Last month, we began the first of a two-part series discussing the wonderful world of commercial mortgage-backed security issuances (or CMBS). In that article, we discussed how a CMBS issuance is assembled and securitized as well as the fact that there is no true underlying guarantor for the issuance in the event of a default. This month, we are going to talk about what exactly happens when things go wrong with one of the properties that are a part of the pool.
In order to better understand what can happen at the end, we have to start at the beginning. As a part of the origination process, there is a detailed and dense document known as a pooling and servicing agreement (PSA) that provides the rules of the road. It describes how the trust fund that constitutes the issuance is administered and serviced, how the payments are made, what the servicing duties include and how the distributions are made to the certificate holders, among many other scintillating details. It also lays out the roles and responsibilities of the primary parties to the PSA – the trustee, the master servicer and the special servicer. There is one additional party that is generally not covered by the PSA but certainly in the middle of things – the primary servicer.
The primary servicer is the entity that has regular contact with the borrower. Most borrowers will use the services of a mortgage broker to assist in originating their loan and the mortgage broker will continue to have ongoing contact directly with that borrower. They will oft en collect the monthly payment from the borrower as well as assemble and analyze various financial information related to the borrower’s real estate, such as rent rolls, lease abstracts, income and expense statements, etc. However, the primary servicer doesn’t have a lot of authority related to the larger issuance and is typically acting under the watchful eye of the master servicer. The master servicer is responsible for the servicing of all of the loans included in the pool. The PSA governs exactly what and how the master servicer can and cannot do. Generally, they aggregate payments and financial information from all of the borrowers, maintain customer relations, complete regular mortgage performance reporting and field borrower requests. The master servicers also transfers the collective payments to the trustee on a regular basis. The trustee’s primary role is to hold all of the loan documents and distribute the payments received from the master servicer to the bondholders in accordance with the securitization issuance.
When things are going well, this is the general flow of money; borrower to primary servicer to master servicer to trustee to bondholder. So, what happens when things go wrong – defined in this instance as an individual borrower defaulting on their obligation? Enter the special servicer, who takes over specific loans that meet certain criteria. These include loans with monthly payments more than 60 days delinquent, loans that have not been paid off at maturity, loans that are deemed to have an imminent material default and collateral that has been issued a notice of foreclosure, among other instances. The special servicer will first evaluate all of the facts and circumstances surrounding the loan and underlying real estate. They will then develop the best strategy to maximum the recovery of outstanding principal and interest. The special servicer has a variety of tools and strategies at its disposal but must operate within what is called the servicing standard. This basically says that the best interests of the certificate holders must always come first and the special servicer must always act within the terms set forth in the PSA.
Special servicers can and do use a variety of alternatives to complete their task. They can use loan modifications and/or waivers, such as extending the maturity, deferring or forgiving interest, deferring or forgiving prepayment penalties or yield maintenance charges, and permitting the substitution of the collateral or the borrower. They can conduct a loan sale, provided that the loan is sold at fair market value as determined by an appraisal. And they can sell the property either via a foreclosure action or an REO liquidation. In this instance, the trustee ultimately determines if the bid is at fair market value.
It is estimated that approximately $2.7 billion of CMBS loans will be maturing this year. This is an unprecedented volume and although the general commercial real estate landscape is healthy, it appears that special servicers will certainly be keeping busy for a couple more years. Ira Krumholz CPM