Eliot Brown of the Wall Street Journal recently published a great article titled “Bad-Loan Revival Unburdens Banks” which articulated how the rising real estate values are allowing banks to dispose of REO assets without incurring much of a loss.
For the classic banking institution, there is no doubt that the rising values are a boon, but for CMBS Trusts beholden to complex rules, it serves more as a means to realize losses, and generate servicing fees- a forcing of their hand, if you will. To explain, I will need to run through a quick CMBS refresher course:
1. Advances: The CMBS structure allows for special servicers to lend money to CMBS trusts, as well as for the Trust to spend money on a loan or REO property (for specific purposes) so long as the investment can be recovered; this is based on the opinion of the servicer, which is formulated as a result of the due diligence it has conducted where the servicer lends money to the Trust (many times for the payment of interest to bondholders)
2. Borrower Negotiations: Many stories have been written regarding special servicers consistently denying borrowers’ proposals. For as long as I can remember, Morningstar’s CMBS Research Reports have included a comment similar to “A denial by special servicers of borrower requests for loan extensions, modifications or debt restructuring, or a decision by borrowers to surrender the collateral, are still legitimate concerns.” The primary reasons behind this have been largely driven by the lenders’ opinion that the proposal set forth by the borrower may represent a lower Net Present Value than the alternative (foreclosure and REO sale, or Note Sale). In essence, the lender felt that a sale of the asset would net a greater return.
3. CMBS Bond Stack: As previously explained via the infographic posted on this Blog, the most subordinate bond tranche in the CMBS structure — also known as a “B-Piece” — and has a first loss position. In return for its risk, it is granted the title of “Controlling Class,” and has the unilateral right to appoint the special servicer and dictate strategy. This tranche usually is owned by hedge funds and special servicing companies. The tranches above it, progressively rated higher and more secure, are usually each owned by more conservative investors than the one beneath it. Once the lowest tranche realizes losses in excess of a certain percent (let’s say 75%) the control is passed to the bond class directly above it. In today’s market, many of the legacy CMBS trusts are one or two tranches away from being controlled by pension funds or insurance companies- if they aren’t already.
Over the past few years, it was in the best interest of the controlling class (not necessarily the Trust as a whole) to do everything possible to defer losses and have the special servicer collect fees (which it would then share with the controlling class ownership). As it would not be collecting interest distributions, and principal recovery was at a best a pipe dream, in many cases special servicers focused primarily on its fee income as opposed to the interests of the trust as a whole. There, I said it.
Today, with rising values and practical bond ownership, special servicers/controlling classes can for the most part no longer collect fees while just promising a better day, especially while making advances. The numbers just don’t work and there is way too much uncertainty. The inflation in property values, forces the special servicer to recommend a sale.
The good news? When a servicer sells a loan or property, they make a significant fee- a golden parachute .
The bad news? With the reality of a defined exit price and losses realized, perhaps the distressed borrowers offer was in fact the best net present value to the trust!