I want you to try something for me. If you can,
just close your eyes for a second. But please,
if you're driving, do not close your eyes. Definitely
don't do that. Yeah, no, seriously. But for everyone
else, imagine you are standing on a street corner,
maybe in the middle of a huge metropolis. Let's
say midtown Manhattan or the city of London or
Chicago. You're just standing there. You can
feel the wind. You can hear the traffic. And
you look up. What do you see? Well, the obvious
answer is the skyline. You see... Concrete, acres
and acres of glass, steel beams going up into
the sky. Skyscrapers. Skyscrapers. Massive shopping
centers. Maybe one of those sprawling apartment
complexes that just takes up an entire city block.
Exactly. You see the physical city, you know,
the hardware. But here's the thing. For this
deep dive, I want to hand you a special pair
of glasses. We'll call them finance glasses.
And the moment you put these on, that skyline.
It just completely changes. Oh, yeah. Those buildings
aren't just piles of concrete and steel anymore.
They're not just architecture. No. Through those
glasses, they look like something else entirely.
They look like, I don't know, financial instruments.
Precisely. Every single one of those towers,
every mall, every apartment block, it represents
a massive, massive bundle of debt. And that debt
is wrapped up. It's sliced into these tiny little
pieces and then sold to investors all over the
world. We're not just looking at buildings. We're
looking at securitization. That is the word.
And that brings us right to the topic we are
really going to unpack today. It's an acronym
that, you know, it completely dominates the commercial
real estate world. But most people outside of
high finance have probably never really looked
under the hood. We are talking about commercial
mortgage -backed securities. Or CMBS. CMBS. Now,
I know what you might be thinking. That sounds
like the driest, most technical topic you could
possibly choose. But here's our mission today.
We want to prove that this is actually the hidden
operating system of the modern city. That's a
great way to put it. It's the machinery that
decides what gets built, what stays open, and
who actually owns the places where we all work
and shop. And it is a machine that operates by
a completely different set of rules than, say,
the mortgage on your house. Oh, totally different.
That's the critical thing to understand from
the get -go. If you think you know how mortgages
work because you bought a house once, you really
need to just kind of throw that knowledge out
the window. CMBS is a different beast entirely.
So we are going to strip this whole thing down
to the studs. We have a massive stack of source
material here. I mean, we've got technical documentation.
We have industry definitions, structural classifications,
legal frameworks. We are going to use all of
this to decode how a billion dollar mall gets
funded, who gets paid, and maybe most importantly.
What happens when the money stops flowing? Exactly.
And it's a journey. Honestly, we're going to
go from like the basement plumbing of tax law,
which is surprisingly dramatic. I'm intrigued
already. All the way up to the penthouse where
the masters of the universe sit and make these
decisions that affect entire neighborhoods, entire
cities. OK, so let's start at square one. The
absolute basics. We've got these documents in
front of us. How does the source material actually
define a CMBS? At its simplest level, and this
is the starting point, the source defines a commercial
mortgage -backed security as a type of mortgage
-backed security that is secured by, and this
is the key phrase, commercial and multifamily
mortgages. Commercial and multifamily. I want
to stop there immediately because that feels
like the huge fork in the road. We need to contrast
this with what most people know, which is RMBS.
Residential Mortgage -Backed Securities. Right.
And I really feel like we can't overstate this
distinction. When people hear MBS or Mortgage
-Backed Security, their brains go straight to
the big short. Yeah, 2008. They think about 2008.
They think about all those suburban houses in
Florida or California. But we are not talking
about single -family homes with a white picket
fence and a golden retriever in the yard. talking
about business assets. That is the fundamental
divide. And that's really, you know, section
one of our deep dive today. You have to understand
that you cannot treat these two things, residential
and commercial, the same way. Yeah. They are.
They're different species. So let's break down
that asset class distinction a bit more. When
we talk about the residential side, the RMBS,
what are we really looking at? What's in that
bundle? In an RMBS deal, The bundle or the pool
of loans is made up of home loans. So you're
thinking of, I don't know, 1 ,000, maybe 5 ,000,
just regular people. Regular homeowners. Yeah,
they live in the suburbs. They have 30 -year
mortgages. And the mechanism is pretty simple,
right? The investors who buy those bonds, they
benefit from the mortgage payments and the interest
that's paid by all those homeowners every month.
