The Handoff That Happens When a Property Loan Goes Bad

Two Servicers, Two Jobs

When a bank originates a commercial mortgage and sells it as a securitization the loan doesn't disappear into an anonymous trust without anyone caring. Someone still has to collect payments review financial statements and decide what happens when a borrower defaults. That job is split between two contractually distinct roles and most people outside the industry never know the split exists until a loan they're interested in defaults

the master administrator manage the loan as it runs.Collect payments.Manage escrow accounts for taxes and insurance.Monitor the property's finances for early warning signs.It's a high-volume low-margin business generating a small commission spread across a huge pool of loans that for the most part sit there paying on time

the special administrator It only appears when a loan is in trouble or about to be. Your job is not administration it is judgment: modifying the loan extending it foreclosing it selling the note or taking the keys and managing the property directly. This is a fundamentally different skill than processing payments and it is compensated in a fundamentally different way. I didn't realize how different until I first read the fee schedule for a special servicer. It looks like an incentive plan because that's exactly what it is

The Transfer Event

A loan moves from master servicing to special servicing based on triggers written into the contract. pooling agreement and services the contract that governs the entire securitization. The obvious trigger is a late payment. Less obvious ones include imminent default borrower bankruptcy and certain covenant breaches. What surprised me most when I first read one of these agreements is how often the trigger is activated before any payment is missed at which point a borrower simply calls and asks for help

That handover is of enormous importance to the borrower and most borrowers don't see it coming. The counterparty changes. The fee structure changes. The room to negotiate changes sometimes for the better and sometimes not. A borrower who was dealing with what amounted to a payment processor suddenly finds himself dealing with a turnaround specialist whose economics look nothing like the one he replaced

Why the Compensation Structure Matters

A special servicer typically earns three different things. A monthly fee on any balance currently in special service. a training fee when a loan successfully returns to foreclosure status.a settlement fee on the proceeds when a loan or the underlying property is sold

Look at any one of those fees alone and it's defensible. Put all three in the same servicer's pocket at the same time and real tension appears. The monthly fee rewards keeping loans in special servicing a slight hurdle to resolving them quickly. The training fee tends toward modification. The settlement fee drives the sale. How much traction you gain depends on the relative size of the fees in a given deal and I've seen the balance struck differently between servicers and deals

The Controlling Class: Who Actually Appoints the Special Servicer

This is the detail that took me the longest to digest and it's the one that makes the rest of this make sense. The special administrator is not a neutral arbitrator who enters the deal from the outside. He is appointed by the controller class the most subordinate class of bonds that still has real principal outstanding

In most pooling and servicing arrangements the controlling class has genuine power: the right to appoint and remove the special manager to be consulted or approve important decisions such as modifications and extensions and to receive information that other bondholders do not automatically see. That power lies with the class of investor who is first in line to absorb losses which is exactly the class with the strongest incentive to determine how a solution develops

In many deals the controlling class holder and the special servicer are either the same company or affiliated with each other. That's not a scandal it's a publicized and well-known strategy. Buying the most junior first-loss portion of a CMBS deal often called piece B specifically obtaining the right to appoint and direct the special administrator is a business in which some companies specialize.My reading is that this is the most important phrase you can find in the disclosure of any agreement. Whoever is in that position is the one who really decides what happens with a defaulted loan and your money is in the position where you have the least to lose

Servicer Advances: Who Fronts the Cash While the Loan Sits There

One more mechanic worth knowing before the numbers because it changes what it actually costs to extend a loan. When a borrower defaults the servicer is generally obligated to continue advancing principal and interest to the trust anyway out of its own funds so bondholders continue to receive cash even when the underlying loan is in default. That's a administrator advance

Advances are not charity. They accumulate interest and are placed ahead of the principal of the bond in the final payment repaid on what the loan or property ultimately produces. A servicer may also stop advancing if he determines in his own judgment that an advance would be irrecoverableThat determination is itself a real lever as it can cut off cash from bondholders who would otherwise remain intact

Put those two pieces together and every extra month that a loan is in special servicing is not free. Fees add up. Advances earn interest on top of themselves. Everything is paid before a single dollar of bond principal quietly reducing the pie that is left once a resolution is finally reached even in a scenario where the final sales price looks good on paper

