By Michael S. Merriam, Director, Standard & Poor's Ratings Services

To see just how far commercial mortgage-backed securities (CMBS) servicing has come during the past 10 years, it's vital that we look back to see how different the world was during the early 1990s. Back then, tools like the Internet, cell phones and digital cameras were not yet a part of the mainstream business environment and culture.

In fact, most company e-mail networks weren't Web-based, and businesses relied primarily on fax machines for rapid written communication. At the same time, CMBS servicing was just emerging as a true industry. In the early 1990s, CMBS servicing was, on many levels, a basic blueprint for what exists today with respect to overall market penetration, reporting duties and investor expectations and needs. Concurrently, Standard & Poor's Servicer Evaluations criteria have undergone a similar evolution.

Factors influencing maturation of CMBS servicing

In a relatively short time, technology advancement has played a pervasive role in reinventing the operational tools available to mortgage servicers, just as it has affected so many critical aspects of global business and culture. Consequently, advances in technology have propelled CMBS servicing to a much more mature stage than it was just a decade ago. The advent of standardized reporting requirements, a key progression that dramatically changed the way reporting was previously handled, has also helped reshape CMBS servicing. In 1994, investor reporting standards were anything but standard. However, standardization, principally achieved through the efforts of the Commercial Mortgage Securitization Association (CMSA) and its predecessors, has helped transform commercial mortgage-backed securities into more freely traded, easier-to-monitor, and mainstream investment vehicles. In response, CMBS servicers have readily adapted to the new standards by investing in additional staff training and retooling system specifications.

The other catalyst affecting the CMBS servicing paradigm, possibly more so than technology and reporting standards, has been the rapid evolution of loan- and pool-level transactions into highly sophisticated structures. Fostered by investor demand, this progression transpired as issuers developed ways to satisfy the diverse range of needs with regard to risk and yield. For example, the CMBS servicer of 10 years ago did not routinely contend with loans involving mezzanine financings, B-note investors, defeasance requests and different pieces of debt on the same real estate spread across multiple CMBS pools. However, in today's environment, it's not unusual for a typical CMBS transaction to require a prospectus comprising a few hundred pages due to a deal's inherent complexities. As a result, servicing- industry advocates are continually attempting to clearly define a servicer's expanded and transaction-specific duties within each transaction's pooling and servicing agreement (PSA) to ensure compliance. Despite industry efforts, irregular situations not specifically addressed in the governing PSAs still materialize. Therefore, the need for servicers to continually exercise proper judgment and use more sophisticated tracking mechanisms has intensified in significance.

Technology and

standardization bring

industry up to speed

Together, the convergent factors of technology, standardized reporting requirements, and transaction sophistication have steadily influenced Standard & Poor's criteria and expectations regarding servicing practices and performance. These factors directly impact whether a servicer's practices regarding automation and controls, PSA compliance and information management, analysis and delivery are deemed to be inadequate, simply sufficient, or perhaps exceptional.

In 1994, a CMBS servicer could earn an ABOVE AVERAGE, or even a STRONG ranking without having many of the operational elements required for a 2004-era servicer to attain an AVERAGE ranking - the baseline requirement for inclusion on Standard & Poor's Select Servicer List. To put this into perspective, if a highly ranked servicer from 1994 were thrust into today's servicing environment without warning, it would be at a perilous disadvantage simply because of its technological shortcomings. Processes such as payment processing, investor reporting, loan accounting and financial statement analysis were conducted much differently than they are today. Servicers still processed a high volume of live checks on site just 10 years ago, and very few had fully integrated interfaces between their systems and the lockbox facilities they used for automated payment depositing and posting. With respect to overall functionality, a servicer's loan accounting and bank statement reconciliation process still involved many processes that were not automated. For example, online bank statements were considered innovative just a few years ago, as was the concept of electronic Uniform Commercial Code (UCC) filings.

