A Statistician’s View Into How COVID-19 May Impact the CMBS Market and Litigation

By IMS Insights Podcast

In this episode of the IMS Insights Podcast, we speak with statistical applications and economic investigations expert, Dr. Charles Cowan, about the impact on commercial litigation during and after the COVID-19 pandemic.

Teresa Barber: It's really great to have you here today on the IMS Insights Podcast.

Charles (Chuck) Cowan: Thank you Teresa. It's very nice to see you again.

Barber: Good to see you too. I want to talk about Analytic Focus a little bit, your firm. See, I know you've been involved in over 130 lawsuits. I know we've worked with you at IMS on a few dozen important matters with clients ourselves. You've been working on residential mortgage-backed securities matters on behalf of investors, federal agencies, monoline insurance companies who offered credit enhancements and even federal home loan banks. In these cases, Analytic Focus has been performing almost any task required as a part of litigation including analytics to determine the frequency of false statements or violations of underwriting guidelines, sampling of loan pools to provide a representative subset of loans that could be underwritten to determine the number of guidelines violations.

Barber: Underwriting of the loans using the guidelines of the originating institutions, automated valuation models or AVM to determine the value of underlying collateral, review of due diligence performed on loan pools to determine what was found in due diligence that may have not been disclosed or corrected in the pool, and even calculation of damages under different legal models, including the rescission of sale and security or partial compensation based on the proportion of defective loans found in the pool.

Barber: This litigation still ongoing started back in 2010 and it's been a substantive part of your work. Based on this experience, it's my understanding at IMS and my colleagues that Analytic Focus is really sensing that a wave of litigation related to commercial lending will begin in the next year. You and I were talking a while back and you suggested that your position is that you expect that these lessons learned from the RMBS litigation will apply to the litigation that will ensue from CMBS, ABS and CLOs. Investors, insurance companies and federal and state agencies, and even the law firms who represent them should begin monitoring these investments now. Can you talk to me a little bit about this? And with 10 years of this work behind you, what resources do you and your firm bring to all of these entities?

Cowan: Sure, I'd be happy to. Historically when we started on this 10 years ago, we had a lot of the skills needed in place. My background is in sampling theory and statistics, so we knew how to provide that type of support because these securitizations and residential mortgage-backed securities were quite large, they needed some sampling. The ability to do AVMs we had done in the environmental side for toxic tort when there was groundwater contamination. So, these are all disparate skills that we have pulled together or in the case of underwriting, I formed a whole new team and we had underwriters who could help support this litigation.

Cowan: But as we went on, we became the nexus for a lot of information about RMBS because we were working for so many law firms and on so many cases, that we were the one constant going through all of that. So, it was not unusual for us to be providing advice to law firms, or at least bringing them up to speed on what was going on in other cases without disclosing anything about the specific case but just to talk in general. That's another set of skills on top of the technical skills that we think that we've honed. So now I'm looking at commercial mortgage-backed securities and seeing that there is risk in those, plus there is information that's come out recently about the quality the valuations and I'm beginning to see the same trends. The things that stoked the particular development of residential mortgage-backed security problems, I'm now seeing that with the commercial mortgage-backed securities.

Cowan: So I've got an experienced staff who understands about the litigation and the type of work that we need to do. I've got a valuation staff. I have a group of people now who underwrite commercial loans. We still do residential loans too, but we've expanded into commercial loans not because we saw a problem, but because there's a huge demand for underwriters of commercial loans these days, particularly for smaller institutions. So, we've covered the waterfront in terms of what I think is going to be needed for this next wave of litigation.

Cowan: But the real problem is that many of the problems that might've remained dormant are now coming to the fore because of the pandemic. So, what you're going to see is a lot of failures, a lot of problems and they're all driven by the fact that the pandemic came along and unearthed problems in the underwriting and valuation on these commercial mortgage-backed securities. As we're discussing this, I'm not saying that the pandemic is necessarily the driving force in terms of what's going to happen in the future, but I think it is an excellent backdrop to understand where the economy is going to go and what's going to happen.

Barber: Yeah, really you laid that out very nicely and also speaking about the team that you have working with you at Analytic Focus. You've got analytic staff as PhDs in finance, and statistics, and economics. Even a good bit of work on litigation working as testifying experts. And I'm curious, you mentioned the pandemic. I wanted to ask you specifically for litigators, what are the key issues that should be of concern in the CMBS market right now?

Cowan: What's happening, and I think there have been some stories in the news and especially on the business channels on TV about what's going on, but there are individual stories about different types of problems. Renters are having trouble paying their rent when they're living in multifamily. If that happens with a lot of folks, then all of a sudden, the owner of the multifamily can't pay their debt service. So for individual renters, I understand that it's a problem and in many cases, what they're getting is forbearance from the owners. But the problem is that the owners still have the debt to service and they're not getting forbearance. So what's going to happen is they're going to miss payments that go into the security, or there's going to be no ability to recover because they're losing so much money and they have to invest in things to maintain the buildings that are in. That's one example. I can go down the list of different types of companies, and buildings, and property types.

