01/23/2009

Loan Extensions Add Wrinkles to Market

Special servicers are increasingly extending the terms of maturing commercial MBS loans that can't be refinanced, a move that is pitting senior bondholders against B-piece players and is complicating the efforts of fledgling finance shops to get off the ground.

The practice is often viewed as providing much-needed breathing room for borrowers, reducing the need for forced liquidations that contribute to the downward spiral of property prices.

But extensions are coming under fire from some triple-A bondholders, who object to the delay in principal repayment and worry that collateral values will fall, jeopardizing their positions. Yet not all investors are upset - extensions result in a windfall for holders of interest-only strips because their payments continue longer than expected.

At the same time, extensions are eating into the potential business of finance companies that were set up to exploit the credit crunch. The extensions eliminate borrowers who would otherwise be under severe pressure to take out new loans at the higher rates now prevailing.

Some critics even contend that the practice is adversely affecting the real estate sector at large by delaying the process of determining market-clearing price levels.

Firm numbers on the volume of extensions are unavailable, but servicers said the volume has clearly risen in recent months and will accelerate over the course of this year. At one large special servicer, the terms were extended on about 1.5% of the several hundred loans that matured last year, according to an executive.

The spurt in extensions stems from the credit crunch, which is hindering the ability of borrowers to refinance maturing loans - even if the property is performing well. Special servicers can extend loan terms at their discretion. The extensions are typically for three months at a time, for up to a year in total. The decision of whether to extend is often based upon the borrower's track record, and borrowers usually have to make some type of concession. Servicers also assess extension fees - perhaps $55,000 for a $5 million loan.

The special servicer has to weigh whether the granting of an extension will maximize cashflows to the securitization trust. For example, if a borrower is likely to be able to line up refinancing within a few months, extensions make sense. However, the risk is that liquidation is only delayed and the value of the property declines in the meantime, resulting in larger bondholder losses.

This highlights a long-recognized potential conflict of interest for the special servicer, which is controlled by the deal's B-piece holder. Because the B-piece holder incurs the first losses from collateral loans, it is usually motivated to maximize returns from problem loans. But if the B-piece holder's position is close to being wiped out, it might be tempted to grant an extension in order to buy time.

On the other side, triple-A bondholders, who would likely be made whole in any liquidation because of their seniority, want their principal returned on time. They don't like the idea of delaying loan resolutions, because of the risk that deterioration will lead to bigger losses.

At the investor conference this month sponsored by the Commercial Mortgage Securities Association, one triple-A investor griped: "Loan extensions can work against the interests of investment-grade bondholders. Perhaps we should ask if the senior investor is becoming a patsy for loan extensions."

Darrell Wheeler, a CMBS analyst at Citigroup, said in a report last week that "most servicers' decisions have been driven by their desire to maximize loan recovery for the entire trust."

For holders of interest-only bonds, extensions are an unexpected gift. When they acquire IO strips, they are effectively paying a lump sum up front for the right to a stream of payments over an expected period. The extensions lengthen that payment stream, jacking up returns.

Extensions are indirectly affecting some of the new lending shops that have sprung up in the wake of the credit crunch. For example, Ladder Capital's efforts to line up loans have been undercut by the practice, said Greta Guggenheim, president of the New York firm. Guggenheim cited a case in which her firm had agreed to provide a mortgage of less than $15 million, but the borrower backed out at the last minute because he was able to obtain a loan extension at the same rate as his original mortgage - about 5.5%. That was considerably less than available for new loans. Ladder was looking to write the loan for slightly less than 10%, Guggenheim said.

Some real estate pros said to the degree that extensions only delay the inevitable, they are undermining the bottoming process for the real estate market because liquidations are needed to establish "clearing prices" for properties.

Michael Newman, chief executive of Golub & Co., said that the sales market is largely frozen because sellers and buyers can't agree on values. "When the lenders start to take back properties and start to dispose of properties, that will break the logjam," he said.

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