The worst of the global financial crisis may be past, and we may even be well on the road to economic recovery, but there still may be considerable pain yet to come, particularly in connection with commercial mortgages. Increased vacancies, declining property values and shortages of refinancing capital could mean increasing numbers of commercial mortgage defaults ahead.
These problems could spell trouble for banks holding commercial mortgage loans, as well as for those who invested in securities backed by commercial mortgages (CMBS). These problems likely will lead to commercial mortgage-related litigation, in what may be the final surge in the credit crisis-related litigation wave.
Background
The business pages recently have been full of tales of commercial mortgage defaults. For example, an October 6, 2009, Bloomberg article (here) reported that hotel foreclosures in California tripled in the first half of this year. An October 13, 2009 Wall Street Journal article (here) reports that declining hotel room demand in Hawaii "means a number of Hawaii’s resorts no longer generate enough revenue to pay the mortgage" and overall Hawaii’s distressed debt tied to hotels totals nearly $1.6 billion.
Similarly an October 15, 2009 Wall Street Journal article (here) detailed the danger of default on the massive mortgage debt of the Peter Cooper Village and Stuyvesant Town properties, which the article noted could "signal[] the beginning of what is expected to be a wave of commercial property failures." The lead article on the front page of the October 16, 2009 Cleveland Plain Dealer asks the question "Will Bad Commercial Loans Leave Cleveland Area Banks Targets" (here).
An August 31, 2009 Wall Street Journal article entitled "Commercial Real Estate Lurks as Next Potential Mortgage Crisis" (here) explores the sources of the problems in the commercial mortgage sector. Many of the mortgage-related problems "are simply the result of bad underwriting." The Wall Street "CMBS machine" lent owners money "on the assumption that occupancy and rents of their office buildings, hotels, stores or other commercial property would keep rising," but now "a growing number of properties aren’t generating enough cash to make principal and interest payments."
Another source of difficulty is that property owners are unable to refinance as mortgages come due. The August 31 Journal article reports that by the end of 2012, $153 billion in loans that make up CMBS are coming due, and as much as $100 billion will face difficulty in refinancing.
Declining property values are contributing to the problem. According to Bloomberg (here), commercial property prices have fallen 39 percent since their 2007 peak. As the Journal article notes, the property values have "fallen so far that borrowers won’t be able to extend existing mortgages or replace them with new debt."
All of this spells serious trouble for already struggling banks. Banks hold $1.8 trillion in commercial mortgages and construction loans, and as the Journal notes, "delinquencies on this debt already have played a role in the increase in bank failures this year."
Indeed, banks’ exposure to commercial mortgage losses is a serious concern for banking regulators, particularly since banks have been "slow to take losses on their commercial real estate loans," according to an October 7, 2009 Wall Street Journal article (here). According to one analysis quoted in the article, banks with heavy exposure to real estate loans have set aside just 38 cents in reserves during the second quarter for every $1 of bad loans. As the Journal article notes, "the recession combined with inadequate loan loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real estate market."
A significant amount of commercial mortgage debt is also held by the pools backing the CMBS. According to an October 2009 memorandum from the Robbins, Kaplan, Miller & Ciresi law firm entitled "Caught in the Credit Crunch: An Investigation into Commercial Mortgage Backed Securities" (here), there was nearly $650 billion in CMBS issuance during the period 2005 to 2007, at the same time as there was a "dramatic decrease in the underwriting standards for commercial mortgages." The recent problems in the commercial real estate sector have "resulted in more loan defaults and potentially significant losses for CMBS investors."
Potential Litigation
The commercial mortgage woes have already led to a certain amount of litigation. By far the most significant number of lawsuits growing out of commercial mortgage problems involves the handful of cases where companies and their directors and officers have been sued by the company’s own shareholders for alleged misrepresentations or omissions about the company’s ability to support its mortgage debt or commercial property acquisition debt obligations. Examples of the companies involved in these kinds of lawsuits include General Growth Properties (about which refer here); Station Casinos (refer here); Perini Corporation (refer here); and MGM Mirage (refer here).
There may well be more of this type of shareholder or investor driven "commercial mortgage disclosure" litigation ahead, as commercial mortgage defaults continue to emerge in the months ahead.
There also seems to be every prospect for litigation to emerge in the wake of bank failures caused by commercial mortgage defaults. There certainly has already been considerable litigation following in the wake of bank failures driven by residential mortgage losses. Example of this kind of residential mortgage-related failed bank litigation include the lawsuits filed by the shareholders of Corus Bank (refer here) and Pacific Capital Bancorp (refer here). At this point, it seems prudent to expect that as rising commercial mortgage defaults lead to further bank failures that there would be similar failed bank litigation pertaining to the banks’ commercial mortgage losses.
The more interesting question may be whether there will be investor litigation relating to the CMBS. The Robins Kaplan memo linked above notes that "while there hasn’t yet been much specific CMBS litigation yet," as the CMBS mature over the next few years, litigation could arise similar to the many lawsuits that have emerged involving residential mortgage backed securities (RMBS).
The law firm memo does go on to note that there could be some practical considerations that could forestall, or at least complicate, prospective CMBS-related litigation. For example, the memo notes, CMBS offering documents "generally have substantially more property specific information" than for example typically was found in RMBS offering documents, which "may eliminate" omission-based claims of the type that have been asserted in RMBS-related litigation.
In addition, as time passes, CMBS investors’ ability to bring ’33 Act claims based on alleged misrepresentations or omissions in the offering documents may face statute of limitations constraints. Indeed, given that the CMBS marketplace ground to a halt in after the financial crisis in September 2008, we may already be past the point where CMBS investors will even have the option to pursue ’33 Act claims alleging misrepresentations or omission in the offering documents, due to the operation of the applicable one-year statute of limitations.
Nevertheless, and despite these litigation impediments, as growing defaults mean mounting losses for CMBS investors, the aggrieved investors likely will seek alternative theories on which to pursue claims, including, for example, common law fraud or misrepresentation. A long-running CMBS lawsuit now being pursued against the Cadwalader law firm and related to a 1997 CMBS offering (about which refer here) dramatically underscores how far into the future the litigation threat may extend. Moreover, if the commercial mortgage-related losses prove to be anywhere near the current theoretical potential, investors will have substantial incentives to pursue claims, even if it means relying on a wider array of legal theories in order to assert their claims.
All of which suggests that there may yet be a further surge of credit crisis-related lawsuits before the credit crisis litigation wave has finally played itself out.