• Specially-Serviced Loans: What Investors Need to Know
  • March 20, 2009 | Authors: Patrick C. Sargent; John J. Tucker
  • Law Firm: Andrews Kurth LLP - Dallas Office
  • Given the current economic climate, investors in securitized pools of mortgage loans want to understand the impact a “specially-serviced” loan has upon their investments. For the investment grade investor in particular, whose loan-level diligence and deal participation are less substantial than below-investment grade investors, what does it mean when one or more of the mortgage loans underlying the trust securities become “specially-serviced”? 

    In general, a specially-serviced loan is one in which a payment is 60 days past due or a payment or other default is imminent or likely to occur within a specified time, which default the servicer determines in good faith is reasonably likely to materially and adversely affect the interests of the certificateholders. 

    What happens to a specially-serviced loan?

    When one of these conditions is met, the master servicer transfers the servicing authority to the special servicer.

    The trust pooling and servicing agreement (“PSA”) requires the special servicer to service the loans with the same skill, care and diligence as is normal and customary for similar loans in the industry, or as it would for loans it holds for its own account, with a view to the maximization of the recovery of principal and interest on the specially-serviced loan for the certificateholders as a collective group on a net present value basis, but without regard to any relationship with the borrower or affiliates, any certificates the servicer may own, or any fees or reimbursements it may be entitled to receive. This obligation is known as the “servicing standard.”

    Since the special servicer is frequently also the B-piece or junior certicate investor, and as such its investment is exposed to the “first loss” on the underlying loans arising from loan performance problems, it typically has a vested interest in the performance of the loan. This economic interest, however, is checked by the servicing standard.

    The special servicer first physically inspects the property and prepares an asset summary report (“ASR”). The ASR describes the property condition and the special servicer’s strategy for dealing with the troubled loan. The special servicer must consult with the representative of the junior certificateholders (if another party owns the certificates) before implementing the strategy set forth in the ASR. However, the special servicer is ultimately responsible for the course of action chosen.

    Options in Dealing with Specially-Serviced Loans

    What options are available to the special servicer in dealing with troubled loans?  

    The PSA generally provides the servicer significant leeway in dealing with defaulted loans, subject to the servicing standard. For example, after assessing the local market, tenant status and estimated economics for operation of the property, the special servicer may determine that the best prospect for recovery to certificateholders is to amend or modify the loan by extending the maturity date, reducing the interest rate, and/or deferring or forgiving certain payments and charges such as prepayment premiums, yield maintenance fees and late charges. Additionally, the special servicer may decide to allow a discounted payoff of the mortgage loan by the borrower. Another option is to conduct a sale of the defaulted mortgage note. Finally, the special servicer could pursue foreclosure proceedings resulting in either a sale of the property if an adequate bid is offered or the trust owning the property pending an ultimate sale to another user. In exercising its judgment, the servicer will weigh the economic benefit to the trust of owning and operating the property temporarily against the benefits expected to be gained from exercising the other options described above.

    Through this process, certificateholders may derive comfort from the servicing standard, the reputation of the servicer in the industry and the requirement that the servicer meet rating agency criteria. The PSA’s arrangement of rights and responsibilities is intended to align and balance varying economic interests. The construct is sure to be tested in this recessionary period, but special servicers may well prove that this principled flexibility is both necessary and effective to mitigate mortgage losses and protect the interests of investors.