The CMBS market is finally emerging from its two-year hiatus. New transactions evidence a number of changes that will impact subordinate investors and special servicers. Many of these changes are being made by issuers in response to investment-grade bondholder demands. Some represent enhancements to the CMBS structure that will benefit all investors. Others appear to be misguided and could create potentially detrimental consequences.

When CMBS credit issues were minimal, senior and subordinate investors shared an alignment of interest consistent with the servicing standard of maximizing recovery on a net present-value basis.

The loss severities for defaulted commercial real estate assets increase proportionately with the resolution or liquidation time period. There is truth in the maxim that "the first loss is the best loss:' Net operating income and property values deteriorate, fees, expenses and advances accumulate to erode net recoveries over time. Among special servicing resolution alternatives, foreclosure and REO sales take the longest time and historically yield the lowest recovery percentage rate.

In conjunction with assuming the first loss risk, subordinate CMBS investors typically have the right to appoint the special servicer. As CMBS losses accumulate and erode the most subordinate position, the investor faces a loss of control and a potential change in special servicing to the new controlling class. At some point, the value of the special servicing revenue stream is worth significantly more than the value of the subordinate bonds. Confronted with this prospect, subordinate investors are motivated to delay resolutions and liquidations. Accordingly, special servicers are directed to change resolution strategies, notwithstanding the potential conflict with the servicing standard.

A number of mechanisms in recent CMBS transactions address the issue of divergent economic interests between senior and subordinate investors. The first is using current appraised value,

in addition to actual realized losses, to effect the change of control. This accelerates the change of control and reduces any motivation to hold assets in special servicing to delay resolution and the realization of losses. Additionally, new deals have a variety of mechanisms for the senior investors to replace the special servicer either after a change

of control or, in some cases, through a super majority vote of the bondholders. A recurring complaint has been the lack of transparency related to special servicers' evaluation and execution of alternative resolution strategies. In some new transactions, the trust advisor has additional oversight responsibility for the special servicer's activities.

Some of the new CMBS transactions have mechanisms allocating certain fees collected from borrowers by the master or special servicer to offset trust losses. This creates economic incentives for the servicers that could result in outcomes not in the best interests of bond holders and may conflict with the servicing standard. If a portion of late fees or other ancillary fees are redirected to the trust, the servicers have an incentive to either increase the fees charged to borrowers or to transfer the loan in special servicing and collect a resolution fee for the same activity.

Some transactions have caps on the amount of special-servicing resolution fees earned. If resolution fees on large assets are capped at a fixed dollar amount, the special servicer has an economic incentive to delay resolution to continue to receive monthly fees. Capped resolution fees also create an incentive for the special servicer to use outside legal counsel and other third parties that are a trust expense to support their asset management staff, resulting in a greater loss. Senior investors should be careful what enhancements they are asking CMBS issuers to incorporate into new transactions. There are a number of changes that are beneficial and will improve the CMBS structure. Others have the potential to create economic incentives resulting in outcomes not in the best interest of the investors.

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New Day for CMBS Special Servicing

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