With the current weak economy, the problem of imminent defaults, or loans that are current but expected to go sour, is becoming more common in CMBS deals.
In these situations, determining what constitutes a loan in imminent default - therefore resulting in a servicing transfer - is left to the judgment of either the master or the special servicers on the affected CMBS transactions. The language typically used in traditional CMBS Pooling and Servicing Agreements (PSAs), which is often open to interpretation, is at the root of the subjective nature of this exercise.
Due to the lack of any standardized definition of what ultimately constitutes an "imminent default," disagreements between parties involved in these deals could easily come up. This is becoming more common especially as more credit risk situations occur, said participants at a recent Standard and Poor's teleconference, which included B-piece investors and representatives from master and special servicers.
Additionally, the sensitivity of these disagreements are heightened because the fees involved in any servicing transfer would naturally cost the investors money.
Roy Chun, managing director at S&P, heard from some master and special servicers that there has been disagreement going on as to when a loan can actually be declared in imminent default, and the servicers had asked if S&P could provide a forum in which the issue could be discussed.
"The issue of imminent defaults is something that will be coming up more often," said Chun. "Given the state of real estate and the economy, there are a lot more gray areas popping up. Although this issue may not be readily resolved, if some of the dynamics and parameters of it are worked through early on, it is something that could be addressed and have there be much more agreement than disagreement."
Opening communication lines
Participants in the teleconference agreed that maintaining open lines of communication between parties and regular surveillance are necessary in identifying problem loans.
"Cooperation does nothing but work in everyone's favor," said John Church, managing director at Wachovia Securities Inc., at the S&P teleconference. Wachovia is a large master and special servicer.
In a separate interview, Larry Duggins, president and chief operating officer at ARCap REIT, Inc., a Texas-based special servicer, stated that the interests of the bondholders are best served when "we look at the facts around every situation individually and then make individual judgments about whether an imminent default is a transfer or not."
He stated that there have been situations of potential imminent defaults where his company had worked very closely with master servicers. By working with the master servicer, the problems were addressed without a transfer to the special servicer, which are always costly to the trust.
"There are situations where we believe that the master and the special servicers or the directing certificate holder and the master servicer could work together to take care of a problem without having the trust incur those costs," said Duggins. "Leaving judgment in the default definition is really very important because in many cases the master servicer is completely competent to handle issues that are involved."
Aside from the continuous dialog between the parties involved, another alternative for solving less clear-cut situations would be sending a questionable loan to special servicing on a "non-transfer" basis, suggested Douglas Cooper, principal at Allied Capital Corp. at the press conference.
Cooper explained that this process involves the support and insight of the special servicer without the fees that come with transferring a loan to special servicing. The advantages of doing this is it would not only bring the special servicer up to speed early on but it would also alleviate concerns that the trust is being unnecessarily burdened with servicing and performing loan fees.
Potential default situations
A potential default situation mentioned in the conference call is tenant bankruptcies.
These types of bankruptcies are not always clear-cut. While a bankruptcy of a borrower is always going to entail a transfer of assets, a bankruptcy of a tenant is not necessarily always viewed as a cause to transfer assets to special servicing.
However, panelists said that although the loan may be current in these cases, the bankruptcy also poses a slew of potential factors that may hinder the loan from performing, such as a lease being rejected.
Thomas Nealon, division general counsel at LNR Property Corp, said at the teleconference that in a case like this, the master servicer usually tries to balance the need to both be proactive with industry and investor concerns about special servicing fees and the need to be prepared when an event like this occurs.
The issue of the lack of terrorism insurance coverage can also raise questions regarding imminent defaults. Wachovia's Church said that this issue has led to some imminent default transfers. He stated that in these instances the transfer to special servicing typically comes after a series of judgments made on an individual or "case-by-case" basis. He added that with the attention focused on the insurance issue, a lot more leeway could be made in determining the real necessity for a servicing transfer.
The fee schedule becomes a crucial point in cases where the lack of terrorism insurance is an issue, particularly for single asset deals. Panelists said that in the past year, many investors have been rather surprised by the amount of special servicing fees pertaining to insurance-related transfers. They said that buysiders should be aware of the possible effect of these fees to the classes they are contemplating. Master and special servicers should also work jointly to lessen unnecessary fees to the trust.