So effectively, if I buy a residential bond,
I'm basically betting that John Smith in Ohio
is going to keep his job. Right. And Jane Doe
in Texas is going to keep her job and they're
both going to pay their bills on time. Correct.
You are betting on the credit worthiness. of
thousands of individuals. You are betting on
the American homeowner. OK, but now shift your
gaze. Let's look at CMBS. The source material
lists some examples. What are they? office buildings,
retail stores, shopping centers, and apartment
complexes. And this leads us to what the source
called the cash flow nuance. And this is something
I really want to dig into because it just feels
like it changes how you have to assess the risk
of the whole thing. It changes everything. Why
is an apartment complex or a shopping mall fundamentally
different from John Smith's house? Well, it all
comes down to where the money is coming from.
In a residential loan, the source of the payment
is usually a salary. You know, you go to work,
you get a paycheck, you pay the bank. It's personal
income. Simple enough. But with CMBS, the source
explicitly states that the security provides
investors with cash flow from the income these
properties generate. Ah, so the building itself
has to earn its own keep. It has to have a job.
It's an economic entity. An apartment complex
isn't just a place to sleep. It's a rental business.
An office building is a space leasing business.
A shopping mall is a retail hub. So if the businesses
inside the building fail, the loan itself fails.
That's the risk. It feels like a massive shift
in mindset, right? You're not betting on a person's
moral obligation to pay for their shelter. You
are betting on the economic viability of a specific
business model. You're analyzing a business.
If you lend money to a shopping mall, you couldn't
care less about the owner's salary. You don't
care at all. You care about is the gap selling
enough jeans? Is the food court busy on a Saturday?
Are people still physically going to malls or
are they just shopping on Amazon? Which means
the risk is tied to the brighter economy in a
much, much more direct and volatile way. And
that leads right to the next point in the source
material, complexity and volatility. The source
makes a really specific claim here. It says that
CMBS tend to be more complex and volatile than
residential securities. You know, that might
sound counterintuitive to some people. You'd
think a massive skyscraper is somehow safer than
just some random house in the suburbs. So why
does the source say it's more volatile? It's
because of, and this is a quote, the unique nature
of the underlying property assets. Think about
housing for a second. It's kind of commoditized.
Standardized. It's a standardized product. A
three -bedroom house in a suburb of Dallas is
economically very, very similar to a three -bedroom
house in a suburb of Atlanta. The risks are similar.
The buyer profile is similar. You can model it
pretty easily. But commercial properties? They're
snowflakes. Yeah. Every single one is unique.
Can you give me an example of that snowflake
nature, just to make it concrete? Sure. Take
a hotel on Miami Beach versus, say, a coal storage
warehouse in North Dakota. Okay. Both are commercial
real estate. But the hotel relies on tourism.
On the weather, on discretionary spending, airline
ticket prices, travel trends. A million different
inputs. A million. The warehouse, on the other
hand, it relies on logistics supply chains. Maybe
agricultural yields from the surrounding farms
or trucking routes and fuel costs. And a shopping
mall in Ohio faces totally different risks than
a high -rise office tower in Manhattan. Completely
different worlds. Yeah. If you own an office
tower right now, you are worried about tech companies
downsizing. And the work from home trend. Right.
Is my building going to be empty? But if you
own that mall, you're worried about a big department
store like Macy's going bankrupt and leaving
a giant hole in your property. Each property
is a unique business entity with its own management
team, its own specific list of tenants and its
own local economic drivers. So you can't just
run a simple algorithm across 10 ,000 of them
and say this is a safe bet. You have to actually
understand the story of each building. You do,
which makes the securitization, the bundling
of all these different loans so much more complex.
You're trying to bundle together a lot of very,
very different stories into one portfolio. OK,
so we have established the playing field. We're
dealing with business assets, not homes. They
are complex. They're unique. They rely on cash
flow, not salaries. Now, I want to get into the
mechanics. How do they actually build this machine?
