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CRE Finance World, Summer 2012

The New World Order for Special Servicers: Is the Cure Worse Than the Disease? the controlling class holder typically does not. Senior investors do a base asset management fee paid monthly on the outstanding not currently have the information to evaluate what alternatives principal balance of the associated loan, and a resolution or liqui- the special servicers considered, and why they chose the selected dation fee paid as a percentage of net recoveries. The resolution fee resolution strategy. Therefore, with the lack of evidence to the typically represented two to three years of base special servicing contrary, they may be assuming that special servicers are acting fees, creating the appropriate economic incentive to resolve assets in their own self interest. expeditiously. In conjunction with assuming the first loss risk, subordinate CMBS Defaulted commercial real estate loan loss severities increase as investors have the right to appoint the special servicer. Before the resolution or liquidation time period increases. There is truth in 2008, in many cases, this was an affiliated entity. As CMBS losses the maxim that ‘the first loss is the best loss.’ Net operating income accumulate and erode the most subordinate position, the investor and property values deteriorate; fees, expenses and advances faces the loss of control and potential change of special servicing accrue to erode net recoveries over time. Historically, foreclosure to the new controlling class. As losses accumulate, at some point the and sale of the resultant real estate owned takes the longest time value of the special servicing revenue stream is worth significantly and yields the lowest recovery percentage among special servicing more than the value of the subordinate bonds. Confronted with resolution alternatives. Because of the time required to foreclose this prospect, subordinate investors may be motivated to delay on a defaulted loan and then sell the resultant real estate owned, resolutions and liquidations. Under these circumstances, special special servicing fees may be higher for this resolution strategy servicers could be directed by subordinate investors to change than a restructure, modification or loan sale. resolution strategies, notwithstanding the potential conflict with the servicing standard. Some of the changes in new issue CMBS are targeted at economic issues that created potential misalignment of interests between Unlike legacy CMBS, most of the new issue transactions have special senior and subordinate investors and the special servicers over servicers who are unaffiliated with the subordinate investor (B-piece the life of a CMBS transaction. However, some of these changes buyer.) As the controlling class holder or directing certificate holder, create new potential issues that could manifest in unforeseen the subordinate investor appoints the special servicer and ultimately consequences that again pit the senior investors against the bears the cost of the base asset management and resolution or special servicers. Increased transparency and disclosure of special liquidation fees they collect from the CMBS trust. The subordinate servicer compensation is a much better fix than attempting to micro investor typically has approval or consultation rights related to the manage special servicer activities and economics in a dynamic special servicer’s asset management and resolution strategies. market for transactions that have 10 year life spans. All CMBS However, the special servicer has the obligation to act in the best investors benefit from having an experienced and well staffed economic interest of all of the investors and can overrule the special servicer that is appropriately compensated over the life controlling class holder’s directions. This structure creates over- of a transaction. sight and discipline on the special servicer’s compensation and if dissatisfied, the subordinate investor can terminate and replace Investor Control Rights. New issue CMBS transactions have ad- the special servicer on very short notice. dressed the issue of divergent economic interests between senior and subordinate investors through a number of mechanisms. The A number of the proposed changes are directed at perceived issues most important is using appraised value, in addition to realized with subordinate investors and affiliated or controlled special losses to effect the change of control. This accelerates the change servicers. When CMBS credit issues were minimal, the senior and of control calculation and reduces any motivation to hold assets in subordinate investors shared an alignment of interest consistent special servicing to defer resolution and the realization of losses. with the servicing standard of maximizing recovery on a net pres- In many of the new issue transactions, when a change of control ent value basis. Special servicers focused on tactics to expedite event occurs, the remaining investors are represented by an oper- resolution and maximize net recoveries. Special servicers receive ating advisor who provides oversight and approval of the special CRE Finance World Summer 2012 16


CRE Finance World, Summer 2012
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