By Andrew McIntyre

Law360 (May 22, 2020, 11:54 AM EDT ) In this edition of Coronavirus Q&A, one of Dechert's global real estate finance leaders discussed the ways COVID-19 is impacting the commercial mortgage-backed securities market and likened the current pandemic to the unknowns faced by early explorers and cartographers.

Rick Jones, co-chair of Dechert LLP's global finance and real estate practice groups, shared his views as part of a series of interviews Law360 is doing with lawyers to examine how the pandemic has impacted businesses and brought about a new set of legal questions.

Jones divides his time between Dechert's New York and Philadelphia offices, and specializes in CMBS and various other complex real estate financing matters.

This interview has been edited for length and clarity.

What have the last couple months been like for you in terms of real estate finance work?

Like everyone else, it's been a tale of two cities. The beginning of the year was super strong, a lot of deals backed up across all the products in our global finance group. Whether [collateralized loan obligation] or [asset-backed security] or [commercial real estate] loan origination, or CRE securitization, the latter where I live. That's my day job. Things were super busy. I write a regular column called Crunched Credit, and my January column was, 'things look fantastic as long as no black swans — or I think I also usually reference black swans and orange swans — swim across our pond.' And of course thinking that no such thing is likely to happen, or couldn't envision it.

And then a herd of black swans, or whatever one calls a bunch of black swans, all landed, and the world changed. And we were probably walking around like a chicken with our head cut off, not realizing we were dead for several weeks before the realization occurred that we were heading for something comprehensively different from everything we've ever seen in the lockdown. But if you translate to look at January-February and then compare it to late March-early April, it's two hugely differently worlds. And we're still trying to find our way.

I was describing the other day that the contours of the world in which we live is like those 14th-century maps where the cartographer didn't know what was a little further away and would just write 'here be dragons' and show sea monsters. So they had no idea what was going on, and I think we're kind of there, right? Anyone who has certainty about where we're going is just fooling themselves at least.

Like the early explorers who sailed up the coast of California and thought it was an island.

Exactly. Here be dragons.

California appears as an island on early maps.

Exactly. And that's sort of where we are. We don't know where we're going. We have kind of a house view, because you need a view right now. Any business venture that says, 'Well, we don't know what is happening,' is expressing a view but not recognizing they have one. Our view is that the depths of the disruption or the economic disruption is relatively short-lived, and then by the early fall, business will be returning to some level of normalcy. Not, by the way, the same level of normalcy we saw before the pandemic arrived. There's not a month that I can see in the next 18 months that looks like it should be the month following the January 2020 that we experienced. It's just not there. But some return to normalcy.

So we're all sheltered in place, our clients are all sheltered in place. But, for those of us who have seen a couple of cycles and who are permanently scarred by the Great Recession, this is different. They are all different. The difference in this sense is that when the wheels came off by the fall of 2008 and we were dipping into this significant bathtub-like trough, nothing happened for awhile. We just were staring at the walls. There was no transactional activity.

What makes this a little different is that transactional activity has sort of held up. People are getting deals done. We're not seeing, or at least until the last couple of weeks, we were not seeing much new credit extended in the commercial real estate market. Borrowers weren't borrowing in a regular way from lenders, but leverage was being provided to financial assets. Leverage was being provided to pools of assets. Securitization transactions were being assayed. And in the last couple of weeks, we're hearing clients talk about, at least in the [single asset-single borrower] space, we're seeing some deals starting to move, with apparently the expectation that they will get closed and subsequently securitized.

When you think across the last couple of months, was there a specific moment or a specific event that comes to mind where you just had the realization that, 'Oh gee, the orange and black swans have arrived?'

I wish there was. It's almost like, where were you on 9/11? Where were you when Kennedy was shot? Is there a moment out there that crystallizes the fact that we're in deep shit? I don't think there was. It was sort of a creeping realization. Probably finally crystallized when the shelter-in-place orders came out. But even then, the question was, 'Well, how long?' And no one knew what it was. It's like, we can use the words shelter in place, but no one actually knew what it meant. We understood what the words were but we didn't understand what it meant in terms of how business would progress and how capital formation would progress and what folks would do. So, it's a continuum from 'this is fantastic' to 'Jesus Christ, what a mess we're in.' It kind of crept in there day by day. You know the analogy is the boiling frog. And I've never tested this theory, but I've been told that if you put a frog in a pot in cold water and you slowly increase the temperature, it will sit there until it dies. Maybe this was the boiling frog version of the crisis.

You mentioned securitization earlier. What's your sense of how the CMBS market has held up through the pandemic thus far, and where do you see it heading?

Well, it was a busy first part of the year, and when the frog began to boil, prices blew out, and I think the last deal that got done in the public markets was the last CSAIL deal from Credit Suisse. And, after that, it was kind of like, for the moment, turn off the lights and lock the door. And deals were pulled and stopped, and everyone sort of paused. Right now we're in the middle of a period of price discovery, I think. There are a number of deals that have been closed in the last two weeks, and a significant number that are going to get priced and closed during the balance of this month, including conduit and SASB and at least one CRE CLO.

