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Rating Agency: CDO Servicers Face Challenging Times

Rating agency Standard & Poor's says that the growth of collateralized debt obligation issuance poses challenges for the servicers of real estate loans that are pooled into these deals.

S&P said the "inherent complexities" of CDOs requires special consideration in evaluating the servicing of CDO assets. S&P recently issued a report detailing how it evaluates servicers and special servicers assigned to manage the cash flows and collections associated with loans backing CDO transactions.

Michael Merriam, a director in S&P's servicer evaluations group, said in a news release that the structure of CDO transactions usually involves the participation of several parties working together to ensure that the servicing functions are managed well.

"In light of the growing presence of CRE CDOs in the market, we have broadened the scope of our servicer evaluation to determine the operational capabilities of servicers administering CRE CDO-type loans and participating in rated CRE CDO transactions," he said. "Specifically for CRE CDOs, we distinguish among the following roles: the servicers, who may be referenced as the transaction's master servicer, and the special servicer, which is a role normally assumed by the CRE CDO's collateral manager."

He said that S&P considers how well a firm's administrative and portfolio management capabilities correspond with and can support its planned role and duties for the transaction when evaluating CDO servicers.

In order to serve as a CDO special servicer for commercial real estate loans on an S&P-rated transaction, a collateral manager must either be on S&P's select servicer list as a commercial mortgage special servicer or be qualified by S&P for such a role. Concurrently, the named servicer for a CRE CDO must be included on S&P's select servicer list.

However, Mr. Merriam said that collateral managers without an S&P servicer ranking can serve as a subservicer for a transaction and can be delegated many servicing functions as long as the named servicer for the deal is an S&P-rated commercial mortgage servicer or master servicer.

In a report on servicing real estate loans in CDO transactions, S&P said that a one-size-fits-all approach to commercial real estate servicing has never been appropriate. The increasing number of permutations in CDO transactions only adds to the complexity. Those transactions "have different repayment priorities and control rights among the invested parties within the capital structure risk hierarchy," S&P said. That differentiates CDO transactions from CMBS, where greater investor reporting standards and industry-accepted best practices have led to more conformity.

CDO transactions backed by real estate collateral can include whole loans, subordinate notes, CMBS and mezzanine debt, along with other forms of debt and equity, S&P noted.

"Given the variants involved, a servicer administering the loans in a CRE CDO must therefore contend with customized, intensive reporting and portfolio management duties that present their own challenges - challenges that servicers have to address while simultaneously carrying out many duties similar to those associated with servicing the loans in a traditional CMBS transaction," the S&P report said.

That creates an "intensive servicing" environment, the rating agency said.

CDOs often contain loans with shorter maturities than CMBS, often with floating rate components and future funding commitments linked to financing improvements when new leases are signed. That basket of mixed collateral is one reason CDO real estate loans require more servicing expertise.

In addition, S&P said the absence of universally accepted investor reporting standards today also is taxing for servicers. The rating agency noted that efforts are underway to promote standardization for reporting in CDO transactions.

When loans default, the collateral manager often steps into a "special servicing" role. While the absence of REMIC rules allows greater workout flexibility, it also complicates oversight of the special servicing role. In fact, within a CDO a defaulted real estate loan can be bought out at par and replacement assets added to the pool. That allows the foreclosure and REO sale to occur outside of the securitization structure. (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com