Why the “holdback” may be the next big mortgage bond risk

The real estate finance environment could be rosier this year, but there’s always another risk around the corner. Just ask investors in this San Francisco multifamily portfolio.

Investors in a Bay Area portfolio were blindsided by a holdback earlier this year, Bloomberg reported. Those investors — big names including TPG Angelo Gordon, LibreMax Capital and Lord Abbett & Co. — lost $164 million as a result of the holdback.

Things started simply enough. Investors bought into a bond deal that financed the acquisition of dozens of apartment buildings in San Francisco in 2021. By the end of the following year, the borrowers, Veritas Investments and Baupost Group, defaulted and the $675 million loan backing the securities was promptly sold at a loss.

After coming on to oversee the debt in November 2022, special servicer Midland Loan Services — a division of PNC Financial Services Group — decided to hang on to the holdback, which could be the largest in the sector’s history. The transfer of the buildings took place two months ago, but Midland hasn’t explained its holdback and isn’t required to do so, though a past statement said it was “appropriate.”

The holdback is typically a clause in a loan agreement that puts aside a certain amount of the loan after the deal closes. The funds are typically held by a lender until a certain objective is met.

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In this instance, Midland’s holdback may have had to do with being prepared for unforeseen circumstances, such as litigation, sources told the publication. Midland sold the debt to Brookfield for $513 million, far below what the investors called for, and in so doing, exposed multiple investment-grade-rated classes and boldholders alike to losses. 

The circumstances surrounding this holdback may have been specific to the situation, but investors could become more wary of holdbacks and special servicers as a result. In a note, JPMorgan strategist Chong Sin said that Midland’s lack of explanation is among several factors that could make investors less confident about the securities.

“It opens the door to a new level of risk that could materially disrupt investors’ expected returns,” Liza Crawford, co-head of securitized research at TCW Group, told Bloomberg.

— Holden Walter-Warner