In the summer of 2001, the commercial mortgage-backed securities (CMBS) market was headed for a record year. Coming into September, $58.5 billion of domestic deals had been issued, or $7.3 billion a month. The market was a runaway train that could only be stopped by a force of unimaginable magnitude.

The wreck occurred on Sept. 11, when the terrorist attacks on the World Trade Center wreaked havoc on the country's psyche and the national real estate market. The buildings destroyed in the attack were covered by two separate CMBS securitizations: a $563 million loan backed by GMAC Commercial Mortgage and a $383 million issue led by Bank of America.

Suddenly, investors and lenders feared the risk associated with large commercial buildings. In the six weeks that followed the deadly attack, only $3.8 billion in CMBS issuances were priced, a severe reduction in the market.

Investors Grow Skittish

Even though bond buyers that held World Trade Center loans were ultimately paid off by the insurance that covered the buildings, many investors were no longer comfortable buying CMBS pools with large property loans in them. Lenders began to search for ways to avoid risks tied to single assets. Additionally, they needed to find a way to place large property loans into CMBS deals.

The result — the “pari passu” structure — was a godsend for the CMBS market. (“Pari passu” is a Latin phrase meaning “on equal footing” or “without partiality.) The pari passu structure occurs when an issuer splits a large loan on a single commercial property into multiple pari passu notes that are placed in assorted CMBS deals. Although the different notes are not necessarily of equal size, they are of equal payment priority.

What's the benefit of that structure? “It increases or promotes diversification in a transaction,” says Erin Stafford, an analyst with Dominion Bond Rating Service, a credit rating agency. Instead of a large loan representing 20% of the CMBS pool, for example, a pari passu piece of that loan may represent only 5% of the pool.

The use of the pari passu structure heated up in late 2002, with large trophy office properties and super-regional malls generating the lion's share of activity, says Lisa Pendergast, director of CMBS research at Greenwich, Conn.-based RBS Greenwich Capital, an investment bank that prices major CMBS deals.

The percentage of CMBS deals containing pari passu notes jumped from 41% last year to 68% as of late July of this year, according to Dominion. There were 81 individual pari passu pieces, totaling $5.65 billion, placed in deals in all of 2003, and 62 pieces in the first half of 2004, totaling $5.63 billion, according to Dominion. At this rate, Dominion projects there could be 100 pieces totaling $10 billion in 2004.

A recent $2.6 billion CMBS deal led by Goldman Sachs includes four pari passu pieces of large loans, or 17% of the loan balance being pari passu. The deal includes two A-note pieces, totaling $189.5 million, of the total $426 million mortgage for the Grand Canal Shoppes, a 536,890 sq. ft. mall at the Venetian Casino Resort in Las Vegas. Four other pari passu notes for the loan still need to be placed in separate CMBS deals.

No Panacea

Now viewed as the only way for large property loans to be included in CMBS deals, the structure is not likely to go away anytime soon, experts agree. But that doesn't mean the structure is not without flaws. Recently, rating agencies have been sounding alarms that the structure has become too complex. Specifically, loans are being cut into too many pieces, critics argue, and when the pieces are placed in deals it is not always clear which noteholders have control in the event of a loan workout.

No one is pushing the panic button just yet, since defaults for CMBS deals have remained very low in the product's lifetime. Over the past 14 years the cumulative default rate is just 0.2% of the dollar balance of all CMBS-rated classes, according to Fitch Ratings' 2004 U.S. CMBS Bond Default Study.

Still, the complexity of CMBS transactions and the multitude of players in the process makes any loan workout especially difficult. For example, a typical loan structure may have one “A” note, or senior note, cut into four pieces along with a “B” note, the subordinate part of the loan. The “A” note pieces are placed into separate CMBS deals, while the “B” note is held by a private party (see glossary, page 33).

Now, add to the mix a master servicer who collects loan payments made by the borrower, and a special servicer who handles the workout in the event the loan goes bad. Those servicers need to take into account the rights of the “B” piece investors (the controlling class holders in the various CMBS deals), along with the holder of the “B” note.

Fitch Ratings analysts Daniel Chambers and Zanda Lynn question whether there are “too many cooks in the kitchen” in such deals. In a report they co-authored last November, the analysts compared the pari passu structure to that of the syndicated real estate loans popular in the 1980s and 1990s.

During that period, when a loan in syndicated deals went bad, the agent that coordinated and administered the loan had to obtain the consent of everyone holding a piece of the loan before making loan modifications or taking enforcement actions, according to the analysts.

“Participants rarely agreed, consensus took months, and minority participants often rejected any proposal in an effort to be bought out — the agent was effectively barred from taking any timely or meaningful action,” the authors wrote.

The worry now is that similar problems could occur in a loan workout involving a pari passu note. At issue is control. Either a lead noteholder — the B-piece investor in the first CMBS deal into which the first pari passu A-note is placed — has control; or a majority of such B-piece investors in trusts where all the remaining A-notes are placed has control.

“By having all these people involved, the additional time could lead to additional losses,” Chambers says, pointing to Fitch's research that shows the longer it takes for loans to be worked out, the greater the losses will be to bondholders and the servicers of the deals.

