Testing times for CMBS servicers

Servicing commercial mortgages is complex, particularly since the number of loans in default has risen. Mark Miller of LNR Partners & Hatfield Philips discusses how CMBS servicers’ responsibilities have increased

The commercial mortgage servicing market has had to change quite rapidly over the last 12 months, both for balance sheet lenders and the commercial mortgage-backed securities (CMBS) servicers. However, much like the proverbial swan, the majority of this evolution goes unseen.

 

CMBS started in Europe in the late 1990s, but it had been around in the US for almost a decade previously, and as an investment class it was exceptionally popular as it provided liquidity and diversification. However, its success also attracted interest, which in turn led to a greater diversity of structures being employed, some of which, in hindsight, were a little over-optimistic, or failed to take account of all future economic conditions.

 

If we roll the clock back 18 months, less than 1 per cent of our £35 billion servicing portfolio was in default, but now the picture is very different and the number of loans in default, especially the more high profile securitisations, has meant that commercial servicers are in the spotlight.

 

However, as a servicer that looks after both CMBS and balance sheet portfolios it is important to stress that there is nothing fundamentally wrong with either approach and both will play a part in the commercial lending market in the future.

 

As discussed, the issues that servicers are dealing with today were born out of a time when ‘optimistic’ lending was a means to an end for originators and the demands of bond purchasers. At the time the loans were being made, the complexity of the market was heralded as it enabled the expansion of the lending market and also meant that potential could be realised through the tranching of debt.

 

It is too easy for commentators to single out for blame specific parties to the commercial and residential property bubble. It is also a mistake just to look at the CMBS industry; many balance sheet lenders have just as many, and equally significant, issues with their loans. However, as the former has to make all of its decisions public, it obviously receives much more media attention and scrutiny.

 

RMBS

There is also no single problem or solution, but the industry should take some credit for the fact that it has handled the situation responsibly as the situation could have been much worse; potentially dwarfing the issues surrounding residential mortgage-backed securities (RMBS).

 

Unlike the RMBS, which equally got itself into the well publicised mess across the world, their contracts between borrower and lender were more or less uniform and, within reason, robust. Whether it was too much champagne or just a rush to get onto the next deal, the contracts that are now unravelling in the CMBS market are far from perfect.

 

Complexity

Special servicers, as a result, have been criticised for being too passive in their management of loans. However, this could not be further from the truth. What rarely gets reported is the fact that there are many complex issues at play, especially with a large loan.

 

Deciphering the documents and recommending the most appropriate solution is often a time consuming process, the complexity of which is compounded by loans that may have been originated in one country, but whose security is in another. Broadly speaking, a loan, which originated in the UK, and is for UK businesses, can be ‘worked out’ much faster than that for a similar UK-originated loan, but which is for German assets.

 

The same is true for many other European countries whose legal processes can be idiosyncratic, to say the least. In some jurisdictions, for example, the willingness of a borrower, or lack thereof, to do a workout can actually receive judicial support; a concept that is different to US and UK practices, but none the less needs to be factored in by the servicer.

 

Four Seasons

For example, we can certainly attest to the complexity of the highly-publicised Four Seasons Health Care debt restructuring. Apart from having some very highly coveted real estate, including over 400 care homes, Four Seasons is also the second largest for-profit provider of elderly and specialist care services in the UK. So, not only is there a lot of money at stake in this transaction – £1.6 billion, taking into account the securitised, syndicated and mezzanine debt – but there is also an otherwise profitable business on the line that employs and cares for thousands of people.

 

It just so happens that this business was acquired at, or near, the top of the market with a £1.2 billion real estate loan that was subsequently securitised, re-cut and sold onto the 11 lenders for whom we act as primary and special servicer. Unfortunately, as with many commercial loans, the sponsor and many of the original contacts at the various banks involved in the transaction are now gone. In addition, securitisation imposes certain limitations on what actions the servicer and special servicer can take without the consent of all parties within the deal structure, which can make it more difficult to manoeuvre, in comparison to how a normal lender would act in a restructuring.

