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New 'Watch List' Could Become Standard for CMBS Industry

In another indication of the evolution of the commercial mortgage-backed securities market, a watch list for use by servicers of CMBS transactions has been developed by the Commercial Mortgage Securities Association. The watch list serves to identify loans that need to be monitored for possible delinquency. This explicit listing of criteria for servicers to use is likely to become the standard for the CMBS industry. And going forward, it may even set the norm for the entire commercial mortgage industry.

The New York-based CMBS trade association's recommendations are the first such listing of criteria for the industry. Dottie Cunningham, executive director of the CMSA, said that prior to this, different servicers had different criteria for their individual watch lists. The CMSA effort - developed with input from different CMBS industry participants including servicers, lenders and the rating agencies - is an effort to standardize the process. Ms. Cunningham expects that it will now be easier for investors to compare CMBS deals.

Mary MacNeill, a senior director with Fitch Ratings' CMBS group (Fitch was also involved in developing the watch list criteria), believes that the watch list will serve as an early warning system to investors. The watch list is likely to be reviewed annually, but Ms. MacNeill expects the present list to be the prevailing version going forward, with some "tweaks here and there."

A loan could be put on the watch list for issues ranging from "financial conditions" - such as delinquent principal and interest payments, delinquent taxes, delinquent or force-placed insurance, declines in debt service coverage ratios - to "borrower issues," such as operating license or franchise agreement default and the bankruptcy of a borrower or guarantor. "Property condition" issues such as a "potentially harmful environmental issue" revealed by an inspection, or a property's being "affected by major casualty or condemnation proceeding affecting future cash flows," will also cause a loan to be on the watch list. Servicers also need to watch for lease rollover, vacancy, and tenant issues, such as approaching lease expirations for major tenants. A loan approaching its maturity or anticipated repayment with a balloon balance due could also cause it to be on the CMSA-recommended servicer watch list. And it is also left to the discretion of the servicer to put a loan on the watch list for "any other situation that indicates an increased level of default risk that may create potential losses to investors."

Wachovia Securities (No. 2 on the Mortgage Bankers Association's list of CMBS servicers by volume, with a $61 billion CMBS servicing volume as of Dec. 31, 2002) is one of the early adopters of the CMSA watch list. John Church, head of Wachovia Securities' servicing group believes that the immediate impact of the watch list will be a 20%-30% spike in the number of loans that servicers will need to watch. This is because of the broader criteria that have been adopted by the CMSA such as the inclusion of operational criteria in addition to the usual financial criteria that servicers usually use to put loans on watch. While events such as a tenant rollover don't necessarily lead to losses for an investor,

Mr. Church pointed out, the idea is to identify a risk event that servicers need to manage and that investors need to be aware of.

Mr. Church believes the standards will effectively raise the bar for servicers.

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