Risks and realities of mezzanine loans.

• Author: Berman, Andrew R.
• Position: Symposium: A Festschrift in Honor of Dale A. Whitman

I presented an earlier version of this paper at the University of Missouri School of Law Festschrift in honor of Dale A. Whitman (1)--a great teacher, thinker, and legal scholar. As many already know, Dale Whitman is largely responsible for the creation of the new academic discipline focusing on real estate finance law--once primarily the province of business schools, accountants, and economists.

Dale's scholarship and writing has had a significant influence and impact on so many of us, including my own interest in teaching and researching in the area of property law and real estate finance. When I look over Dale's lifetime of scholarship, I see several important and recurring themes, including the following:

(i) the interconnection between common law property principles and contract law and the necessity for legislative reform; (2)

(ii) the uneasy and constantly changing dynamic between the mortgagor-borrower and mortgagee-lender; (3)

(iii) writing effectively to both legal academics and practicing lawyers; (4)

(iv) respecting the enduring role of a real estate lawyer as, first and foremost, a "dirt lawyer"--and that is not a pejorative--with his focus on recording issues, (5) mortgage drafting, (6) and other similar core real estate issues; and

(v) in all of his articles, focusing sharply on the intersection of property law and real estate finance. (7)

With this in mind, this current article exploring the risks and realities of mezzanine loans is dedicated to the legacy of Professor Dale Whitman's lifetime of work in real estate and property law.

1. INTRODUCTION

   The last decade has witnessed an astounding increase in the outstanding amount and new issuances of mortgage-backed securitizations. (8) In 2005 alone, there were issuances of mortgage securitizations exceeding $1.5 trillion. (9) These securitizations, consisting of pools of both residential and com mercial mortgage loans, (10) now constitute over $5 trillion in outstanding mortgages and account for over 20% of all outstanding mortgages in the United States. (11) The growth in mortgage securitizations has also led to the creation of new real estate financing techniques, including mezzanine loans. (12)

   These new financings are not directly secured by real estate and do not even directly involve land. In the real estate industry, mezzanine financing, for example, "refers to a loan secured principally by the borrower's equity in other entities. Unlike conventional mortgage financing where the [mortgage] borrower owns real estate, a mezzanine borrower doesn't directly own any real property nor does it operate any business--it acts merely as a sort of holding company." (13) A mezzanine borrower typically only owns limited liability interests in a limited liability company, and this intermediary entity owns the entity that actually owns the underlying real estate. (14) Both economically and legally, the value of the mezzanine borrower's collateral derives solely from its indirect ownership of the underlying mortgaged property.

   Property owners have increasingly favored combining mortgage financing along with mezzanine loans as a method to obtain higher loan-to-value ratios and therefore higher proceeds. (15) Oftentimes, the addition of a mezzanine loan to the borrowing structure can bring the total loan-to-value ratio of a transaction to 90-95% (and sometimes as high as 105%) of the total value of the underlying real estate. (16) This is compared to a loan-to-value ratio of 85-90% with traditional junior mortgage financing. (17) As a result, mezzanine loans have been quickly replacing the junior mortgage as the principal means to provide real estate owners with additional financing. (18) In calendar year 2005 alone, the amount of new mezzanine loans soared almost 300% from the preceding year. (19) According to Moody's, the issuance of mezzanine loans included in collateralized debt obligations (CDO) has increased from approximately $25 million in 2004 to over $3.22 billion per year in 2006. (20) Given this large increase in CDO issuances, the size of the mezzanine debt may be close to $135 billion, and some estimate that it may represent up to 10% of the entire $4.5 trillion real estate sector. (21)

   In my previous article, "Once a Mortgage, Always a Mortgage," I explored the historical development of mortgage financings, securitizations and these new non-traditional financing techniques. I argued that courts should use their equitable powers to recharacterize mezzanine loans and preferred equity investments as junior mortgages. (22) In that article I principally examined the benefits of recharacterizing mezzanine financing from the borrower's viewpoint. This article, however, examines the hazards of mezzanine loans for lenders at two different points of time. At the very beginning of the debtor-creditor relationship, lenders often find it difficult to ensure the creation, attachment, and perfection of a security interest in mezzanine loan collateral. Furthermore, later on in that relationship if the mezzanine borrower defaults, there are many limitations on the remedies available to mezzanine lenders. (23)

