Conflict Resolution

MBS and ADR

I have always believed that any problem created by a human being could be solved by a human being.  As I get older I realize this might be an article of faith rather a report of experience — war, for example, is a problem that is too easy to create and too difficult to solve.  Still, I start each mediation with the confidence that the problem in front of me is one that the people in the room can fix.  Except….

I had a very interesting lunch the other day with some really smart people.  There was a federal judge and a general counsel and a partner at a mega-firm and a managing director of a global financial institution.  And this problem was put before us:

Four years ago, a commercial developer purchased land worth $500 million, using a loan of $400 million from a Bank.  Before she was able to commence her planned development, credit became tight and the real estate market collapsed.  Now she owns vacant land worth only $150 million, but is still saddled with a debt of $400 million.

 She has no incentive to continue to pay the debt.  However, instead of mailing in the keys she proposes a deal with the Bank:  She will pay the loan but only if it is reduced to $150 million, the current value of the land.  The Bank considers that payment on a readjusted loan is better than no payment at all, and the Bank is prepared to agree.

 However, the Bank has structured this loan so that it retains $200 million of risk while other, subordinate lenders take the other $200 million.  Because they are junior to the Bank, they will not get paid at all until after the Bank is paid in its entirety. 

With the loan at $400 million, there is no chance they will ever be paid and their participation in the loan is worthless.  Once the principal goes below their trigger point they are certainly frozen out.  They might, however, be able to create some value from this “out-of-the-money” position through that subtle economic force: Coersion.

 As a matter of law, the Servicer of this loan must act for the benefit of the participants and cannot cut a deal that favors one tranche of investors over another.  If the Bank adjusts the terms of the loan to reduce the principal, and if the economy somehow rebounds and the land’s value trebles, the junior participants could later argue that the Servicer acted to freeze them out.  They could sue the Servicer and seek to recover losses that they allege were caused by the Bank’s renegotiation. 

 This won’t result in recovery of course – but the threat of suing later may well have value to them now.  Despite being locked into a certain loss now, they could object to the renegotiation of the loan and hope to be paid off today to withdraw that possible claim tomorrow. 

That is, if they know about the proposed adjustment, and if the Servicer can find them.  Because the developer’s original loan has been thrown into a pot with 1,500 other similar loans, combined and securitized, and now is part of a larger instrument – a Mortgage-Backed Security (MBS) – slices of which have been widely sold to investors around the world.

 How can the developer’s loan be refinanced to avoid foreclosure?  How can the junior participants be identified and notified that their rights are being adjusted and, if they could, why would they agree?  Once the solution to these questions is found, we have the seed of a “best practices” approach to a single loan adjustment. 

Now multiply it times 1,500 and we can resolve the problems with one MBS. 

And once we solve one MBS we can approach the tens of thousands of MBSs in the market today.

It’s a good thing the food at this lunchwas good because the conversation gave me a headache.  Folks like me would prefer to start chewing on big problems in bite-sized pieces.  And I was having trouble right out of the box.  What interest-based approach do you take with the holder of a junior interest in a loan, when that interest gains value only if the holder objects to the adjustment necessary to keep the payments coming?

Anybody?  Yes?  Anybody?

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