By Andrew McIntyre

Law360 (May 14, 2020, 9:47 AM EDT) --

Ethan Penner

The COVID-19 pandemic has the potential to fundamentally reshape the commercial mortgage-backed securities market and also make a "bloodbath" out of mezzanine loans, Mosaic Real Estate Investors executive Ethan Penner, who's widely credited as having founded the CMBS market three decades ago, told Law360 in a recent wide-ranging interview.

Penner, who is founder and managing partner of Mosaic and also serves as the company's chief investment officer, said that while CMBS loans in their early days were closely tied to the underlying properties, they are now much farther removed, a fact that could spell disaster amid the pandemic.

While CMBS investors in the early 1990s undertook incredible due diligence on the underlying properties, that level of diligence and knowledge of the properties no longer exists with CMBS in its current guise, and that's become a handicap for investors, Penner said.

"I think [the COVID-19 pandemic] has the potential to destroy CMBS as we know it and allow for CMBS to potentially be reborn in another way," Penner said.

"In times like this, one needs to be in a position of maximum control of their own destiny," he said. "Owning an asset or owning a loan gives one a reasonable chance of being in control of one's destiny. Owning a CMBS bond is kind of the exact opposite. Those are ... the shortcomings of investing in CMBS."

For that reason, Penner said, his firm prefers to focus on buying loans and assets, and believes investors may start to shy away from CMBS as the pandemic continues.

"Those shortcomings become ... exacerbated in times of confusion and times of distress," Penner said. "In the early '90s ... transparency was very available. So there was a great degree of investor skepticism. Investor skepticism is generally a very healthy hallmark of a good market."

Penner was one of the key players in the CMBS market in the early '90s. The general idea is mortgages for dozens or even hundreds of properties are pooled, securitized and then sold.

CMBS origination grew steadily throughout the 1990s and then soared in the aughts in tandem with the housing boom, surpassing $200 billion in origination in 2007, before the housing bubble burst.

"I remember in order to sell CMBS to institutional investors, we ... literally had to present each and every loan in its most great detail. Oftentimes, in the early years, we would charter a plane and fly people around to see the properties ... backing the loans," Penner said. "The level of due diligence in the early '90s was similar to diligence of buying a loan or buying an asset."

But that level of diligence later changed.

And following years of economic boom after the mini recession in the early 1990s, investors also became complacent, Penner said.

In the 1990s, "we had a recovery in the economy. In a recovery economy, you don't test the weakness of a system. The weakness of a system is tested during challenging times, not successful times," Penner said.

"Complacency set in because performance was very good. From '93 to '98 and '99, 2000, you had a reasonably straight shot of recovery. Performance was generally good from the underlying bonds. From performance you get complacency. Complacency is not necessarily a good thing," he added.

Indeed, while CMBS lending came back after the Great Recession, CMBS has never really faced a test like what's happening with COVID-19, Penner said.

"Markets avoid at all costs creative destruction. Creative destruction threatens jobs. Creative destruction is an important component of ... optimism. CMBS has avoided creative destruction, even during challenging times like the financial crisis," Penner said.

"I think this pandemic ... could shake CMBS to its foundation. It's definitely possible. Imagine that a quarter to a half of all loans in CMBS end up in special services. That would precipitate a situation that one can imagine would be very, very challenging for the CMBS model to survive in its current form," he added.

While the CMBS market faces great uncertainty amid the pandemic, the situation could be equally dire for mezzanine loans.

Such loans generally sit in the middle of the financing capital stack, a common way of organizing various loans tied to a property or business.

Penner said that while lenders are showing some patience at the moment, that patience can only last so long.

"I think that we have a reasonable prospect where most mezzanine capital investments have been wiped out in many, many investment areas. It probably wouldn't be a stretch to say that every mezzanine investment in the hotel area could be worthless," Penner said. "The same might be said for mezzanine investments in senior housing. The same might be said for mezzanine investments in business loans, medium-sized businesses."

While loans above mezzanine loans may have the financial backing of big banks or insurance companies and the loans below may be central to the operation of a business, mezzanine loans fall in an awkward place, and could thus be hit the hardest by the pandemic, Penner said.

"The mezzanine part of the capital structure today is the one that is in most jeopardy of being destroyed. That's a lot of money to be lost. I don't think anyone's there to save it. The senior part of the capital structure is far safer," Penner added.

"The ownership below the mezzanine level has less risk because there's some operational value. If you own a hotel and operate a hotel and have a bank as a senior lender ... you need someone who has operational expertise and you can create some equity ... for that player that brings that value," he added.

Indeed, as the COVID-19 pandemic continues, investors will scrutinize all aspects of the capital stack looking for value.

And when that value proposition is put to the test, the mezzanine loans could be particularly hard hit.

"The mezzanine player doesn't bring any value. Losses could be concreted in the mezzanine portion. I think it would be a bloodbath there," Penner said. "It's extremely early. We're at the beginning of the first inning. The fans haven't arrived at their seats yet, if you want to use the baseball analogy. The first pitch might have just been thrown out."

--Editing by Marygrace Murphy.

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