And we're going to go to school on that pricing. The pricing's looking better than where it was at the nadir about a month ago. Not as tight as the pricing from January-February, but if you're within 50 basis points of the Triple A's and a couple hundred basis points down the capital stack, you can probably move your legacy book without filing bankruptcy. And then once we have some price discovery, I know a number of clients who are mortgage lenders who are of the view that after they see where May came out, they will have enough data to inform reentering the lending marketplace. And then we'll have to see whether borrowers want to borrow at those levels. They've gotten pretty spoiled with these incredibly low rates these past several years, so there's going to be some sticker shock. If you have to finance, you have to finance.

I'm interested in the comparison between the current climate and the Great Recession with regards to CMBS. Of course CMBS was a major factor in the Great Recession, a major cause of it. How do you see things this time around with regards to CMBS?

Well, I think my people might quibble with your notion that CMBS was the cause of it. The epicenter of the mess was the resi business, not the commercial business, although both businesses cratered. CMBS was a $270 billion hunk of loan origination in 2006, 2007. And it went to 0. Went to 0. And it shared the toxic state of its resi cousin. I remember at the time, at some point in that time, saying to my senior management, 'I'm not that worried. The problems are resi problems.' Those people really screwed the pooch and commercial was fine, and then contagion was stronger than the differentiation between those markets. And then CMBS dove as well.

I think it's different now. First of all, CMBS isn't anywhere near as large a component in capital formation today. It's not insignificant, but nowhere near as large a component as it was back then. The [government-sponsored enterprises] were not putting out $110 billion a year in multifamily product back in those days, just for a for instance. It's different today because at least today, a CMBS player could stand up and say, 'Hey man, it's not my fault.' Even President Trump doesn't call it the CMBS virus. It's an exogenous event and we're dealing with it like everybody else, which I think gives people a better feel about what they're trying to do and trying to navigate through this mess.

One thing I'm very mindful of, and I've been talking about quite a bit, is the fact that regardless of differentiation, there may be political issues on the backside of this crisis. We certainly learned as an industry in 2008 that politicians found it to be an absolutely delightful exercise to castigate lenders in general and Wall Street in particular and reinforce the narrative, the meme, of Wall Street versus Main Street. And I think anyone in our business today who is unaware of how that happened last time and how it could happen again is misguided. We're at a place now where borrowers are going to have a hard time making payments, and I think how the industry responds to struggling borrowers may have a lot to do with how the industry is looked at when we're finally on the other side of this recession.

If nothing else, we learned last time that a politician doesn't really need a strong legal theory in which to extract billions of dollars of funds from institutions nor to eviscerate executives in front of congressional committees. I think we need to be mindful that when the tide comes back out, maybe it's just the way politics works. Maybe it's just the way media and the 24-hour news cycle functions today. But there's going to be a process of looking for good guys and bad guys, and [companies might think] 'I'm anxious to make sure that my business doesn't turn into one of the black hats if we get there.'

Where do you see the capital markets heading over the next several months?

Our base case is that they're going to rally considerably. Not to the levels we saw late last year, but we're going to see some healthy rallying in the space. Lenders will lend, capital markets financing of loans will continue. We may see a more disparate range of transaction types. I think we're going to see some of the liquidating trust structures from the Great Recession come back, where loans that are either nonperforming or sub-performing are re-securitized, sold into vehicles and securitized to get financing against those types of assets. I think we'll see some of that. And I'm sufficiently confident that I printed off all my old distressed debt bibles from the last cycle to bring them with me down to my new home office here because I figured I'd be using them again.

I think we'll see some regular-way deals. I think SASB is likely to come back first. I think that the CRE CLO market is likely to come back well, largely because of the unusually terrific alignment between investors and sponsors in the CRE CLO space. Maybe we won't see dynamic transactions where sponsors are entitled to repurpose proceeds to acquire additional assets, but in the static deal structure I think that'll be popular with investors. Because in those structures the sponsor has something like, on average, 20% skin in the game versus the 5% of the so-called risk retention skin in the game, and that makes a significant difference. So good alignment there.

Conduit, it might be a little slower getting back. How do you lend? How do you borrow 10-year fixed-rate money in a period where price discovery is recent and the markets and Main Street and Wall Street are disrupted? That may be tough. I wish [term asset-backed securities loan facility] had been extended to new-issue CMBS, and for the life of me, I can't think of why it didn't, except maybe they just are mad at us or something. TALF is available for many other asset classes. It expressly excludes new-issue conduit, and that just seems bizarre to me, because that's capital formation for Main Street. And it would have a significant positive impact on bringing credit back to Main Street borrowers. Not the big guys. Not the mega-borrowers, but the small-town borrowers across square states, where CMBS is an important credit source.

I'm still hopeful that on reconsideration, the Treasury will decide to open TALF to that type of product and extend the life of TALF. TALF ends on Sept. 20, which seems in some ways a long way away, but in some ways, if you're trying to get a transaction done, a heartbeat away. I've not had anyone — I've talked to a lot of folks — been able to adequately explain to me why new-issue conduit was stripped out as an acceptable assets category for TALF. Maybe someone knows, but they're not talking to me.

--Editing by Rebecca Flanagan.

Check out Law360's previous installments of Coronavirus Q&A.

Correction: An earlier version of this article misstated the name of Jones' column and misstated the type of deal Credit Suisse recently did. The errors have been corrected.

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