WEBVTT 00:00:00.000 --> 00:00:02.560 I want you to try something for me. If you can, 00:00:02.700 --> 00:00:04.459 just close your eyes for a second. But please, 00:00:04.559 --> 00:00:06.559 if you're driving, do not close your eyes. Definitely 00:00:06.559 --> 00:00:09.839 don't do that. Yeah, no, seriously. But for everyone 00:00:09.839 --> 00:00:12.939 else, imagine you are standing on a street corner, 00:00:13.160 --> 00:00:15.839 maybe in the middle of a huge metropolis. Let's 00:00:15.839 --> 00:00:18.699 say midtown Manhattan or the city of London or 00:00:18.699 --> 00:00:20.440 Chicago. You're just standing there. You can 00:00:20.440 --> 00:00:22.820 feel the wind. You can hear the traffic. And 00:00:22.820 --> 00:00:25.920 you look up. What do you see? Well, the obvious 00:00:25.920 --> 00:00:30.750 answer is the skyline. You see... Concrete, acres 00:00:30.750 --> 00:00:33.909 and acres of glass, steel beams going up into 00:00:33.909 --> 00:00:37.210 the sky. Skyscrapers. Skyscrapers. Massive shopping 00:00:37.210 --> 00:00:39.649 centers. Maybe one of those sprawling apartment 00:00:39.649 --> 00:00:42.030 complexes that just takes up an entire city block. 00:00:42.509 --> 00:00:44.950 Exactly. You see the physical city, you know, 00:00:44.969 --> 00:00:46.890 the hardware. But here's the thing. For this 00:00:46.890 --> 00:00:48.850 deep dive, I want to hand you a special pair 00:00:48.850 --> 00:00:50.609 of glasses. We'll call them finance glasses. 00:00:51.049 --> 00:00:53.850 And the moment you put these on, that skyline. 00:00:54.560 --> 00:00:57.200 It just completely changes. Oh, yeah. Those buildings 00:00:57.200 --> 00:00:59.560 aren't just piles of concrete and steel anymore. 00:00:59.619 --> 00:01:02.520 They're not just architecture. No. Through those 00:01:02.520 --> 00:01:04.939 glasses, they look like something else entirely. 00:01:05.359 --> 00:01:07.579 They look like, I don't know, financial instruments. 00:01:07.879 --> 00:01:10.099 Precisely. Every single one of those towers, 00:01:10.219 --> 00:01:13.420 every mall, every apartment block, it represents 00:01:13.420 --> 00:01:17.620 a massive, massive bundle of debt. And that debt 00:01:17.620 --> 00:01:20.590 is wrapped up. It's sliced into these tiny little 00:01:20.590 --> 00:01:23.689 pieces and then sold to investors all over the 00:01:23.689 --> 00:01:25.829 world. We're not just looking at buildings. We're 00:01:25.829 --> 00:01:28.730 looking at securitization. That is the word. 00:01:30.299 --> 00:01:32.099 And that brings us right to the topic we are 00:01:32.099 --> 00:01:34.879 really going to unpack today. It's an acronym 00:01:34.879 --> 00:01:36.980 that, you know, it completely dominates the commercial 00:01:36.980 --> 00:01:39.959 real estate world. But most people outside of 00:01:39.959 --> 00:01:41.780 high finance have probably never really looked 00:01:41.780 --> 00:01:43.900 under the hood. We are talking about commercial 00:01:43.900 --> 00:01:47.659 mortgage -backed securities. Or CMBS. CMBS. Now, 00:01:47.760 --> 00:01:50.019 I know what you might be thinking. That sounds 00:01:50.019 --> 00:01:52.239 like the driest, most technical topic you could 00:01:52.239 --> 00:01:54.060 possibly choose. But here's our mission today. 00:01:54.620 --> 00:01:57.120 We want to prove that this is actually the hidden 00:01:57.120 --> 00:01:59.560 operating system of the modern city. That's a 00:01:59.560 --> 00:02:01.519 great way to put it. It's the machinery that 00:02:01.519 --> 00:02:05.000 decides what gets built, what stays open, and 00:02:05.000 --> 00:02:07.480 who actually owns the places where we all work 00:02:07.480 --> 00:02:10.520 and shop. And it is a machine that operates by 00:02:10.520 --> 00:02:13.699 a completely different set of rules than, say, 00:02:13.860 --> 00:02:16.259 the mortgage on your house. Oh, totally different. 00:02:16.379 --> 00:02:18.400 That's the critical thing to understand from 00:02:18.400 --> 00:02:21.000 the get -go. If you think you know how mortgages 00:02:21.000 --> 00:02:23.659 work because you bought a house once, you really 00:02:23.659 --> 00:02:25.360 need to just kind of throw that knowledge out 00:02:25.360 --> 00:02:27.439 the window. CMBS is a different beast entirely. 00:02:27.979 --> 00:02:29.800 So we are going to strip this whole thing down 00:02:29.800 --> 00:02:32.340 to the studs. We have a massive stack of source 00:02:32.340 --> 00:02:34.659 material here. I mean, we've got technical documentation. 00:02:34.879 --> 00:02:38.879 We have industry definitions, structural classifications, 00:02:38.979 --> 00:02:41.800 legal frameworks. We are going to use all of 00:02:41.800 --> 00:02:44.860 this to decode how a billion dollar mall gets 00:02:44.860 --> 00:02:48.479 funded, who gets paid, and maybe most importantly. 00:02:48.990 --> 00:02:51.069 What happens when the money stops flowing? Exactly. 00:02:51.270 --> 00:02:53.210 And it's a journey. Honestly, we're going to 00:02:53.210 --> 00:02:56.210 go from like the basement plumbing of tax law, 00:02:56.310 --> 00:02:59.210 which is surprisingly dramatic. I'm intrigued 00:02:59.210 --> 00:03:01.289 already. All the way up to the penthouse where 00:03:01.289 --> 00:03:03.810 the masters of the universe sit and make these 00:03:03.810 --> 00:03:06.270 decisions that affect entire neighborhoods, entire 00:03:06.270 --> 00:03:09.789 cities. OK, so let's start at square one. The 00:03:09.789 --> 00:03:11.969 absolute basics. We've got these documents in 00:03:11.969 --> 00:03:14.930 front of us. How does the source material actually 00:03:14.930 --> 00:03:18.810 define a CMBS? At its simplest level, and this 00:03:18.810 --> 00:03:21.550 is the starting point, the source defines a commercial 00:03:21.550 --> 00:03:24.610 mortgage -backed security as a type of mortgage 00:03:24.610 --> 00:03:27.969 -backed security that is secured by, and this 00:03:27.969 --> 00:03:30.569 is the key phrase, commercial and multifamily 00:03:30.569 --> 00:03:33.680 mortgages. Commercial and multifamily. I want 00:03:33.680 --> 00:03:35.159 to stop there immediately because that feels 00:03:35.159 --> 00:03:37.400 like the huge fork in the road. We need to contrast 00:03:37.400 --> 00:03:40.039 this with what most people know, which is RMBS. 00:03:40.560 --> 00:03:42.379 Residential Mortgage -Backed Securities. Right. 00:03:42.520 --> 00:03:44.400 And I really feel like we can't overstate this 00:03:44.400 --> 00:03:47.319 distinction. When people hear MBS or Mortgage 00:03:47.319 --> 00:03:49.620 -Backed Security, their brains go straight to 00:03:49.620 --> 00:03:52.360 the big short. Yeah, 2008. They think about 2008. 00:03:52.580 --> 00:03:54.180 They think about all those suburban houses in 00:03:54.180 --> 00:03:56.659 Florida or California. But we are not talking 00:03:56.659 --> 00:03:59.000 about single -family homes with a white picket 00:03:59.000 --> 00:04:01.479 fence and a golden retriever in the yard. talking 00:04:01.479 --> 00:04:04.199 about business assets. That is the fundamental 00:04:04.199 --> 00:04:06.500 divide. And that's really, you know, section 00:04:06.500 --> 00:04:09.039 one of our deep dive today. You have to understand 00:04:09.039 --> 00:04:11.659 that you cannot treat these two things, residential 00:04:11.659 --> 00:04:14.539 and commercial, the same way. Yeah. They are. 00:04:14.740 --> 00:04:17.120 They're different species. So let's break down 00:04:17.120 --> 00:04:19.379 that asset class distinction a bit more. When 00:04:19.379 --> 00:04:22.100 we talk about the residential side, the RMBS, 00:04:22.439 --> 00:04:24.300 what are we really looking at? What's in that 00:04:24.300 --> 00:04:28.199 bundle? In an RMBS deal, The bundle or the pool 00:04:28.199 --> 00:04:30.939 of loans is made up of home loans. So you're 00:04:30.939 --> 00:04:32.920 thinking of, I don't know, 1 ,000, maybe 5 ,000, 00:04:32.939 --> 00:04:35.019 just regular people. Regular homeowners. Yeah, 00:04:35.019 --> 00:04:36.360 they live in the suburbs. They have 30 -year 00:04:36.360 --> 00:04:38.639 mortgages. And the mechanism is pretty simple, 00:04:38.699 --> 00:04:41.500 right? The investors who buy those bonds, they 00:04:41.500 --> 00:04:43.800 benefit from the mortgage payments and the interest 00:04:43.800 --> 00:04:45.480 that's paid by all those homeowners every month. 