There is no question that the way in which we have conducted securitizations in the past is broken.
I agree with Ethan Penner (in his July 10, 2008 Opinion Article in the WSJ, The Future of Securitization) when he says “Yesterday’s business model has been invalidated.” However, I do not agree with his conclusion that securitization can survive “with a simple tweak.”
Mr. Penner makes the case that, in addition to transferring credit risk, the two primary benefits of securitization are
- a vehicle that allows a lender to match the terms of its assets and liabilities and
- the “transparency that it brings to bear on the system.”
Penner’s article concludes that for securitization to return the lender must originate loans and have enough equity/balance sheet to keep the first loss piece, while securitizing the senior pieces with CMBS bonds to get the benefit of risk transfer and to match fund the loans.
In other words, by the lender keeping skin in the game, the interests of the lender and the investor stay aligned and, therefore, everything will work again. The article makes no mention of the role of transparency and standards (other than them being one of the key benefits of securitization).
While aligning economic interest is absolutely a good idea, I would suggest that point is so fundamental that it should be assumed as mandatory. If the equity and the investor do not have aligned economic interests, we should not even consider bringing back securitization.
But how much equity is needed to keep all players’ interests aligned? 10%, 20%, 50%? The amount of required equity will no doubt vary depending on the market, the assets and the relationship between the equity (lender) and the investor.
History has shown that in good times the lenders will be required to keep very little (if any) skin in the game. In bad time, lenders will be required to put up more equity.
While coming up with equity is a fairly simple “tweak,” it does not represent the permanent reforms that are required.
Standards and transparency
For me, Skin in the Game is not the long-term answer (although it will probably be required for lenders to re-enter the securitization market as it crawls back to life).
The keys are standards and transparency with all parties using common underwriting models. Having spent the last eight years creating the most widely used common underwriting tool in the CMBS market, I can say that all lenders do the math the same way. Bank of America, Royal Bank of Scotland, Hypo International, CWCapital, AIG and Genworth all underwrite using the same software. Rating Agencies including Standard and Poor’s and DBRS underwrite using the same tool. The reason the market has not historically shared underwriting has to do with the fact the no common underwriting platform existed, not because the math is different from shop to shop.
The systems used by the big players were developed (at great cost) internally and typically have an Excel-based calculator. Since the models are fairly complicated (although the math itself is fairly simple), each party sets up its systems a bit differently. They do not share identical structures, and they do not communicate. And, since these systems were expensive and painful to develop, many people have vested interests in keeping the systems in place — so they don’t look like wasted technology dollars.
Underwriting is NOT an “art form”
Of course, some lenders have not been interested in sharing the math because, when times were good, they simply did not need to. I remember one prospectus where the issuer actually called underwriting an “art form” and, therefore, could not explain the math behind the numbers.
If underwriting is defined as an Art Form, then making up numbers because of aggressive assumptions becomes OK and very hard to detect. If they could sell the assets without the disclosure, why bother? One true benefit of the credit crash is that this position, as we have said, has been declared invalid.
A common underwriting platform
How do we, as an industry, get to a common underwriting platform?
To date, the industry effort to create standards has been led by the CMSA through its work on the IRP (Investor Reporting Package) and the MBA under the C-MISMO banner (Commercial Mortgage Industry Standards and Maintenance Organization).
The CMSA IRP is a decent standard in that people generally use it, but the data available in the file is deficient. The MBA has tried hard (and continues to try hard) to “herd the cats” and get everyone to agree on the data standards. It should be noted that CMISMO is not trying to standardize underwriting, only data terms and structures. Even with this reduced scope, the process of creating standards has been painfully slow and, after eight years of trying, only a handful of standards have been created with minimal industry adoption.
However, even if CMISMO were successful in short order, since there is nothing in the standards regarding underwriting, the ultimate value of the standard is questionable. That being said, we are members of CMISMO and have offered our tools, free of charge, to help the CMSA gain traction in rolling out IRP 6 (in XML).
On the private sector side, my product (Backshop) has been the most successful in gaining market acceptance. It is the only third party application in which 100% of the underwriting is done within the website and the database (no Excel!), so the system is 100% structured.
But Citi Bank, Goldman Sachs, JPMorgan, Morgan Stanley, Wachovia and others still use proprietary models. I can attest that selling enterprise software into these big companies is a slow and painful process with all sorts of barriers that often have nothing to do with the product. That being said, these institutions have never experienced an “Invalidated” business model, so the time may be now.
True, long-lasting change
If we, as a market, all used the same “calculator” and were willing to share our underwritings with the rating agencies and the investors in an open, transparent manor, that would bring true and long-lasting change to the securitization market.
It is more than a “tweak” — because creating standards is harder than raising capital.
However, if the legacy systems of a few major players are shelved and the remaining players have a path to join a common standard, the math would open up, and the risks of the loans and securities would be transparent.
Investors would no doubt return if they were comfortable they were getting a positive risk-adjusted return and that, in my opinion, is the way to bring back the CMBS market.
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Jim Flaherty is CEO of CMBS.com and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.
It is September 11, 2008 and I have started preparing content for my soon-to-be released-blog, CMBS 2.0. The history of the company is deeply connected to September 11, 2001 and what better day than the 7-year anniversary of the attacks to chronicle that history.
