Concerns over a wave of defaults in commercial mortgage-backed securities clouds industry prospects
By the end of 2011, uncertainty over the future of distressed commercial mortgage-backed securities (CMBS) overshadowed positive signs of lower delinquency rates. Defaults declined this past November after two straight monthly increases, which could indicate that CMBS delinquencies might be leveling off. But observers like Trepp, which tracks CMBS-delinquency data, warned that the retreat of defaults might just be the calm before the storm.
The grounds for these concerns may be valid. Many of the loans that were originated in the 2007 commercial real estate bubble will mature this year. Additionally, the second half of this past year witnessed a curtailing of new CMBS issuance, which puts further upward pressure on the delinquency rate, according to Trepp.
Delinquency rates of distressed CMBS seemed to be on track to improve by the end of this past year, declining 26 basis points to 9.51 percent this past November. This was the second biggest drop in ’11, after a drop of 36 basis points in August. The rate had fallen for four out of the first eleven months in this past year, according to Trepp.
This positive change, or the leveling off in CMBS defaults, is unlikely to be sustainable this year. There has been a large amount of resolutions made in the past 18 months that contributed to this apparent leveling-off activity.
Although the aftermath of the last crisis seems to be behind us, the industry is at risk for another giant wave of delinquencies that is likely to hit this year. Commercial mortgage brokers must keep this in mind and remain on top of the changes in the CMBS industry, which can affect the lending environment.
Before addressing the types of resolutions that have been made so far, it is important to get an overall picture of the special servicers because they are responsible for handling and resolving all distressed CMBS loans.
Special servicers are assigned at the securitization by the controlling-class representative (CCR) — that is the owner of the lowest tranche of bond, which are the ones with the first loss and highest risk. It makes sense that the owners of first-loss bonds would want to control the resolution of defaulted loans because that is what will cause their loss.
Nearly 85 percent of the total current CMBS pools were originated and securitized in 2005, 2006 and 2007. When those special servicers were being assigned, there were few defaults in the industry, and special servicers were staffed based on this level of defaults.
When the first wave of defaulted loans came rushing into the special servicing shops in late 2008 and through the first half of 2010, they were not able to handle all the defaults. Accordingly, delinquency rates increased, and so did special-servicer costs. Because of skyrocketing costs and low profits, most special servicers required recapitalization themselves.
The top three special servicers in the industry, which account for nearly 75 percent of all the business, had the following ownership changes in 2010:
- LNR was recapitalized by a consortium of five opportunistic buyers of commercial real estate.
- Centerline was bought by Island Capital and changed its name to C-III. Island Capital also acquired J.E. Robert Company Inc.
- CWCapital was bought by Fortress.
The important point about these ownership changes is that these special servicers are now owned by companies that have more aggressive “real estate like” return targets. They also have alternative investment motivations, which can make a difference in their decisions regarding the resolution of defaulted loans.
Sources of fees
Before these ownership changes, there were two primary ways that a special servicer could earn fees:
- A special servicing fee: Equal to 25 basis points of the outstanding principal balance of the loan it is resolving
- A disposition fee: Equal to 1 percent of the outstanding balance of the loan as it is resolved, either through a modification, sale of real estate owned (REO) property or reinstatement of the loan
Today, there are many other ways a special servicer earns fees through its affiliations — sales and brokerage listings for REOs to name two. This clearly calls into question the motives of a special servicer when confronted with a defaulted loan.
Let’s go back and look at the resolutions that led to some sort of leveling off in delinquency rates. There has been $82 billion in CMBS loans resolved since 2007, of which more than $63 billion was resolved in the 18-month period from January 2010 to June 2011, according to Fitch Ratings. Here’s how that $63 billion in loans was resolved:
- 39 percent were modified
- 16 percent were reinstated — the problem cured itself or the borrower decided to pay out of pocket to make the loan current
- 15 percent were a discounted pay-off, and the average discounted amount was more than 50 percent
- 12 percent were paid in full, which were most likely maturity defaults that were eventually paid off
- 9 percent were sold via a note sale
- 9 percent were foreclosed and sold as REO, which might be because the recovery rates have historically been the lowest on foreclosures and REOs
The loans that were modified have three interesting common characteristics:
- The average loan size is more than $30 million.
- Borrowers were represented by an adviser or a borrower advocate. This likely greatly helped them achieve a modification.
- The special servicer’s position moved up in the bond stack.
Remember that the special servicer is appointed by the CCR that is the first in line to suffer a loss. Therefore, as losses occur on loans and pools, the position of the CCR will move up the bond stack. Currently, some of the worst-hit pools are suffering losses all the way to the AAA-rated borrowers, and the same scenario may be repeated if a second wave of delinquencies hits.
When a special servicer is forced to make a decision on the appropriate resolution of a loan, it is bound by a servicing standard that basically says that it must take the action that will result in the highest recovery and the least loss for all the bondholders, regardless of its own personal position in the bond stack or its monetary gain.
Yet it is clear by the statistics that the current special-servicers bond position impacts its decision. Remember that the special servicer receives a 1 percent fee upon resolution from the trust — regardless of the resolution.
If — and this is merely a hypothetical — the special servicer that is owned by an opportunistic fund had invested a large amount of money in a particular pool, and its current position in the bond stack meant that it would not be in a position to get any more fees on that pool, it might be encouraged to take a quicker action on defaulted loans to get the 1 percent fee. This has been referred to by some as the fast-resolution versus the patient servicer.
Another course of action for these special servicers is to buy the bonds at the next level in the bond stack, and that is currently a significant focus of some of these opportunistic funds. The debate over fast-resolution versus patient special servicers likely will come up in the CMBS industry more frequently this year as special servicers’ positions are being wiped out.
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The first wave of delinquencies has hit the beach, and the industry has been dealing with the ups and downs of its aftermath. The question now is whether a second wave is within sight and how much damage it could cause.
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