Commercial Mortgage-Backed Securities 2.0 - Calls out lenders - by David Goldfisher

CMBS Transitions
Was the CMBS 2.0 moniker simply a rebrand of CMBS 1.0 created to put a new spit shine on an old pair of worn out shoes?  Post the 2008-2009 financial crisis, investors of CMBS bonds learned a few valuable lessons as CMBS loan defaults hit record levels and bondholders had to entrust special servicers to fairly adjudicate losses and recoveries in CMBS loan pools. Not completely satisfied with the process, many B-piece bondholders were reluctant to re-invest in these loan pools. Investors buying CMBS after 2009 were looking for CMBS issuances to be more pristine with tighter underwriting standards and stronger risk alignment. CMBS 2.0 was announced.

Extenders and Pretenders 
CMBS 2.0 underwriting standards have certainly become more stringent over the last 5 to 7 years. Lenders have reduced LTV’s, added more cash management agreements, originated fewer interest only loans and demanded more substantive escrows. In our opinion, however, the most impactful change coming out of CMBS 2.0 targets the special servicers and the controlling class holders. CMBS 2.0 has tightened the reins on the “extend and pretend” plays orchestrated by controlling class holders. CMBS 2.0 forces appraisal reductions/ASER’s (Appraisal Subordination Entitlement Reduction) to be taken on more of a spot basis forcing lenders to mark to market their loans.

“In the Money”
In a typical CMBS transaction, the majority holder of the junior most bonds is designated as the controlling class representative and as such appoints the special servicer for the underlying loan pool. This arrangement works well in the early stages of the REMIC investment where property values are generally stable and market fluctuations are minimal. The controlling class representative is perceived by the investors to have “skin in the game” and interests are generally aligned in maximizing trust asset recoveries. The CCR is “in the money” so to speak.

“Out of the Money”
CMBS mechanics did not react quickly to the changing landscape of the precipitous market decline and property devaluations experienced after 2008. A special servicer could stall the appraisal valuation process for up to six months (allowed by contract) and hold the asset for 36 months (governed by the PSA specifically) in REO. Control holder status often took far too long to migrate up the capital stack under CMBS 1.0. 

Special servicers and the controlling class holders often did not take “real-time” appraisal reductions on severely over-leveraged assets in the early stages of the REMIC pool. So, it was often difficult for borrowers to negotiate a fair economic loan restructure with the servicer because by doing so the servicer may have pushed himself “out of the money” and out of the control position.

Presently, the 2007 pools are winding down; servicers and bondholders alike are trying to figure out how to make money on the remaining collateral. More Fair Market Value Purchase Options (FMVPO’s) are being exercised by the CCR’s. Servicers are still delaying resolutions on certain assets in order to maximize their profits.

By forcing lenders to take a more “spot” approach to asset valuation, CMBS 2.0 takes a proactive step in resolving borrower, lender and bondholder disputes involving conflict of interest issues. A lender who is “out of the money” should not dictate resolutions that inhibit the trust from yielding the highest possible NPV and prevent borrowers from resolving their CMBS loan issues in real time.

David Goldfisher is a principal at The Henley Group, Inc., Natick, Mass.