• Adjusting to the Down-Cycle: Insurance and Loan Surveillance Issues Take Center Stage
  • October 15, 2003 | Authors: Peter K. McKee; Patrick C. Sargent
  • Law Firm: Andrews Kurth LLP - Dallas Office
  • The events of 2001 promise far-reaching changes in mortgage lending best practices, not least in the CMBS industry. The emerging recession and the aggravating impacts of the terrorist attacks of September 11 represent new challenges:

    First Stresses on CMBS Structures Expected. The U.S. economy has been in recession since March 2001, and some economists posit that real estate, which typically lags a year or so beyond a technical recovery as absorption catches up, will feel like a recession for 2002. Loss frequency and severity will be closely watched, particularly to see how bond structures hold up where loan losses are suffered. The impact of SPEs on the time needed time to recover delinquent assets will also provide an interesting point of comparison with prior recessionary cycles.

    Insurance: Premiums Up and Coverage Down. September 11-related claims reportedly wiped out three years of insurance industry profits. Insurers have responded by (i) inserting terrorism exclusions; (ii) refusing to write or renew policies for various property segments; and (iii) raising premiums across the board by 20%-70%. Trophy properties are particularly susceptible to non-renewal risk, because re-insurers are threatening to abandon the market, but any property segment with a claims history is endangered. The consequences are staggering: (i) underwriting issues arising out of premium increases (i.e., lower DSCRs); (ii) loan document troubles: non-delivery of required insurance, downgrading of insurance providers, activation of DCSR-triggered lockboxes, and other incipient defaults mandating action under servicing agreements; and (iii) reduction in new commercial mortgage lending originations, including the possible flight of pension fund investors (having a low appetite for risk) from CBD office properties or other trophy assets. The totality of the fallout will depend in part on Congress, which failed to address such insurance market shocks in its last session, and on rating agencies, to the extent they impose terrorism coverage requirements across all property types.

    Financial Reporting: Stringent Expectations. CMBS servicers and investors have a shared view on the importance of timely and sufficient financial information as an early warning sign of property troubles. Not surprisingly, borrowers can be less forthright at the very moment when servicers and investors have the greatest need to know what's going on. Meaningful loan document requirements and incentives, including audit rights for loans that are large or have sponsor history issues, are now expected. Servicer surveillance efforts will intensify to identify and mitigate troubled loans.

    Tenant Risk-Related Information. Whether at origination, securitization or servicing, tenant risk-related information has not been consistently collected or interpreted. As tenant credit quality is threatened, however, the market will insist on it. Trends include greater scrutiny of major lease terms and story tenants, more stringent loan-level representations, and more detailed watch list criteria for lease issues.

    OFAC Watch List Screening Procedures. The U.S. Treasury's Office of Foreign Assets Control has the responsibility for implementing the Executive Order aimed at curtailing anti-terrorist activities. The scope of these measures is potentially broad enough to impact loan proceeds or property income coming from or passing through blacklisted individuals or organizations. Some lenders have already added blacklist searches to their loan application processes.

    Other Loss Severity Issues. Information that correlates to loss frequency or severity will be increasingly valuable to the market, as it searches to distinguish factors that improve risk assessment. With increased delinquencies, jurisdictional differences in exercising lender remedies may be more systematically apparent and, once discerned, pricing or terms changes may not be far behind.