The dizzyingly complex securitized deals of the 2000s were alittle like polygamous marriages in which the vows-in this case,pooling and servicing agreements did not really count on facingsickness as well as health, or being poorer as well as richer. Aslong as cash flow was positive and debt was serviced, the marriageswere harmonious. But as the market turned turbulent and deals beganto run aground, the spouses began to squabble. More to the point,they hauled one another into court to assert their rights withinthe capital stack and protect their investments.

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The result is an outbreak of tranche warfare: infighting amonglenders and, in some cases, investors. Arguably the highest-profileexample has stemmed from the foreclosure of the Peter CooperVillage/ Stuyvesant Town complex in Manhattan, but it's hardly anisolated incident.

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Mark Edelstein, New York City based partner in the realestate/workout practice at Morrison & Foerster, tellsDistressed Assets Investor that "there are tons of litigation goingon." Although his firm, which has been involved with the ExtendedStay Hotel and General Growth Properties bankruptcy cases,predicted the advent of tranche warfare two years ago, "it's beenmore than we expected."

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One reason is the sheer volume of CMBS deals financed at themarket's peak, and the concurrent mountain of distressed debtresulting from the downturn, as commercial property values fell 40%from 2007 levels. Another factor is the structure of CMBStransactions, in which investors purchase bonds that are groupedaccording to tranches, with an A/B-note structure.

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Those with the lowest risk-i.e. buyers of the highest-ratedbonds-are first

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in line for payment should some of the receivables go intodefault. Then those at the next risk level have a right to payment,and so forth. Therefore there's an inherent tension among thosevarious risk levels.

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Still another factor is that the CMBS structure gives mezzaninedebt holders

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a level of control that's not concurrent with the size of theirstake in the deal "You've got the B-note holders," who are oftenspecial servicers, "and you've got the A-note holders, who actuallyhave the bigger piece of the deal," Transwestern's Steve Pumpersaid in a recent video interview on GlobeSt.com. "But the firstloss position, being the B-note holders, is actually in a positionto make the decision" in the event of a default.

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The theory, says Edelstein, is that since B-piece holders "wouldbe the first ones to lose value, they're going to fight to protectthemselves and therefore indirectly protect everybody above them."Given the fiduciary role that the mezz debt holders play, "somepeople have thought that there's an inherent conflict of interestwith B-piece holders in the first-loss position assuming fees fromspecial servicing, doing asset management, dispositions, that kindof thing," says Pumper, Transwestern's Dallas-based executivemanaging director of investment services. "So it's been a bone ofcontention. But in my estimation, the special servicers have done avery good job."

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It isn't as though intercreditor agreements make no provisionsfor crisis management. Yet when it comes down to it, the wording ofthe provisions frequently is open to interpretation, and, Edelsteinsays, many of these complicated deals are being settled outside thecontext of the documents, not inside.

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"A lot of this stuff is not being resolved the way the documentshad contemplated," he says. "They often require the more juniordebt to buyout the senior debt or keep them current while theyforeclose. A lot of these deals are not working out that way."

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A case in point is the default on the John Hancock Tower inBoston in late 2008. Discussed elsewhere in this issue as anexample of hedge fund activity (see page 15), it also illustratesone scenario for successfully waging tranche warfare. As seniordebt holders sought immediate foreclosure on the 60-story officetower and junior debt holders sought more time to repay the loans,a joint venture of Normandy Real Estate and Five Mile CapitalPartners acquired the mezz debt and forced foreclosure, buying theproperty for $660.6 million in early 2009.

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The purchase price represented a deep discount on the $1.2billion that Broadway Partners had paid for it two years earlier."By bidding only approximately $20 million more than the existingmortgage debt, the joint venture was able to obtaingreater-than-90%-plus financing at a top-of-the-bubble, belowmarket interest rate," wrote Dechert LLP attorney Matthew Clark inan article this past summer.

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Following their acquisition, the JV spent about $50 million onupgrades to the property and secured the market's largest leasethus far in 2010: a IS-year, 208,000-square- foot deal by locallybased Bain Capital. With the tower's occupancy now at 95%, the JVin October sold the Hancock building to Boston Properties in a$930-million deal that includes the assumption of a $640-millionsecuritized senior mortgage loan.