00:04:45.639 --> 00:04:48.100 So effectively, if I buy a residential bond, 00:04:48.360 --> 00:04:50.819 I'm basically betting that John Smith in Ohio 00:04:50.819 --> 00:04:53.540 is going to keep his job. Right. And Jane Doe 00:04:53.540 --> 00:04:55.660 in Texas is going to keep her job and they're 00:04:55.660 --> 00:04:57.759 both going to pay their bills on time. Correct. 00:04:58.399 --> 00:05:02.480 You are betting on the credit worthiness. of 00:05:02.480 --> 00:05:04.699 thousands of individuals. You are betting on 00:05:04.699 --> 00:05:07.500 the American homeowner. OK, but now shift your 00:05:07.500 --> 00:05:11.000 gaze. Let's look at CMBS. The source material 00:05:11.000 --> 00:05:14.019 lists some examples. What are they? office buildings, 00:05:14.360 --> 00:05:17.240 retail stores, shopping centers, and apartment 00:05:17.240 --> 00:05:20.019 complexes. And this leads us to what the source 00:05:20.019 --> 00:05:22.240 called the cash flow nuance. And this is something 00:05:22.240 --> 00:05:24.360 I really want to dig into because it just feels 00:05:24.360 --> 00:05:26.459 like it changes how you have to assess the risk 00:05:26.459 --> 00:05:28.339 of the whole thing. It changes everything. Why 00:05:28.339 --> 00:05:31.019 is an apartment complex or a shopping mall fundamentally 00:05:31.019 --> 00:05:33.660 different from John Smith's house? Well, it all 00:05:33.660 --> 00:05:36.639 comes down to where the money is coming from. 00:05:36.920 --> 00:05:39.660 In a residential loan, the source of the payment 00:05:39.660 --> 00:05:42.100 is usually a salary. You know, you go to work, 00:05:42.139 --> 00:05:44.160 you get a paycheck, you pay the bank. It's personal 00:05:44.160 --> 00:05:47.480 income. Simple enough. But with CMBS, the source 00:05:47.480 --> 00:05:49.899 explicitly states that the security provides 00:05:49.899 --> 00:05:52.779 investors with cash flow from the income these 00:05:52.779 --> 00:05:55.259 properties generate. Ah, so the building itself 00:05:55.259 --> 00:05:58.019 has to earn its own keep. It has to have a job. 00:05:58.060 --> 00:06:00.079 It's an economic entity. An apartment complex 00:06:00.079 --> 00:06:02.639 isn't just a place to sleep. It's a rental business. 00:06:02.959 --> 00:06:05.300 An office building is a space leasing business. 00:06:05.839 --> 00:06:09.279 A shopping mall is a retail hub. So if the businesses 00:06:09.279 --> 00:06:12.399 inside the building fail, the loan itself fails. 00:06:12.800 --> 00:06:15.319 That's the risk. It feels like a massive shift 00:06:15.319 --> 00:06:18.199 in mindset, right? You're not betting on a person's 00:06:18.199 --> 00:06:20.879 moral obligation to pay for their shelter. You 00:06:20.879 --> 00:06:23.839 are betting on the economic viability of a specific 00:06:23.839 --> 00:06:26.139 business model. You're analyzing a business. 00:06:26.439 --> 00:06:28.779 If you lend money to a shopping mall, you couldn't 00:06:28.779 --> 00:06:30.759 care less about the owner's salary. You don't 00:06:30.759 --> 00:06:33.889 care at all. You care about is the gap selling 00:06:33.889 --> 00:06:36.850 enough jeans? Is the food court busy on a Saturday? 00:06:37.029 --> 00:06:39.689 Are people still physically going to malls or 00:06:39.689 --> 00:06:41.790 are they just shopping on Amazon? Which means 00:06:41.790 --> 00:06:44.310 the risk is tied to the brighter economy in a 00:06:44.310 --> 00:06:47.050 much, much more direct and volatile way. And 00:06:47.050 --> 00:06:48.769 that leads right to the next point in the source 00:06:48.769 --> 00:06:52.689 material, complexity and volatility. The source 00:06:52.689 --> 00:06:55.089 makes a really specific claim here. It says that 00:06:55.089 --> 00:06:57.949 CMBS tend to be more complex and volatile than 00:06:57.949 --> 00:07:00.050 residential securities. You know, that might 00:07:00.050 --> 00:07:02.189 sound counterintuitive to some people. You'd 00:07:02.189 --> 00:07:05.009 think a massive skyscraper is somehow safer than 00:07:05.009 --> 00:07:07.290 just some random house in the suburbs. So why 00:07:07.290 --> 00:07:09.389 does the source say it's more volatile? It's 00:07:09.389 --> 00:07:12.250 because of, and this is a quote, the unique nature 00:07:12.250 --> 00:07:15.709 of the underlying property assets. Think about 00:07:15.709 --> 00:07:18.810 housing for a second. It's kind of commoditized. 00:07:19.089 --> 00:07:20.730 Standardized. It's a standardized product. A 00:07:20.730 --> 00:07:24.129 three -bedroom house in a suburb of Dallas is 00:07:24.129 --> 00:07:27.170 economically very, very similar to a three -bedroom 00:07:27.170 --> 00:07:30.250 house in a suburb of Atlanta. The risks are similar. 00:07:30.410 --> 00:07:32.870 The buyer profile is similar. You can model it 00:07:32.870 --> 00:07:35.110 pretty easily. But commercial properties? They're 00:07:35.110 --> 00:07:37.310 snowflakes. Yeah. Every single one is unique. 00:07:37.529 --> 00:07:39.449 Can you give me an example of that snowflake 00:07:39.449 --> 00:07:41.970 nature, just to make it concrete? Sure. Take 00:07:41.970 --> 00:07:44.910 a hotel on Miami Beach versus, say, a coal storage 00:07:44.910 --> 00:07:47.470 warehouse in North Dakota. Okay. Both are commercial 00:07:47.470 --> 00:07:51.129 real estate. But the hotel relies on tourism. 00:07:51.769 --> 00:07:55.149 On the weather, on discretionary spending, airline 00:07:55.149 --> 00:07:57.829 ticket prices, travel trends. A million different 00:07:57.829 --> 00:08:00.509 inputs. A million. The warehouse, on the other 00:08:00.509 --> 00:08:04.050 hand, it relies on logistics supply chains. Maybe 00:08:04.050 --> 00:08:06.310 agricultural yields from the surrounding farms 00:08:06.310 --> 00:08:08.949 or trucking routes and fuel costs. And a shopping 00:08:08.949 --> 00:08:11.550 mall in Ohio faces totally different risks than 00:08:11.550 --> 00:08:14.389 a high -rise office tower in Manhattan. Completely 00:08:14.389 --> 00:08:16.649 different worlds. Yeah. If you own an office 00:08:16.649 --> 00:08:19.889 tower right now, you are worried about tech companies 00:08:19.889 --> 00:08:22.899 downsizing. And the work from home trend. Right. 00:08:23.040 --> 00:08:25.379 Is my building going to be empty? But if you 00:08:25.379 --> 00:08:27.600 own that mall, you're worried about a big department 00:08:27.600 --> 00:08:29.899 store like Macy's going bankrupt and leaving 00:08:29.899 --> 00:08:32.899 a giant hole in your property. Each property 00:08:32.899 --> 00:08:36.080 is a unique business entity with its own management 00:08:36.080 --> 00:08:39.100 team, its own specific list of tenants and its 00:08:39.100 --> 00:08:41.759 own local economic drivers. So you can't just 00:08:41.759 --> 00:08:45.259 run a simple algorithm across 10 ,000 of them 00:08:45.259 --> 00:08:47.710 and say this is a safe bet. You have to actually 00:08:47.710 --> 00:08:50.269 understand the story of each building. You do, 00:08:50.429 --> 00:08:53.129 which makes the securitization, the bundling 00:08:53.129 --> 00:08:55.789 of all these different loans so much more complex. 00:08:55.909 --> 00:08:57.730 You're trying to bundle together a lot of very, 00:08:57.809 --> 00:09:00.289 very different stories into one portfolio. OK, 00:09:00.350 --> 00:09:02.690 so we have established the playing field. We're 00:09:02.690 --> 00:09:05.190 dealing with business assets, not homes. They 00:09:05.190 --> 00:09:07.169 are complex. They're unique. They rely on cash 00:09:07.169 --> 00:09:09.429 flow, not salaries. Now, I want to get into the 00:09:09.429 --> 00:09:11.370 mechanics. How do they actually build this machine? 