The robust credit performance of European CMBS has shielded servicers from widespread scrutiny. But those with experience of how much difference a good servicer can make are warning investors to pay greater heed to the role before it is too late. The advent of 'A/B' note structures, meanwhile, has resulted in a pointed debate about the best way to act when things do go wrong.
"Investors are growing increasingly concerned at the impact of economic slowdown in Europe and the performance of servicers is coming under ever closer scrutiny," said Fitch in its new criteria report entitled Rating European Residential and Commercial Mortgage Loan Servicers in March.
Given that in administering and monitoring the mortgage loans and underlying property a servicer exerts a heavy influence on mortgage loan portfolio performance, this is not altogether surprising.
But in the past the job has not always enjoyed such a high profile, and even today seasoned market participants warn that its importance is not fully acknowledged.
"Servicing has often been overlooked," says David Beale, director of debt markets at Merrill Lynch in London. "It is extremely important when the market isn't good, but because the market is particularly benign at the moment, it is not given the recognition that is required, particularly by investors.
"When the market is bad, then it is the servicers that have to make sure that their systems, their processes, their technology, their speed to react, etc are top notch, and that they recover as much as possible, and that is what the expertise should be directed towards. That is something that investors ought to keep in mind, and lenders, too, in terms of making sure that they have that expertise and ability there for the stormier weather."
Andrew Currie, CMBS analyst at Fitch in London, says that part of the reason for the lack of focus on servicers is that there is little evidence to consider.
"In the UK we have relatively few examples of a servicer adding value to recoveries," he says. "If there is a downturn and we gain more data on how successful different strategies are, then investors could start to make judgements on the issues of servicing."
On the spot checks
Investors acknowledge that despite their best efforts, such issues are a problem. "On a regular basis we visit commercial lenders and servicers on the spot as frequently as possible," says Danny Frans, senior portfolio manager, ABS, at Fortis Bank in Brussels, "looking at their financial status, operations, systems, collection procedures, management, etc.
"But sometimes even after a due diligence, we can still be left with some concerns by not having been able to cover everything, which can leave 'blind spots'. We are therefore always very keen in talking to the rating agencies in order to get a confirmation or non-confirmation of our own findings."
However, keeping an eye on the goings-on at servicers can give investors certain intelligence. "Eurohypo recently had a lot of key people leave to join competitors," says one London-based investor, "so they had to reorganise a little bit. So while they have a really good track record on previous deals, they will have a percentage of new employees working on the management team and we want to see how they perform going forward."
While such investors are clearly taking the role of the servicer seriously, some market participants say that certain issuers needed time to understand what is involved.
"A number of servicers for some of the more traditional lenders saw themselves as still servicing for the actual lenders themselves, instead of servicing for the capital markets," says one. "It is quite a mental jump for them to make. They had to understand that their cosy relationship of agreeing terms and amending documents for borrowers could no longer exist."
If the strengths of servicers are likely to come under pressure in an economic downturn, then those of special servicers could be even more severely tested. Stepping in after certain triggers have been set off to maximise recoveries, a strong special servicer can make a big difference.
But if the lack of problem histories in the European securitisation market makes appraising servicers difficult, the problem is even more acute among special servicers.
Fitch's ratings are therefore a measure of servicer performance regardless of the mix of securitised and unsecuritised mortgage loans in their portfolio. The rating agency acknowledges that "European servicer portfolios may contain only a small volume of securitised mortgage loans as compared to unsecuritised mortgage loans."
Candace Valiunas, director of specially serviced assets at Hatfield Philips International, one of the few third-party servicers in Europe, says that as well as having a track record in securitisation, much of the firm's experience and expertise comes from outside the securitisation market.
Fitch's rating criteria
1. Company history and management experience
In its servicer evaluation of the company in September 2004, Standard & Poor's noted that Hatfield Philips's asset management team has considerable understanding of the UK commercial real estate market. Each manager has on average 10 years of experience in the industry as asset managers, commercial real estate lenders or surveyors.
At the time of the report, Hatfield Philips was special servicing 59 loans, most of them in one commercial loan pool that the company had been operating as special servicer on for seven years.
"HPI has demonstrated its ability to effectively manage down a portfolio of non-performing assets," said S&P. "Asset managers have specialised skills to engage in loan restructuring, modification, liquidation, or discounted pay-offs."
One observer says that the these abilities are becoming increasingly appreciated in Europe.
"If you compare it to the US, CMBS in Europe is just starting to catch up and there isn't the same depth of experience here, so we haven't seen the types of problems that can arise," she says, "but there is a growing appreciation of the role that the special servicer can play.
The success of special servicers in the US is perhaps not surprising given the incentives involved. "What they have done in the US is compensate special servicers better when returns are better," says one market participant. "The work-out fee is usually about 1% of all collections of the loan over its term after they have cleaned it up, and the liquidation fee is 1% of the net liquidation proceeds.
"You do not have a compensation structure like that at a bank and that is why the default ratios of CMBS portfolios compared to bank portfolios are significantly different, with CMBS portfolios having historically performed better than bank loans."
