Abf Risk Article
- 1. JANUARY 2008 VOL. 6, NO. 1 FOR THE COMMERCIAL FINANCE PROFESSIONAL | W W W. A B F J O U R N A L . C O M Title Insurance for Secured Lenders: A New Twist for a Time-Tested Risk Management Tool BY THEODORE H. SPRINK Relaxed standards and a shaky market have shown a need for even more protections for lenders. With that need comes a tested idea not yet common beyond the real estate market: title insurance. As a way to assist financiers in the here and now, Ted Sprink poses the argument for why title insurance isn’t just for real estate lenders anymore. B efore July 2007, the market was awash in liquidity with people and systems.” From the perspective of risk managers, far “too much money chasing too few deals.” Perhaps supervisors and shareholders, the consequences of such we should say too few well-structured deals: Hedge failures are severe. As we will discover, one of the risk funds and private equity partnerships in competition with or management tools that bridges credit and operational risk financed by banks, were seeking to deploy vast sums of money for secured Commercial & Industrial (C&I) loans has been from the constant flow of contributions from pension plans, used by bankers for years within their real estate portfolios. endowment funds and foreign investors. In the wake of this The Basel Committee on Banking Supervision’s Consultative competition, relaxed covenant packages and historically low-risk Document on Operational Risk stated: “The primary mecha- pricing, there has been very little room for error. nism currently used for mitigating operational risk exposure is Attorney Scott McPhee of the Los Angeles office of Morrison insurance.” Title insurance has been used by risk managers to Foerster LLP, who represents Countrywide as well as other shift risk in the past, and has become an essential component leading lenders, notes, “Loan markets have suffered in recent of the real estate secured lending business and mortgage- THEODORE H. SPRINK years with ‘excess capital,’ which has led to greater competi- backed securitization market. SVP/National Marketing tion for loan originations and relaxed underwriting standards.” Traditionally, real estate lenders for both commercial and Director, UCC Risk Mgmt. McPhee refers to such relaxed underwriting standards as having residential transactions, as well as investors, have used title Division, Fidelity National an impact on credit quality, loan pricing, potential legal fees, insurance to minimize documentation errors and to manage Financial Family of Companies reliance collateral, default rates and ultimately, recoveries. problems associated with challenges to lien priority. Lenders It has been noted over the last two year’s of Quarterly Senior have benefited from the related improvement in credit quality, Loan Surveys that underwriting standards continue to trend secondary market value and liquidity. downward. Implicit in these findings, loss-given-default expo- As late as the mid-1950s, real estate title insurance had sures have risen. At a recent Standard & Poors (S&P) sympo- not yet become universally accepted or utilized by lenders. sium on CLOs and commercial loans, it was suggested that the Lawyers’ legal opinions and abstracts were widely utilized in recovery rates on the S&P migration tables would need to be the nation’s real estate markets. Standardized real property title recalibrated to reflect an increased level of risk. policy forms of coverage, endorsed by the American Land Title S&P further proffered that the next cyclical downturn could Association (ALTA), were still a decade away. be more severe than recent experience. Bruce Fraser of the Los Many believe it was the secondary market, with the advent of Angeles office of Sidley & Austin, who represents Wells Fargo Fannie Mae and Freddie Mac that led to not only the importance Bank as well as other major lenders, states, “The current and of title insurance for individual loan originations, but the invest- expected unstable future economic conditions will likely result ment community’s need for enhanced, high-quality, real estate in increased loan defaults, which will cause greater reliance on related “securities.” In short, the advent of mortgage-backed credit quality and risk management tools.” securities relied on the efficiency and efficacy of title insurance The exposure to operational risk has also escalated as a fundamental risk management tool. substantially and has made many institutions more vulner- While title insurance is a cornerstone of the real estate able to losses from “failed or inadequate internal processes, lending practice, traditional real estate title insurance has “ conditions will likely resultunstable futureloan defaults, The current and expected in increased economic which will cause greater reliance on credit quality and risk management tools. ” — Bruce Fraser, Sidley & Austin Los Angeles office
- 2. limited defaults in recent years. Documentation “ The transaction itself benefits from the efficiency and attention to detail required in the process defects that will directly impact value and recover- ability of collateral have been kept somewhat below the surface by the simple fact that many of the of obtaining UCC insurance as a closing affected loans are not in default. Morrison Foerster’s McPhee notes that, “The transaction itself benefits requirement. ” — Scott McPhee, Morrison Foerster Los Angeles office from the efficiency and attention to detail required in the process of obtaining UCC insurance as a closing requirement.” evolved over the last few years to become an Perceived equity cushions and ample alternative accepted risk management tool for secured lenders sources of capital may have artificially hidden prob- — primarily within the private equity space. development in the financial markets. Similar in lems associated with loan concentration, market However, there is one significant difference: it is many respects to traditional real estate title insur- saturation, and actual cash flow and management now available