00:09:11.590 --> 00:09:14.210 And that brings us to section two of our outline, 00:09:14.409 --> 00:09:16.350 the structure. This is where we get into the 00:09:16.350 --> 00:09:18.769 plumbing. And I'll warn you, it sounds technical, 00:09:18.809 --> 00:09:21.830 but it's actually fascinating because it's designed 00:09:21.830 --> 00:09:26.049 to solve a huge fundamental problem. I saw a 00:09:26.049 --> 00:09:28.799 term in the source material that just it. immediately 00:09:28.799 --> 00:09:30.460 stuck out to me. It sounds like a character from 00:09:30.460 --> 00:09:34.039 a sci -fi movie or maybe a piece of heavy artillery. 00:09:34.440 --> 00:09:38.159 The ARAMEC. The ARAMEC, yes. It stands for a 00:09:38.159 --> 00:09:41.539 Real Estate Mortgage Investment Conduit. A conduit. 00:09:41.720 --> 00:09:44.200 That is such an interesting word choice. A conduit 00:09:44.200 --> 00:09:46.279 is just a pipe, right? Something flows through 00:09:46.279 --> 00:09:48.340 it. That is the perfect visualization, and you 00:09:48.340 --> 00:09:50.399 should absolutely hold on to that. The source 00:09:50.399 --> 00:09:52.600 explains that the typical structure for these 00:09:52.600 --> 00:09:56.120 securitizations is a REMEC. which isn't a company 00:09:56.120 --> 00:09:58.179 in the traditional sense. It's a creation of 00:09:58.179 --> 00:10:00.899 tax law. Okay, hold on. Why do they need a special 00:10:00.899 --> 00:10:04.019 creation of tax law? Why can't a bank just put 00:10:04.019 --> 00:10:05.840 a bunch of loans in a bucket, call it the big 00:10:05.840 --> 00:10:08.179 bucket of loans incorporated, and then sell shares 00:10:08.179 --> 00:10:10.679 in it? They could, but they would immediately 00:10:10.679 --> 00:10:13.159 run into a giant wall called double taxation. 00:10:13.500 --> 00:10:15.399 And I want to stick on this for a second because 00:10:15.399 --> 00:10:18.039 I feel like this is where regular people's eyes 00:10:18.039 --> 00:10:20.120 just glaze over, but it's actually the entire 00:10:20.120 --> 00:10:22.940 reason this market can even exist. It is. It's 00:10:22.940 --> 00:10:25.690 the linchpin. Think about it like this. If you 00:10:25.690 --> 00:10:28.149 and I start a regular business, let's say it's 00:10:28.149 --> 00:10:30.610 a lemonade stand, and that business makes a profit. 00:10:30.809 --> 00:10:34.549 Okay. The IRS taxes that profit. That's corporate 00:10:34.549 --> 00:10:38.110 tax. Right. Step one, the business pays tax on 00:10:38.110 --> 00:10:40.590 what it made. Then, from the money that's left 00:10:40.590 --> 00:10:43.129 over, we pay ourselves a dividend, we take that 00:10:43.129 --> 00:10:46.190 profit home, the IRS then taxes us on that income. 00:10:46.309 --> 00:10:48.470 That's personal income tax. So the same dollar 00:10:48.470 --> 00:10:51.500 got taxed twice. Once when the business earned 00:10:51.500 --> 00:10:53.059 it and a second time when I put it in my pocket. 00:10:53.220 --> 00:10:55.240 Exactly. And for a lemonade stand, you know, 00:10:55.240 --> 00:10:57.100 maybe that's annoying, but it's fine. But if 00:10:57.100 --> 00:10:59.139 you're trying to move billions of dollars in 00:10:59.139 --> 00:11:00.919 mortgage interest payments around the globe, 00:11:01.039 --> 00:11:03.799 it's a complete deal breaker. It kills the return. 00:11:04.139 --> 00:11:06.320 Completely. Wall Street looked at that and said, 00:11:06.360 --> 00:11:09.519 we cannot lose 21 percent or 30 percent or whatever 00:11:09.519 --> 00:11:12.080 the rate is of the yield just because the money 00:11:12.080 --> 00:11:15.299 sat in a holding company for five minutes. It 00:11:15.299 --> 00:11:17.899 makes the entire investment unappealing. So they 00:11:17.899 --> 00:11:20.049 needed a loophole. Well, maybe not a loophole, 00:11:20.090 --> 00:11:23.929 but a very specific vehicle, the Aramic. And 00:11:23.929 --> 00:11:26.389 the source notes that the Aramic is a pass -through 00:11:26.389 --> 00:11:29.289 entity. It is not subject to tax at the trust 00:11:29.289 --> 00:11:32.090 level. So it's basically a ghost. It's a robot 00:11:32.090 --> 00:11:35.090 that the IRS agrees to ignore. As long as that 00:11:35.090 --> 00:11:37.590 robot follows a very, very strict set of rules, 00:11:37.830 --> 00:11:40.389 it can't run a business, it can't buy new buildings, 00:11:40.549 --> 00:11:43.070 it can only passively hold these specific loans, 00:11:43.289 --> 00:11:46.070 the IRS just pretends it doesn't exist. The tax 00:11:46.070 --> 00:11:48.629 liability just passes through it. Passes right 00:11:48.629 --> 00:11:50.470 through to the investors. So the money flows 00:11:50.470 --> 00:11:53.029 from the mall owner into the ERMIC and straight 00:11:53.029 --> 00:11:55.389 out to the bondholder. And the ERMIC itself doesn't 00:11:55.389 --> 00:11:57.669 take a cut for taxes. It's just a pipeline. A 00:11:57.669 --> 00:12:00.549 pure conduit. And that efficiency is what makes 00:12:00.549 --> 00:12:02.610 the math work for everyone. That makes a ton 00:12:02.610 --> 00:12:04.809 of sense. It's all about preserving the yield 00:12:04.809 --> 00:12:07.610 for the investor. Speaking of yield, you know, 00:12:07.610 --> 00:12:09.929 getting paid. Let's talk about the interest rates. 00:12:10.029 --> 00:12:12.350 The source breaks this down into two main buckets, 00:12:12.669 --> 00:12:16.049 fixed rate and floating rate. Right. And this 00:12:16.049 --> 00:12:18.049 is all about how the investor actually gets the 00:12:18.049 --> 00:12:21.110 return. Fixed seems simple enough. It's a standard 00:12:21.110 --> 00:12:23.190 percentage. You know what you're getting. Yeah. 00:12:23.230 --> 00:12:25.450 You buy the bond. The bond says, I will pay you 00:12:25.450 --> 00:12:28.919 5 % a year. Simple, predictable. Easy to model. 00:12:29.200 --> 00:12:31.820 But the floating rate is where things get a bit 00:12:31.820 --> 00:12:34.539 more dynamic. The source says this is based on 00:12:34.539 --> 00:12:37.379 a benchmark plus spread. And it mentions a couple 00:12:37.379 --> 00:12:41.350 of specific benchmarks. LIBOR or EUROBOR. Right. 00:12:41.429 --> 00:12:43.889 The London Interbank offered rate and the Euro 00:12:43.889 --> 00:12:46.590 Interbank offered rate. Now, we should also mention 00:12:46.590 --> 00:12:49.289 that those specific benchmarks have been evolving 00:12:49.289 --> 00:12:51.850 and changing over time. But the concept is what 00:12:51.850 --> 00:12:53.690 really matters. The concept is that the interest 00:12:53.690 --> 00:12:56.690 rate moves. It floats. Exactly. So if the benchmark 00:12:56.690 --> 00:12:59.470 rate in the wider economy goes up, the bond starts 00:12:59.470 --> 00:13:02.470 paying more. If it goes down. The bond pays less. 00:13:02.629 --> 00:13:05.950 And this connects directly to the loan term categories 00:13:05.950 --> 00:13:08.009 that are mentioned in the text. You have to ask 00:13:08.009 --> 00:13:10.629 yourself, why would a borrower choose a floating 00:13:10.629 --> 00:13:13.110 rate versus a fixed rate? What's the strategy? 00:13:13.389 --> 00:13:15.190 I noticed that distinction in the source, too. 00:13:15.350 --> 00:13:18.389 It separates things into like the long game versus 00:13:18.389 --> 00:13:20.629 the short game. Let's look at the longer term 00:13:20.629 --> 00:13:23.529 loans first. The source defines these as five 00:13:23.529 --> 00:13:25.899 years or longer. And these are typically for 00:13:25.899 --> 00:13:28.500 the stabilized properties. And what does stabilized 00:13:28.500 --> 00:13:31.980 mean in this context? Imagine a big, shiny office 00:13:31.980 --> 00:13:35.200 building in Chicago. It's fully built. It's 95 00:13:35.200 --> 00:13:38.200 % full of tenants. All the leases are signed 00:13:38.200 --> 00:13:40.679 for 10 years with big, credit -worthy companies. 00:13:41.100 --> 00:13:43.639 It's basically a boring, steady money printer. 