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Wharton Emeritus Professor Dr. Peter Linneman discusses mezzanine financing, what intercreditor agreements are, and what functions they perform.
BRUCE KIRSCH: And so we also talk about mezzanine financing. And this is a category of financing that can manifest itself in a number of different ways. It could be what people know as a second mortgage. It can take the form of preferred equity, or as a hybrid of debt and equity among other forms.
The one common thread among these various manifestations of mezzanine financing is that they are all subordinate to the senior loan. And this hierarchy, or this pecking order, is formalized through an intercreditor agreement. What exactly is this intercreditor agreement, and what does it mean to be subordinate? And what else does this agreement typically address?
PETER LINNEMAN: Well, intercreditor agreement– it’s a legal contract that says, here is my legal right. Let’s start with the first mortgage issuer. First mortgage issuer says, I have a complete right to be paid first. I get paid monthly first. I get paid my principal first if there’s a problem, et cetera.
If you want to have other creditors involved, they have to get me to agree to change my rights. So I might say, yes, you can take on a second mortgage, but the second mortgage is not in excess of. Well, but I still get paid first, and I come first in line if there’s a bankruptcy.
And you say, well, what does the intercreditor agreement deal with in a more subtle way? In a more subtle way is what happens if the first mortgage isn’t due until the tenth of a month, and the second mortgage happens to be due the first of the month, simply by the timing of when the first mortgage was taken out– happened to be on the 10th, and the interest is due every month on the 10th.
Well, suddenly, then, I’m worried, as the first mortgage holder, that on the couple of days before my money is due, you’re sending money out to another party. And am I cool with that? And the answer is, not if it’s six minutes before me. And so, yes, even though the loan may be taken out on the first, I make them pay interest sooner and all sorts of mechanicals.
The other thing that enters into it is, yes, you can put a second mortgage on the property, but you can’t have that second mortgage transferred to any other borrower or lender without my approval. Well, in today’s world where mortgages are often sold, the person issuing the second mortgage may be very uncomfortable with that term.
Why does the first mortgage holder want it? They want to know who’s in line in front of them. They want to know the kind of people and business strategy of those in front of them. And they want to know who’s borrowing from them.
So you’re going to have issues like collateral. You’re going to have issues of timing. You’re going to have issues of transfer of ownership of the instruments. Items like that will be what will fill up.
And you say, well, it sounds like all technical, mechanical stuff. It is all technical, mechanical stuff. But it’s expensive because you’ve got to have lawyers negotiate it. You have to proof it, and it will restrict your operating behavior, especially when times are tight.
BRUCE KIRSCH: Sometimes the first mortgage holder and the mezzanine financing entities are under the same umbrella. Let’s say, Citibank is providing both the senior loan, and a different division within Citibank is providing the mezzanine financing. Is there any leniency or difference when it’s all coming from the same umbrella company? Or are these types of issues still fought out tooth and nail down to the last letter?
PETER LINNEMAN: It is easier only because it’s easier to negotiate with yourself. However, the fact that Citi, in your example, knows that it may someday want to sell, especially the first mortgage position, into the market, means they’re going to want to make sure that it has terms that can maximize the value of that.
Doesn’t mean there might not be a little more leniency in the terms, not quite as cookie cutter, because they can keep it on their balance sheet. But it does mean that there is some tendency for even if it’s done with the same party, to have tough terms in the first that you have to focus on. It’s just they are easier to get at because you’re negotiating with yourself.
I’ll give you a very good example. It’s a little advanced. But one of the things people do is when they borrow from a bank, Citi, in your example, they take technically a floating rate interest rate loan. And then Citi issues– from a different desk, Citi will issue a swap. And that swap effectively converts a floating rate loan into a fixed rate loan.
And from the borrower’s point of view you say, well, yeah, now I’ve got a fixed rate loan for 10 years, even though technically, for 10 years it’s a floating rate loan with an offsetting swap that results in a fixed rate of interest. Interestingly, both the mortgage and the swap use the real estate as collateral. Namely, if you don’t pay your floating rate mortgage, they can take your property. And if you don’t pay your swap, they can take your property as collateral. And Citi, in your example, agreed to share their mortgage collateral with the swap owner. So that was an intercreditor agreement, that they both can use that collateral.
For example, HUD, when they make loans on apartments, will not share their collateral. Namely, they say, you know, you can’t have a swap that also has a claim on the collateral. Only our mortgage can be there, come hell or high water, that’s all– that we will not agree to anything else.
So there’s a situation where negotiating with, quote, “yourself,” Citi negotiating with Citi, results in a bit more flexibility than a swap provider, say, Citi, negotiating with some straight mortgage holder who doesn’t want to compromise their collateral.