As a great songwriter once wrote, "the times they are a-changin'..." For the first time since its inception in the early 1990's, the United States CMBS market and CMBS servicer capabilities are being tested by the very economic stress that was the impetus for the creation of the CMBS market.
The servicing of distressed real estate loans is presenting many problems for borrowers as their loans become troubled due to the continued downward spiral of the market. One of the major challenges for borrowers are the various restrictions on CMBS loans that severely limit the flexibility of loan servicers (who take the place of lenders in the CMBS framework) when working out distressed loans. This limited flexibility means that many loans that may have been worked out in the past (e.g., properties that are fundamentally sound but are facing short-term economic distress resulting from excessive vacancy or unexpected one-time expense) cannot be worked out due to the fact the loan has been securitized.
CMBS Structure: An Overview
Unlike non-securitized loans, the structure of CMBS is complex and there is a complicated interplay of parties with conflicting interests, documentation, structures and rigid tax rules.
In a CMBS transaction, a loan originator makes a loan secured by a mortgage on commercial real estate. The loan originator holds the loan until it accumulates a pool of loans of varying size, property type, location and risk classification for securitization. The loan originator then sells the pool of loans to a depositor, whereupon the depositor transfers the pool of loans to a trust which, if properly structured and maintained, acts as a pass-through entity exempt from federal income taxation. Typically, in order to assure such favorable tax treatment, this trust will be a real estate mortgage investment conduit (REMIC), authorized by the Tax Reform Act of 1986, amending the Internal Revenue Code (the "Code"). A REMIC is an investment vehicle that holds various mortgages in trust and issues securities representing a specified undivided interest in such mortgages. The REMIC assembles mortgages into pools and then issues a series of bonds with various risk and maturity classes or tranches. The bonds are then sold to investors who wish to purchase interests in the secondary mortgage market. The CMBS transaction is structured and priced based on the assumption that it will not be subject to double taxation (i.e., the REMIC itself will not be taxed on its income). As such, any deviation from the tax rules set up for REMICs may result in taxation of the REMIC entity as well as the bondholder.
Servicing the Loan: The Pooling and Servicing Agreement
Upon securitization, the loans are serviced in accordance with the applicable loan documents and the pooling and servicing agreement (the PSA). The PSA (i) dictates the allocation and distribution of any loan proceeds and losses to the various bondholders; (ii) establishes the management structure for the pool of loans; (iii) sets forth the responsibilities and duties of the servicers handling the pool of loans; and (iv) provides guidance to ensure that the trust complies with REMIC rules to insure that the trust will maintain favorable tax treatment. The parties to the PSA typically include the master servicer, special servicer and trustee.
Master Servicer
Customarily, the master servicer is selected by the depositor to service the pool of performing loans and is charged with processing borrower requests. The master servicer acts as an advancing agent and serves as a fiduciary to the trust. It is responsible for arranging for the collection of payments from borrowers, calculating the amounts due to bond holders, and remitting such amounts. It is responsible for insuring that the servicing of the loans will be performed in accordance with the trust requirements.
The master servicer responds to borrower requests for approvals, such as loan assumptions, leases or reserve or impound withdrawals. The master servicer must be creditworthy as it must advance principal and interest payments to the bondholders, even if the borrowers do not make such payments, until it determines that such payments are not likely to be recovered from disposition of the property.
Special Servicer
If the borrower fails to make a payment of principal and interest within 60 days of a due date, the servicing of the loan is transferred to the special servicer (who also has the authority to oversee actions such as loan modifications).
The special servicer is usually the holder of the lowest level tranche (called first-loss or B-piece) of the CMBS pool, which has the most risk. The special servicer handles the workout or foreclosure process and otherwise services defaulted loans. If a loan default is cured, the special servicer will return the servicing of the loan to the master servicer. Typically, the special servicer and a majority of the subordinate bondholders have the option to purchase a defaulted loan at a price equal to the lesser of (i) unpaid principal, accrued interest and advances or (ii) "fair value". Unless this purchase option is exercised, the special servicer is required to proceed with resolution strategies, including foreclosure.
Additionally, the special servicer may have the right to "put" the defaulted loan back to the loan originator in the event of a document defect or breach of a representation or warranty by the borrower which materially and adversely affects the value of the loan.