And that brings us to section two of our outline,
the structure. This is where we get into the
plumbing. And I'll warn you, it sounds technical,
but it's actually fascinating because it's designed
to solve a huge fundamental problem. I saw a
term in the source material that just it. immediately
stuck out to me. It sounds like a character from
a sci -fi movie or maybe a piece of heavy artillery.
The ARAMEC. The ARAMEC, yes. It stands for a
Real Estate Mortgage Investment Conduit. A conduit.
That is such an interesting word choice. A conduit
is just a pipe, right? Something flows through
it. That is the perfect visualization, and you
should absolutely hold on to that. The source
explains that the typical structure for these
securitizations is a REMEC. which isn't a company
in the traditional sense. It's a creation of
tax law. Okay, hold on. Why do they need a special
creation of tax law? Why can't a bank just put
a bunch of loans in a bucket, call it the big
bucket of loans incorporated, and then sell shares
in it? They could, but they would immediately
run into a giant wall called double taxation.
And I want to stick on this for a second because
I feel like this is where regular people's eyes
just glaze over, but it's actually the entire
reason this market can even exist. It is. It's
the linchpin. Think about it like this. If you
and I start a regular business, let's say it's
a lemonade stand, and that business makes a profit.
Okay. The IRS taxes that profit. That's corporate
tax. Right. Step one, the business pays tax on
what it made. Then, from the money that's left
over, we pay ourselves a dividend, we take that
profit home, the IRS then taxes us on that income.
That's personal income tax. So the same dollar
got taxed twice. Once when the business earned
it and a second time when I put it in my pocket.
Exactly. And for a lemonade stand, you know,
maybe that's annoying, but it's fine. But if
you're trying to move billions of dollars in
mortgage interest payments around the globe,
it's a complete deal breaker. It kills the return.
Completely. Wall Street looked at that and said,
we cannot lose 21 percent or 30 percent or whatever
the rate is of the yield just because the money
sat in a holding company for five minutes. It
makes the entire investment unappealing. So they
needed a loophole. Well, maybe not a loophole,
but a very specific vehicle, the Aramic. And
the source notes that the Aramic is a pass -through
entity. It is not subject to tax at the trust
level. So it's basically a ghost. It's a robot
that the IRS agrees to ignore. As long as that
robot follows a very, very strict set of rules,
it can't run a business, it can't buy new buildings,
it can only passively hold these specific loans,
the IRS just pretends it doesn't exist. The tax
liability just passes through it. Passes right
through to the investors. So the money flows
from the mall owner into the ERMIC and straight
out to the bondholder. And the ERMIC itself doesn't
take a cut for taxes. It's just a pipeline. A
pure conduit. And that efficiency is what makes
the math work for everyone. That makes a ton
of sense. It's all about preserving the yield
for the investor. Speaking of yield, you know,
getting paid. Let's talk about the interest rates.
The source breaks this down into two main buckets,
fixed rate and floating rate. Right. And this
is all about how the investor actually gets the
return. Fixed seems simple enough. It's a standard
percentage. You know what you're getting. Yeah.
You buy the bond. The bond says, I will pay you
5 % a year. Simple, predictable. Easy to model.
But the floating rate is where things get a bit
more dynamic. The source says this is based on
a benchmark plus spread. And it mentions a couple
of specific benchmarks. LIBOR or EUROBOR. Right.
The London Interbank offered rate and the Euro
Interbank offered rate. Now, we should also mention
that those specific benchmarks have been evolving
and changing over time. But the concept is what
really matters. The concept is that the interest
rate moves. It floats. Exactly. So if the benchmark
rate in the wider economy goes up, the bond starts
paying more. If it goes down. The bond pays less.
And this connects directly to the loan term categories
that are mentioned in the text. You have to ask
yourself, why would a borrower choose a floating
rate versus a fixed rate? What's the strategy?
I noticed that distinction in the source, too.
It separates things into like the long game versus
the short game. Let's look at the longer term
loans first. The source defines these as five
years or longer. And these are typically for
the stabilized properties. And what does stabilized
mean in this context? Imagine a big, shiny office
building in Chicago. It's fully built. It's 95
% full of tenants. All the leases are signed
for 10 years with big, credit -worthy companies.
