05/25/2012

CMBS Buyers Weigh Special-Servicer Habits

As special servicers build up their track records for loan workouts and liquidations, secondary traders of commercial MBS are increasingly looking for patterns that might help them predict the fate of underlying loans.

The way each special servicer has handled the post-crash flood of troubled loans has joined a multitude of other factors that investors consider when evaluating bonds they own or might want to buy. The relatively recent practice remains more of an art than a science, but there is a growing trove of information to draw upon.

A year ago, “there was not enough data to differentiate between special servicers and have an informed view about the potential effects of their behavior on the underlying cashflows. Now, there is,” said Tom Digan, a buy-side CMBS trader at Sorin Capital of Stamford, Conn. “This creates opportunities for the shrewd investors willing to do the work and take a view.”

Decisions made by special servicers can affect all bondholders. But they can be especially crucial to investors in mezzanine classes of legacy multi-borrower issues, because speedy liquidations or aggressive workouts could cause collateral losses for such bonds.

“If you’re holding bonds below the ‘A-J’ level, even the special servicer’s handling of the smaller loans in the collateral pool matters,” said one CMBS portfolio manager.

Buyers of mezzanine bonds — those initially rated in the double-A, single-A and triple-B ranges — generally would prefer straightforward loan extensions or other modifications that keep interest payments flowing. The tranches below those investment-grade levels are typically held by B-piece buyers that also control the special servicers.

With so many variables involved, buysiders said it’s still difficult to predict with any certainty how a particular special servicer will handle a specific loan. It’s also unclear how such assessments affect the values of outstanding bonds. “It’s hard to quantify and it makes investors really nervous,” said a veteran CMBS portfolio manager. Still, “it has become another thing to consider and people are definitely tracking it.”

The six most-active special servicers liquidated $18.6 billion of loans, by balance, in 2008-2011, according to recent research by Darrell Wheeler, head CMBS strategist at Amherst Securities. LNR Partners liquidated the largest volume by far: $7.5 billion, or 40% of total liquidations. It also registered the second-lowest loss severities on those loans at 51%, but that was close to the average of 54%.

In a report this month, Wheeler analyzed the dispositions of 1,580 loans, with a total balance of $30 billion, that were in special servicing as of June 2009. He found that LNR liquidated the highest percentage of the loans it handled — 30% of the nominal balance of $9.6 billion, compared to an average liquidation rate for the six servicers of 24%.

For loans with balances over $50 million, special servicers will almost always try to work out the debt, investors said. But there, too, the approaches differ. The rough consensus among investors is that LNR is usually most willing to pursue aggressive modifications — such as splitting a troubled loan into an “A” note that continues to pay interest and a zero-coupon “B” note, or “hope note,” that may pay off later if the property’s financial situation improves. Meanwhile, CWCapital and C-III Asset Management are perceived as more likely to simply extend loans.

When it comes to smaller loans, especially those under $25 million, special servicers are more apt to sell them at discounts to save time and effort, possibly cutting their losses rather than stringing out the process. C-III and LNR, for instance, have repeatedly conducted bulk sales of nonperforming securitized mortgages.

All other things being equal, mezzanine-level investors are likely to prefer bonds from deals whose special servicers are more inclined to grant extensions or less-severe modifications.

Special servicers are obligated to pursue troubled-loan remedies that deliver the greatest overall benefit to all CMBS holders in a transaction, and they contend that liquidations are often the best path to that result.

Traditional wisdom has it that holders of super-senior bonds favor quick liquidations because they’re first in line to receive the proceeds. But that’s not necessarily true anymore, since bonds can only be paid off at par and most super-seniors have long been trading at a premium amid rock-bottom Treasury rates. For investors who bought under those conditions, liquidations that terminate interest payments could lead to losses. What’s more, they might find it difficult now to re-invest in products with similar yields.

To be sure, analyzing the credit-quality of securitized commercial mortgages remains the top priority for investors in any CMBS, from the super-senior bonds down to the most-junior classes. There’s no way yet to discern the weight that investors give to anticipated special-servicer activities versus credit measures, such as delinquency rates, cumulative losses and the amount of loans from a collateral pool that have been assigned to special servicing.

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