November 14, 2001

Commercial Mortgages:
"B-piece" Buyers

As discussed in past articles, the commercial mortgages and capital markets are driven by a number of factors as they relate to competitiveness of capital mortgage terms offered to borrowers. One factor is the role of "B-piece" buyers and the effects they have on lending practices. The last credit crunch we witnessed took place in the fall of '98 when a "flight to quality" ensued and anyone coming to market with their securitizations was left standing at the alter. The shakeout of that particular time has left us with far fewer B-piece buyers, and thus less liquidity/exit for lenders.

So what is a B-piece buyer? Essentially, a B-piece buyer is someone willing to buy the riskiest portion of a pool of loans or commercial mortgages. REMIC's (Real Estate Mortgage Investment Conduits) are set up to issue bonds based on the cash flow generated from the pool of loans and commercial mortgages. There are several "tranche's", or levels of risk, established within a given bond issuance. A simpler perspective is to say that there are three or so levels of risk in a given pool, and buyers line up to purchase those bonds based upon their tolerance of risk. Just like a typical real estate partnership, there's a "waterfall" of cash flow to investors, and if you're first in line to receive a return, your position is considered less risky. Pension funds and insurance companies are common investors for the low-risk bonds. Mid-tier investors come in all shapes and sizes to purchase the next level of bonds often referred to as CBO's (Collateralized Bond Obligations). The last, and most risky tranche, is where the B-piece buyers invest. In the event of a default, B-piece buyers are last to get paid, so they tend to scrutinize the assets very thoroughly. B-piece buyers are now the dominant consideration relative to lender underwriting vs. the traditional approach where rating agencies controlled most of the lender underwriting criteria. Rating agencies still play a key role; however, they're not the ones ultimately buying the loans. If the B-piece buyer kicks a particular deal out of a portfolio, the lender suffers the fate of having to live with that loan longer than anticipated. Holding loans are NOT a part of the Conduit business model.

Since 1998, the number of B-piece buyers has diminished significantly from twenty or so players to four or five today. These four or five B-piece buyers wield an amazing amount of control - because without them the whole securitized structure is a non-starter, and the supply chain of capital dries up in a hurry. It should be noted however, that B-piece buyers are deal makers - they know and understand real estate and commercial mortgages - much more so than rating agencies. They tend to give credit for strong fundamentals (low LTV, borrower experience & financial strength, etc.) rather than try to fit everything into a box and ignore the merits of a transaction. Here's a quick analogy...think of a B-piece buyer as a mechanic buying a used car. The mechanic will understand the risk of buying a used car, especially if he/she knows the clutch has been replaced, the transmission is in good shape, and there's still some life on the factory warranty. In this example, they won't pay more than its worth, but they will certainly understand exactly what they're getting. If the car doesn't meet their parameters, they'll move on and cherry-pick the one that does. Lenders, like car dealers, want to move inventory, so they do their best to deliver loans they know will be attractive to prospective buyers.

There's more to discuss on this topic, but I wanted to re-introduce the subject in order to lay the groundwork for further explanation. At some point in the future we'll cover some of the specifics of what exactly sells and what doesn't in the capital and commercial mortgage markets.

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