It's basically a boring, steady money printer.
So that owner, they want certainty. They don't
want any surprises. Right. They want a fixed
rate. They want to know exactly what their mortgage
payment is going to be for the next 10 years
so they can budget their profit margins perfectly.
They lock it in and forget about it. But then
you have the shorter term loans. The source says
one to three years. These are for the transitional
properties. Let's say you're a developer named
Bob and Bob buys an empty rundown warehouse.
It's got no tenants. It's ugly. Bob's plan is
to renovate it and turn it into hip, new loft
apartments. So Bob doesn't want a 10 -year loan
on an empty building. No, because Bob doesn't
plan to own it for 10 years. He plans to fix
it up in, say, 18 months, get it fully leased
up with tenants, and then either sell it for
a profit or refinance into a better long -term
loan. So he needs flexibility. He needs flexibility.
So he takes a short -term floating rate loan.
He takes on the risk that interest rates might
go up in the short term because what he really
needs is the ability to get out of the loan easily.
And the source notes a key difference in that
flexibility, too. It says the shorter loans usually
allow free early repayments. Right. So if Bob
finishes his renovation project in 12 months
instead of 18, he could just pay off a loan and
walk away. No penalty. But the longer term loans,
those fixed rate ones, that is a completely different
story. And this brings us right to Section 3.
The lockout. This is where the CMBS market gets
really, really aggressive. This is where those
finance glasses start to reveal some pretty heavy
duty handcuffs on the borrower. The source sets
up a scenario here that I think everyone can
understand. In a regular home loan, generally
you can pay it off early. If you win the lottery
or you inherit some money, you just write a check
to the bank, you pay off your mortgage and you
have a party. You own your home free and clear.
Right. Banks generally have to accept your money.
I mean, there might be a tiny administrative
fee or something, but prepayment is a right for
most homeowners. But the source states, many
American CMBS transactions carry less prepayment
risk than other MBS types. Now, less prepayment
risk is classic banker speak. It sounds like
a positive thing. But what it actually means
from the borrower's perspective is you are literally
not allowed to pay us back. Wait, pause on that.
That sounds insane. Why would a lender be mad
about getting their money back early? If I lend
you $100 and you give it back to me tomorrow,
I should be happy. The risk is gone. But you're
thinking like a person, not like an investor.
Remember, these loans are all chopped up into
bonds. So imagine you're a pension fund manager.
You have a legal obligation to pay retirees for
the next 10 years. You buy a 10 -year CMBS bond
because it promises you a steady 5 % yield for
a decade. You are counting on that specific cash
flow. Okay, I see. I built my entire financial
model, my budget, around that 5 % check coming
in every single month for 10 years. Exactly.
Now, what happens if the borrower pays a loan
off in year two? Suddenly you have your principal
cash back. Great, right. No. No, because now
you have a giant pile of cash, but maybe in the
meantime, interest rates have dropped. You can't
just go out and find another safe 5 % return.
Maybe the market is only offering 3 % now. So
I have reinvestment risk. I lost my great deal.
And now I can't meet my obligations to my pensioners.
You lost your yield. And Wall Street hates losing
yield. So the entire system is rigged to prevent
that from happening. And the source outlines
the specific mechanisms for this. It's called
call protection. And the first and most blunt
line of defense is the lockout provision. Which
sounds exactly like what it is. It is. The source
states it's typically a period of, say, one to
five years where there can be no prepayment of
the loan at all. Period. So even if I have the
cash sitting in a suitcase and I walk into the
bank and say, here, I want to clear my debt.
The master servicer will politely return your
check. They will say, I'm sorry, we contractually
cannot accept this. You are locked out. You must
stay in debt. That is just wild. You are forced
to keep paying interest you don't want to pay.
But what about after that initial period or in
different structures? The source mentions two
terms that sound incredibly technical. Defezins?
And yield maintenance. These are the golden handcuffs.
Yeah. Let's look at defesance first, because
it is honestly one of the most bizarre concepts
in all of finance if you haven't seen it before.