With respect to investor reporting and portfolio surveillance, a highly ranked servicer in 1994 might have offered investors electronic access to portfolio data, which would have involved a dedicated modem and remote computer terminal. While Standard & Poor's has always expected servicers to house sensitive information in a central, secure system, limited technology and functionality just 10 years ago made this somewhat more challenging for some servicers. Similarly, E-mail was not yet widely used for investor reports, digital cameras and electronic downloads for property inspection data were considered cutting edge, and deal structures involved shorter "lists of things to know."

Technology and

standardization do not

alleviate all risk

While improvements in technology have clearly alleviated administrative burdens and reduced the risks stemming from inaccurate data management involved in many traditionally routine servicing tasks, improved access to enhanced technology has in no way eliminated servicing risk altogether. However, servicers that capitalize on and exploit the latest technology are the ones who have been simultaneously able to achieve the economies of scale necessary to sustain their businesses. In fact, it has become necessary for CMBS servicers to comply with standardized reporting requirements and focus on advancements in automation in order to survive. Additionally, the ongoing task of upgrading technology has evolved into a critical element with respect to managing operational risk. In today's market, other elements of servicing risk have surfaced or taken on greater prominence. This has occurred as a result of a newer, more intricate generation of deal structures despite standardization and automation improvements. These risk elements also emanate from and feed off the demands of investors and rating agency analysts for faster, more transparent and accurate data delivery from the servicers.

Closer examination and improved communication

Servicer portfolio surveillance quality is one area that Standard & Poor's now examines more closely with respect to servicer performance. One of the pressing issues in this arena right now focuses on each servicer's control of its advance recoverability decisions. Standard & Poor's expects top-ranked CMBS servicers to demonstrate a controlled process for tracking outstanding loan advances vis-a-vis property values that are based on conservative advancing threshold limits. Standard & Poor's also expects top-ranked CMBS servicers to question special servicers' asset valuations, as necessary, as part of every advance decision. Once it makes a non-recoverability decision, a servicer typically does have the right to immediate reimbursement from the applicable transaction's general collections for those advances deemed non-recoverable. However, a top ranked servicer should strongly consider how its actions regarding the timing of repayment of a non-recoverable advance will affect the trust.

A servicer should demonstrate a reasonable willingness, whenever possible, to follow a repayment path that can minimize the impact of interest shortfalls to senior-most bondholders. As a corollary to this issue, Standard & Poor's contemporary ranking criteria considers how well a servicer can communicate with its constituents, particularly the rating agency surveillance analyst, who relies on timely information and proper notice from servicers regarding applicable, loan-level issues that can affect ratings. It is now a standard expectation for a CMBS master servicer to provide portfolio data to investors and rating agencies through a self-service Web site. However, the degree to which a servicer's investor Web site meets its information delivery goals can still vary.

Concurrently, Standard & Poor's criteria regarding CMBS special servicers have undergone a similar transformation during the past decade. As in the master and primary categories, advancements in technology and complex deal structures continually raise the expectations that special servicers must strive to meet. One of the most noticeable changes has been in the level of quantitative performance data that Standard & Poor's now requests. A special servicer's asset recovery success can no longer be measured primarily by the overall size of its recovery on a net present value basis compared to the underlying collateral value. Standard & Poor's quantitative analysis now gives increased attention to a special servicer's relative speed of recovery and the aging of transferred assets, which can be equally critical variables affecting bond-level cash flows and loss severity. Particular attention is also given to the communication practices between special and master servicers. Standard & Poor's expects highly ranked special servicers to demonstrate proactive procedures in communicating material changes in their estimates of asset value. Standard & Poor's also expects highly ranked special servicers to warn master servicers about non-recoverability situations and provide an accurate accounting of asset-level expenses to master servicers. In the context of non-recoverability advance determination, ineffective special servicing in this regard takes on a heightened level of risk, as it can directly cause a master servicer to over-advance principal and interest or submit an inaccurate tally of property protection advances.

Through its evaluation of CMBS and third-party commercial mortgage servicers, Standard & Poor's will continue to examine how servicers control risk and build efficiency across all traditional servicing functions. Similarly, Standard & Poor's Servicer Evaluations criteria is in an ongoing state of refinement, as new variables pertaining to servicer and special servicer performance arise to represent, ceteris paribus, greater risk potential with respect to satisfying and protecting investor interests.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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