Investors Loose with Hope Notes

‘Hope Note’ Strategy Is at Times Hopeless

Splitting Mortgages Into A and B Parts Can Sting Investors


A controversial method to work out defaulted commercial real-estate loans isn’t always working out for the bond investors involved.

When Gotham Realty Holdings defaulted on a $90 million mortgage on part of a landmark Manhattan building that was once the Bowery Savings BankWMIH -0.78%the loan servicer, seeking to avoid foreclosure, split the mortgage into a $65 million “A” slice that would pay interest through maturity in 2017 and a $25 million “B” note that paid no interest.

The B note, also known as a “hope note,” is now worthless, highlighting pitfalls still facing investors who have bought up commercial mortgage-backed securities containing such loans this year. Most of these loan modifications are resulting in full losses for the hope notes, according to Credit Suisse CSGN.VX -1.44% .

“‘Hope notes’ are precisely that: a noninterest-bearing certificate that if everything works perfectly, there is a hope of a recovery,” said Edward Shugrue, chief executive officer of Talmage, a CMBS investor and servicer.

The arrangement over part of the building at 110 East 42nd St., across from Grand Central Terminal, is tied to a CMBS created in 2007 by Wachovia Corp. It was negotiated in 2011 and was meant to win time for the borrower to boost revenue on the property.

These sorts of loan workouts are supposed to give investors a better deal than they would get in a foreclosure.

In such cases, the A note typically represents more than 100% of the current appraised value, so that CMBS investors have a claim above the estimated value if the building were to be sold. The remaining loan balance becomes the hope note, which is last in line to get repaid, even behind any new money invested by the building’s owners. That means holders of B notes can only recover if the building’s value rises substantially before it is sold or refinanced.

The latest episode of dashed hopes came as SL Green Realty Corp., SLG -1.42%which took control of the 42nd Street property after the Gotham default, refinanced the loan five years before maturity, according to Trepp, a CMBS data provider. It isn’t clear what terms SL Green got on the new loan, but the proceeds were only enough to pay off most of the $65 million A note.

SL Green’s co-chief investment officer, David Shonbraun, declined to comment.

A monthly report from Wells Fargo WFC -0.77% & Co., the trustee for the CMBS, said the B note was written off, while the A note lost $103,000 for the bondholders, according to Trepp. The loss on the B note was $18.1 million, the note’s size when it was created.

Wells Fargo, which acquired Wachovia in 2008, declined to comment.

Edward Piccinich, executive vice president at SL Green, told investors a year ago the building was part of a planned redevelopment of a “spectacular trophy asset.”

The loss just a year after the modification casts doubt on the wisdom of using the method aimed at giving delinquent borrowers another chance, and salvaging CMBS principal.

Servicers say the modifications at least minimize investor losses compared with foreclosure, and recoveries on the A notes bear that out.

Investors have fared well with a minority of hope notes. A Credit Suisse study of 15 modifications found that while seven hope notes posted 100% losses, five had no loss. Chances of recovery on hope notes in general continue to be slim, however, said Roger Lehman, head of securitized debt research at Credit Suisse.

Mr. Lehman noted some degree ofsurprise among investors over the 110 East 42nd St. hope note. But he, and other analysts, have long held low expectations for the debt.

“Our view is that many hope notes are in fact ‘hopeless hope notes,’ as a significant improvement in the value of the properties must occur before losses are mitigated,” said Richard Hill, a CMBS strategist at RBS Securities.

The 110 East 42nd St. loan was about 3% of a CMBS whose investors took the loss. CMBS deals from 2007, which saw a record $230 billion of issuance, are seen as the riskiest in the market because lenders were rapidly loosening standards in order to boost volume. In this case, the loan included assumptions that occupancy and rents would rise.

Contracts on about 60% of the leasable space were up for renewal in the first five years of the loan, and occupancy fell to 70% in 2012, from 98% in 2007, according to Trepp. Rents that in 2007 were projected to be 1.26 times the annual debt service never reached that level, it said.

Write to Al Yoon at


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