The use of pari passu notes as a means to dilute the risk associated with single-asset CMBS transactions has become standard practice for large trophy properties, though it raises questions about who controls these loans should they default, as each slice involves a separate servicer.

The structure involves splitting a loan into several pieces and placing those pieces in separate transactions, thereby minimizing the impact of any one asset on a

given deal.

The trend has been driven primarily by the lack of investor appetite for single-asset CMBS in the wake of 9/11, said Moody's Investors Service Senior Analyst Daniel Rubock.

"Very few, if any, large, single-asset securitizations have come out of the gate since 9/11," he said.

According to a report from Dominion Bond Rating Service Ltd., 2003 saw 69 CMBS transactions containing pari passu notes, compared with fewer than 20 in 2002. Investors are concerned that workout agreements are becoming unwieldy.

"Initially, the special servicer of the deal with the first piece would control the workout on all the other deals. Now they're contemplating bringing arbitration into play," said Principal Capital Real Estate CMBS manager Marc Peterson. "With so many parties involved, it is hard to come up with the most efficient workout, and the time and cost involved becomes a trust expense."

Deerfield Capital Management CMBS portfolio manager Lipkee Lu said that investors have been given no reason to doubt the efficacy of this structure to date. However, he agreed that problems could arise in the event of a workout if various servicers were to find themselves at odds.

"If there are any issues with coordinating the workout, it could hurt the triple-A investors because there could potentially be a delay in collecting interest or principal recovery," Lu said. "For loans with a B note, we want to make sure the workout runs smoothly. This would most likely only be a consideration for loans with a high LTV."

Erin Stafford, vice president at DBRS, said that in some instances there might be as many as four different trusts, each with different master and special servicers, which could cause a breakdown in communication. A loan split into three trusts is acceptable, Deerfield's Lu said, but any more than that may raise a red flag.

Peterson said that the number of trusts involved has not been a decisive factor in his investment process. "We need to know how the loan is structured, and who the controlling class is. Up to this point, we have been comfortable with who controls these loans," he said.

Currently, all of the loans involved in these transactions are performing and the workout mechanisms have yet to be tested.

"All it would take is for one of these loans to go bad to see what would really happen," Dominion's Stafford added.

Moody's position is that the methods currently being used to address the control issue are sufficient, Rubock said.

"There has to be proper dispute resolution mechanisms and the time to determine the outcome of differences of opinion," he said. "As long as those are written into the documentation, we think that complexities can be minimized to the point of credit neutrality."

Lu maintains that since all the parties' interests are aligned, differences of opinion should not pose a significant threat. "Even if one party wants to modify the loan, and another wants to foreclose, in the end, they are all working toward the same goal - the best recovery," Lu added. Despite the possible complications, investment-grade buyers are not overly concerned. "These are high quality loans on high quality properties. The probability of default is pretty low. This hasn't presented itself as a primary issue for us so far," Peterson said.

Another potential concern for investors could be exposing themselves to the same loan in multiple transactions, Stafford said, depending on where they buy in the structure. "This would probably not be as much of an issue for a double-A buyer as it would for a mezzanine buyer," noted Stafford.

Peterson said that if it were a very strong loan, he would likely try to gain as much exposure as possible. "But if you get the third or fourth piece and you have exposure there, and they are all big exposures, then I think that's an issue you'd have to consider," he said.

Some transactions may include as many as seven pari passu notes, Stafford said, which makes it even more difficult for investors to sort out issues of control. Loans as small as $50 million are being split up into pari passu notes, Stafford said.

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