00:13:43.860 --> 00:13:46.500 So that owner, they want certainty. They don't 00:13:46.500 --> 00:13:48.320 want any surprises. Right. They want a fixed 00:13:48.320 --> 00:13:50.820 rate. They want to know exactly what their mortgage 00:13:50.820 --> 00:13:52.700 payment is going to be for the next 10 years 00:13:52.700 --> 00:13:54.639 so they can budget their profit margins perfectly. 00:13:54.940 --> 00:13:57.039 They lock it in and forget about it. But then 00:13:57.039 --> 00:13:59.080 you have the shorter term loans. The source says 00:13:59.080 --> 00:14:01.259 one to three years. These are for the transitional 00:14:01.259 --> 00:14:03.480 properties. Let's say you're a developer named 00:14:03.480 --> 00:14:07.120 Bob and Bob buys an empty rundown warehouse. 00:14:07.399 --> 00:14:10.519 It's got no tenants. It's ugly. Bob's plan is 00:14:10.519 --> 00:14:13.220 to renovate it and turn it into hip, new loft 00:14:13.220 --> 00:14:15.919 apartments. So Bob doesn't want a 10 -year loan 00:14:15.919 --> 00:14:18.799 on an empty building. No, because Bob doesn't 00:14:18.799 --> 00:14:21.360 plan to own it for 10 years. He plans to fix 00:14:21.360 --> 00:14:24.879 it up in, say, 18 months, get it fully leased 00:14:24.879 --> 00:14:27.120 up with tenants, and then either sell it for 00:14:27.120 --> 00:14:30.639 a profit or refinance into a better long -term 00:14:30.639 --> 00:14:33.480 loan. So he needs flexibility. He needs flexibility. 00:14:33.480 --> 00:14:36.220 So he takes a short -term floating rate loan. 00:14:36.739 --> 00:14:39.340 He takes on the risk that interest rates might 00:14:39.340 --> 00:14:41.019 go up in the short term because what he really 00:14:41.019 --> 00:14:43.539 needs is the ability to get out of the loan easily. 00:14:43.740 --> 00:14:45.559 And the source notes a key difference in that 00:14:45.559 --> 00:14:48.460 flexibility, too. It says the shorter loans usually 00:14:48.460 --> 00:14:51.419 allow free early repayments. Right. So if Bob 00:14:51.419 --> 00:14:53.460 finishes his renovation project in 12 months 00:14:53.460 --> 00:14:55.820 instead of 18, he could just pay off a loan and 00:14:55.820 --> 00:14:58.340 walk away. No penalty. But the longer term loans, 00:14:58.519 --> 00:15:01.279 those fixed rate ones, that is a completely different 00:15:01.279 --> 00:15:03.559 story. And this brings us right to Section 3. 00:15:04.269 --> 00:15:07.049 The lockout. This is where the CMBS market gets 00:15:07.049 --> 00:15:09.409 really, really aggressive. This is where those 00:15:09.409 --> 00:15:12.149 finance glasses start to reveal some pretty heavy 00:15:12.149 --> 00:15:14.669 duty handcuffs on the borrower. The source sets 00:15:14.669 --> 00:15:16.250 up a scenario here that I think everyone can 00:15:16.250 --> 00:15:19.710 understand. In a regular home loan, generally 00:15:19.710 --> 00:15:22.490 you can pay it off early. If you win the lottery 00:15:22.490 --> 00:15:25.190 or you inherit some money, you just write a check 00:15:25.190 --> 00:15:27.289 to the bank, you pay off your mortgage and you 00:15:27.289 --> 00:15:29.490 have a party. You own your home free and clear. 00:15:29.649 --> 00:15:32.269 Right. Banks generally have to accept your money. 00:15:32.620 --> 00:15:34.220 I mean, there might be a tiny administrative 00:15:34.220 --> 00:15:37.299 fee or something, but prepayment is a right for 00:15:37.299 --> 00:15:40.080 most homeowners. But the source states, many 00:15:40.080 --> 00:15:43.360 American CMBS transactions carry less prepayment 00:15:43.360 --> 00:15:46.200 risk than other MBS types. Now, less prepayment 00:15:46.200 --> 00:15:49.559 risk is classic banker speak. It sounds like 00:15:49.559 --> 00:15:52.000 a positive thing. But what it actually means 00:15:52.000 --> 00:15:54.720 from the borrower's perspective is you are literally 00:15:54.720 --> 00:15:57.059 not allowed to pay us back. Wait, pause on that. 00:15:57.100 --> 00:15:59.440 That sounds insane. Why would a lender be mad 00:15:59.440 --> 00:16:01.320 about getting their money back early? If I lend 00:16:01.320 --> 00:16:03.139 you $100 and you give it back to me tomorrow, 00:16:03.279 --> 00:16:05.659 I should be happy. The risk is gone. But you're 00:16:05.659 --> 00:16:07.899 thinking like a person, not like an investor. 00:16:08.600 --> 00:16:10.500 Remember, these loans are all chopped up into 00:16:10.500 --> 00:16:12.720 bonds. So imagine you're a pension fund manager. 00:16:12.899 --> 00:16:15.259 You have a legal obligation to pay retirees for 00:16:15.259 --> 00:16:18.580 the next 10 years. You buy a 10 -year CMBS bond 00:16:18.580 --> 00:16:21.759 because it promises you a steady 5 % yield for 00:16:21.759 --> 00:16:25.159 a decade. You are counting on that specific cash 00:16:25.159 --> 00:16:27.639 flow. Okay, I see. I built my entire financial 00:16:27.639 --> 00:16:30.399 model, my budget, around that 5 % check coming 00:16:30.399 --> 00:16:32.940 in every single month for 10 years. Exactly. 00:16:33.179 --> 00:16:35.740 Now, what happens if the borrower pays a loan 00:16:35.740 --> 00:16:38.019 off in year two? Suddenly you have your principal 00:16:38.019 --> 00:16:41.139 cash back. Great, right. No. No, because now 00:16:41.139 --> 00:16:43.960 you have a giant pile of cash, but maybe in the 00:16:43.960 --> 00:16:46.200 meantime, interest rates have dropped. You can't 00:16:46.200 --> 00:16:48.419 just go out and find another safe 5 % return. 00:16:48.720 --> 00:16:51.000 Maybe the market is only offering 3 % now. So 00:16:51.000 --> 00:16:53.740 I have reinvestment risk. I lost my great deal. 00:16:54.269 --> 00:16:56.769 And now I can't meet my obligations to my pensioners. 00:16:56.830 --> 00:16:59.009 You lost your yield. And Wall Street hates losing 00:16:59.009 --> 00:17:01.350 yield. So the entire system is rigged to prevent 00:17:01.350 --> 00:17:03.490 that from happening. And the source outlines 00:17:03.490 --> 00:17:05.589 the specific mechanisms for this. It's called 00:17:05.589 --> 00:17:08.369 call protection. And the first and most blunt 00:17:08.369 --> 00:17:11.730 line of defense is the lockout provision. Which 00:17:11.730 --> 00:17:14.890 sounds exactly like what it is. It is. The source 00:17:14.890 --> 00:17:17.769 states it's typically a period of, say, one to 00:17:17.769 --> 00:17:20.630 five years where there can be no prepayment of 00:17:20.630 --> 00:17:23.710 the loan at all. Period. So even if I have the 00:17:23.710 --> 00:17:26.349 cash sitting in a suitcase and I walk into the 00:17:26.349 --> 00:17:28.190 bank and say, here, I want to clear my debt. 00:17:28.390 --> 00:17:31.990 The master servicer will politely return your 00:17:31.990 --> 00:17:35.309 check. They will say, I'm sorry, we contractually 00:17:35.309 --> 00:17:38.049 cannot accept this. You are locked out. You must 00:17:38.049 --> 00:17:40.789 stay in debt. That is just wild. You are forced 00:17:40.789 --> 00:17:42.450 to keep paying interest you don't want to pay. 00:17:42.650 --> 00:17:45.869 But what about after that initial period or in 00:17:45.869 --> 00:17:47.769 different structures? The source mentions two 00:17:47.769 --> 00:17:50.490 terms that sound incredibly technical. Defezins? 00:17:51.190 --> 00:17:54.170 And yield maintenance. These are the golden handcuffs. 00:17:54.289 --> 00:17:56.430 Yeah. Let's look at defesance first, because 00:17:56.430 --> 00:17:58.589 it is honestly one of the most bizarre concepts 00:17:58.589 --> 00:18:00.509 in all of finance if you haven't seen it before. 00:18:00.650 --> 00:18:02.289 It sounds like a spell from a fantasy novel. 00:18:02.509 --> 00:18:04.930 I cast defesance. It's effectively a financial 00:18:04.930 --> 00:18:07.349 transmutation spell. Let's say you own a mall. 00:18:07.690 --> 00:18:10.210 You're in year six of a 10 -year loan. You want 00:18:10.210 --> 00:18:11.970 to sell the mall to a new owner, so you need 00:18:11.970 --> 00:18:14.509 to clear the debt off the property. But you have 00:18:14.509 --> 00:18:16.630 a defesance clause. You can't just pay off the 00:18:16.630 --> 00:18:19.380 loan. So what do I have to do? You have to perform 00:18:19.380 --> 00:18:22.099 a substitution. The source calls it a pledge 00:18:22.099 --> 00:18:25.019 of substitute collateral. Here's how it works 00:18:25.019 --> 00:18:28.140 in practice. You, the borrower, have to go out 00:18:28.140 --> 00:18:30.380 into the open market and buy a whole portfolio 00:18:30.380 --> 00:18:34.190 of U .S. government securities. Treasury bonds, 00:18:34.390 --> 00:18:36.549 basically. OK, that seems weird, but all right. 