It sounds like a spell from a fantasy novel.
I cast defesance. It's effectively a financial
transmutation spell. Let's say you own a mall.
You're in year six of a 10 -year loan. You want
to sell the mall to a new owner, so you need
to clear the debt off the property. But you have
a defesance clause. You can't just pay off the
loan. So what do I have to do? You have to perform
a substitution. The source calls it a pledge
of substitute collateral. Here's how it works
in practice. You, the borrower, have to go out
into the open market and buy a whole portfolio
of U .S. government securities. Treasury bonds,
basically. OK, that seems weird, but all right.
And not just any bonds. You have to hire a team
of accountants and lawyers to construct a custom
portfolio of government bonds where the interest
and principal payments from those bonds perfectly
match to the penny and to the day. The mortgage
payments you owed on your original loan for the
remaining four years. Wait, wait. So I have to
build a synthetic version of my own mortgage
using super safe government debt. You are cloning
your debt obligations. You buy this custom portfolio
of bonds. You hand them over to the trustee,
the CMBS deal. The trustee says, OK, these bonds
are now the collateral for the loan. The mall
is released. The lien is lifted. You can sell
your mall. But the loan technically still exists.
It's still out there. The loan lives on. But
now, instead of being paid by the rent from the
GAB and the food court, it is being paid by the
full faith and credit of the U .S. Treasury Department.
That sounds incredibly expensive and complicated.
Expensive and complicated is an understatement.
It can cost tens, even hundreds of thousands
of dollars just in legal and accounting fees
to set this up. Plus, buying that specific portfolio
of bonds is almost always more expensive than
just paying off the loan principal. It's a massive,
massive headache. So why on earth would anyone
do it? Because it is the only way out of the
handcuffs. And from the investor's perspective,
it's amazing. Their risky loan that was backed
by a dying mall just turned into a super safe
loan backed by the U .S. government. Their credit
rating goes up. Their yield is absolutely secure.
It's a huge win for them. It really seems like
the borrower is forced to take all the pain so
that the investor feels none of it. That is the
fundamental design of the machine. And yield
maintenance is the other term that was mentioned.
I assume that's something similar. It's simpler,
but it can be just as painful. It's basically
just a math formula. The lender says to the borrower,
OK, you can pay us off now, but you have to write
us a check for a penalty. And that penalty is
calculated to be equal to the present value of
all the interest the investor would have made
if the loan had stayed open until its maturity
date. So it's basically you can leave the party
early, but you still have to pay us for all the
drinks we expected you to buy for the rest of
the night. Exactly. You are maintaining their
yield. Either way, they get their money. And
interestingly, the source notes a regional difference
here. It says that European CMBS issues typically
have less prepayment protection than American
ones. Yeah, the American market is just uniquely
aggressive about locking borrowers in. In Europe,
the market's developed a bit differently, often
with more flexibility, like allowing for simple
percentage -based prepayment penalties. But if
you are financing a big commercial property in
America, get ready for the golden handcuffs.
Okay, so we know the asset. these unique business
properties. We know the vessel, the Erie Mac
tax robot. We know the rules. You can't leave
the party early. Now, I want to talk about the
people who are actually running this show. This
brings us to section four, the cast of characters.
This is one of the most important parts of the
source material because it really breaks down
the hierarchy. A CMBS trust isn't a building
with people in it. It's a stack of legal contracts.
But real human beings have to execute those contracts.
And the source lists them in a... very specific
order. Let's go through them and try to give
them a bit of a personality. First up on the
list, the master servicer. The master servicer.
I think of them as the algorithm, the day to
day manager. And the source says their responsibility
is to service the loans in the pool through to
maturity. What does service mean? It means they
do all the boring administrative work. They're
the ones sending out the monthly bills. They
collect the checks. They make sure the property
taxes are paid on time. They check that the building
has the right insurance coverage. They manage
the constant flow of data from the borrower to
the trust. And the source specifically notes
they interact with the performing borrower. That
is the key phrase, performing. As long as you
are a good boy, as long as you pay your bill
on time, the only entity you will ever talk to
is the master servicer. And what's that interaction
like? It's very impersonal. They're usually a
massive financial institution, like a big bank.
