With deals involving the placement of terrorism insurance facing more and more interest shortfalls and those that have accumulated advances for properties suffering from plunging real estate values, Moody's Investors Service released a report on smoothing recoveries of servicer advances to lessen interest shortfalls in CMBS.
In the cases that involved the forced placing of terrorism insurance policies by special servicers, courts have ruled that borrowers were not liable to pay the insurance premiums as well as legal fees accumulated by the servicer. The imposition of these charges, advanced by the servicer beforehand against the CMBS trust in a single month, has caused interest shortfalls that have hurt investment-grade bonds.
Moody's special report examined the advancing mechanism and also suggested some ways of reducing the occurrence of these events to senior classes when the servicer could recover large accumulated advances.
The issue of interest shortfalls is a problem that has occurred in several cases so far, but this might occur in a great many more cases later as transactions approach the stub end - at which point there is only a few assets left in the deal - and most have paid off. Brian Furlong, vice president at Moody's, said that at times there is an element of adverse selection so assets that are remaining in the pool would sometimes be of lower quality compared with the average quality of the assets when most of them have yet to pay off - an emerging problem that the industry should be able to solve.
The rating agency's review of interest shortfalls has led to some key findings that define the problem and also presents some possible solutions. One key finding of the study: Current advancing mechanisms could be hurting more than helping senior certificates, in some cases. Aside from this, the report also said that recent vintage CMBS deals have more exposure to interest shortfalls that are due to their smaller subordinate classes and lower certificate coupons.
Servicer advances
In CMBS deals, servicer advances for principal and interest, property protection and trust expenses are reserved for providing the liquidity needed to create high-rated securities backed by less-liquid assets. Moody's ratings assess the timely payment of interest. If some months were missed, this would materially change the expectations of investors and would vary the meaning of the ratings. These ratings are dependent on having a liquidity facility within the transaction to smooth out the payments. Analysts are focused on whether there is sufficient value in the collateral pool that could be relied upon to pay back the advancing entity.
The problem occurs when in some transactions the advancing mechanism does not work as expected. Sometimes the advancing occurs to allow for the full payment of the interest. This creates the possibility that the shortfalls would eat into the investment-grade classes.
Moody's view is that if the collateral pool as a whole provides a very high level of support for the repayment of those advances, and the advances are in fact senior to a lot of principal in the transaction, the advances should occur to cover the shortfalls.
There are two main ways this could be done. The first is to have the servicer spread out the recovery of the accumulated advances over a certain number of months in order to force the shortfall very low into the rating scheme, to unrated securities or very low grade securities, rather than investment-grade securities if it is taken all at once. Another mechanism that would work well, according to Moody's, is to have the servicer look to principal flows that do not have a scheduled date to begin with. Thus, there is no expectation of a timely payment, but rather the eventual payment of principal. With a small degree of slippage in the timing of the principal payment, the interest shortfall could be avoided by recouping the principal rather than interest.
The Moody's report said that of the 327 outstanding CMBS deals rated by Moody's, 119, or approximately one-third, have some amount of advancing outstanding as of June 1. The average amount advance is about 0.44% of the deal balance, which ranges from a high 6.58% to a low of 0.01%.
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