGP is an isolated case and new cases (which are definitely coming) will prove that Delaware law works for bankruptcy remote SPEs. But given the sad state of the securitization markets, nobody wants to take a chance, and structurers are quickly moving away from Delaware. The jurisdiction of choice is now the Cayman Islands, where directors (when they get back from the beach) will side with the debt holders. And hedge funds that want to obtain non-recourse leverage (to the extent it's available) even for their onshore funds, will be setting up Cayman SPEs.

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