It's a volume game for them. They have software
that's processing thousands and thousands of
loans at once. They are not your friend. Okay,
so next on the list is the primary servicer,
or sometimes called the subservicer. How is that
different from the master? Well, the master servicer
might be a giant bank headquartered in North
Carolina, but the building itself is a little
strip mall in Oregon. The master servicer doesn't
know the local market in Oregon. So they need
someone with boots on the ground. Exactly. The
source points out that the primary servicer is
often the loan originator or mortgage banker
who sorts the loan. It's the local guy who actually
sold the deal in the first place. Ah, so the
local relationship guy, the one who knows the
borrower. Yes. The master servicer officially
subcontracts duties to them. The master is the
ultimate boss, but the primary servicer is the
one who is actually going to pick up the phone
when the borrower calls to ask a simple question.
They maintain that direct relationship. Okay,
so those are the good times people, the folks
you talk to when everything is going exactly
according to plan. But then the source introduces
a character that sounds a bit more intense, the
special servicer. Ah, yes, the special servicer,
the fixer, the wolf, the closer. The source says
they only step in upon certain specified events,
and the main one is a default. This is the critical
handoff. This is the moment the entire mood in
the room changes. In a regular bank loan, if
you get into trouble, you go talk to your local
loan officer, the guy you play golf with, and
you say, hey, times are tough. Can we work something
out? And usually the bank wants to help you because
they don't want to end up owning your house.
Right. They want to avoid foreclosure. But in
CMBS, it is completely different. The moment
you miss a payment or a major tenant goes bankrupt,
what they call a trigger event, the master servicer
takes your file. Stamps it default and sends
it down the hall to the special servicer. What
is their role exactly? What's their mandate?
The source calls them the handler of defaulted
loans. Their job is not to be your friend. Their
one and only job is to maximize the financial
recovery for the bondholders. That's it. So they
are the ones who make the hard decisions. Do
we foreclose? Do we try to sell the building
for scrap? Exactly. Or do we try to restructure
the loan? Do we find a new owner? And the source
mentions they have approval authority over material
actions like loan assumptions. This is important.
Even if the loan isn't in default, if the borrower
wants to do something big like sell the building
and have the new owner take over the existing
debt, the master's... The provisor usually can't
say yes on their own. They have to ask permission.
They have to get approval from the special servicer.
Why? If the loan is performing, why does the
fixer get to have a say? Because the special
servicer is often tied directly to the financial
risk. And we'll get to that in the next section.
But usually, the special servicer is appointed
by the investor who stands to lose the most money
if things go wrong. So they want strict oversight
on any major decision that could change the risk
profile. So if the master servicer is the polite
but robotic accountant. The special servicer
is the guy who shows up with a tow truck and
a clipboard. That's a great analogy. So when
a loan file goes to special servicing, everyone
in the industry knows that property is in the
ICU. It is a major distress signal. A huge red
flag. Okay, moving on down the list, we have
the trustee. This sounds very official. The trustee
is the librarian. The custodian of the documents.
The source says their primary role is to hold
all the loan documents. And it sounds passive,
and it largely is, but it's a legally vital role.
They are the ones who physically or digitally
hold the original loan notes, the mortgages,
the title deeds. They are the official safe deposit
box for the entire deal. And the source also
says they distribute payments received from the
master servicer to the bondholders. Right. So
they're also the cashier. The master servicer
collects all the money from all the different
malls and office buildings, sends one giant check
to the trustee, and the trustee looks at the
master spreadsheet and sends out all the individual
checks to the hundreds of different investors.
They keep the score. And they make sure the pooling
and servicing agreement, which is like the constitution
for the trust, is being followed. That's their
main job. But the source notes that while they
have this broad authority, they typically delegate
actual work. To the servicers. They're not getting
their hands dirty. No. The trustee doesn't want
to manage buildings or foreclose on properties.
They're usually the trust department of a big
bank. They just want to ensure the legal and
financial structure remains intact and everyone
follows the rules. And finally, the last character
on the list. The rating agency. The referees.