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Although the Stuy- Town foreclosure on $3-billion of securitizeddebt has not yet been resolved, and certainly not in the wayoriginally intended by a JV of Pershing Square Capital Managementand Winthrop Realty Trust, Edelstein says it provides anotherexample of how a mezz debt holder can come out a winner.

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The possible agreement between the JV and senior lenders-stillnot finalized as of this writing-would mark a more successfuloutcome than an earlier attempt of waging tranche warfare on the11,227 -unit multifamily complex.

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In February of this year, a hedge fund controlling more than 25%of the $3-billion senior debt on Stuy- Town filed a motionchallenging CW Capital Management. The hedge fund, AppaloosaManagement, alleged in a court document that the special servicerviolated its fiduciary duty to debt holders by seeking foreclosure"when other less hazardous avenues were available." Judge Alvin K.Hellerstein, the US District Court presiding over the Stuy- Towncase, shot down Appaloosa's motion.

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Six months later, the Pershing Square/ Winthrop JV sought toforeclose on the complex based on its acquisition of $300 millionin senior mezz debt, which it had bought for 15 cents on thedollar. A New York State Supreme Court judge blocked the JV'sefforts-but according to the Wall Street Journal, the partnershipthen met with CW Capital about a buyout of the mezz debt.

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If the agreement pans out, Edelstein says, it would illustrate"how a mezz lender that is out of the money can play its hand withall of the intercreditor rights in the structures today to actuallyget paid something. Many people have been under the impression thatin

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these tranched deals, if you're out of the money you walk awayor you get foreclosed. But you have a lot of folks looking to buythose positions because they have leverage, notwithstanding whatthe documents say."

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He notes, however, that as tranche warfare goes, the battlelines were pretty clearly drawn in this instance. "When you talkabout Stuy- Town, you're talking about senior versus junior," saysEdelstein. "But within these structures, there are many juniors." Aloan could be carved up into many more levels than simply A or B,for example. "So there are many fights that go on." For example,"when they do an appraisal and readjust the CMBS, the people whoare getting cut out sue over that."

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Such widespread litigation was a hallmark of the Extended Staybankruptcy. Following the June 2009 filing, the largest in US hotelhistory, "You actually had two types of tranche warfare: betweenthe senior and the mezz, and then you also had potential warfarebetween the different tranches of the CMBS stack," says Edelstein.Prior to the filing, there were additional squabbles between levelsof mezz debt holders.

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Although the Extended Stay restructuring was resolved, with agroup led by Center bridge Partners prevailing in an auction with a$3.93-billion bid this past May and the company emerging frombankruptcy last month, the competition between the Center bridgegroup and a rival plan from Starwood Capital Group led to anotherround of warfare. Following that May auction, a group of unsecuredcreditors filed a motion in support of a new plan put forth by theStarwood-led group to acquire three-quarters of the Spartanburg,SC-based company and backstop a $ 140-million equity-rightsoffering that would enable the creditors to buy up to 20% ofExtended Stay.

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Although the volume of tranche warfare has kept workoutattorneys busy, we may not have seen anything yet. New distress mayhave plateaued recently, yet Pumper points out, "If you look at2005, 2006 and 2007 CMBS origination, the domestic numbers were$150 billion, $21 0 billion and $250 billion. That is coming duehere. And a lot of that pertains to the office sector, which hasbeen a lagging indicator."

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As CMBS defaults increase, so will battles between debt holders,Edelstein predicts. "What might help is that as more of these casesplay out in court, there will be more guidance as to what some ofthese agreements mean," he says.

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In the Stuy- Town case, for instance, Supreme Court JudgeRichard Lowe's interpretation of the intercreditor agreement"impacted many other deals. That established a precedent of record,although many lawyers think it's not much of a precedent, becausethe agreements vary in the way they're worded. But as more of thesecases come up, hopefully they will be settled more quickly. A lotof the issues coming up now are issues of first impression,"meaning that they haven't come before the court previously. A clearwinner in tranche- to- tranche battles is often the beleagueredproperty owner, for whom the warfare can buy some time. "It givesrise to delay if the lenders fight among themselves," Edelsteinsays. "The borrower hangs around while the lenders duke itout."


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