INTRODUCTION
: Since the start of the financial crisis, the deterioration in the credit markets has dried up traditional sources of financing for commercial real estate development. George Smith Partners is presenting a new short series of articles focusing on the CMBS (commercial mortgage-backed securities) market to provide insight into a key part of the capital markets and track developments in government policy. This series of articles will attempt to provide professionals with insider industry knowledge so they better understand the underlying forces that drive and shape the commercial real estate market. To read the first part of this series of articles please click on the following link- Capital Markets Insight : Part I.
The turmoil within the CMBS industry and the wreckage left upon the commercial real estate markets is often looked at from a macro viewpoint. While data points and forecasts are helpful, the information is useless without comprehending the mechanics of the securitization process. Both professionals looking for signs of recovery and borrowers negotiation workouts for securitized mortgages need to know the players and relationships to navigate the rough terrain of today’s CMBS market. Understanding the dynamics behind headlines will allow participants to identify seemingly small developments that drive change in the CMBS industry.
The defining difference between portfolio lending and CMBS is that once a lending institution originates the mortgage, assigns it to a pool, and sells it off to be securitized, the Borrower will most likely never interact with the originating Lender again. When a mortgage is originated and sold to a CMBS trust for securitization all warranties and representations are transferred from the lending institution to the CMBS Trustee via the Mortgage Loan Purchase Agreement. Once the trust owns the mortgages the traditional relationship between borrower and lender is over. The Originator of the mortgage no longer performs all the functions involved in servicing the mortgage and communicating with the Borrower as a handful of players come into the picture.
After the mortgages are sold to the trust, the issuing investment bank structures multiple classes of bonds which are sold as certificates of ownership in the trust to investors. The Bondholder has effectively become the owner of the mortgages and ultimately, has control and final say over what happens if problems arise with mortgage payments. CMBS created in the 2005-2007 boom years frequently had twenty to thirty different bond classes structured from each pool of mortgages. A borrower trying to negotiate the terms of their mortgage or find a resolution cannot possibly bring twenty stakeholders to the table, especially since bondholders have little to no experience originating mortgages and interacting with borrowers. Luckily the process is less daunting and borrowers do not have to try and speak with all, or even some, of the bondholders as intermediaries facilitate relations between the groups.
Servicers are put in place to monitor the mortgages in the CMBS pool and pass on monthly mortgage payments to the Trustee who then disperses the cash accordingly to the Bondholders. The Master Servicer performs these functions when the Borrower is making timely payments and there are no foreseeable problems for repaying the outstanding loan balance as the maturity date nears. If payments become delinquent or a default appears to be imminent the mortgage is transferred to the care of the Special Servicer.
The Special Servicer is specifically tasked to oversee the mortgage in default and find a resolution, whether it requires them to wait for the Borrower to cure the default, negotiate a loan workout, or foreclose and take ownership of the property. Both the Master and Special Servicers are bound to act in the interest of the Bondholders by a lengthy document called the Pooling and Servicing Agreement (“PSA”). Though the document can exceed four hundred pages, there is a specific article within it that lays out the responsibilities and manner in which the Servicers handle the mortgages, especially if they are in default.
The Servicing Standard dictates that both the Master and Special Servicers must act in the interest of all the Bondholders, and in the same manner they would if they were the owners of the mortgages themselves. The Servicing Standard also makes clear that the Master and Special Servicers must hold the Bondholders’ interests above their own if they have some other participating interest in the securitization such as ownership of a subordinate bond. The entire PSA is geared towards making sure the Servicers have clear guidelines in any given situation and their actions are always in line with the interests of the Bondholders.
At first it seems there is little difference between a CMBS loan and a mortgage held on the balance sheet of a lender. The servicing department of a lender that originated a mortgage would still act in their own institution’s interest over a borrower’s, much like the Servicers acting in the interest of the Bondholders. The major distinction between a CMBS loan and a portfolio loan are the intermediaries and dissemination of responsibilities. The Master Servicer and Special Servicer are often different companies and may have no relation to the issuing institution or the Trustee. The separation of responsibilities means far more communication and transfer of information is required between the Borrower, Servicer, and Bondholders.
With a CMBS loan there is minimal familiarity and little communication between the Bondholders who retain the credit risk, the Servicers who monitor the mortgage, and the Borrower who risks their equity. The inclusion of the Servicers provides a buffer and a means of communication for CMBS borrowers, but lacks the connection to the transaction that portfolio lending provides. Though the Servicers have their edict from the PSA, their decisions are not autonomous during a modification or resolution. Remedying a troubled CMBS loan has more steps to undertake before a borrower can get a firm response to their request.
For most modifications and resolutions the Special Servicer must consult the Controlling Certificate Class, the most subordinate Bondholder, for input and approval. While the Controlling Class has the right to give input, the Special Servicer still must act in accordance with the Servicing Standard and make a decision in the interest of all the Bondholders. The Special Servicer must weigh the opinion offered by the Controlling Class, who bears the most immediate risk of loss, against their interpretation of the PSA. The situation is further complicated as two more outside parties can become involved during a modification and loan resolution.
The Rating Agencies are employed to determine the credit ratings assigned to each bond class when the CMBS is created according to the quality of the collateral backing the mortgages. In addition, the Rating Agencies must consider the level of protection from losses afforded to each bond class by looking at the number and size of tranches subordinate to a specific bond class’ position. The Rating Agencies continue to monitor the performance of the loans and analyze whether delinquencies and liquidations justify downgrading bond classes exposed to losses. Not only does every decision made by the Servicers have to take into account potential losses for specific bondholders, they must also consider the effect on credit ratings as many institutional investors, such as pension funds, are mandated to only hold investment grade bonds.
The other consideration when working out a defaulted mortgage is the status of the mortgage pool as a tax-exempt Real Estate Mortgage Investment Conduit, or REMIC. Losing the pool’s tax exempt status would result in taxation on the mortgage payments paid to the trust and the cash flow passed on to the Bondholders severely diminishing the value of the bonds. Significant modifications to a mortgage can jeopardize its standing as a “qualified mortgage”, which would obviate the REMIC status. The determination of whether a modification is acceptable under the REMIC regulations requires an outside legal opinion from a qualified law firm. The CMBS framework begins to look more and more daunting as yet another party must be involved in the process of remedying a defaulted mortgage.
The CMBS structure appeared sensible and efficient when commercial real estate values were appreciating and delinquencies were at low levels. But the credit crisis has exposed the structure’s complexity to have serious drawbacks for borrowers and bondholders as the numerous hurdles involved in resolving a troubled loan are more than cumbersome. Involving so many participants presents a long and expensive process even when the real estate and capital markets are functioning. Add to the equation extreme financial stress on borrowers, overburdened special servicers, rating agencies whose credibility has been called into question and anxious bondholders and the well functioning CMBS machine quickly deteriorates into an unwieldy monster.
Borrowers are unable to discuss their interests directly with bondholders forcing servicers to resort to their best judgment when considering the Servicing Standard, the Rating Agencies’ views, and the REMIC tax regulations. The problems presented by the multitude of participants is further complicated as each group has varying interests and is incentivized towards different outcomes. While the CMBS market provided borrowers with a liquid and inexpensive form of capital, the tug of war resulting from the sudden lack of financing has left borrowers in an intimidating situation.
In the next article we will go into greater depth focusing on the complexities of the bond world and the relationships between bondholders and special servicers. While the structure may seem intricate now, we have just scratched the surface on the fragile relationships and contradicting incentives that are crippling the CMBS industry.