Cowan: Restaurants, another fine example. I was looking at a securitization this morning on Bloomberg and it talked about restaurants and retail, some of which is freestanding and some of which is in malls. Well, malls are a problem unto themselves to begin with, but now it's been exacerbated because people aren't going to malls which is killing the retail, especially for the smaller stores. And so, you hear about bankruptcy, after bankruptcy, after bankruptcy for Pier 1. Who knew Pier 1 would go out of business? Or, restaurant chains that just can't afford to maintain the entire chain because of the problems that they're facing in terms of not bringing in sufficient business. So, there's a variety of different things that are all coming together at the same time. The overused cliché is it's the perfect storm, but that's actually what's going on.

 Cowan: So we can talk about multi families, we can talk about retail, we can talk about the office buildings and I believe that that's an even bigger problem because several companies, I believe Facebook and Twitter both came out and said, "You know, this is working pretty well. We're not going back to the office." Well, that means that suddenly in the middle of San Francisco you've got a lot of empty buildings, and who's going to move in that would be of the same size? And, where's the demand going to be for office space? In all of these cases, you have different things that are a result of the pandemic but they're all coming together. I believe that that is going to lead to a real problem in the future and it's a problem that I don't think was anticipated properly at the time these loans were made that went into the securitization.

Barber: Good questions too that you're raising to about whether some of that behavioral change from consumers will be sustained behavioral change, and then what's the long run effect on demand? Let's boil that down a little bit for our listeners to the bottom line of it. What do you think is going to happen to the commercial mortgage-backed securities market and space, and when do you see this happening?

Cowan: First of all, let me add something to your last comment, which is it's not just consumers, it's businesses. Many businesses are now reconsidering, do they need to pay for expensive office space, or can everybody just stay home and work in that fashion? I wanted to point out that this trend actually started in the late 90s when WebEx was first developed and then bought by Cisco Systems. Then we've got GoToMeeting which I didn't know but goes back to 2004. All these other interesting technological change things that were creeping along are now suddenly in play, and you and I are having a conversation on Zoom. How great is that?

Barber: Right. You mentioned some of the big tech firms and their announcements to employees and I recall seeing a couple of months ago announcements from Twitter and Facebook. One of the announcements was stating in perpetuity, "Our employees are working remote in perpetuity," which is definitely significant business behavior change, so interesting. And I know Chuck, you and Analytic Focus have a long history in RMBS litigation specifically. We've worked with you on a number of matters too. Do you see any parallels between what happened there with RMBS and what you're predicting now?

Cowan: Yes. What I'm seeing boils down to a couple of key indicators. In residential mortgage-backed securities, what we looked for were situations where loans were made to people who couldn't afford them, and the way you judge that is by looking at their debt to income ratio. The standard in the industry, especially promulgated by the American Mortgage Association is 43%. That's the upper limit. Then a lot of the loan underwriting guidelines that we've seen in case, after case, after case it's 42%, 43%, sometimes as high as 45%. But that's the upper limit because if you add taxes on top of that at 30%, now all of a sudden you don't have much money left for interesting things like food. The real problem there is that you don't want to overextend the borrower because all you're doing then is creating a problem that they're going to have to overcome or otherwise they can't pay off their loan. That's in residential mortgage-backed securities.

Cowan: The second indicator is the loan to value ratio. If the loan to value ratio is very high, somebody is more likely to default than if they have a lot of equity put into the house. Not only that, but it's also an indicator about how much value you're going to get back. It's why it's called loan to value. So, if the loan does for close, then you have this house that is collateral, it comes back to you as the servicer because at this point, the loan has been sold into a security. As a servicer, I have to take that house into a real estate owned and then sell it, and the proceeds of that go into the waterfall that feeds the securitization. Well, the same thing happens in commercial mortgage-backed securities and other types of assets. I mean, we're focusing on CMBS, but there's also asset-backed securities, and there's CLOs and a lot of other acronyms. But the same problem occurs there.

Cowan: First of all, many companies are severely over-leveraged, and this is fairly well known in the industry, but the one that surprised me most recently was Hertz Corporation. Hertz had to declare bankruptcy because of course people weren't renting cars anymore, and Hertz was over-leveraged through the purchase of Thrifty and Dollar. They couldn't maintain their debt service. Even though we were relatively early on in the pandemic, they just couldn't afford it, so they declared bankruptcy and they're having to cut back. Well, that was because they were famously over-leveraged. If that's the case, that meant that they were at the limits and they couldn't even afford one or two months downtime, which is typically the standard, and that would be the standard and RMBS too. That's the one problem.