Given the prospect of second-guessing and the subjective nature of its duties, the special servicer is typically exculpated in the PSA for its actions or omissions taken in good faith, excluding any willful misfeasance, bad faith or negligence in the performance of its obligations or duties.
Trustee
The trustee holds the loan documents and distributes payments received from the master servicer to the bondholders. Although the trustee generally has broad authority under the PSA with respect to managing the loans, it typically delegates its authority to the special servicer or the master servicer. Because the trustee is the holder of the loan documents, the trustee is the one who will be named in enforcement actions (i.e., lawsuits or non-judicial foreclosures).
REMIC Rules
In order to preserve its preferential tax treatment and avoid penalties, the trust must comply with REMIC tax rules, which are comprised of Code provisions and related Treasury regulations, including:
* substantially all the assets must be "qualified mortgages" or certain permitted investments - with debt secured by real property having a market value of at least 80% of the loan amount constituting a qualified mortgage;
* no new loans may be contributed or substituted more than three months after formation (as discussed below, a modification or workout of an existing loan may be considered a substitution of a new loan);
* no material changes in the yield or timing of payments;
* limitations on substitution, addition or deletion of obligors;
* limitations on changes to security or credit enhancements; and
* no changes in the priority of debt instruments.
Servicing Standard
Additionally, the master servicer and special servicer must comply with standards provided in the PSA (servicing standard). The servicing standard requires that loans be treated with the same care, skill, prudence and diligence as their own similar loans or those held for other institutional investors, whichever standard is higher. The servicing standard intends to serve the best interest of the bondholders. The servicer may not offer any concessions to the borrower even if it is a major client.
Loan Workouts
Invariably, any loan workout will involve some modification of the loan. Before the master servicer will agree to modify any loan it will consult with the rating agencies which rated the bonds at issuance, since the rating agencies have the power to lower ratings in the event of any changes to loan terms.
To avoid the negative consequences of any downgrade, the master servicer may require borrower to deliver a "no downgrade letter" from the rating agency to confirm that the modification will not result in a lower rating. The master servicer may also require borrower to deliver a legal opinion from qualified counsel (REMIC Opinion), to confirm that the proposed modification will not violate the REMIC rules causing the REMIC to lose the benefit of a pass-through entity exempt from federal income taxation.
Unlike in a portfolio loan, the special servicer (by definition) has not participated in any loan administration until an event has occurred which caused the master servicer to transfer servicing of the loan to it. The special servicer has little knowledge of the history of the loan and may face difficulty in performing its due diligence, thus frustrating its decision-making ability.
Additionally, REMIC rules impose limits on the Special Servicer's ability to utilize many tools available to lenders restructuring troubled loans. For example, the special servicer may not accept additional collateral from the borrower or convert a partial or limited guaranty into a full guaranty. In a non-securitized loan transaction, these credit enhancements would be beneficial to a lender and could be sought in exchange for other concessions, but would violate REMIC rules. Also, the special servicer may not lend additional money, capitalize past due interest or divide the debt into multiple obligations.
Notwithstanding general REMIC rules, if a loan is in default or at risk of being in default, the special servicer has greater flexibility in making modifications, subject to the servicing standard and other PSA requirements. IRS regulations permit a modification "occasioned by default or a reasonably foreseeable default" of the borrower. In those circumstances (provided the PSA permits), the special servicer may agree to modifications such as interest rate reduction, principal or maturity date deferral, forgiveness of principal, accrued interest or prepayment penalties, or forbearance from any enforcement action.
In addition to REMIC restrictions, accounting rules require that the PSA limit the discretion of the special servicer in decisions regarding disposition of assets. since the special servicer is considered an agent of the REMIC, in order to insulate the REMIC from bankruptcy issues that may affect the depositor, it is necessary that the transfer from the depositor to the REMIC be a "true sale" (meaning that the transfer is complete and no rights remain as in a financing). The transfer will not qualify as a "true sale" if the Special Servicer has broad discretion in the sale of REMIC assets. Therefore, the PSA will restrict these rights making it more difficult to sell assets as part of a workout strategy.
Conclusion
In a workout of a securitized loan, the special servicer is constrained by the REMIC rules and the PSA. Due to the various relationships, the special servicer may not be familiar with the loan history. Notwithstanding the limitations imposed on the special servicer, a loan may be successfully modified if care is taken to abide by the applicable requirements.
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