00:18:36.609 --> 00:18:39.289 And not just any bonds. You have to hire a team 00:18:39.289 --> 00:18:42.029 of accountants and lawyers to construct a custom 00:18:42.029 --> 00:18:44.630 portfolio of government bonds where the interest 00:18:44.630 --> 00:18:46.789 and principal payments from those bonds perfectly 00:18:46.789 --> 00:18:49.490 match to the penny and to the day. The mortgage 00:18:49.490 --> 00:18:51.869 payments you owed on your original loan for the 00:18:51.869 --> 00:18:54.119 remaining four years. Wait, wait. So I have to 00:18:54.119 --> 00:18:56.940 build a synthetic version of my own mortgage 00:18:56.940 --> 00:18:59.859 using super safe government debt. You are cloning 00:18:59.859 --> 00:19:02.559 your debt obligations. You buy this custom portfolio 00:19:02.559 --> 00:19:04.859 of bonds. You hand them over to the trustee, 00:19:04.859 --> 00:19:08.160 the CMBS deal. The trustee says, OK, these bonds 00:19:08.160 --> 00:19:10.619 are now the collateral for the loan. The mall 00:19:10.619 --> 00:19:12.559 is released. The lien is lifted. You can sell 00:19:12.559 --> 00:19:14.920 your mall. But the loan technically still exists. 00:19:15.000 --> 00:19:17.819 It's still out there. The loan lives on. But 00:19:17.819 --> 00:19:20.059 now, instead of being paid by the rent from the 00:19:20.059 --> 00:19:22.880 GAB and the food court, it is being paid by the 00:19:22.880 --> 00:19:25.039 full faith and credit of the U .S. Treasury Department. 00:19:25.359 --> 00:19:27.880 That sounds incredibly expensive and complicated. 00:19:28.299 --> 00:19:30.480 Expensive and complicated is an understatement. 00:19:30.500 --> 00:19:33.380 It can cost tens, even hundreds of thousands 00:19:33.380 --> 00:19:35.859 of dollars just in legal and accounting fees 00:19:35.859 --> 00:19:39.279 to set this up. Plus, buying that specific portfolio 00:19:39.279 --> 00:19:41.740 of bonds is almost always more expensive than 00:19:41.740 --> 00:19:44.119 just paying off the loan principal. It's a massive, 00:19:44.180 --> 00:19:46.519 massive headache. So why on earth would anyone 00:19:46.519 --> 00:19:49.400 do it? Because it is the only way out of the 00:19:49.400 --> 00:19:51.619 handcuffs. And from the investor's perspective, 00:19:51.900 --> 00:19:55.079 it's amazing. Their risky loan that was backed 00:19:55.079 --> 00:19:58.019 by a dying mall just turned into a super safe 00:19:58.019 --> 00:20:00.559 loan backed by the U .S. government. Their credit 00:20:00.559 --> 00:20:03.220 rating goes up. Their yield is absolutely secure. 00:20:03.460 --> 00:20:05.869 It's a huge win for them. It really seems like 00:20:05.869 --> 00:20:08.549 the borrower is forced to take all the pain so 00:20:08.549 --> 00:20:10.670 that the investor feels none of it. That is the 00:20:10.670 --> 00:20:12.809 fundamental design of the machine. And yield 00:20:12.809 --> 00:20:14.690 maintenance is the other term that was mentioned. 00:20:14.750 --> 00:20:16.849 I assume that's something similar. It's simpler, 00:20:16.990 --> 00:20:19.430 but it can be just as painful. It's basically 00:20:19.430 --> 00:20:23.089 just a math formula. The lender says to the borrower, 00:20:23.230 --> 00:20:26.230 OK, you can pay us off now, but you have to write 00:20:26.230 --> 00:20:29.230 us a check for a penalty. And that penalty is 00:20:29.230 --> 00:20:31.769 calculated to be equal to the present value of 00:20:31.769 --> 00:20:33.630 all the interest the investor would have made 00:20:33.630 --> 00:20:36.069 if the loan had stayed open until its maturity 00:20:36.069 --> 00:20:39.430 date. So it's basically you can leave the party 00:20:39.430 --> 00:20:42.130 early, but you still have to pay us for all the 00:20:42.130 --> 00:20:44.049 drinks we expected you to buy for the rest of 00:20:44.049 --> 00:20:46.650 the night. Exactly. You are maintaining their 00:20:46.650 --> 00:20:49.069 yield. Either way, they get their money. And 00:20:49.069 --> 00:20:51.569 interestingly, the source notes a regional difference 00:20:51.569 --> 00:20:55.049 here. It says that European CMBS issues typically 00:20:55.049 --> 00:20:57.690 have less prepayment protection than American 00:20:57.690 --> 00:21:00.210 ones. Yeah, the American market is just uniquely 00:21:00.210 --> 00:21:03.210 aggressive about locking borrowers in. In Europe, 00:21:03.250 --> 00:21:05.190 the market's developed a bit differently, often 00:21:05.190 --> 00:21:07.529 with more flexibility, like allowing for simple 00:21:07.529 --> 00:21:10.250 percentage -based prepayment penalties. But if 00:21:10.250 --> 00:21:12.210 you are financing a big commercial property in 00:21:12.210 --> 00:21:14.609 America, get ready for the golden handcuffs. 00:21:14.789 --> 00:21:18.299 Okay, so we know the asset. these unique business 00:21:18.299 --> 00:21:21.160 properties. We know the vessel, the Erie Mac 00:21:21.160 --> 00:21:23.539 tax robot. We know the rules. You can't leave 00:21:23.539 --> 00:21:26.059 the party early. Now, I want to talk about the 00:21:26.059 --> 00:21:28.160 people who are actually running this show. This 00:21:28.160 --> 00:21:30.839 brings us to section four, the cast of characters. 00:21:31.160 --> 00:21:33.039 This is one of the most important parts of the 00:21:33.039 --> 00:21:34.759 source material because it really breaks down 00:21:34.759 --> 00:21:37.579 the hierarchy. A CMBS trust isn't a building 00:21:37.579 --> 00:21:40.319 with people in it. It's a stack of legal contracts. 00:21:40.579 --> 00:21:44.480 But real human beings have to execute those contracts. 00:21:44.759 --> 00:21:47.339 And the source lists them in a... very specific 00:21:47.339 --> 00:21:49.660 order. Let's go through them and try to give 00:21:49.660 --> 00:21:51.880 them a bit of a personality. First up on the 00:21:51.880 --> 00:21:55.339 list, the master servicer. The master servicer. 00:21:55.420 --> 00:21:57.200 I think of them as the algorithm, the day to 00:21:57.200 --> 00:21:59.279 day manager. And the source says their responsibility 00:21:59.279 --> 00:22:02.200 is to service the loans in the pool through to 00:22:02.200 --> 00:22:05.339 maturity. What does service mean? It means they 00:22:05.339 --> 00:22:07.720 do all the boring administrative work. They're 00:22:07.720 --> 00:22:09.279 the ones sending out the monthly bills. They 00:22:09.279 --> 00:22:11.039 collect the checks. They make sure the property 00:22:11.039 --> 00:22:13.640 taxes are paid on time. They check that the building 00:22:13.640 --> 00:22:16.160 has the right insurance coverage. They manage 00:22:16.160 --> 00:22:18.759 the constant flow of data from the borrower to 00:22:18.759 --> 00:22:21.279 the trust. And the source specifically notes 00:22:21.279 --> 00:22:24.099 they interact with the performing borrower. That 00:22:24.099 --> 00:22:27.410 is the key phrase, performing. As long as you 00:22:27.410 --> 00:22:29.930 are a good boy, as long as you pay your bill 00:22:29.930 --> 00:22:33.049 on time, the only entity you will ever talk to 00:22:33.049 --> 00:22:35.789 is the master servicer. And what's that interaction 00:22:35.789 --> 00:22:39.309 like? It's very impersonal. They're usually a 00:22:39.309 --> 00:22:41.930 massive financial institution, like a big bank. 00:22:42.089 --> 00:22:44.769 It's a volume game for them. They have software 00:22:44.769 --> 00:22:47.789 that's processing thousands and thousands of 00:22:47.789 --> 00:22:51.180 loans at once. They are not your friend. Okay, 00:22:51.220 --> 00:22:53.680 so next on the list is the primary servicer, 