Cowan: The other is that there seemed to be issues with the valuation of these buildings. And keep in mind if you're talking about a very large building, that's a real problem for the servicer. It's one thing to foreclose on a house because there's a big market, but if you foreclose on a large building, there's two impacts. One is, there are fewer loans in the commercial mortgage-backed securities than there would be in RMBS. We saw RMBS type securitizations that had 1,000 loans 10,000 loans, but in commercial mortgage-backed securities, that'd be really unusual to have that many. So, if you have one big foreclosure, that really impacts the whole securitization on the commercial side.

Cowan: And then on top of that, now as the servicer, you are handling a really large building. Think of an apartment complex with 1,000 apartments. As a servicer, you don't really want to be managing that on an ongoing basis. So, you may sell that for a significant haircut, which means that the money doesn't go back to pay off the investors and the investors lose principal. Those are two amazing parallels with residential mortgage-backed securities, and now we're seeing the same thing on the commercial side.

Barber: Interesting. Let's talk about the pandemic too and how that interplays with some of what you're seeing and what you're predicting. Is there an argument that could be made that a downturn resulted from the pandemic and that losses therefore are due to COVID-19 and so therefore there would be basis or no basis to litigate?

Cowan: This is another parallel with residential mortgage-backed securities because for most of RMBs, those securitizations were fine. For every one that you find that was litigated, there's probably five or six that were perfectly fine, kept paying and there were no particular problems. That's because the underwriting was just fine, and it allowed for the fact that people would have things that happened to them. They'd lose their jobs, temporarily hopefully, some people would get sick, couldn't make their payments, there are all sorts of things that happened to people. But as long as you factored that in so that you know that those people had reserves so that they could continue to pay until they got their job back or they got back on their feet after an illness, things were fine. But if you didn't have the reserves, or if you foreclosed on the house and it really wasn't worth what it was supposed to be, then all of a sudden you had this big problem.

Cowan: So, the same thing is happening now on the commercial side. You asked me whether the pandemic was really the driver. Well, I'm sure some people will claim that, but the fact is that many commercial mortgage-backed securities will perform just fine. But if there's bad underwriting, if there's overvaluation of properties or if there's something else that's going on which is what we found in RMBS, then no that's not due to the pandemic. That's due to overextending and letting the risk be carried by whoever it was you sold the loan tip and it got put into a securitization. I'm not saying that every commercial mortgage-backed security is going to be the subject of litigation. In fact, I'm saying that only a fraction are going to be, but the reason that they're going to be is because of bad underwriting or overextending and overvaluing what the real return is going to be on that property.

Barber: Right, interesting. I want to get this straight too because some of what you're sharing it's harrowing, a harrowing perspective. Are you saying that given the situation we've got and the economic fallout around today's current climate and the pandemic, do you ... Are you saying that all CMBS is going to fail?

Cowan: No. In fact, I'll reiterate what I've said which is, only a fraction of it is going to fail, but you can predict which ones are going to fail. Then the question is, well, did they fail just because the burden was so overwhelming, or did they fail because they shouldn't have been made in the first place because the underwriting was bad, a loan was made to a buddy, there was an overvaluation of the property? I'm saying it's that latter group that should be looked at with some cynicism as to why they failed. I recognize that a number of loans are going to fail.

Cowan: One of the things that we didn't discuss was apartments. People can't afford to pay their rent because they're out of work, but they can get forbearance. The problem is when they come back to work, in April alone, wage rates dropped 11%. So, a lot of people are coming back to work or they're taking new jobs, and they're finding they're not getting the pay that they had before? Well if they don't have the pay that they had before, they're not going to be able to spend money on a variety of things and anytime anything goes wrong, they're no longer going to have reserves. So the pandemic is going to continue to have that kind of impact, but again, the responsibility was on the mortgage lender in the first place to be sure that the person who owned the property who was looking for the loan had sufficient reserves to weather a problem for a month or two.

Barber: Right. Yeah, interesting. If we were to wave our magic wand and suddenly the pandemic wasn't here, do you believe that we would still be in a situation where a substantial number of CMBS could be preparing to fail anyway?

Cowan: I wouldn't use the term substantial, but I would say substantive and the answer is that ... So in RMBS, you didn't get that many loan defaults up until the time that the economy got bad. Then all of a sudden, everything got triggered and it all happened at the same time. What I'm saying is, here again you've got some problem in the economy caused in this case by the pandemic, and it's going to trigger a whole lot of problems. However, to answer the question you actually asked me, I think in some cases some of the CMBS might slide if there wasn't a pandemic and you'd never know. Or alternatively, the problem would surface but they wouldn't all happen at the same time.