The Standard That Is Supposed to Govern

The agreement documents do not allow the special administrator to do whatever suits him. They impose a service standard requiring it to act in the best interests of certificate holders as a collective group and maximize recovery on a net present value basis without favoring its own interests or those of any particular class

I want to believe that a rule like that solves the problem. It doesn't not at all because it applies to decisions that are inherently judgment calls. Whether extending a loan for two years produces better present value than executing it today depends on assumptions about property performance the timing of market recovery and disposition costs that two reasonable well-informed people can disagree on in good faith

That's why litigation over director conduct tends to focus on the process rather than the outcome. The question usually is whether the analysis was actually performed and documented not whether the answer in retrospect turned out to be correct. It's not easy to put a number on a sale that never happened

What It Means for the Borrower

From where the borrower sits the transfer changes the economics of asking for help and very few borrowers understand that before it happens to them

Special servicing costs are typically charged to the loan itself so the borrower ends up financing his or her own solution. Legal fees appraisal costs and servicing fees are accrued to the loan balance. A borrower who called to request a short and simple extension may find that the amount he or she actually owes is substantially higher when the terms are finalized

The character of the counterparty also changes. A master servicer manages a contract and not much else. A special servicer is actively weighing whether the property is worth more if it is restructured or sold and has the authority to pursue either option. A borrower who approaches his servicer to point out a maturity issue often triggers the exact transfer he hoped to avoid

A Worked Example: Modify and Extend Versus Foreclose Now

Just illustrative numbers nothing here describes a real business. Let's say a trust has a single defaulted loan with $100 million of unpaid principal and the bonds backed by that loan are divided into three classes based on their age: a senior class with 70 million a mezzanine class with 20 million and a junior or first-loss class with 10 million. Losses come from the bottom up. Profits are paid from the top to the bottom senior class first

Path one foreclosure now. The special servicer puts the property up for sale immediately in a market that is not very good at the moment. The net proceeds after transaction costs legal fees and settlement fee amount to 55 million. Paying from the top the upper class receives the first 55 million of their 70 million a recovery of 55 divided by 70 or 78.6 percent. There is nothing left for mezzanine or junior. Boththey recover zero

Way two extend two years and the market returns. Instead the special administrator grants a modification and a two-year extension. Let's say the property stabilizes and sells for 80 million net at the end of that period. Senior receives the full payment the 70 million a 100 percent recovery. That leaves 10 million for the mezzanine which is 10 divided by 20 or 50 percent. Junior still receives nothingbecause not even 80 million exceeds the first 90 million of the stack

Way three extend two years and the market continues to decline. Same decision same two-year wait but the property is worth less in the end not more because the neighborhood or property type continues to deteriorate. Let's say it sells for 38 million net. Senior now recovers only 38 divided by 70 or 54.3 percent. Both Mezzanine and Junior get zero same as before

Sit down with what that table actually shows. The junior class recovers exactly zero dollars in all three paths. It has nothing to lose regardless of the decision the special manager makes which means that from a purely dollar point of view it is always rational for the junior holder to press for the extension. There is no version of this where waiting costs him anything and a version where waiting eventually reaches its end if the market recovers enough. The Mezzanine incentive points in the samedirection since 0 percent on two of three paths is no worse than the 0 percent you get from an immediate sale and the path up is a real 50 percent recovery. The class that really bears the bilateral risk of this decision is the senior class the one that everyone assumes is isolated. It goes from 78.6 percent assured to a range between 100 percent and 54.3 percent and gets no vote

The service standard I described above asks whether the extension clears the recovery bar on a present value basis not nominal. If we discount that 80 million in two years at say 10 percent per year purely illustratively its present value is 80 divided by 1.1 squared which gives about 66.1 million comfortably above the 55 million available today. The 38 million bad cases reduce to about 31.4million far below. On paper the standard is supposed to separate the good bet from the bad. In practice no one knows for sure which path they are on until two years have passed

Case Study: Stuyvesant Town and the 2010 Handoff

The example that everyone in real estate finance ends up running into is Stuyvesant Town and Peter Cooper Village the massive Manhattan apartment complex that Tishman Speyer and BlackRock bought in 2006 for about $5.4 billion one of the largest single real estate transactions in the country at the time