   Lenders frequently attempt to mitigate some of these risks by requiring that borrowers are special purpose and bankruptcy remote entities, and lawyers deliver legal opinions on the enforceability of the loan documents. In addition, lenders purchase "mezzanine loan" title policies and/or endorsements, and enter into intercreditor agreements with the senior mortgage lender. Unfortunately, dealing with these hazards often leads to inefficient and wasteful practices that end up compounding the problem, leading to further market imperfections. The result is over-confident lenders who overlend at interest rates that do not adequately reflect all of the hazards inherent in these complicated financings. In effect, this causes a classic market imperfection since there is a mismatch between (or mispricing of) risks and rewards. This is clearly a concern for mezzanine lenders since they bear the risk of default. Overlending is also a concern for the real estate marketplace in general since it will inevitably bear many of these risks (sometimes referred to as negative externalities) if and when the borrowers in these complicated financial arrangements begin to default.

   This article is a first step in evaluating and discussing some of the hazards, legal risks and uncertainties inherent in mezzanine financings and the way in which the market fails to adequately take these factors into account. In Part II, I describe the legal background and structure of mezzanine loans. Part III focuses on the risks and realities of mezzanine loans. In particular, I describe some of the difficulties in perfecting a security interest in, and foreclosing upon, mezzanine loan collateral. In Part IV, I argue that the recent subprime mortgage crisis offers a cautionary tale for many of the hazards that may be looming in the near future for the mezzanine loan market, that mezzanine lenders must better understand and evaluate these hazards, and that the legal system needs to produce clearer rules on these non-traditional financings.

2. BACKGROUND--LEGAL STRUCTURE OF MEZZANINE LOANS (24)

   In the financial markets, the term 'mezzanine financing' describes many different types of financings such as junk bonds, unrated debt, unsecured notes, zero-coupon bonds, deferred interest debentures, and convertible loans. (25) These financings are all related but have different legal structures, responding in part to the needs of specific industries and their regulatory regimes and/or market participants. (26) The common thread, however, in all mezzanine financing is a capital structure with debt that is senior to equity but junior to other more senior debt. Like a theater, mezzanine debt sits in the mezzanine section between senior debt in the more expensive orchestra, and equity sitting in the cheaper section of the balcony.

   In real estate, "mezzanine financing" refers to a particular type of debt that is junior to the senior mortgage loan but senior to the equity investors. (27) The senior mortgage loan is typically secured by income-producing real estate owned by the underlying mortgage borrower. (28) A mezzanine loan, however, is secured solely by equity interests in other entities that either directly or indirectly own income producing property. These "Equity Interests" are usually membership interests in a limited liability company, sometimes stock in a corporation, and rarely limited or general partnership interests in a limited or general partnership. (29) The collateral for a mezzanine loan consists solely of the mezzanine borrower's (direct or indirect) Equity Interests of the mortgage borrower--the underlying entity that actually owns the income-producing real property.

   Mezzanine loans are typically secured by the Equity Interests in the mortgage borrower, but mezzanine borrowers do not directly pledge the equity of the underlying mortgage borrower. Instead, the mezzanine loan is structured as a "second tier" (or even "third tier") financing. Consequently, the mezzanine borrower pledges the Equity Interests in its subsidiary--an intermediary entity that directly or indirectly owns the underlying mortgage borrower. (30)

   Whereas a mortgage borrower directly owns real estate, a mezzanine borrower only owns equity. In fact, the national rating agencies often require that the mezzanine borrower be structured as an entity that is both special-purpose (SPE) and bankruptcy remote (BRE), and that owns no assets other than its equity ownership in other entities. (31) Since only the bottom-tiered entity (the mortgage borrower) actually owns real property, the mezzanine borrower's entire net worth, cash flow, and value of its collateral is derived solely from its (direct or indirect) equity in the entity that owns the underlying income-producing property. (32) The mezzanine borrower typically...