Tug of War
- Jul 03, 2012
Ownership Changes Among Special Servicers Prompt Concerns Regarding Fairness
By Keat Foong
New mergers and acquisitions are giving rise to a tug-of-war of sorts among CMBS special servicers, and some A-note holders and others are concerned about the potential for resulting conflicts of interest.
Granted, some of the concerns may simply be expressions of tranche warfare between the holders of the higher- and lower-rated CMBS. The special servicer’s responsibility under the pooling and servicing agreement of the trust that controls the CMBS securitization is to maximize recovery of the troubled loan on behalf of all bondholders. Nevertheless, “special servicers have come across a lot of scrutiny in terms of their motivations,” commented Glenn Brill, managing director of real estate solutions for FTI Consulting.
Problems are arising in a couple of areas. Some of the major special servicers are now owned by real estate entities that may or may not be interested in acquiring the defaulted assets they are processing. In addition, some of the investment entities that own special servicers are also B-piece bondholders who could give the special servicing contracts to their subsidiaries.
The corporate acquisitions often cited are those of the largest three of the 19 special servicers that all occurred in 2010. LNR Partners Inc. was recapitalized by five buyers: Vornado Realty Trust, Cerberus, Oaktree, iStar Financial and Aozora Bank. CWCapital L.L.C. was purchased by Fortress Investment Group L.L.C. (currently in the process of selling it to Walker & Dunlop). And as Centerline, C-III Asset Management L.L.C. was purchased by Andrew Farkas’ Island Capital Group L.L.C.
One potential ramification of investment company ownership of special servicers is a temptation to hold onto distressed assets, since the parent company can raise equity to purchase them. Beyond that, if these special servicers are transitioning into being part of fully diversified real estate companies, they could also be paired with equity, loan sale, property brokerage and other capabilities.
Of course, there are counterarguments to this claim. “It is much harder to do in practice than you may think,” said David Rodgers, principal of Park Bridge Financial L.L.C. He noted that it may not be possible to profitably pull out loans in default, because they often have to be auctioned off and the value of the loan sale has to be justified.
Indeed, Fitch Ratings noted that of over 7,000 CMBS loans resolved since 2009, only 11 fair market value options (FMVOs) were exercised—all of them after November 2010 and the recapitalization of the largest special servicers. The agency attributed the limited occurrence of the purchases to “the complexity of execution and negative market perception.” Fair Market Determinations must be made by a party other than the special servicer—usually the master servicer—and confirmed by the trustee, if the option holder turns out to be an interested party, explained Fitch. Fitch recommended that “of the concerns inherent in the role of special servicer, FMVOs should be a lower priority.”
Another possible aspect of the new ownership model is the nature of the companies buying special servicers: These new parents, as it turns out, can be either owners of the lowest-rated portions of CMBS pools or owners of the lower-rated bonds that are next in line to become the lowest classes as loan losses hit the CMBS pools. Either way, as owners of the lowest tranches of the bonds—and thus the controlling-class certificate holders—these companies have the right to select the special servicers for the assets. They are therefore in a position to award this business to their own affiliates. In fact, “this is why they bought the special servicers,” opined one source.
This could shift the balance in market share. Special servicing has transferred from independent, third-party special servicers that are not owned by controlling-class certificate holders to the largest special servicers, which are owned by controlling-class certificate holders. As a result, some of the top special servicers can become even busier.
For borrowers, this can impact responsiveness of the special servicers—both their “aggressiveness” and “timeline,” observed Ann Hambly, co-CEO & founder of 1st Service Solutions Inc., a CMBS workout specialist representing borrowers. Another important implication of the portfolio transfers for borrowers is the chance of the special servicer changing midstream through the workout. The new special servicer may not agree to the same terms, Hambly noted. (Tune in to CPE TV for CMBS workout advice from Ann Hambly.)
Nevertheless, although it may seem that the top three special servicers could be gaining a whole lot of new business, this was not the case last year (see “The Winners” for details). Nor do their parents seem to be on a roll to purchase interests in the lowest-rated securities as a way to access special servicing contracts, either: A table provided by “Commercial Real Estate Direct” shows that none of the parent companies of the top three special servicers were the most active B-piece buyers last year (as illustrated in the chart “Driving Deals”). Only three of the seven investors that bought B pieces last year owned special servicers, Orest Mandzy, managing editor of CREDirect pointed out: Torchlight Investors, Northstar Realty Finance and LNR.
Nonetheless, many of the special servicers’ parents that hold CMBS could become controlling-class certificate holders in future as defaults hit the issuances. Manus Clancy, senior managing director at Trepp L.L.C., agreed there is a lag between the time the loans default and when any losses wipe out the CMBS B-piece buyers as the loans are disposed of. According to Trepp, average loss severities are trending moderately upwards and are in the mid-40 to mid-50 percent range.
(Read more about special servicers’ latest business efforts in “Special Servicers’ New Revenue Drive.”)