Mezz holders look to specialists
The ability of a special servicer to recover as much as possible during a work-out is arguably most important to the most subordinated holder of the loan secured on the asset. While this party would typically be the holder of the junior piece of a securitisation, in the CMBS market in Europe it is increasingly the holder of a 'B' note, or mezzanine loan.
Following a similar practice in the US, conduit lenders are splitting the real estate loans they are putting into their securitisations in two, selling a junior, 'B' note into the bank market. This practice allows them to create the securitisation from the investment grade portion of the loan — the 'A' note — with the aggregate pricing of the two working out more efficiently than a securitisation of the original loan.
Key to this arrangement is the intercreditor agreement between the 'A' and 'B' notes, which will determine the waterfall of payments through the life of the securitisation, as well as enforcement rights, security rights and amendment rights, to name but a few.
Although the use of such structures is only beginning in Europe — one rater says that he has seen around 10 over the past year — the exact nature of the intercreditor agreement has become a hot topic. And, not for the first time, the debate revolves around how useful a US model is for the European market.
"Broadly speaking we see 'B' notes falling in two categories," says Ronan Fox, director and co-head of CMBS at Standard & Poor's in London. "One is where the servicing standard is set for the benefit of the 'A' noteholders, but the 'B' piece holder retains several rights including consents to major changes to the loan and the right to call for security to be enforced under certain circumstances.
"The other, which is referred to as a traditional US 'A/B' structure, is where the recovery standard is set for the 'A' and the 'B', and the special servicer and controlling party are appointed by the 'B' until a control evaluation event. If the 'B' note is written down to less than 25% of its economic value, a typical control evaluation event provision would see control pass from the B noteholder to the most junior class of notes in the securitised 'A' loan."
Why follow the US?
The first category — considered the European camp — has emerged from the continent's mezzanine market. Its supporters question why, instead of building on this experience, Europe's CMBS market should blindly follow the example of a different jurisdiction.
"I am not sure how relevant US structures based on Chapter 11 mitigation are to a European context," says Peter Denton, managing director, European debt capital markets, at Eurohypo in London. "We are more emphasising a review of the actual underlying law that we are living with, particularly in the UK, as well as established banking practices and seeing what that gives us.
"There are unquestionably good lessons to be learnt from the US market, but we are seeking to start without preconceptions and with a blank sheet of paper and come up with something that is pertinent to this market."
Others, however, place greater emphasis on the lessons that the US can offer. Charles Roberts, a partner in the capital markets department of Cadwalader Wickersham & Taft in London, for example, highlights the way in which control rights and the employment of a special servicer can improve the lot of the 'B' noteholder in the US.
"If the servicer doesn't have a servicing standard to the subordinate, but only the senior, then he will just sell an asset for the best price he can get," he says. "But under the 'A'/'B' model that has been developed with the rating agencies for CMBS, the special servicer is required, within reason, to do its best to enhance the value of the asset.
"This could involve delaying litigation in order to renovate or otherwise re-position a property, leasing up a property, or finding ways to cause poorly performing leases and contracts relating to the property to be reworked or terminated."
But it is in areas like this where some observers say that the different legal jurisdictions can act as a mitigating factor. "In the UK a receiver has to get the best price reasonably available for an asset and cannot just have regard to one class of the secured creditors who appointed him," says Jayne Black, an associate in the international finance group at Sidley Austin Brown & Wood in London. "So inherently within the legal regime he cannot just look to the interests of the senior creditors, which is what some people believe might happen."
'No standardisation soon'
As chair of the international committee of the Commercial Mortgage Securities Association, Cadwalader's Roberts is chairing a working group looking into the debate. Other parties involved include, among others, Eurohypo and Sidley Austin, as well as the European arm of the US firm LNR, which both buys 'B' notes and owns Hatfield Philips.
Scott Goedken, investment director at LNR Partners in London, says that he does not expect to see standardisation of 'A/B' structures anytime soon — even if he believes that they would benefit the market.
"Our view is that we want to put ourselves in a position to manage the work-out process, or at least be able to consult or consent on certain elements of that process," he says. "But there are parties out there that do not require the same package of rights as LNR.
"There is currently a variety of different packages being offered in the market and one package is not necessarily better than the rest. Depending upon a firm's experience and tolerance for risk though, it may find that certain structures, and certain packages of rights, are better suited to its investment parameters."
At S&P, which is preparing a report on the subject, Fox says that the rating agency is being flexible in its approach. "The overriding objective from an S&P point of view is clarity," he says, "so that issues such as enforcement, work-out, or whatever are dealt with in a prescribed format that is set out at the start in an inter-creditor agreement and we can assess its impact on credit.
There should be a common understanding between the parties what the agreement is seeking to achieve and how it would work in practice."
However, if one model does prevail then it will have important consequences for the development of the 'B' note market as it is likely to determine the investor base for the product.
"On the one side you have the European banks, comfortable in taking normal lending risk against property, which are looking to become 'B' note investors simply because of the attractive yield on offer," says one banker. "And then on the other you have the mezzanine funds and CDOs coming from a US background.
"They are keen for the US model to be adopted as they know that European banks don't like it, and then they will have a competitive advantage. But at the moment they aren't the most competitive and aren't getting much of a look in."