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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§or_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§or_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.
124Forte,MezzanineFinance,supranote14,at441.
125Fitch,EvaluatingAdditionalDebt,supranote113,at6.
126Fitch,EvaluatingAdditionalDebt,supranote113,at6.
127Forte,MezzanineFinance,supranote14,at441.
128Fitch,EvaluatingAdditionalDebt,supranote113,at6.
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.