Is it less difficult, albeit more tricky, to modify loans in CMBS 2.0?

For borrowers of commercial mortgages that are part of CMBS and are in distress, there is now a greater possibility of achieving a CMBS loan workout than it was in the last downturn.

One of the decision-makers may have nothing to lose.

Let’s take a peek at the inner workings of the CMBS trust.

The initial iteration of CMBS that imploded in 2009 (CMBS 1.0) made it very difficult for a borrower seeking to restructure and workout their loan.

They had an ominous competitor in the process - the Controlling Class Representative or the CCR.

The CCR is a CMBS bondholder with approval rights on various actions including modifications and can also replace the special servicer.

However, the CCR only has these rights to the extent they don’t experience a “control transfer event.”

In CMBS 1.0, in order to lose control, a CCR’s bonds “face value” would have had to lose 75% of their actual value with the trust suffered actual monetary losses. So, a CCR could remain in control by refusing to approve workouts, foreclosing and holding the property as REO for as long as possible – thereby preventing a greater loss to the trust.

The motivation for this was twofold. Firstly, there are often side letter fees that the special servicer would kickback to the CCR. Secondly, and this is key, being a CCR in CMBS 1.0 came with an amazing perk. They had the right to buy any defaulted loan from the trust at the then discounted value – the FMV option. So if a defaulted $50 million loan was determined by the special servicer to have a $10 million value, the CCR buy that loan for $10 Million even if it may eventually be worth $35 million. This is also a regardless of the fact that if the borrower would’ve wanted to work out this loan, they would have to give the special servicer an offer exceeding the present value of the $35 million.

Over time, this resulted in many loans deteriorating while on the lender’s books, and while the CCR made significant money, the deterioration of these assets resulted in other bondholders realizing a greater loss than they would’ve otherwise have realized, had the lender just done a deal with the borrower or sold the assets earlier on.

So, when the powers that be got together post-recession to formulate a better mousetrap, two of the major changes resulting in CMBS 2.0, are the removal of the FMV option, and the way to change control. Whereas in CMBS 1.0 it required an actual loss for the change of control, in CMBS 2.0 if the properties in the trust aggregate appraisals are reduced in a total amount equal to 75% of the CCR’s bond face value, even though the bond may still pay out interest and no actual losses have been recorded, the CCR loses control and the new CCR takes its place.

The result is that actual losses are already baked into this CCRs bonds. The practical implication is that when a borrower approaches the special servicer for a modification or discounted payoff of the loan, and the special servicer goes for approval to the CCR, it is likely that the current CCR will have no direct impact by approving this action. So, whereas in CMBS 1.0 you had someone who would likely resist a deal, and even potentially be a competitor for your property, CMBS 2.0 that party may no longer be in a position of power.

All this being said, it is obviously far from easy to get a deal done for various reasons. Chief among them, is that it’s easier for the CMBS special servicer to foreclose than to bother with a modification. There are also other factors that come into play.

Another major factor, and one that I have previously written about, is that due to anti-litigation clauses that are common in almost every CMBS 2.0 recourse (or Bad Boy) carveouts, the longer a borrower waits to address a workout, the greater the chance of failure.

Shlomo Chopp is the managing partner of CPS - www.caseps.com.