Someone with a suspicious frame of mind and a pencil could have figured that there were some perverse incentives possible in such a structure

TO BE NOTED: From the FT:

"Clash of interest between lenders and special servicers

By John Dizard

Published: May 17 2009 10:25 | Last updated: May 17 2009 10:25

“When I sit down with my friend, he is not sitting down with his friend.”

Intelligence profession maxim.

The fights around the commercial real estate waterhole are getting nastier as even the mud dries up. Defaults are rapidly increasing among the $850bn (£560bn, €627bn) or so of loans that were pooled into commercial mortgage-backed securities, and groups of lenders and mortgage servicers who started out as allies are now on the verge of open warfare.

It was always the case that different tranches in securitisations had divergent interests, but those were concealed, or elided, when property prices were rising and owner/developers had plenty of margin for their debt service. What has shocked some of the holders of senior debt is that the professionals they counted on to act as collection agents for troubled loans instead want to stretch out the terms as long as possible. The senior lenders, who thought they were well insulated from risk, even in the event of a default, are finding that their capital is being involuntarily locked up in loans for years longer than they counted on. Particularly for those who bought senior CMBS securities at a discount, this means not just illiquidity, but substantial reductions in yield – assuming that they get back their principal as promised.

I think I am on firm ground in thinking that many of the people who own “triple A” CMBS securities have not read every line of the pooling and servicing agreements that delineate their rights. And if they did, they did not game out what the other participants in the deal would do when trouble hit.

The senior certificate holders, the triple-A people, are now particularly angered by the “special servicers”. These are the companies called in to deal with troubled loans. They get typically 25 basis points in annual servicing fees on those loans, along with 1 per cent of principal and interest payments they collect, or 1 per cent of the recoveries in liquidations.

The special servicers were not, however, just fee-for-service people. In order to make sure their interests were aligned with those of the actual lenders, they were encouraged to buy junior pieces of debt, called the “B-piece”, so they would have an additional incentive to get those collections done.

Many of the special servicers also bought “interest only” or “i/o” slices of the securitised deals, which carried no rights to principal payments, but which paid a piece of any interest payments.

Someone with a suspicious frame of mind and a pencil could have figured that there were some perverse incentives possible in such a structure. In practice, it turns out, the special servicers have an incentive to stretch out loan repayments on the troubled commercial properties, while the senior lenders do better if foreclosure and recoveries proceed quickly. Most of the time, the impending defaults come about not because the owner/developer simply stops paying debt service, but because he cannot refinance a balloon repayment. It’s not just that credit is generally hard to come by, but because property values have dropped so much that a new loan would have to be smaller than the original loan.

Still, there is enough rent coming in to cover the interest payments. That means that the special servicer’s i/o “strip” could be covered, along with the interest payments on the junior tranches as well as the special servicer’s continuing fee income. However, the senior lenders, who may have bought the triple A tranche at a discount, suddenly have their duration lengthen and their returns drop.

So, to the now unconcealed rage of the seniors, the special servicers are incented, as they say, to extend the loans. Just to make it easier to do so, they have petitioned the Treasury to give tax-law cover for this and other forms of forbearance. I wouldn’t bet against them.

Those who defend the emerging role of special servicers as soft touches point out that they are governed by the requirements of the PSAs. These say the special servicers must maximise the net present value of the loans in work-out, and must protect the interests of all the classes. But net present value isn’t some invariant material truth; it depends on whether you assume that property values will rise or fall in value over time.

For some time now, those values have been falling, and falling fast for troubled properties. The assumption that this is just a temporary blip may turn out to be true, or it may just be a self-serving fiction on the part of the servicers, the junior security holders, and their lawyers that allows them to suck out payments for a few more years. We’ll find out some years from now.

There’s also a difference in philosophy. Are we better served by rapid recognition of losses, quick write-offs, and elimination of speculative lenders and weak owners? Or should we give everyone a second, third, or nth chance?

I think you could make an argument for compassion for honest civilians down on their luck. But developers? Junk lenders? Collection agencies – sorry, I mean special servicers? Come on.

johndizard@hotmail.com"