Master Servicers Get More Scrutiny from Fitch

The role of servicer in commercial mortgage transactions has come a long way since the Resolution Trust Corp. days of the early '90s.

With the increasing complexity of commercial mortgage deals and the growth of the commercial mortgage-backed securities market, the servicer's activities have expanded beyond loan administration and payment processing. For one, investor reporting activities have become more complex, involving multiple investors and loan structures. Another fundamental change is that the servicer has along the way become responsible for making advances.

Acknowledging the larger role that servicers play, Fitch Ratings has decided to incorporate the ratings of master servicers in their CMBS rating model. The rating agency believes that "master servicers who have strong controls regarding advancing and recoverability determinations, proactively transfer assets in a timely manner to special servicing, and employ sound credit policies regarding loan assumptions and borrower requests can serve to mitigate risks in CMBS structures."

Stephanie Petosa, a senior director with Fitch's CMBS group, said that the servicing process has become "much more complicated and challenging," involving a "whole lot more than just collecting payments," leading to the increased use of technology. She said, "In the early '90s, you didn't tell anybody anything. Servicers had no information. Those were the days when financials weren't even required to be collected from borrowers. When you get and receive more information from the borrowers, then you have investors that want to receive more information as well." And Richard Carlson, a director with Fitch's CMBS group, noted that loan structures have become more complex "with 'A' notes and "B' notes and 'C' notes, mezzanine loans, loans that have springing lock boxes and other debt service coverage triggers that have to be monitored." Also, he observed that "there is a lot more real estate knowledge that is required now in servicing than there was in the past."

The role of the servicer in making advances is also getting more formalized. Ms. Petosa has seen the language in pooling and servicing agreements getting tighter in that "the parties involved are trying to get more structured language in there." And she has seen more discussions on whether there should be limits on advances and more stringent rules for recovery. "It's at a point in the industry now where people are trying to address it," according to her. Advancing is more of an issue with the older and more mature deals. Mr. Carlson said, "Most of the deals pass and then you're left with a few that are subperforming or that aren't as strong as those you had before and that's why you're having this issue." They don't believe that payouts servicers have made to put in terrorism insurance will continue to be an issue, seeing it as a "one-time thing in the past, mostly on large single-borrower deals." For the most part, these have been repaid and recovered, but there are a few cases involving litigation that are still pending.

Stacey Berger, executive vice president with Midland Loan Services, a major CMBS servicer, said that servicer advances have always been "somewhat of an issue," but more recently servicers have been called upon to advance more as their portfolios have got larger and more and more loans are delinquent or in default.

Another way the servicer role has evolved is that somewhere along the way, CMBS servicers became investors and began to purchase servicing rights. Mr. Berger wonders if servicers are now paying too much for the servicing rights. He said, "I can't tell you what our competitors are doing, but we think that servicing is being priced exorbitantly high at this point. Either people don't understand the economics or there is some accounting artifice that is getting in there. But I don't have an explanation for why people are paying what they're paying." He also believes that it limits competition since "there are very few people who can participate either by virtue of scale or the capital required to invest in servicing rights." Other shortcomings to this arrangement, as Mr. Berger sees it, are that since the servicer is now an investor, quality gets compromised. It also means that CMBS servicers can't be terminated. According to Ms. Petosa, "it has always been that 80% of the servicing has been with 20% of the servicers." And she believes that the bids are high since servicers can't achieve efficiencies without volume. Mr. Carlson believes the bids are high because of the pressure for larger companies to continue to add new business.

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