The birth of Backshop
The company was incorporated in July 2000 with $500,000 of “Angel” money. We used that money to convert our starting technology (that we created at my first company, GateCapital) from Microsoft Access to Microsoft SQL and ASP (a desktop application to a Web based enterprise application).
By early 2001 we had a product that was functional (albeit grossly deficient in underwriting tools) and started the effort to sell the software. Right away we realized how hard it was going to be because we had two big strikes against us.
First, we were an undercapitalized “.com” from San Francisco (this was well after the internet bubble burst) competing against well capitalized competitors ($50MM each for CapitalThinking and MortgageRamp).
Second, we were trying to convince lenders that their Excel models were useless and they needed to dump those models and join Backshop.
In fact, I used to go into meetings with a button that had the word Excel on it with a line through it and was preaching my “No Excel” mantra. Needless to say, we could not find any banking executives who had vision and confidence in our ability to deliver on the promise of “Goodbye Excel”. So we started looking at other ways to survive.
In the summer of 2001 I had (I thought) found it. A local Bay Area company called LoopNet (a commercial real estate multiple listing service) was going through a tough time as a result of the .com crash. They were forced into a merger with a competitor, had investors screaming for better cash flow and did not have a proven revenue model.
In August 2001, I put up $75,000 and signed a contract to buy a division of LoopNet called LoopLender. The strategy was to link our newly created loan origination software with the equity listings on LoopNet to create deal flow which, in turn, would help us close software business because the banks would not only get a no-Excel, kick-ass system, they would also get deal volume.
So, on September 10, 2001, with the LoopLender business plan fresh off the printer, I took the “pink” eye to New York, Checked in to the Soho Grand (Canal and W. Broadway), and woke up bright and early on Tuesday the 11th to go and raise the money to fund LoopLender.
My 9 a.m. meeting was on Wall Street with Steve Schwartz at JPMorgan/Chase, and I had a 10:30 a.m. meeting ON THE 26th FLOOR OF TOWER 1 with Jim Kehoe, my old GateCapital partner. In fact, Kehoe and I had talked about a breakfast meeting at Windows On The World before the JPMorgan meeting but, thank God, we are both a bit too lazy for that so we settled on the 10:30.
On my way to my 9 o’clock on Wall Street, the first plane hit, and I witnessed firsthand the destruction of that day. The explosions, the realization it was a not an accident but a terror attack, the people jumping from the burning towers, and then, the collapse of the towers. I went back to my room, called my family to tell them I was OK, and then slept until 4 o’clock that afternoon. For the next few days (I did not leave New York until Friday), I lived 10 blocks from Ground Zero and spent time with all sorts of people who had similar stories of close calls. In the days immediately following the attack, the spirit of New Yorkers was amazing and I built on that vibe for my healing process.
So, when the realties of the event sunk in, I realized that the deal I had cut to buy LoopLender was not going to get funded. Of course I should have just taken my $75k hit and walk away. But, being the optimistic entrepreneur, I figured if I could get LoopNet to lower its price, maybe I could close it. I ended up chasing the deal for another 6 months, throwing another $125k in deposits to keep the deal alive while I was trying to close the equity. While I had negotiated hard and got the pricing way down, I could not get my equity to close (Wimps!), and ultimately lost $200,000 when I could not close without them. Ouch!
For those of you who don’t know, Loopnet had (is having) a happy ending. They dominate the commercial MLS space and had a successful IPO. Check them out on the NYSE under the ticker “LOOP.”
Time to rock
After a rough couple of months and a move out from an office in San Francisco to a desk in Sausalito, I finally got a break in November 2002. Through an introduction from Chris Tokarski of Coastal Capital (and later Countrywide), I met Perry Gershon at RBS Greenwich Capital (now of Loan Core Capital). He had just been brought in with Mark Finnerman to ramp up the real estate group.
I went in for my sales call, gave my “No Excel” pitch, and finally got the response I had been praying for: “You’re the first guy who knows what he is talking about.”
Perry had developed an Access database at Nomura under Ethan Penner, so he knew the value of getting out of spreadsheets and getting the business into a database. And he is one of the smartest folks in the business.
Over the next 12 months, we built out the deficient pieces of Backshop (we called it cUnderwriter back then) so you could do lease-by-lease underwriting and everything you needed to originate and securitize loans on stabilized properties.
We started marketing the product in January 2004. We signed up our second client (Chris Tokarski and his partners at Countrywide) in April and have been rolling ever since. We were lucky enough to get different types of clients who needed discounted cash flow modeling for properties other than stabilized real estate in the United States. So, we built out the multiyear cash flow models and construction lending models, and we could account for different currencies and date formats, etc.
We also made two significant acquisitions. First, we acquired Conquest bond modeling software and CMBS database from Standard and Poor’s in late 2005. This acquisition has positioned us to become a content as well as software provider. Second, we acquired DealCentral from MortgageRamp / CapMark in 2007 (one of our $50MM funded competitors). We consolidated DealCentral clients onto Backshop and eliminated a competitor.
Transparent standards — today!
And now, we embark on perhaps our biggest challenge: the adoption of a transparent standard for the real estate finance industry.
This mission is bold but necessary.
We are committed to making the software widely available to all who want to join the standard. We hope, with continued widespread adoption, we can balance the transparency requirements with privacy issues and create a more credible, open standard for the resumption of the CMBS business.