Are Servicers Doing too Much to Offset Interest Shortfalls?

The commercial mortgage-backed securities industry is making progress in dealing with the issue of interest shortfalls on deals, but it is possible that the issues could crop up later in a different form. The issue has also raised questions about whether servicers are being called upon to provide credit enhancement, in addition to their usual role of facilitating liquidity in CMBS transactions.

The problem came to the fore as the performance of some commercial real estate properties declined in the recent economic downturn. If borrowers do not make payments on their loans, as has happened with certain health care and hotel properties which have seen sudden declines in value over short periods, servicers could still believe that the situation can be worked out, or that there is enough cash in the property to repay the servicer as well as pay off the loan if it has to be sold in case a default situation arises.

Lisa Pendergast, a managing director with the RBS Greenwich Capital CMBS research group, noted, "However, sometimes they are wrong. So they overadvance, or advance funds that are not going to be there when the loan is liquidated. And because the servicer is really only getting paid for providing liquidity and not for stepping up and advancing these cash amounts, they are entitled to recover these advances in one month's sum once these amounts have become nonrecoverable." And the way pooling and servicing agreements have been set up, the servicers could recover that amount from interest payments from the general pool collection. This led to a problem of interest shortfalls, with shortfalls occurring rather high up the "waterfall" of payments. In order to ameliorate the situation, changes have been made to pooling and servicing agreements in some recent CMBS transactions to allow for the use of principal to be used for the payment of these nonrecoverable advances, rather than interest. And while the solution does do away with the concerns about interest rate shortfalls and possible downgrades, it does not entirely solve the problem.

For one, it has the potential to extend the life of a bond.

Ms. Pendergast said, "People have run various scenarios and the extension to date is minimal. Obviously, the concern is if in any one given deal you have an excessive amount of these situations, then in fact your extension issues become all the more prevalent. Right now, it is some form of solution that gets you out of the immediate downgrade situation that is foremost in investors' minds." However, if the bonds were stressed in some form by, for instance, another dip in the economy or a steep rise in interest rates, it would, as Ms. Pendergast sees it, "add stress to the system and potentially cause a situation where you would have enough of these loans and enough of these situations to really put some pressure on the average lives of the front pay bonds." And while there is the possibility that this ...