CREFW-Summer2015

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CRE Finance World Summer 2015
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Leslie Hayton
Managing Director
Wells Fargo Bank, N.A
Stacy Ackernman
Partner
K & L Gates LLP
ne of the outcomes of the market downturn in 2007 was
an increased focus on advances. Master servicers saw
exponential growth in the liquidity needs of the CMBS
trust, and as obligated by the Pooling and Servicing
Agreements (“PSA”), master servicers advanced funds
accordingly. According to Trepp, the aggregate amount of outstanding
advances increased from approximately $426 million in the first
quarter of 2006 to approximately $617 million in the first quarter
of 2008.1 Declining collateral values during the downturn created a
surge in the use of the Appraisal Reduction Amount (“ARA”) 2 and
Appraisal Subordinate Entitlement Reduction (“ASER”) mechanics
in PSAs. The use of ARAs and ASERs is described in further
detail below but ultimately may result in a reduction of the amount
of interest a master servicer advances as part of a principal and
interest advance (“P&I Advance”). Between CMBS 1.0 and 2.0
there was a change in the priority of ASER recoveries such that in
most CMBS 2.0 PSAs, certain loan recoveries (primarily liquida-
tion proceeds) are allocated in those deals to unpaid principal
instead of being allocated as a recovery of prior interest shortfalls
to subordinate certificateholders. We as an industry need to be
prepared for the practical application of this waterfall change and
the implications thereof.
The calculations of both an ARA and subsequent ASER are defined in
most PSAs and are tied to the decline in the value of the underlying
collateral. An ARA is triggered when a certain specified event
(“Appraisal Reduction Event”) occurs. An Appraisal Reduction
Event typically includes certain modifications, a transfer to special
servicing, bankruptcy and payment defaults. Following the occurrence
of an Appraisal Reduction Event, a new appraisal is ordered and
any ARA is recalculated as prescribed in the PSA. In its simplest
form, an ARA is calculated as follows: (outstanding principal balance
plus outstanding advances and interest on advances) minus
(90% of the appraised value + escrows). If a new appraisal is not
obtained within a specified period of time, most PSAs allow for
an assumed ARA of 25% of the outstanding principal balance of
the loan. If the outcome of this exercise is positive, it indicates that
the value of the underlying property does not currently support
the debt outstanding. Each monthly P&I Advance will therefore be
reduced by the shortfall as calculated by the ASER. The ASER is
typically calculated as (ARA/Scheduled Principal Balance) * Net
Scheduled Interest. This reduced P&I Advance results in less cash
flow being sent to subordinate tranches during the normal monthly
remittance cycle in recognition of the decline in collateral value
and potential future loss.
It is important to understand the cash flows of the CMBS transaction
and the implications of an ASER on the deal cash flows prior to
liquidation. The bond waterfall calculations allow for the shorted
interest due to the ASER to reduce the cash flows to the most
subordinate bond classes. It should also be noted that once a
master servicer deems a loan non-recoverable, the point is moot
since the master servicer has stopped making P&I Advances.
There were no changes to the calculation and impact of the ASER
in the ongoing cash flows of a deal in CMBS 2.0 versus CMBS 1.0.
Once a loan with an ASER is liquidated, most CMBS 1.0 deals
provide for the recapture of the ASERs prior to the allocation of
proceeds to principal repayment but after the recovery of servicer
advances, liquidation fees and other holdbacks. The outcome of
this basically wiped out everything that was intended to happen
with the ASER. Subordinate classes which previously absorbed
shortfalls are then reimbursed for their shortfalls as opposed to
directing the funds to senior classes as principal. In addition to
delaying the principal repayment to senior classes, this increases
realized losses to subordinate classes, thus reducing the credit
support across the structure and potentially affecting controlling
class rights.
If the goal of the ASER was to account for expected losses due
to the declining value of the collateral and prevent enrichment to
the subordinate classes at the expense of principal bond holders
higher in the capital stack, this ASER/ARA mechanism in CMBS
1.0 deals (combined with the liquidation proceeds definitions within
the PSAs) has failed its goal.
The CMBS industry is constantly evolving to meet the demands
of investors and adjust for the changing marketplace. PSAs, while
individual to each issuer, all typically contain certain industry-wide
concepts. When an adjustment is needed, all PSAs will eventually
conform to the new market standard. We saw this with the
introduction of Work-Out Delayed Reimbursement Amounts