Magazine article Mortgage Banking

CMBS Special Servicing-A World of Conflict

Magazine article Mortgage Banking

CMBS Special Servicing-A World of Conflict

Article excerpt

Special servicers are unique market participants that provide the resources and expertise to address and resolve credit issues, delinquencies and default in commercial mortgage-backed securities (CMBS) transactions. According to the most recent CMBS statistics compiled by New York-based Trepp LLC as of Sept. 30, 2011, there are 4442 assets in special servicing representing a combined unpaid principal balance of approximately $81.6 billion. This represents 13.2 percent of all outstanding CMBS issuance, and is expected to remain at historically high levels as the total outstanding continues to contract.

The magnitude of the situation has elevated the scrutiny level that special servicers find themselves under from senior bondholders, rating agencies, industry analysts and the media.

Prior to the financial crisis of 2008, default rates within CMBS trusts were relatively benign and new issuance was at record levels. Up until then, the discussion of special-servicer conflicts of interest and their adherence to the servicing standard were primarily theoretical discussions, with little historical data to support either side of the argument.

However, as the volume of transfers increased and realized losses accumulated over the past three years, the special-servicing community has been thrust under the microscope, and its resolution strategies have been debated and routinely criticized by various market participants.

The special servicer's mandate under the CMBS governing documents (specifically the Pooling and Servicing Agreement, or PSA) is basically to represent all of the constituent parties in a CMBS transaction as a collective whole, and to achieve the best resolution possible based on the highest net present value outcome for the trust. This mandate can create the potential for conflicts (either real or perceived), especially given the fact that some special servicers have not always been completely transparent in their disclosure of how resolution strategies were arrived at and executed, nor have they been universally forthcoming in the disclosure of fees received.

Special servicers are typically named to their role by the owner of the most subordinate class of bondholder, routinely referred to as the controlling class representative (CCR), directing certificate holder (DCH) or simply the B-piece holder. The theory behind this structure was that because the B-piece would suffer interest shortfalls first, as well as absorb the first losses from defaulted assets, it was in the B-piece holder's best interest to have aligned interests and the right to consult with the special servicer tasked with resolving said assets.

So long as the initial B-piece holder retained some portion of the principal balance of its bonds, it retains control over the special-servicing appointment rights with the right to terminate and replace the special servicer with or without cause. Despite this broad power, it was the special servicer that was obligated to make decisions impacting the entire trust and to do so in an impartial manner, without particular regard to the B-piece's self-interest.

As losses mount and the B-piece position erodes in legacy CMBS deals, control shifts upward in the capital stack to the next class of bondholder most at risk for loss.

As described here, this tension can create potential conflicts between the parties when one (special servicer) has a responsibility to act on behalf of multiple interests while the other (B-piece holder) retains the ability to terminate and replace the party (special servicer), as well as act in its own self-interest.

This situation is further exacerbated when the B piece and the special servicer are controlled by or affiliated with the same corporate entity. As losses have mounted in legacy CMBS pools, interest shortfalls to subordinate bonds have accumulated so that in some cases, the only source of revenue generated to these affiliated parties comes from the fees generated for special-servicing activities. …

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