If a loan's been delinquent, the advancement of payments will still be made and bond holders will continue to receive interest payments, “but at some point, the servicer may stop advancing,” Chambers says.

Another potential dilemma, analysts say, is that a problem with a loan might not occur until five or six years after the pari passu structure was created. In what financial shape will investors and servicers be down the road? Will some of the B-piece investors still be around?

Exacerbating the problem is that loans are being cut up into too many pieces, analysts say. In the case of the Venetian deal, the loan was carved into six A-pieces. That's far too many, emphasizes Pendergast of RBS Greenwich Capital. Ideally, investors are looking for two pieces at most, she says.

Double-Edged Sword

B-piece investors acknowledge the potential problems in the structure, but remain thankful that pari passu came into existence. “It is absolutely a good thing as far as we're concerned,” says Larry Duggins, president of ARCap REIT Inc., a major B-piece buyer based in Irving, Texas.

“The concept of being able to take large investment-grade or near investment-grade assets and put them into CMBS transactions is very supportive. It gets you high-quality collateral, and lets CMBS lenders compete with insurance companies and pension funds,” adds Duggins.

Because investors are no longer comfortable with including a large loan on a major commercial building in a CMBS deal, the only option is to cut it up into several pieces, the theory goes. Otherwise, insurance companies and pension funds will remain the only lenders willing to assume the risk on such single-asset mortgages.

With pari passu, investors and lenders have once again become comfortable with placing large loans in CMBS deals, as evidenced by the recent $1.3 billion CMBS deal led by Deutsche Bank Securities Inc., which includes a piece of the $314 million A-note on the Bloomberg headquarters office building in Manhattan.

Daniel Shindleman, a director of the European office of Bridgemer Investment Properties, which represents B-piece investors, says the “[pari passu] concept is a very good one, but like all good concepts it needs some time to work out some issues.”

Possible Solutions

ARCap has come up with a proposal endorsed by most major rating agencies that aims to tighten up the structure. The gist of ARCap's proposal is that the B-piece investor of the first trust in which one of pari passu pieces is transferred has the option, but not the obligation, to also own the most subordinate piece of the large loan — whether it is a B-note or a C-note.

If the first B-piece investor doesn't want the subordinate piece, the option moves to the next B-piece investor. In the end, one of the B-piece investors must assume control of the B-note on the large loan. “They're trying to tie the risk in with the control,” says Chambers of Fitch Ratings.

In short, the proposal attempts to standardize who assumes control in the event of a workout. It also aims to make the process of assigning control more equitable.

ARCap's Duggins says the problem now is that the process just rewards the first person in the door (who is the majority investor in the CMBS deal where the first pari passu piece is placed). At least ARCap's proposal gives the B-piece investor, who would now hold the subordinate piece of the large loan, economic incentive to govern the control process, Duggins says.

“The idea is that this is one alternative that is acceptable to the B-piece guys and the rating agencies. It's not the only one that will get used,” Duggins says.

An Evolving Process

As time goes on, the pari passu structure might evolve like the syndicated loan structure did, where restrictions were made on transferability of shares, Shindleman of Bridgmer says. A borrower could put restrictions on the loan, for example. B-piece buyers could put restrictions on other B-piece buyers. Perhaps only buyers from a certain B-piece list would be allowed to participate. “But that's only anti-competitive,” Shindleman argues, since it shields out potential investors.

But what could be done within the scope of the law, Shindleman says, is that like a syndicator a lender could mandate that “anyone can be a B-piece holder so long as they meet a certain criteria.”

The upshot is that the pari passu structure requires investors to pay closer attention to the fine print in their CMBS loan agreements. “It's not necessarily a disaster, it's just more wear and tear on the investor,” says Pendergast of RBS Greenwich Capital.

Stafford of Dominion Bond Rating Service takes a similar position. “As long as the credit quality on the loans remains high … such as investment-grade … then the risk of all these things that could happen remains low,” she says. “[Pari passu] is here to stay, but nuisances are still evolving.”

Nicholas Yulico is a San Francisco-based writer.

CMBS Glossary of Terms

“A” note: A term that is used to represent the senior note when a whole loan has been bifurcated into one or more notes, in which payment priority may be shared with a subordinate “B” note. However, in the event of loan default the “B” note is subordinate to the senior “A” note and as such will absorb losses first. In a pari passu structure, the “A” note is segmented into several pieces that share payment priority and will incur losses proportionately.

“A” Pieces: Security classes, or tranches, that are rated as investment-grade and are deemed appropriate for institutional investors. Also referred to as senior pieces.

“B” Pieces: A term applied to the classes or tranches of commercial mortgage-backed securities (CMBS) rated double-B and lower. Also called “BIG,” or below-investment grade.

Master Servicer: A firm engaged to service mortgage loans collateralizing a CMBS on behalf and for the benefit of the certificate holders.

Special Servicer: Some transactions have a separate special servicer, in addition to the master servicer, who is responsible for managing loans that go into default and who conduct the “workout,” or foreclosure process.

Sources: CMSA, Dominion Bond Rating Service