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SECTOR IN-DEPTH

21 June 2016

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CMBS - US

Credit Neutral Servicing Agreements Account for Hope Notes

A small but growing share of pooling and servicing agreements (PSAs) in recent commercial mortgage-backed securities (CMBS) transactions more accurately reflects the loss potential of “hope notes”¹ in determining who controls a CMBS transaction. In our view, this feature maintains credit-neutrality and corrects a potential misalignment of interests that may otherwise arise.

Credit neutral PSAs provide for the calculation of a “collateral deficiency amount” (CDA) when a hope note has been created from a mortgage loan, which reflects the under-collateralization of the mortgage loan. Credit neutral PSAs then provide for the application of the CDA in a manner similar to the way appraisal reduction is used, in order to determine whether a control termination event has occurred and to identify the transaction’s controlling class. Finally, credit neutral PSAs provide that, in connection with the application of loan recoveries and liquidation proceeds, monies are applied to accrued interest on the CDA portion of the related mortgage loan only after recovered loan proceeds are first allocated to outstanding loan principal.

Background of Appraisal Reduction and Hope Notes

Appraisal Reduction

Appraisal reduction amounts² are used to help calculate the point at which control of a CMBS transaction shifts to reflect reductions in related mortgaged property values before losses are ultimately realized. Appraisal reduction amounts allow a CMBS transaction to operate in a way that considers current underlying property values, and to do so sooner than would otherwise occur had consideration only been given to realized losses. Once the appraisal reduction amount has been calculated, it plays two critical roles in a CMBS transaction:

This second impact of the appraisal reduction amount is effected in CMBS 2.0 PSAs by two important definitions.

However, neither the appraisal reduction nor its impact lasts forever. The typical PSA generally provides that any mortgage loan previously subject to an appraisal reduction amount, which has become a “corrected mortgage loan” (which is the term used to identify a loan that is no longer in special servicing), and with respect to which no other appraisal reduction event has occurred and is continuing, will no longer be subject to an appraisal reduction amount. Presumably, the rationale for this mechanism is that a mortgage loan that has been corrected is no longer in distress and no longer requires an appraisal reduction to indicate a troubled status.

Hope Notes

The elimination of the appraisal reduction with respect to a corrected mortgage loan leads to a potentially incongruous result when a mortgage loan is modified and a hope note is created.

Following a loan default, which may have resulted from the significant decrease in the value of the related mortgaged property, the servicer may agree with the borrower to split the related mortgage loan into two separate components: (1) a senior note A (or, in some cases, a senior tranche A), which pays interest and has a principal balance that has been sized to roughly align with the current value of the related mortgaged property, and (2) a subordinate note B (or, in some cases, a subordinate tranche B), which often accrues - but does not currently pay - interest and has a principal balance that generally represents the difference between (a) the original principal balance and (b) the principal balance of senior note A. The subordinate note B may have a principal balance that is substantially higher or substantially lower than the principal balance of senior note A. The borrower may contribute capital as part of the modification. The contributed capital may be entitled to receive a preferred return before any payments are made to the holder of subordinate note B and, after the contributed capital has received its identified return, the borrower may split remaining cash flows with holder of subordinate note B until the principal balance of subordinate note B is reduced to zero.

The subordinate note B is often called a “hope note” because it will only be repaid if the related mortgaged property experiences an increase in value.

Before the mortgage loan becomes a corrected mortgage loan, the mortgage loan is subject to an appraisal reduction, which typically impacts the control determination and the identity of the controlling class. However, by operation of the PSA provisions described above, following the closing of the modification and once the mortgage loan becomes a corrected mortgage loan, the appraisal reduction related to this mortgage loan will no longer be applied. Likewise, when a hope note is created, there is no write-down to the balance of the related mortgage loan, so there is no “realized loss” related to the hope note to allocate to the control eligible certificates.

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Thus, while the property value has decreased, the hope note is unlikely to be repaid and the mortgage loan has not been restored to status quo ante as it relates to credit quality, under most PSAs there is no adjustment made to the determination of the controlling class or whether a control termination event exists. A PSA that permits this result is credit negative because it allows the controlling class representative to retain control of the transaction past the point they would lose control had the economic impairment of a distressed asset been captured by an appraisal reduction. This has the effect of misaligning control and economic substance, thereby leading to the potential for erosion of servicing quality and giving rise to negative credit implications.

Collateral Deficiency Amounts

PSAs from certain recent transactions have attempted to correct this result. Under these agreements, the special servicer calculates a CDA with respect to each “AB modified mortgage loan,” which is generally defined as a mortgage loan that has become a “corrected mortgage loan” owing to a modification thereto that resulted in the creation of an AB note structure (or similar structure), as to which the new junior note(s) did not previously exist or the principal amount of the new junior note(s) was previously part of either an A note held by the trust or the original unmodified mortgage loan and with respect to which an appraisal reduction is not in effect.

The CDA is generally equal to the excess of:

Under these PSAs, once the special servicer has calculated the CDA, the CDA is required to be applied to each class of the control eligible certificates, for purposes of determining the controlling class and the occurrence of a control termination event, just like an appraisal reduction:⁵ in reverse sequential order to notionally reduce the certificate balance thereof until the related certificate balance of each such class is reduced to zero.

PSAs that contain such provisions are credit neutral because they maintain the alignment of economic positions and incentives with transaction control. We view PSAs that do not include these provisions as credit negative because these agreements allow the B-piece investors to potentially retain control over a transaction beyond the point where they would have otherwise lost control.

P&I Advances and Allocation of Cash Flows

As discussed above, the typical PSA proportionally limits the master servicer’s or trustee’s advance of principal and interest on a mortgage loan subject to an appraisal reduction. We do not believe that a corresponding provision regarding P&I advances with respect to CDAs is necessary for credit-neutrality. Some hope notes do not carry interest. Most hope notes do carry interest, but such interest accrues but is not currently payable, and is thus not eligible for advancing. Finally, many servicers may be reluctant to deem advances on hope notes practicably “recoverable.”

However, in connection with the allocation of cash flows from, for instance, mortgage loan collections, liquidation proceeds or other recoveries on the mortgage loan, a PSA may allocate accrued interest on the mortgage loan—including accrued interest on the portion of the mortgage loan that is a CDA —ahead of outstanding principal. This provision leads to the additional incongruous result of the junior investors receiving accrued interest on a CDA ahead of receipt of principal by the senior investors.

We believe that a PSA that does not address this incongruity is credit negative because it allows the subordinate investors to collect interest on an unsupported principal balance ahead of the senior investors’ receipt of remaining principal. Credit neutral PSAs provide that accrued interest on the CDA portion of the mortgage loan will be allocated in a manner similar to interest that has accrued on an appraisal-reduced portion of a mortgage loan, that is, it is paid only after recovered loan proceeds are first allocated to outstanding loan principal.

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Moody’s Related Research

Below are links to publications from Moody’s related to the indices and underlying trends:

COMMERCIAL REAL ESTATE RELATED:

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

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