When marathon negotiations between Chrysler Corp. and its creditors broke down, the embattled auto company marched into court and filed a petition for bankruptcy protection. The developments had an immediate impact on the corporate finance world, and caught the attention of commercial real estate investors.

The bankruptcy filing underscored just how much the demands of various stakeholders in any given transaction — including real estate projects — can cause the entire ship to sink in a hurry.

Shortly after the Chrysler announcement, bondholders for General Motors proposed grabbing a 58% equity stake in GM in exchange for their claims, and to share that ownership with the United Auto Workers and the U.S. Treasury.

The concept of swapping existing debt for equity, or for more lenient credit terms, is dominating corporate finance today. It is now the avenue of choice for resolving distressed debt, and will likely further proliferate into the CMBS world. It is difficult at this point for many to imagine how this type of debt resolution will work in CMBS, and provokes the thought of bondholders inadvertently owning distressed properties and loans.

To be sure, the idea of lenders negotiating the exchange of debt in a faltering real estate venture is neither foreign, nor is it novel. But CMBS bond investors have so far been shielded from such draconian measures.

The fight for seniority

Like non-securitized structured real estate debt, CMBS is typically issued in levels of seniority, or tranches. The AAA-rated tranche is the gold standard because it is well protected in the event of a borrower default. The lower-rated tranches bear more risk in exchange for a higher return. But in the worst-case scenario, a bond default can cause financial losses for even the most well-insulated investors.

Of course, there are some investors for whom this possibility is more daunting than for others. For instance, some institutional CMBS holders may be prohibited from owning bonds that have been downgraded to below investment grade. In such cases, the investors will be forced to sell their holdings at the first hint of an impending bond default.

Many of these assumptions are being tested with developments such as the recent General Growth Properties bankruptcy filing. Questions are being raised about the security of the special purpose entity in General Growth’s legal claims. The special purpose entity is a loan holding trust that protects the safest bondholders by advancing interest and principal payments while the special servicer seeks loan resolution.

But General Growth is trying to access the loan holding trust to obtain significant loan modifications in its securitized pools of debt. This maneuver led Huxley Somerville, managing director and U.S. CMBS group head at Fitch Ratings, to conclude that “positions taken by GGP to date lead Fitch to believe that certain CMBS bondholder protections may be in jeopardy in the future.”

These are ominous words to investors because they suggest that if loans in a CMBS structure default, and first-loss holders are unable to bear the loss and keep the senior holders whole, the structure could collapse. Often the default resolution of choice is to take an equity interest in the property or borrower while taking asset management steps to resume cash flow or restore value.

But according to Somerville, during a workout, special servicers generally use their control over the cash accounts to elicit borrower concessions. And since General Growth’s loan holding trusts are part of the bankruptcy filing, decisions that are usually the province of the special servicer are now within the jurisdiction of the bankruptcy court.

Bondholders’ dreaded scenario

Property values are down, there’s a scarcity of buyers, limited refinancing options exist, and high-risk investors are demanding higher returns. That means holders of the most secure portions of a bond structure may be called upon to give up income or value in exchange for saving the bond structure itself.

There are many legal protections for these secure investors before they reach the point of having to take such drastic measures. But if CMBS defaults continue to rise, chances are legal counsel for both bondholders and issuers may have to explore this dreaded scenario.

Analysts note that major commercial and investment banks have reported sizeable loan write-downs for commercial mortgages and CMBS. Against that troubling backdrop, suddenly a breach of bondholders’ security is a looming possibility.