Or maybe the book critics. The source says there
can be as few as one or as many as four of them
involved in a single securitization. And their
job is to establish bond ratings for each bond
class when the deal is first created. Right.
AAA, AAA, ABBB, and so on. These little letters
are incredibly powerful. They determine the interest
rate on the bond. And more importantly, who is
even allowed to buy these bonds? How so? Well,
a lot of big institutions like pension funds
or insurance companies have rules in their charters
that say they're only allowed to buy the safest
AAA -rated bonds. So the rating agency is effectively
the gatekeeper to the largest pools of money
in the world. But the source points out an important
ongoing duty. They don't just rate it once and
then walk away. No, absolutely not. They have
to monitor pool performance. They are constantly
watching the data that's coming from the master
servicer every month. So if that big mall in
Ohio loses its anchor tenant. The rating agency
sees that data point. They might run their models
and issue a downgrade. They can turn a AAA bond
into an AA bond overnight. And that would send
shockwaves through the market? Huge shockwaves.
because suddenly that big pension fund that was
holding the bond might be legally required to
sell it because it's no longer AAA. This can
cause the price of the bond to plummet. It's
a constant feedback loop. So it's this rigid,
highly structured ecosystem. The master servicer
collects data, gives it to the trustee and the
rating agencies, who then tell the investors
what's happening with their money. And if things
go really wrong, the special servicer steps in
to clean up the mess. It is a machine. A machine
made of contracts. No one can just make a call
based on a gut feeling. You have to follow the
documents. Always. But there is one character
we haven't fully fleshed out yet. And we kind
of hinted at it when we talked about the special
servicer. This brings us to our final section.
Section 5. The power dynamic. And specifically,
the BP spire. This is where the rubber really
meets the road. If you want to understand...
Who really runs the commercial real estate market?
Who calls the shots when things get tough? You
have to understand the B piece. The source introduces
a very powerful sounding term, the directing
certificate holder, which is also called the
controlling class. Controlling class. I mean,
just think about that name. This is the entity
that is in control. This is the one that directs
the action. And who are they? The source says
they are the investor in the most subordinate
bond class. Okay, stop there. Does that make
any sense to you on its face? Honestly, no. It
sounds completely backwards. It's counterintuitive.
Why? What's your instinct? My instinct is that
usually the person with the most money, the VIP,
the one who bought the safest, most expensive
AAA rated bond, they should be the one in charge.
If I buy the first class ticket, I expect to
have some say. But here the source is saying
the subordinate class, the one at the very bottom
of the pile, is the controlling class. It is
deeply counterintuitive. But it is actually a
brilliant, if maybe ruthless, design feature
of the entire system. All right, explain it to
me. Who is this BP Spire? What are they buying?
They are the investors who purchase the B -rated,
BB -rated, and sometimes the unrated classes
of the CMBS deal. These are the bonds that are
dead last in line to get paid. So these are the
junk bonds of the deal. Essentially, yes. They
are high risk and therefore high yield. We call
this the first loss position. I want you to imagine
a waterfall. Okay. The money from the mortgage
payments pours in at the very top of the waterfall.
The AAA investors, who are at the top, they fill
their buckets first. Then the water flows down
to the AA guys, and they fill their buckets.
Then the A guys. The BP spire is standing at
the very, very bottom, holding a thimble and
hoping there is still some water left when it
gets to them. So if the building starts to lose
money, if some tenants stop paying rent and the
waterfall shrinks? The waterfall dries up before
it ever reaches the bottom. The BP's buyer is
the very first one to stop getting paid. If the
trust loses, say, $1 million in a year, that
entire million dollars comes directly out of
the BP's buyer's pocket. And the AAA investors
at the top. They don't feel a thing. They are
completely insulated from that first loss. They
don't start losing money until the BP's, the
BBP's, and all the other subordinate layers are
completely wiped out. Okay, I get the risk now.
