Yesterday, Moody’s issued a Sector Comment expressing concerns with respect to proposed REO-To-Rental deals structured to utilize a collateral package comprised of equity-pledges in the SPV property owners in lieu of individual mortgage liens. Moody’s indicated that such equity-pledge structures may need to have strong third-party oversight (including regular monitoring of the ownership of individual assets) and strong financial sponsorship to achieve the agency’s Baa rating. Issuers were hoping to use such structures as an answer to high transaction costs present in deals comprised of large numbers of low-value individual properties.

The report highlighted four specific areas of concern present in equity-pledge structures:

● Severity of Substantial Consolidation: The lack of individual mortgage liens presents significant risks to investors in the case of substantive consolidation of the property-owning SPV with its Sponsor, as investors would be forced to compete with all of the bankruptcy estate’s other creditors without the benefits afforded to a secured creditor.

● Increased Likelihood of Legal Challenge: A corollary to the first point, the lack of first priority liens on the underlying assets would incentivize creditors of the estate to push for substantive consolidation.

● Unauthorized Sales of Properties: The lack of individual mortgages leaves investors open to property-level risks ordinarily covered by mortgages. For instance, in the event of an unauthorized sale of an underlying property, the investors would still enjoy the protection of the mortgage lien, which would “travel” with the property. Not so in the equity-pledge structure, as investors would need to rely on suing on covenant defaults and would not have direct access to the transferred properties as collateral.

● Additional Liens: The lack of individual mortgages leaves investors open to additional liens, including additional mortgage liens and mechanics’ liens. These liens are ordinarily primed by a first mortgage. In the equity-pledge structure, these liens would need to be satisfied by the foreclosing trust.

For more information on REO-To-Rental structures, please see our prior blog posts here and here, and Dechert OnPoint Updates here and here.