Special servicers are guilty of a series of “blatant conflicts of interests” in a scandal that eventually will lead to multi-billion dollar settlements, a San Diego-based consultant has claimed.
Jack Rose, chief strategist at Breakwater Equity Partners, says in an interview in this month's PERE magazine that there is also “next to no regulation to protect bondholders” and that ratings agencies are doing little to address issues even when presented with “black and white” cases.
Rose highlights various conflicts at special servicers, many of which are now owned by private equity and private equity real estate groups. He says: “They have a series of blatant conflicts of interest between their duties to the bondholders in the real estate mortgage investment conduit (REMIC) trusts and their interest in buying the (same) properties as cheaply as possible.” He adds: “From the bondholder perspective, special servicers have a duty to maximize value, but as an investor, the special servicer wants to get the asset as cheaply as possible. It is simply an insurmountable conflict of interest. It is repeated constantly in the space and it is really obscene what has gone on. The bondholders really don’t understand how badly they are being treated in all of this.”
Under typical structures Breakwater sees, junior tranche bondholders control the REMIC trust and special servicer. He says the special servicer often wants to avoid cashing out even if it makes sense to sell a property and dispose of it. “They will hold onto it so that they can continue to get fees as a special servicer and so that they don’t lose control to the next most senior class of bondholders,” says Rose, adding that special servicers are jockeying for position and buying up bonds and controlling the rights class, leading to “inefficient decisions”. “In other words if they play ‘extend and pretend’, if it turns out that the market cooperates, they end up making money, but if it turns out the other way, someone else bears the costs.”
In another example of conflict of interest, Rose says special servicers are “constantly going out and cutting deals on the discounted loan pay-offs (DPOs) that allow them to make extraordinary fees at the cost of the bondholders”. Taking a hypothetical example of a property under water with a $100 million loan attached to it, the value of that property might be $60 million, which is what the special servicer could sell it for on the open market. But if it can sell for $58 million and have an investor pay them a $2 million fee to take it over, then effectively the bondholder has been short changed by $2 million, he explains.
Another area he describes as a “coup de grâce” for special servicers concerns situations where the original underwriter of the CMBS is part of the same financial institution that also acts as the master servicer and the special servicer if the CMBS goes into default. Because 2006 and 2007 underwriting standards were so lax, many REMIC deals had instances of omissions or misrepresentation. “Bondholders have the right to put back the loan to the underwriter and the originator if they misrepresented it or if there was securities fraud – indeed they have a duty to”, says Rose. “Taking the earlier example, the originator and the underwriter have to write a check for $100 million. They have to give it back to (the investors) at face value. But you have a situation where a trustee has a duty to put the loan back and basically sue the originator, which is part of the same company. How many times in the history of the US CMBS market do you think that has ever happened? Zero.”
Despite obvious conflicts in specific circumstances, Rose assets bondholders frequently “don’t understand how badly they are being treated”, even though they are sophisticated investors.
He also says his firm has frequently blown the whistle to ratings agencies, but they do little.
“The bondholder maybe large institutions, but they are not that sophisticated in this area. Believe me, we have written the rating agencies letters – every one of them – Moody’s, S&P, Fitch – and they are aware of the situation and they have done nothing to resolve it. There are no federal agencies that have oversight here.”
Calling it the Wild West in terms of lack of regulatory framework, Rose adds that ratings agencies have to rate the special servicers, but they do not do much because they are paid by the underwriter and are not aggressive. “We have brought to them black and white examples of wrongdoing on the part of special servicers. They will make a few phone calls and pretend to investigate but basically do nothing. It is a scandal.”
To read the full story in the March issue of PERE, click here.
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