to lenders in which “reliance collat- ance, UCC insurance was introduced specifically difficulties in core lending segments. eral” is personal property as defined by Article to insure the lender’s security interest in non-real Risk management is, of course, everyone’s business 8 and Article 9 of the Uniform Commercial Code estate collateral for validity, enforceability, attach- within the bank. However, risk managers are specifi- (UCC). Morrison Foerster’s McPhee, says, “Both ment, perfection and priority. cally charged with the responsibility to anticipate, lenders and investors benefit from strengthened Additionally, UCC insurance was developed to identify, quantify and manage risk across each of their collateral positions, and shifting risk, as it relates address fraud, forgery, insure the “lending gap” and increasingly complicated portfolio of businesses. to lien perfection and priority, makes sense.” provide cost-of-defense coverage in the event of a And, according to Sidley’s Fraser, “The strong The title industry has essentially adapted the challenge to the lender’s security interest. From a economy in recent years may have led lenders to standard American Land Title Association (ALTA) secondary market perspective and portfolio manage- fail to ‘price-to-risk,’ particularly the legal risks real estate title insurance policy form to provide the ment standpoint, the policies are designed for the associated with equity and other personal prop- benefits of title insurance to commercial lenders “life-of-loan” and are assignable. erty collateral. UCC insurance imposes a disci- securing loans with non-real estate collateral. In a Articles 8 and 9 of the UCC, refer to “personal pline and provides a product that can significantly few short years the nation’s leading title insurers property,” which includes inventory, furniture, reduce these legal risks.” have produced newly available “UCC Insurance fixtures, equipment, accounts receivables, deposit In a complex and threatening environment, Policies” in amounts covering an estimated $350 accounts, general intangibles, securities and pledges evidenced by the recent eruption of subprime- billion in secured lending. (often crucial to the mezzanine lending markets.) related credit quality and liquidity issues, hazards to a bank’s capital are elevated. With a high level of both loan and M&A activity over the past three Traditional real estate title insurance has evolved over the last few years, the opportunity for human error poses an years to become an accepted risk management tool for secured additional but undiagnosed danger. Risk managers are now able to shift commercial lenders primarily within the private equity space. loan risk one might associate with the potential broadening of the current consumer and residen- Sidley & Austin’s Fraser explains, “Historically, More significantly from a lender’s perspective, UCC tial loan quality “meltdown” by utilizing a basic, title insurance has played an important role in the insurance overcomes limited “UCC search vendor” traditional and newly available solution: Time business of loan origination by insuring perfection indemnification in connection to search office errors tested title insurance with a new twist. abfJ and priority of collateral and by protecting lenders and omissions, indexing inconsistencies and financing from fraud, forgery and documentation defects.” statement inaccuracies. According to Fraser, “My firm THEODORE H. SPRINK is senior vice president Fraser adds, “UCC insurance is the natural evolu- has recommended UCC insurance for certain loan and national marketing director for the UCC Risk tion of this concept in light of the growing need to originations in order for our clients to benefit from the Management Division of the Fidelity National establish the strength and quality of commercial additional protection of their lien position.” Financial Family of Companies. Sprink is one of loan assets, particularly for rating agencies in asset- Most commercial loan documentation defects that the original architects of the UCC insurance value backed securitizations.” lead to a lender’s security interest being set aside are proposition, introduced several years ago for the The original concept of applying the benefits clerical in nature: incorrect name of borrower, search mezzanine and securitization market segments. of real estate title insurance to the commercial of the wrong jurisdiction, wrong state of filing, the In the few years since, he introduced the concept finance market segment was simple: If every lack of filing the appropriate documents, an error in of UCC insurance nationally, the industry has bank in the United States originating real estate the collateral description and the like. Moreover, it is produced an estimated $350 billion in loan cover- secured loans requires real estate title insurance, often junior staff at either the bank or the law firm age. Sprink can be reached at 619-744-4410 or would those lenders originating non-real estate that is responsible for perhaps the greatest risk to the by e-mail at tsprink@fnf.com. secured loans not also gain from the risk protec- lender: the loss of reliance collateral. The UCCPlus Risk Management Program is under- tion benefits of title insurance? Loans with documentation problems are usually written by Chicago Title, Fidelity National Title and As the concept evolved, UCC insurance, avail- not an issue until they default. The strong loan Ticor Title insurance companies, collectively Fortune able from the nation’s leading real estate title market has probably “masked” a number of commer- 500 #231. Additional information about UCCPlus insurance companies, became a relatively new cial loan defects, particularly since there have been can be found at www.uccplus.com RISK MANAGEMENT Fidelity National Financial Family of Companies Reprinted with permission from ABFJournal (Vol. 6, No. 1). Copyright © 2008. All rights Reserved. #1-22986477 Reprinted by The YGS Group, 717.399.1900. For more information visit www.theYGSgroup.com/reprints.