00:22:53.779 --> 00:22:56.359 or sometimes called the subservicer. How is that 00:22:56.359 --> 00:22:58.720 different from the master? Well, the master servicer 00:22:58.720 --> 00:23:00.660 might be a giant bank headquartered in North 00:23:00.660 --> 00:23:03.140 Carolina, but the building itself is a little 00:23:03.140 --> 00:23:06.099 strip mall in Oregon. The master servicer doesn't 00:23:06.099 --> 00:23:08.289 know the local market in Oregon. So they need 00:23:08.289 --> 00:23:10.390 someone with boots on the ground. Exactly. The 00:23:10.390 --> 00:23:12.289 source points out that the primary servicer is 00:23:12.289 --> 00:23:15.470 often the loan originator or mortgage banker 00:23:15.470 --> 00:23:18.250 who sorts the loan. It's the local guy who actually 00:23:18.250 --> 00:23:20.630 sold the deal in the first place. Ah, so the 00:23:20.630 --> 00:23:22.849 local relationship guy, the one who knows the 00:23:22.849 --> 00:23:26.130 borrower. Yes. The master servicer officially 00:23:26.130 --> 00:23:29.349 subcontracts duties to them. The master is the 00:23:29.349 --> 00:23:32.410 ultimate boss, but the primary servicer is the 00:23:32.410 --> 00:23:34.390 one who is actually going to pick up the phone 00:23:34.390 --> 00:23:37.109 when the borrower calls to ask a simple question. 00:23:37.519 --> 00:23:40.400 They maintain that direct relationship. Okay, 00:23:40.440 --> 00:23:42.559 so those are the good times people, the folks 00:23:42.559 --> 00:23:44.579 you talk to when everything is going exactly 00:23:44.579 --> 00:23:48.420 according to plan. But then the source introduces 00:23:48.420 --> 00:23:52.299 a character that sounds a bit more intense, the 00:23:52.299 --> 00:23:56.039 special servicer. Ah, yes, the special servicer, 00:23:56.119 --> 00:24:00.019 the fixer, the wolf, the closer. The source says 00:24:00.019 --> 00:24:02.660 they only step in upon certain specified events, 00:24:02.839 --> 00:24:05.720 and the main one is a default. This is the critical 00:24:05.720 --> 00:24:08.569 handoff. This is the moment the entire mood in 00:24:08.569 --> 00:24:10.430 the room changes. In a regular bank loan, if 00:24:10.430 --> 00:24:11.990 you get into trouble, you go talk to your local 00:24:11.990 --> 00:24:14.130 loan officer, the guy you play golf with, and 00:24:14.130 --> 00:24:16.190 you say, hey, times are tough. Can we work something 00:24:16.190 --> 00:24:18.369 out? And usually the bank wants to help you because 00:24:18.369 --> 00:24:19.789 they don't want to end up owning your house. 00:24:20.029 --> 00:24:23.150 Right. They want to avoid foreclosure. But in 00:24:23.150 --> 00:24:25.829 CMBS, it is completely different. The moment 00:24:25.829 --> 00:24:28.430 you miss a payment or a major tenant goes bankrupt, 00:24:28.589 --> 00:24:31.269 what they call a trigger event, the master servicer 00:24:31.269 --> 00:24:34.390 takes your file. Stamps it default and sends 00:24:34.390 --> 00:24:36.930 it down the hall to the special servicer. What 00:24:36.930 --> 00:24:39.289 is their role exactly? What's their mandate? 00:24:39.630 --> 00:24:42.089 The source calls them the handler of defaulted 00:24:42.089 --> 00:24:45.849 loans. Their job is not to be your friend. Their 00:24:45.849 --> 00:24:48.650 one and only job is to maximize the financial 00:24:48.650 --> 00:24:52.009 recovery for the bondholders. That's it. So they 00:24:52.009 --> 00:24:54.049 are the ones who make the hard decisions. Do 00:24:54.049 --> 00:24:56.769 we foreclose? Do we try to sell the building 00:24:56.769 --> 00:24:59.750 for scrap? Exactly. Or do we try to restructure 00:24:59.750 --> 00:25:01.829 the loan? Do we find a new owner? And the source 00:25:01.829 --> 00:25:04.509 mentions they have approval authority over material 00:25:04.509 --> 00:25:07.509 actions like loan assumptions. This is important. 00:25:07.730 --> 00:25:10.309 Even if the loan isn't in default, if the borrower 00:25:10.309 --> 00:25:12.170 wants to do something big like sell the building 00:25:12.170 --> 00:25:14.230 and have the new owner take over the existing 00:25:14.230 --> 00:25:16.970 debt, the master's... The provisor usually can't 00:25:16.970 --> 00:25:19.230 say yes on their own. They have to ask permission. 00:25:19.470 --> 00:25:21.130 They have to get approval from the special servicer. 00:25:21.230 --> 00:25:24.190 Why? If the loan is performing, why does the 00:25:24.190 --> 00:25:26.349 fixer get to have a say? Because the special 00:25:26.349 --> 00:25:28.549 servicer is often tied directly to the financial 00:25:28.549 --> 00:25:30.730 risk. And we'll get to that in the next section. 00:25:30.869 --> 00:25:33.490 But usually, the special servicer is appointed 00:25:33.490 --> 00:25:36.210 by the investor who stands to lose the most money 00:25:36.210 --> 00:25:39.359 if things go wrong. So they want strict oversight 00:25:39.359 --> 00:25:42.339 on any major decision that could change the risk 00:25:42.339 --> 00:25:45.279 profile. So if the master servicer is the polite 00:25:45.279 --> 00:25:48.000 but robotic accountant. The special servicer 00:25:48.000 --> 00:25:50.000 is the guy who shows up with a tow truck and 00:25:50.000 --> 00:25:52.079 a clipboard. That's a great analogy. So when 00:25:52.079 --> 00:25:54.700 a loan file goes to special servicing, everyone 00:25:54.700 --> 00:25:56.720 in the industry knows that property is in the 00:25:56.720 --> 00:26:00.019 ICU. It is a major distress signal. A huge red 00:26:00.019 --> 00:26:02.359 flag. Okay, moving on down the list, we have 00:26:02.359 --> 00:26:05.680 the trustee. This sounds very official. The trustee 00:26:05.680 --> 00:26:08.440 is the librarian. The custodian of the documents. 00:26:08.720 --> 00:26:11.299 The source says their primary role is to hold 00:26:11.299 --> 00:26:14.019 all the loan documents. And it sounds passive, 00:26:14.119 --> 00:26:17.079 and it largely is, but it's a legally vital role. 00:26:17.299 --> 00:26:19.839 They are the ones who physically or digitally 00:26:19.839 --> 00:26:22.039 hold the original loan notes, the mortgages, 00:26:22.059 --> 00:26:25.299 the title deeds. They are the official safe deposit 00:26:25.299 --> 00:26:27.980 box for the entire deal. And the source also 00:26:27.980 --> 00:26:30.619 says they distribute payments received from the 00:26:30.619 --> 00:26:33.839 master servicer to the bondholders. Right. So 00:26:33.839 --> 00:26:36.359 they're also the cashier. The master servicer 00:26:36.359 --> 00:26:38.140 collects all the money from all the different 00:26:38.140 --> 00:26:40.940 malls and office buildings, sends one giant check 00:26:40.940 --> 00:26:43.119 to the trustee, and the trustee looks at the 00:26:43.119 --> 00:26:46.039 master spreadsheet and sends out all the individual 00:26:46.039 --> 00:26:47.720 checks to the hundreds of different investors. 00:26:47.920 --> 00:26:50.519 They keep the score. And they make sure the pooling 00:26:50.519 --> 00:26:52.440 and servicing agreement, which is like the constitution 00:26:52.440 --> 00:26:55.099 for the trust, is being followed. That's their 00:26:55.099 --> 00:26:58.059 main job. But the source notes that while they 00:26:58.059 --> 00:27:00.680 have this broad authority, they typically delegate 00:27:00.680 --> 00:27:03.779 actual work. To the servicers. They're not getting 00:27:03.779 --> 00:27:06.420 their hands dirty. No. The trustee doesn't want 00:27:06.420 --> 00:27:09.019 to manage buildings or foreclose on properties. 00:27:09.380 --> 00:27:11.480 They're usually the trust department of a big 00:27:11.480 --> 00:27:13.940 bank. They just want to ensure the legal and 00:27:13.940 --> 00:27:16.220 financial structure remains intact and everyone 00:27:16.220 --> 00:27:18.839 follows the rules. And finally, the last character 00:27:18.839 --> 00:27:22.759 on the list. The rating agency. The referees. 