Cowan: I'm predicting a ramping up of defaults and failures of CMBS starting in about the second quarter of next year, so this is in the future, but then it's going to continue on for at least a year, maybe longer and the reason that it's all occurring in a compressed time is because of the pandemic. Otherwise, it can be stretched out over a five-year period and you wouldn't notice it that much, it doesn't seem like that much of a deviation.

Barber: What exactly makes you believe that a crash of CMBS would lead to litigation specifically?

Cowan: Well, I believe that what'll happen is that ... Who loses money? It's the investors, it's the federal agencies that have to take over a failed institution because some investment went bad. There are other laws where an investor or a federal agency might sue an institution simply because they recognize that by representing businesses, the federal agency representing businesses, they're trying to recover on behalf of the businesses who suffered. The point of this is that I think that the litigation will come along, mostly because investors will figure out that some of their investments shouldn't have failed, that they were overinflated, and they will want to recover. And let me point out that there is already one filing by the SEC that was published in ProPublica.

Cowan: ProPublica wrote the story about the SEC filing and it has to do with inflation of the valuations that were done on all of these buildings. So, I'm already seeing some articles and some indicators and I know from my own experience in economics that there will be others coming along, and that you will find that there are a few overly exuberant institutions who made loans that they shouldn't have.

Barber: It's interesting you bring up that ProPublica piece and you mention the over inflation of the valuation as a factor. What other factors Chuck are you thinking are going to lead to litigation and against him? Without disclosing anything confidential or ... I'm just curious.

Cowan: There's a really interesting report that was published by FinCEN about collusion. There are four primary causes of fraud in commercial lending, and one of them that they talked about was collusion between banks and their customers. I could easily see that if you were a financial institution and trying to stay on the good side of a really large property owner, that you might work out something with them that you wouldn't have otherwise had you not known that person. Well, FinCEN published this report in, I believe it was 2011 or 2012. Subsequently, there have been a number of other investigations, both by FinCEN and by the US Senate regarding these types of failures in the banking system.

Cowan: I'm not saying necessarily that it's always the bank's fault, but the banks are the gateway. They're responsible for making sure that the information that they got is correct. So, they have available to them the books of the institution or the company that's doing the loan, they know what the cash flows are, they can do their own investigation. I also understand that some investors come along and really do very important and detailed due diligence, but if they're relying on the numbers that they were just handed by the institution, the bank, how good is that?

Barber: It's moot, right. Interesting. So Chuck, you mentioned that you see some of this fallout happening for CMBS in the future. You even mentioned we may not see it until a year from now. But, yeah I know you're very interested, your team has been conducting analysis. You're clearly watching the situation. Why would this be important right now for our audience for litigators and for even in-house counsel to pay attention to and heed right now?

Cowan: I think that in-house counsel for a lot of these investors, and also for the agencies needs to anticipate this. I mean, the last time with residential mortgage-backed securities, I believe it snuck up on folks. That's not the technical term, but we'll call it snuck up on folks. But the real issue is here, we already know that there's a downturn and we already know that in several different areas that I've cited, that there can be a problem. What I usually don't see are people picking multiple facts and putting them into a story that will tell them, where exactly are things headed?

Cowan: So if You're an investor in commercial mortgage-backed securities, you would like to know that somewhere a year from now, there are going to be some problems and that ... Particularly if you're in-house counsel, you'd like to start thinking about what data you need to collect, what kinds of questions should you be asking? What kinds of reports should you be reading? FinCEN reports are not everyday things that one might pick up and read but check now might be a good time to do it. That's why I'm bringing this up, because I believe that people can be much more on top of the type of loss that they might have, and what they can do about it.

Barber: Yeah, that's really good guidance and good points to Chuck. And I would say typically when we're speaking, we're connecting you with outside counsel on litigation, but it sounds like this might be a time to speak with someone like yourself also. To seek that type of consulting and just guidance early on to potentially avoid losses as an investor or be prepared, right?

Cowan: Yes. I will say that over the last 10 years, I've seen a lot of very close collaborative relationships between inside and outside counsel. So, this is a really good talking point for both of them to say, what can we do? How do we know if this is going to happen? How will this impact us? How can we shelter ourselves? I mean, now is the time to be discussing this with if you're outside counsel with your client, and if you're inside counsel, you really don't want a surprise. You would really prefer to be able to go to the CFO and the CEO and say, "I think we ought to be thinking about this now, not a year from now."

Barber: Right. Not necessarily wait for the litigation.

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FEATURING: CHARLES COWAN

Dr. Charles D. Cowan is a nationally recognized statistical applications and economic investigations expert as well as an IMS Elite Expert and contributing thought leader in a range of areas including economics and statistics. He serves as Chief Executive Officer and Co-Managing Member for the national statistics, finance, and economics consultancy, Analytic Focus.  Read more about Charles Cowan>>

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