But that still doesn't explain the power. Why
does that risk give them control? Why do we give
the keys to the car to the guy who is most likely
to go broke? Because of one of the most powerful
concepts in finance, skin in the game. Think
about it. If the building loses 5 % of its value,
who cares the most? The B piece guy. He's losing
his shirt. That 5 % loss could wipe out his entire
investment. Exactly. Now, does the AAA guy care
about that 5 % loss? Not really. He's still fully
covered. He's got, you know, 30 % or 40 % of
subordination below him protecting him like a
giant cushion. The AAA guy is asleep at the wheel.
He has absolutely no incentive to micromanage
the property because he's safe. But the BP's
buyer, he is sweating bullets over every single
percentage point of occupancy, every leaky roof,
every late rent check. His survival depends on
it. His survival depends on it. So the structure
says, you, the BP's buyer, have the most to lose.
Therefore, you get to be the one who decides
how we handle the problems. You're the most motivated
person in the entire room to save the building.
Exactly. And the source says they have significant
influence over the trust, specifically by directing
the special servicer. In fact, I've read in other
places that very often the BP's buyer is the
one who appoints the special servicer. Or they
are the special servicer. Yeah. Often these are
the exact same firms. You'll have specialized
hedge funds or private equity groups that buy
the BP specifically so that they can gain control
of the workout process if and when the loans
go bad. That is just fascinating. It's like saying,
since you are the one sitting on the hood of
the car with no seatbelt, you get to be the one
who drives. Or, since you are the canary in the
coal mine, you're the one who gets to decide
when we evacuate. It aligns the power with the
risk. So let's try to unpack the so what here.
We've covered a lot of really technical ground.
We've gone from the basic definition of CMBS
all the way to the tax structures, the lockout
penalties, the whole cast of servicers, and now
the BP spires. We have really dissected the machine.
So let's go back to that street corner, the one
we started on at the very beginning of this.
You're standing there and you put on the finance
glasses. You look up at that same skyline. What
do you see now? I don't just see a skyscraper
anymore. I see a pass -through entity. I see
a massive bundle of legal contracts that are
only held together by a specific exemption in
the tax code. When I look at that office tower
now, I realize that building isn't just owned
by some simple landlord. It's being managed day
to day by a master servicer algorithm that's
probably located in a different state. Right.
And it's being watched like a hawk every single
month by a rating agency in New York. And if
you look really, really closely at the windows,
you start to realize that the person who really
controls the ultimate fate of that building isn't
the property manager sitting in the lobby. It's
the B -piece buyer, some hedge fund in Connecticut
that bought the riskiest slice of the debt and
is now holding the directing certificate. It
completely changes your perspective on the stability
of the city. We think of buildings as permanent.
They're made of concrete and steel. They're solid.
But financially, they're incredibly fluid. They're
tied to global interest rates, to the bond markets,
to the whims of a special servicer who is controlled
by the most subordinate investor. And here is
a final provocative thought for you to chew on
as you walk through your city. We talked at length
about the special servicer, the fixer. They only
take control when things go bad. when the economy
tanks, when tenants leave in droves, when borrowers
default on their loans. The default cycle. Exactly.
Now think about the world we're in right now.
We have the rise of remote work, which is emptying
out office buildings. We have online shopping,
which is killing traditional malls. If we hit
a major recession or if the way we use real estate
just fundamentally changes for good, that means
defaults. A lot of defaults, which means a lot
of those trigger events are going to happen.
And that means the master servicers are contractually
obligated to hand the keys to the special servicers.
That is the logical flow of the machine. It's
what it's designed to do. So it really raises
the question, in a serious downturn, who actually
owns our cities? It's not the developers who
built the towers. It's not the banks who originated
the loans. It's the fixers. It's the special
servicers. You can see a massive transfer of
control of commercial real estate where our skylines
are essentially being managed by these distressed
asset specialists purely for the purpose of salvaging
whatever yield they can for the bondholders.
It is a sobering thought. The city itself becomes
a recovery operation. Every for lease sign you
see isn't just a sign. It's a desperate attempt
to keep the B piece from hitting zero. The skyline
isn't just architecture anymore. It's a balance
sheet. And right now, we all need to wonder who
is holding the B piece. Thanks for joining us
on this deep dive into the hidden world of CMBS.
It's complex, it's technical, but it's the invisible
framework of the world we all live in. Keep looking
up and keep asking questions.