§25.5 - Conduit Loans

• Jurisdiction: Washington

§25.5 Conduit Loans

"Conduit loans" are commercial real estate loans that collateralize securities sold in the capital markets. The securities, which are backed by either a single, very large conduit loan or, more typically, by a pool of many different conduit loans, are known as "commercial mortgage backed securities" (CMBS).

In "securitized" lending transactions, the rating agencies from Wall Street's world of stocks and bonds have traditionally been directly involved in the underwriting and approval of the commercial real estate project, the borrower, the guarantors, the commercial loan, and its loan documents. Three major rating agencies, Standard & Poor's, Moody's Investors Services, and Fitch/IBCA, Inc., have been the dominant rating agencies for CMBS transactions.

In CMBS transactions, commercial real estate loans, which are usually first-lien, permanent loans, are pooled together and transferred to a trust. The trust then issues a series of bonds that are typically divided into "tranches" distinguished by varying maturities, yields, and degrees of risk. The bonds assigned the lowest ratings (by the rating agencies) typically would have the highest yield, but also the highest degree of risk, being required to bear the first loss in the event problems arise in the underlying pool of loans. Conversely, the highest rated tranche would have the lowest yield but would bear the least amount of risk.

The trust that issues CMBS bonds typically is intended to qualify as a REMIC (real estate mortgage investment conduit) as defined under the Internal Revenue Code and Treasury Regulations. See I.R.C. § 860D; 26 C.F.R. § 1.860D-1; see also Stewart M. Rubin and Nicholas J. Levidy, MOODY'S APPROACH TO RATING U.S. CONDUIT TRANSACTIONS, COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS) RESEARCH 19 (Sept. 15, 2000). A qualified REMIC trust is a pass-through entity that avoids paying taxes on earnings at the trust level, so the bondholders' investment yields are not subject to double taxation. Qualification of the CMBS trust as a REMIC, however, imposes a substantial amount of rigidity both upon the documentation and the long-term administration of the underlying conduit loans. For example, once the pool of mortgage loans in a particular REMIC has been assembled, significant modifications of any particular mortgage loan are not allowed outside the context of a defaulted loan. Thus, a conduit borrower does not have the flexibility after closing to restructure...