The business plan was based on converting rent-stabilized apartments to market rate as tenants changed which was supposed to increase cash flow toward the debt load. In 2009 the New York Court of Appeals ruled in Roberts v. Tishman Speyer Properties that the owner could not deregulate those units while also collecting a certain property tax benefit. That ruling took a significant part of the business plan off the table

Cash flow was well below what the debt required. The property defaulted on the loan in early 2010 and the mortgage which had been securitized went into special service. What happened next is close to the textbook version of all of the above: the mezzanine debt and original equity were eliminated and in the fall of 2010 the property was turned over to the senior lenders in a negotiated transfer rather than trailingto a contested foreclosure auction. CWCapital the special administrator of the deal ended up running the process on behalf of the upper side of capital once the lower classes had nothing left to protect

I mention this not because anyone has done anything inappropriate. No one involved is accused of wrongdoing here and the parties disagreed strongly in public about what the correct outcome was. I mention it because it is a real and widely documented example of the exact mechanism this article is about: an accumulation of capital where the classes closest to the loss see their claims extinguished first and a resolution that ends up being negotiated by whoever is left standing once that happens

The Counterargument: When Extend and Pretend Is Actually Right

I want to attack the other side here because the cynical interpretation of the special service is too easy and not always fair

A forced sale in a frozen market can destroy true value. If almost no one is buying or the few active buyers know the seller has no other choice a foreclosure sale can result in a price well below what the property is actually worth to a patient owner. That's not hypothetical. It happens in real cycles and a manager who refuses to sell in that type of market is not necessarily protecting himself at the expense of bondholders. He could be protecting bondholders.of a bad sale

A modification that allows a fundamentally sound property to survive a temporary crisis is exactly what a turnaround process is supposed to do. Property income can rebound. Interest rates can fall. A neighborhood can come back. None of that happens on a foreclosure timeline and locking in a loss today to avoid the discomfort of uncertainty is obviously not smarter than living with uncertainty. The recent wave of office loan extensions follows exactly this logic and many of the properties behind those extensions may well be worth significantlymore once the office market finds a floor

The real problem is that you can't tell prudent patience from kicking the can down the road. They both look identical from the outside: a loan is in special servicing it's modified and the due date is pushed back. You only find out which one it was once the loan is finally settled years later and by then the servicer's fee timer has already passed regardless of which one turns out to have been

How I Actually Read a Special Servicing Disclosure

My reading and this is an opinion is not a rule anyone should follow: The most useful thing you can look for about a CMBS settlement in special servicing is who the special servicer actually is and whether they are affiliated with the controlling class holder. That fact tells you more about how a distressed loan is likely to be handled than almost anything else in the settlement package

After that I look at the trend in the balance in the special services not just the level. A growing balance with a decreasing resolution rate is a different story than a stable balance that is renewed regularly. I also look at the ratio of modifications to settlements in a servicer's book and how long loans typically remain before being resolved. A servicer with a large book long average resolution times and a high modification rate is either being patient or postponing the issue and I'll be honest: I can't always tell which it is just by thedisclosure. No one outside the agreement can do it in real time

Where I've really changed my mind is trusting the service standard at face value. I used to consider maximizing recovery on a net present value basis as something close to a guarantee of good behavior. I don't read it that way anymore. It's a real legal restriction and it discourages the most blatant self-dealing but it's being applied to judgment calls that are really hard to guess even with good information let alone from outside the deal. I'd rather see who controls the decision and how much they areIt pays to rely solely on the standard to tell me that the result will be fair for all classes

The Bottom Line

Special servicing occurs when a securitized commercial mortgage is actually decided not by a neutral servicer but by a party designated by the class of bondholders who are first in line to suffer losses and is paid through commissions that go in more than one direction at a time. Control of class rights hands real power to the most subordinate holder. Servicer advances keep senior bondholders paid on paper while they silently accumulate claims above the principal of the bonds. The numbersworked out above clearly show the real conflict: the class that has nothing to lose can push for an extension for free while the class that is supposed to be the safest bears the real risk of that same decision. Extending and faking it is sometimes exactly the wrong decision and sometimes exactly the right one and the honest answer is that you can't always know which until years after the fee clock has started ticking. For anyone who owns these bonds who is the special servicer and who controls it is worth more than the credit rating they have.appears on the cover