 

The complexity of CMBS structures was not an issue when the market was buoyant, but as soon as a loan of this nature starts to default with so many interested parties and different levels of risk, you will have a plethora of preferred outcomes. Some would obviously like a ‘fire sale’, others would prefer the debt to be restructured.

 

As the special servicer it is our responsibility to assess what maximises the recovery value of the debt investments, taking into account subordination together with the market conditions. With Four Seasons the debt was spread across multiple lenders: including Titan Europe 2006-4FS plc, a circa £600 million Credit Suisse securitisation, c£600 million of syndicated debt in five tranches and 20 separate mezzanine parties representing c£235 million. For this specific loan we have agreed a Restructuring Lock-Up Agreement for the debt – which was no mean feat.

 

Rating agencies

Another challenge for servicers is that most transactions have language that requires the servicer to seek the confirmation by the relevant rating agencies that the modification of the loan will not have a negative impact on the debt ratings. This could create challenges in the near future as it is possible, albeit we are in uncharted territory, that the rating agencies may be reluctant, or may be unable to give that rating confirmation on modifications.

 

Regardless of these challenges, the servicer will have to determine the most appropriate ongoing strategy. Whether it’s the questionable machinations of a German or French court or even revisions in the policies of the rating agencies, the servicer cannot hide from their responsibility or attempt to take an easier path.

 

CMBS restructuring

When the servicer has determined that a restructuring proposal is the best possible solution and accords with the Servicing Standard it is held to, it sometimes has to make a decision regardless of whether the rating agencies will issue a rating confirmation.

 

In the current market, managing the conflict between senior note holders and junior note holders can prove ‘interesting’; the former may want deals pushed into default and the assets liquidated, because they stand to get their principal back, whilst the latter often want to avoid this and to see if the market improves.

 

What is unprecedented in the current environment is that such action impacts on triple-A loans and not just the non investment grades. As major institutional investors liquidated their portfolios, several triple-A CMBS bonds were traded at a discount often to more opportunistic investors. Once again, such institutions are not potentially in it for the long term and an early enforcement of a loan is their preferred strategy.

 

However, special servicers do not service the loans for any one specific class of bonds. They must take into account what is best for the entire stack of bonds and junior lenders for whom they service. Any decision they take should generate the highest return on a present value basis while taking into account subordination.

 

Unlike the RMBS market, where there are precedents and even government intervention globally on what can and cannot be done, the commercial market, especially at the large end, will have no precedents as no loan is structured the same; every legal document is different; some markedly so, and every set of circumstances in which the borrower is operating is unique.

 

Maturing loans

One of the biggest challenges that both primary and special servicers face in the near future will be maturing loans, many of which had high loan-to-values ratios. Fitch Ratings estimates that around £8 billion of securitised UK loans are due to expire by the end of 2010.

 

What is often overlooked is the servicer’s role in the broader economic environment. The collapse of the residential housing market across the US and Europe has destabilised the world, pushing the global economy into recession. Without the prudent and responsible actions of both balance sheet lenders, in-house teams and the independent servicers in the commercial market, the position could have been far, far worse.

 

Billions of pounds were invested by both private and institutional investors into commercial property funds and, whilst many are managing a potential loss, this could have been far worse had commercial property prices gone into freefall, as defaulting loan security was offered to the highest bidder.

 

Commercial property values

In the UK, commercial property values have fallen for 24 consecutive months according to IPD (Investment Property Databank), although the August drop was the lowest since 2007 at -0.9 per cent.The total decline for all property now stands at -44.1 per cent since the start of the credit crunch and -30.8 per cent over the past 12 months – each month adding to the biggest drop since records began in 1987.

 

A similar picture is witnessed across Europe and thus the special servicer is duty bound to watch the market closely, both at a macro and micro level in order to determine the most appropriate short and long term strategy.

 

In determining the strategy, the number of parties that a CMBS servicer needs to involve is long and includes: investors, lenders, issuers, rating agencies, auditors, broker manager valuers, brokers, swap counterparts, equity providers and trustees.

 

It is also worth pointing out that primary and special servicing are not mutually exclusive and they work most effectively when the special servicer has ongoing insight into the loans that it could end up being responsible for.

 

 

Mark Miller is chief operating officer at LNR Partners Europe & Hatfield Philips