JP Morgan Chase (NYSE: JPM) Reviving Commercial Mortgage Backed Securities for Rialto Capital Loans

Mortgage-backed securities quickly fell out of favor over the past 4 years, though with sufficient yield, a market for them may still exist. This is the hypothesis JP Morgan Chase (NYSE: JPM) must be making, reviving the sales of commercial mortgage backed securities, supported mostly by delinquent loans. The market for these instruments has been non-existent since the late 1990’s, but new incentives for buyers of distressed debt may be bringing them back in to favor.

Today, the bank told investors it will sell $132 million of bonds supported by nonperforming loans or other troubled debt purchased by Rialto Capital Management, a distressed investment firm owned by home-builder Lennar Corp.

The CMBS may be generally unpopular, but their use is not unprecedented. In the late 1980’s to early 1990’s, the government used the Resolution Trust Corp. to dispose of similarly bad residential and commercial loans. At that time, it was widely held that the bad debts sitting on bank balance sheets were stalling the economic recovery from the 1987 recession and real estate collapse – by clearing the loans off the bank balance sheets the regulators were able to help speed the recovery from the savings and loan crisis.

Tad Philipp, director of commercial-real-estate research at Moody’s commented “There is an estimated $75 billion to $100 billion of distressed commercial debt out there that has yet to be dealt with, so this could be part of the cleanup process.” Steven Schwartz, a managing director who oversees loan acquisitions and originations at Torchlight Investors similarly commented “If this kind of financing is available and the market accepts it, the result would be higher prices paid for distressed portfolios of small loans, driving more portfolio sales. That should help break the logjam and speed the recovery in commercial real estate.”

Although news of these instruments may take the market slightly by surprise, the plans apparently have been in the works for quite some time. The bank has been working on this for the past year, believing that structuring such distressed bonds with a “fast pay” structure where interest and principal pays off the investors and then the issuer as the loan servicer sells the property or otherwise resolves the default could be attractive instruments. The faster the resolution of the loans, the faster the issuer gets proceeds and the higher the return on investment.

According to a Moody’s report, Rialto expects to take 60 months to resolve the delinquency on the largest loan in the portfolio, a $51 million note secured by South Carolina hotels.