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Special Servicer Flexibility in Working Out CMBS May End

The flexibility that special servicers have working out delinquent U.S. CMBS loans may be limited in the coming months amid the protracted liquidity freeze, according to a new report by Fitch Ratings.

Fitch's report, "What's in Special Servicing?" highlights the 20 largest delinquent loans in special servicing expanding on its loan delinquency index.

"Though numerous plans are already in place to ease liquidity, the lending markets will open slowly, which potentially opens the door to increased defaults and higher loss severities in CMBS loans," said Fitch managing director Mary MacNeill. "Of particular interest are the number of 2006 and 2007 loans that have already transferred to special servicing just one to two years after securitization."

Special servicers have the flexibility to work out loans in different ways to minimize losses to the trust. Although this flexibility is a positive, options may be more limited in a less liquid environment. Servicers may need to hold on to loans longer than anticipated or sell off loans at fire-sale prices, which may create higher losses. A better option, according to Fitch, may be to work with the existing borrower to modify the debt or find a new borrower willing to assume the existing debt. Fitch's current rated U.S. CMBS portfolio is composed of 475 transactions with an unpaid principal balance of $556 billion. As of Sept. 30, 2008, Fitch's loan delinquency index was 45 basis points due to the delinquency of 488 loans representing $2.5 billion in UPB. Delinquent loans range in size from $87,740 to $112 million, with an average loan size of $5 million. Of all the loans, 17 have outstanding balances greater than $20 million.

There are an additional 246 non-delinquent specially serviced loans totaling $2.5 billion, which have transferred due to imminent default or other non-monetary reasons. Although not all of these loans are likely to become delinquent and are not included in the 45 bps of delinquencies, if they did become delinquent, Fitch's loan delinquency index would double to 90 bps. Loans in special servicing range from $87,740 to $225 million, with an average loan size of $7 million.

These developments may result in servicers having to hold on to loans longer than anticipated or sell off loans at fire-sale prices, which may create higher losses. In this protracted period of illiquidity, it is becoming increasingly difficult to obtain any financing even for performing loans. While numerous plans to ease liquidity are in the early stages, Fitch expects the lending markets will open slowly, which will create increased defaults and higher loss severities in CMBS loans.