00:27:23.359 --> 00:27:26.420 Or maybe the book critics. The source says there 00:27:26.420 --> 00:27:29.160 can be as few as one or as many as four of them 00:27:29.160 --> 00:27:32.279 involved in a single securitization. And their 00:27:32.279 --> 00:27:34.880 job is to establish bond ratings for each bond 00:27:34.880 --> 00:27:37.000 class when the deal is first created. Right. 00:27:37.119 --> 00:27:41.200 AAA, AAA, ABBB, and so on. These little letters 00:27:41.200 --> 00:27:44.220 are incredibly powerful. They determine the interest 00:27:44.220 --> 00:27:46.940 rate on the bond. And more importantly, who is 00:27:46.940 --> 00:27:49.900 even allowed to buy these bonds? How so? Well, 00:27:49.940 --> 00:27:52.019 a lot of big institutions like pension funds 00:27:52.019 --> 00:27:54.660 or insurance companies have rules in their charters 00:27:54.660 --> 00:27:57.000 that say they're only allowed to buy the safest 00:27:57.000 --> 00:28:00.420 AAA -rated bonds. So the rating agency is effectively 00:28:00.420 --> 00:28:02.660 the gatekeeper to the largest pools of money 00:28:02.660 --> 00:28:05.349 in the world. But the source points out an important 00:28:05.349 --> 00:28:07.869 ongoing duty. They don't just rate it once and 00:28:07.869 --> 00:28:10.190 then walk away. No, absolutely not. They have 00:28:10.190 --> 00:28:12.470 to monitor pool performance. They are constantly 00:28:12.470 --> 00:28:14.450 watching the data that's coming from the master 00:28:14.450 --> 00:28:17.269 servicer every month. So if that big mall in 00:28:17.269 --> 00:28:19.910 Ohio loses its anchor tenant. The rating agency 00:28:19.910 --> 00:28:22.769 sees that data point. They might run their models 00:28:22.769 --> 00:28:25.150 and issue a downgrade. They can turn a AAA bond 00:28:25.150 --> 00:28:27.430 into an AA bond overnight. And that would send 00:28:27.430 --> 00:28:29.990 shockwaves through the market? Huge shockwaves. 00:28:30.470 --> 00:28:32.930 because suddenly that big pension fund that was 00:28:32.930 --> 00:28:35.769 holding the bond might be legally required to 00:28:35.769 --> 00:28:38.650 sell it because it's no longer AAA. This can 00:28:38.650 --> 00:28:40.390 cause the price of the bond to plummet. It's 00:28:40.390 --> 00:28:42.710 a constant feedback loop. So it's this rigid, 00:28:42.829 --> 00:28:45.950 highly structured ecosystem. The master servicer 00:28:45.950 --> 00:28:48.509 collects data, gives it to the trustee and the 00:28:48.509 --> 00:28:50.910 rating agencies, who then tell the investors 00:28:50.910 --> 00:28:53.089 what's happening with their money. And if things 00:28:53.089 --> 00:28:55.809 go really wrong, the special servicer steps in 00:28:55.809 --> 00:28:58.380 to clean up the mess. It is a machine. A machine 00:28:58.380 --> 00:29:01.079 made of contracts. No one can just make a call 00:29:01.079 --> 00:29:03.180 based on a gut feeling. You have to follow the 00:29:03.180 --> 00:29:05.640 documents. Always. But there is one character 00:29:05.640 --> 00:29:07.400 we haven't fully fleshed out yet. And we kind 00:29:07.400 --> 00:29:09.339 of hinted at it when we talked about the special 00:29:09.339 --> 00:29:12.019 servicer. This brings us to our final section. 00:29:12.220 --> 00:29:16.339 Section 5. The power dynamic. And specifically, 00:29:16.660 --> 00:29:19.900 the BP spire. This is where the rubber really 00:29:19.900 --> 00:29:22.640 meets the road. If you want to understand... 00:29:22.809 --> 00:29:24.750 Who really runs the commercial real estate market? 00:29:24.890 --> 00:29:27.349 Who calls the shots when things get tough? You 00:29:27.349 --> 00:29:30.119 have to understand the B piece. The source introduces 00:29:30.119 --> 00:29:33.119 a very powerful sounding term, the directing 00:29:33.119 --> 00:29:35.380 certificate holder, which is also called the 00:29:35.380 --> 00:29:38.480 controlling class. Controlling class. I mean, 00:29:38.500 --> 00:29:40.779 just think about that name. This is the entity 00:29:40.779 --> 00:29:43.099 that is in control. This is the one that directs 00:29:43.099 --> 00:29:45.380 the action. And who are they? The source says 00:29:45.380 --> 00:29:47.759 they are the investor in the most subordinate 00:29:47.759 --> 00:29:50.299 bond class. Okay, stop there. Does that make 00:29:50.299 --> 00:29:52.759 any sense to you on its face? Honestly, no. It 00:29:52.759 --> 00:29:55.579 sounds completely backwards. It's counterintuitive. 00:29:55.619 --> 00:29:59.299 Why? What's your instinct? My instinct is that 00:29:59.299 --> 00:30:02.200 usually the person with the most money, the VIP, 00:30:02.500 --> 00:30:04.880 the one who bought the safest, most expensive 00:30:04.880 --> 00:30:08.099 AAA rated bond, they should be the one in charge. 00:30:08.160 --> 00:30:10.619 If I buy the first class ticket, I expect to 00:30:10.619 --> 00:30:13.440 have some say. But here the source is saying 00:30:13.440 --> 00:30:15.779 the subordinate class, the one at the very bottom 00:30:15.779 --> 00:30:18.180 of the pile, is the controlling class. It is 00:30:18.180 --> 00:30:21.059 deeply counterintuitive. But it is actually a 00:30:21.059 --> 00:30:24.240 brilliant, if maybe ruthless, design feature 00:30:24.240 --> 00:30:26.220 of the entire system. All right, explain it to 00:30:26.220 --> 00:30:28.619 me. Who is this BP Spire? What are they buying? 00:30:28.880 --> 00:30:31.339 They are the investors who purchase the B -rated, 00:30:31.539 --> 00:30:33.940 BB -rated, and sometimes the unrated classes 00:30:33.940 --> 00:30:37.200 of the CMBS deal. These are the bonds that are 00:30:37.200 --> 00:30:39.339 dead last in line to get paid. So these are the 00:30:39.339 --> 00:30:42.259 junk bonds of the deal. Essentially, yes. They 00:30:42.259 --> 00:30:44.799 are high risk and therefore high yield. We call 00:30:44.799 --> 00:30:47.400 this the first loss position. I want you to imagine 00:30:47.400 --> 00:30:50.319 a waterfall. Okay. The money from the mortgage 00:30:50.319 --> 00:30:52.900 payments pours in at the very top of the waterfall. 00:30:53.299 --> 00:30:56.000 The AAA investors, who are at the top, they fill 00:30:56.000 --> 00:30:58.279 their buckets first. Then the water flows down 00:30:58.279 --> 00:31:00.119 to the AA guys, and they fill their buckets. 00:31:00.299 --> 00:31:03.680 Then the A guys. The BP spire is standing at 00:31:03.680 --> 00:31:06.119 the very, very bottom, holding a thimble and 00:31:06.119 --> 00:31:08.039 hoping there is still some water left when it 00:31:08.039 --> 00:31:10.000 gets to them. So if the building starts to lose 00:31:10.000 --> 00:31:13.259 money, if some tenants stop paying rent and the 00:31:13.259 --> 00:31:15.740 waterfall shrinks? The waterfall dries up before 00:31:15.740 --> 00:31:18.180 it ever reaches the bottom. The BP's buyer is 00:31:18.180 --> 00:31:21.000 the very first one to stop getting paid. If the 00:31:21.000 --> 00:31:25.059 trust loses, say, $1 million in a year, that 00:31:25.059 --> 00:31:27.420 entire million dollars comes directly out of 00:31:27.420 --> 00:31:29.700 the BP's buyer's pocket. And the AAA investors 00:31:29.700 --> 00:31:32.660 at the top. They don't feel a thing. They are 00:31:32.660 --> 00:31:34.960 completely insulated from that first loss. They 00:31:34.960 --> 00:31:36.980 don't start losing money until the BP's, the 00:31:36.980 --> 00:31:39.460 BBP's, and all the other subordinate layers are 00:31:39.460 --> 00:31:41.460 completely wiped out. Okay, I get the risk now. 00:31:41.839 --> 00:31:44.289 But that still doesn't explain the power. Why 00:31:44.289 --> 00:31:46.430 does that risk give them control? Why do we give 00:31:46.430 --> 00:31:48.890 the keys to the car to the guy who is most likely 00:31:48.890 --> 00:31:51.190 to go broke? Because of one of the most powerful 00:31:51.190 --> 00:31:54.609 concepts in finance, skin in the game. Think 00:31:54.609 --> 00:31:57.549 about it. If the building loses 5 % of its value, 00:31:57.670 --> 00:32:00.809 who cares the most? The B piece guy. He's losing 00:32:00.809 --> 00:32:03.880 his shirt. That 5 % loss could wipe out his entire 00:32:03.880 --> 00:32:07.039 investment. Exactly. Now, does the AAA guy care 00:32:07.039 --> 00:32:09.700 about that 5 % loss? Not really. He's still fully 00:32:09.700 --> 00:32:12.500 covered. He's got, you know, 30 % or 40 % of 00:32:12.500 --> 00:32:14.480 subordination below him protecting him like a 00:32:14.480 --> 00:32:17.579 giant cushion. The AAA guy is asleep at the wheel. 