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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2014

When the CMBS Market Plays Musical Chairs

Declining delinquency rates of commercial mortgage-backed securities loans are no game

Nearly everyone has played the game of musical chairs at some point in their lives. When the music stopped, the unfortunate participant who ended up without a chair at the end of a round had to sit out the rest of that game and wait for the next one to get another chance to play.

Surprisingly, commercial mortgage-backed securities (CMBS) loans have a similarity to musical chairs. How can this be? A look at CMBS loan-delinquency trends helps to make sense of this analogy.

A deceptive decline

Data indicates that these CMBS delinquencies are declining. But this raises the question of how these delinquencies are getting resolved. Have the root problems that led to the delinquencies been addressed, or is it really more like a game of musical chairs with delinquent CMBS loans as the participants being “eliminated”?

U.S. Historical CMBS Delinquency Balance and Rates

First, take a look at the facts and trends indicated by the accompanying chart. The amount of delinquent CMBS loans has declined steadily from an all-time high of more than $62.8 billion in 2011 to about $41 billion by the end of this past year, according to Trepp.

Many people would assume when noting such a drastic decline in the delinquent CMBS loans that the root causes behind the delinquencies have been solved in some way. But the truth is that often loans are modified to “live another day.” Sometimes they are foreclosed on and ultimately sold by the trust, sometimes they are liquidated via a discounted payoff or short sale and other times they were simply “eliminated from the game,” as in musical chairs.

Behind the numbers

In all of these scenarios, the problem loans in question were not resolved, but instead sold to other lenders to handle from that point forward. They were no longer technically delinquencies — they just became someone else’s problem. This was done through both one-off and large note sales. In fact, in 2012 more loans were transferred out of special servicing because of note sales than modifications or reinstatements.

For example, CMBS special servicer ORIX Capital Markets LLC sold nearly $1.5 billion of notes in spring 2013, followed by CWCapital offering more than $2.5 billion of notes at a note auction later this past year. In addition, there were note auctions of smaller amounts by special servicers almost every month throughout this past year, which resulted in the appearance of much lower CMBS delinquency rates by the end of the past year. It is tempting to conclude (incorrectly) that problem loans are being resolved. But in reality, the loans have not been resolved, they simply have been eliminated from the “game” and given to someone else to deal with.

Types of resolution

The following are among the ways loans are being considered resolved in the CMBS pool:

  • Loan reinstated. This may mean either that the problem that existed at the time the loan was transferred to special servicing corrected itself, or that the borrower concluded that the only two options were to go into foreclosure (because the special servicer has taken a hard-line stance), or that it would be necessary to reinstate the loan and face the problem later. In many cases, the problem did not go away, but the borrower concluded there was no other choice at the time.
  • Loan modified. The loan was modified to allow it to perform and, ideally, provide for full payoff at maturity (as best as could be predicted).
  • Loan liquidated. A loan is classified as resolved through liquidation through any of the following methods: discounted pay off, loan foreclosure followed by sale via REO, note sold to the borrower or another third party (often through a note auction) or portfolio sale through an auction (e.g., previously mentioned note sales of ORIX and CWCapital).

Signs point to a continuation of this trend throughout this year, causing CMBS delinquency rates to decline even further. But does that mean the basic issues behind the delinquencies have been fixed? Unfortunately not. It simply means that the loans did not have a “chair left in the CMBS loan game” at the end of that round of musical chairs. In reality, the problem loans haven’t gone away, they just belong to new note holders.

Roots

Why are special servicers selling their problem loans via note auctions? The reason most often given by these companies is because of the combination of favorable financing conditions along with strong investor demand for distressed real estate. Another reason for special servicers selling loans at note auctions is because they want to collect the liquidation fees while they still are servicing the loans. 

Special servicers typically earn a liquidation fee of 1 percent of the unpaid principal balance of the loan at the time of liquidation — so, for example, a portfolio sale of $2.5 billion would yield the special servicer $25 million. Not bad for a few months’ work.

Ultimately, the special servicers may need to leave themselves some room to accept the next large wave of delinquencies coming at them — about half of all of CMBS loans originated before 2008 are due to mature in the next few years, and according to industry predictions, many likely will not qualify for refinance at the time of their maturity.

This cycle of events makes it appear that musical chairs will likely remain a popular game in the world of CMBS loans for years to come.   



 


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