European CMBS issuers need to reconsider how they structure workout fees into their deals, according to Standard & Poor's analysts, who recently cautioned investors about the potential for these fees to disrupt payments even for senior noteholders.
Workout fees on corrected loans are relatively new for European CMBS, being incorporated in transactions only since 2003. Stateside investors venturing into U.K. CMBS apparently sparked the trend. David Beale, director in S&P's structured finance group in London, said the workout fees generally show up in deals when GMAC or Lennar buy the junior tranches, then have the special servicing rights assigned to them. However, there are exceptions.
Overall, roughly a dozen deals factor in workout fees so far, said Beale, who co-authored a recent report on the topic titled, "The Price of Special Servicing in European CMBS Transactions." Examples include Gorgons (European Loan Conduit No. 12) FCC, Iolaus (European Loan Conduit No. 15) PLC, Khronos (European Loan Conduit No. 17) S.A., DECO Series 2003-CIT PLC, Windermere II CMBS PLC and White Tower 2004-1 PLC.
The structuring of the workout fees is not standard across the transactions, and the impact can vary.
None of the deals have experienced any trouble, to date, but Beale added that given the nascent stage of the market, many investors may be unaware of how a corrected loan could potentially disrupt coupon payments.
A special servicer - which, unlike a backup servicer, is found almost uniquely in CMBS - steps in if a loan defaults or a predefined trigger is breached. Fees for correcting loans or liquidating assets are collected from the issuer and typically rank senior in the payment waterfall.
The workout fee, or correction fee, for returning a loan to primary servicing tends to be ongoing. It can be as high as 1% of all future cash flows on the corrected loan - that is, 100 basis points of all interest and principal payments, including any balloon payments.
As currently structured in Europe, such workout fees will cause a payment shock that can result in both interest and principal shortfalls to even investment-grade classes, the S&P report warned.
"If you're using your loan to pay your special servicer, the loan is obviously insufficient to pay the notes in their entirety," Beale said. S&P hopes to prompt debate over what the most efficient way to structure workout fees actually is. Europe appears to be migrating toward the U.S. model, which is problematic, Beale said. S&P's report cited the default of investment-grade tranches in the U.S. transaction - Four Times Square Trust Series 2000-4 TS - where interest shortfalls arose because of legal expenses and special servicing fees.
The impact of workout fees can be even more pronounced in Europe, where conduits generally include far fewer loans than in the U.S. "So is it best to adopt the U.S. approach to workout fees? Or is it better to have a different construct in the U.K.?" Beale asked.
One approach might be to make the borrower liable for workout fees, instead of the issuer, the S&P report said. Another possibility would be to explore fee structures that take into account the complexity of the workout - in effect, offering a lower fee where appropriate.
S&P singled out the White Tower deal from earlier this year, Societe Generale's first U.K. CMBS, as an innovative effort to smooth out the cash-flow distortion of workout fees. Instead of a portion of ongoing payments on a corrected loan, the fee for the special servicer in this transaction - which is Hatsield Philips International - is based on the outstanding principal balance of the loan.
The structure avoids a potential cash drain at the end of the transaction from a balloon payment; the special servicer starts getting paid as soon as its work begins, amortizing the cost across all the remaining years in the deal.
One other issue remains. The fee is senior in the issuer interest waterfall, so there is still potential for a strain on interest payments, S&P noted.
However, that is not necessarily a bad thing, said Jerome Jacques, a managing director of MBS for
SG Corporate & Investment Banking. "Because, if this is a real major cash drain, then [the] whole transaction is entering into an enforcement type of waterfall. So the noteholders, at least the senior ones, are better protected," Jacques said.
He described the structure as allowing a more proactive approach to problem loans. "If the structure is not providing sufficient cash flow to cover the extra cost of the special servicer, then we are recognizing the problem as soon as day one," he said. "So there is more transparency."
SG CIB is also studying the possibility of structuring some CMBS deals with a cash-trapping mechanism, to further protect senior noteholders, Jacques said.
In the case of White Tower, SG CIB worked with the special servicer to create a different pricing grade than is typical on CMBS deals, he added. According to the White Tower offering circular, the special servicing fee is 0.15% of the outstanding balance and the workout fee is 0.025% of the outstanding balance. The liquidation fee is 0.2% of net sale proceeds with the amount capped at 0.2% of outstanding principal balance of the loan.
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