00:32:17.720 --> 00:32:20.099 He has absolutely no incentive to micromanage 00:32:20.099 --> 00:32:22.960 the property because he's safe. But the BP's 00:32:22.960 --> 00:32:26.059 buyer, he is sweating bullets over every single 00:32:26.059 --> 00:32:28.740 percentage point of occupancy, every leaky roof, 00:32:28.900 --> 00:32:31.339 every late rent check. His survival depends on 00:32:31.339 --> 00:32:35.019 it. His survival depends on it. So the structure 00:32:35.019 --> 00:32:38.759 says, you, the BP's buyer, have the most to lose. 00:32:39.180 --> 00:32:41.740 Therefore, you get to be the one who decides 00:32:41.740 --> 00:32:44.339 how we handle the problems. You're the most motivated 00:32:44.339 --> 00:32:46.380 person in the entire room to save the building. 00:32:46.910 --> 00:32:49.490 Exactly. And the source says they have significant 00:32:49.490 --> 00:32:53.710 influence over the trust, specifically by directing 00:32:53.710 --> 00:32:55.970 the special servicer. In fact, I've read in other 00:32:55.970 --> 00:32:58.769 places that very often the BP's buyer is the 00:32:58.769 --> 00:33:00.950 one who appoints the special servicer. Or they 00:33:00.950 --> 00:33:02.990 are the special servicer. Yeah. Often these are 00:33:02.990 --> 00:33:05.210 the exact same firms. You'll have specialized 00:33:05.210 --> 00:33:07.690 hedge funds or private equity groups that buy 00:33:07.690 --> 00:33:10.789 the BP specifically so that they can gain control 00:33:10.789 --> 00:33:13.289 of the workout process if and when the loans 00:33:13.289 --> 00:33:15.940 go bad. That is just fascinating. It's like saying, 00:33:16.039 --> 00:33:17.900 since you are the one sitting on the hood of 00:33:17.900 --> 00:33:19.960 the car with no seatbelt, you get to be the one 00:33:19.960 --> 00:33:22.500 who drives. Or, since you are the canary in the 00:33:22.500 --> 00:33:24.599 coal mine, you're the one who gets to decide 00:33:24.599 --> 00:33:27.440 when we evacuate. It aligns the power with the 00:33:27.440 --> 00:33:30.680 risk. So let's try to unpack the so what here. 00:33:31.240 --> 00:33:33.299 We've covered a lot of really technical ground. 00:33:33.789 --> 00:33:36.910 We've gone from the basic definition of CMBS 00:33:36.910 --> 00:33:39.589 all the way to the tax structures, the lockout 00:33:39.589 --> 00:33:42.809 penalties, the whole cast of servicers, and now 00:33:42.809 --> 00:33:46.069 the BP spires. We have really dissected the machine. 00:33:46.390 --> 00:33:48.250 So let's go back to that street corner, the one 00:33:48.250 --> 00:33:49.690 we started on at the very beginning of this. 00:33:49.750 --> 00:33:51.289 You're standing there and you put on the finance 00:33:51.289 --> 00:33:54.890 glasses. You look up at that same skyline. What 00:33:54.890 --> 00:33:57.509 do you see now? I don't just see a skyscraper 00:33:57.509 --> 00:34:00.539 anymore. I see a pass -through entity. I see 00:34:00.539 --> 00:34:02.960 a massive bundle of legal contracts that are 00:34:02.960 --> 00:34:05.960 only held together by a specific exemption in 00:34:05.960 --> 00:34:08.219 the tax code. When I look at that office tower 00:34:08.219 --> 00:34:10.380 now, I realize that building isn't just owned 00:34:10.380 --> 00:34:13.199 by some simple landlord. It's being managed day 00:34:13.199 --> 00:34:15.539 to day by a master servicer algorithm that's 00:34:15.539 --> 00:34:17.719 probably located in a different state. Right. 00:34:17.820 --> 00:34:20.280 And it's being watched like a hawk every single 00:34:20.280 --> 00:34:23.579 month by a rating agency in New York. And if 00:34:23.579 --> 00:34:25.579 you look really, really closely at the windows, 00:34:25.679 --> 00:34:28.039 you start to realize that the person who really 00:34:28.039 --> 00:34:30.659 controls the ultimate fate of that building isn't 00:34:30.659 --> 00:34:33.059 the property manager sitting in the lobby. It's 00:34:33.059 --> 00:34:35.960 the B -piece buyer, some hedge fund in Connecticut 00:34:35.960 --> 00:34:38.539 that bought the riskiest slice of the debt and 00:34:38.539 --> 00:34:41.380 is now holding the directing certificate. It 00:34:41.380 --> 00:34:44.179 completely changes your perspective on the stability 00:34:44.179 --> 00:34:46.769 of the city. We think of buildings as permanent. 00:34:46.829 --> 00:34:48.610 They're made of concrete and steel. They're solid. 00:34:48.949 --> 00:34:52.150 But financially, they're incredibly fluid. They're 00:34:52.150 --> 00:34:55.510 tied to global interest rates, to the bond markets, 00:34:55.590 --> 00:34:58.769 to the whims of a special servicer who is controlled 00:34:58.769 --> 00:35:02.150 by the most subordinate investor. And here is 00:35:02.150 --> 00:35:04.170 a final provocative thought for you to chew on 00:35:04.170 --> 00:35:06.590 as you walk through your city. We talked at length 00:35:06.590 --> 00:35:09.329 about the special servicer, the fixer. They only 00:35:09.329 --> 00:35:12.130 take control when things go bad. when the economy 00:35:12.130 --> 00:35:15.610 tanks, when tenants leave in droves, when borrowers 00:35:15.610 --> 00:35:18.550 default on their loans. The default cycle. Exactly. 00:35:18.849 --> 00:35:20.449 Now think about the world we're in right now. 00:35:20.550 --> 00:35:22.590 We have the rise of remote work, which is emptying 00:35:22.590 --> 00:35:25.190 out office buildings. We have online shopping, 00:35:25.309 --> 00:35:28.010 which is killing traditional malls. If we hit 00:35:28.010 --> 00:35:30.429 a major recession or if the way we use real estate 00:35:30.429 --> 00:35:33.650 just fundamentally changes for good, that means 00:35:33.650 --> 00:35:37.250 defaults. A lot of defaults, which means a lot 00:35:37.250 --> 00:35:38.809 of those trigger events are going to happen. 00:35:39.179 --> 00:35:42.000 And that means the master servicers are contractually 00:35:42.000 --> 00:35:44.880 obligated to hand the keys to the special servicers. 00:35:44.940 --> 00:35:47.440 That is the logical flow of the machine. It's 00:35:47.440 --> 00:35:49.400 what it's designed to do. So it really raises 00:35:49.400 --> 00:35:52.519 the question, in a serious downturn, who actually 00:35:52.519 --> 00:35:55.840 owns our cities? It's not the developers who 00:35:55.840 --> 00:35:58.219 built the towers. It's not the banks who originated 00:35:58.219 --> 00:36:01.480 the loans. It's the fixers. It's the special 00:36:01.480 --> 00:36:04.019 servicers. You can see a massive transfer of 00:36:04.019 --> 00:36:07.639 control of commercial real estate where our skylines 00:36:07.639 --> 00:36:09.900 are essentially being managed by these distressed 00:36:09.900 --> 00:36:13.320 asset specialists purely for the purpose of salvaging 00:36:13.320 --> 00:36:15.199 whatever yield they can for the bondholders. 00:36:15.400 --> 00:36:18.179 It is a sobering thought. The city itself becomes 00:36:18.179 --> 00:36:21.340 a recovery operation. Every for lease sign you 00:36:21.340 --> 00:36:23.659 see isn't just a sign. It's a desperate attempt 00:36:23.659 --> 00:36:26.519 to keep the B piece from hitting zero. The skyline 00:36:26.519 --> 00:36:28.599 isn't just architecture anymore. It's a balance 00:36:28.599 --> 00:36:32.070 sheet. And right now, we all need to wonder who 00:36:32.070 --> 00:36:34.369 is holding the B piece. Thanks for joining us 00:36:34.369 --> 00:36:36.769 on this deep dive into the hidden world of CMBS. 00:36:37.130 --> 00:36:39.969 It's complex, it's technical, but it's the invisible 00:36:39.969 --> 00:36:42.530 framework of the world we all live in. Keep looking 00:36:42.530 --> 00:36:44.030 up and keep asking questions.