Once the darling of Wall Street, CMBS has become a four-letter word for an increasing number of borrowers. As the commercial real estate industry sinks deeper into recession and more property owners run into financial trouble, the complexity and limitations of the commercial mortgage-backed securities model are coming to light.

At last month's Hunter Hotel Investment Conference in Atlanta, a breakout session titled “CMBS Issues and Answers” attracted a capacity crowd. A few anxious hotel owners expressed concern that loan servicers were being unresponsive to their pleas for assistance. The owners felt helpless.

It's a complaint that Ann Hambly, CEO and president of 1st Service Solutions based in Grapevine, Texas, hears quite frequently. “These hotel owners often are in a situation where they own a property that is not cash flowing and the loan is securitized,” says Hambly, one of three panelists. “These owners are approaching the servicer for a write-down of the debt. And when they're told ‘no’, they are not sure what else they can do.”

Borrowers need to understand the roles and responsibilities of the players in the CMBS process, urges Hambly, who has more than 30 years of commercial mortgage servicing experience. Her business specializes in guiding commercial real estate owners through the approval process for securitized financing, whether it's a loan assumption, modification, or extension.

Web of players

Unlike a whole loan that remains on a bank's balance sheet, a securitized loan is sold into a secondary market that has many tentacles. Up to seven different players have a say in many CMBS transactions, including the master servicer, the primary servicer, the special servicer, the controlling class certificate holder, and the rating agencies.

When the property is cash flowing and the borrower is paying his loan on time, the process runs like clockwork. The bondholders are paid their periodic installments, and most often the borrower is unaware of these players aside from the lender or originator. If a loan becomes non-performing, the special servicer intervenes and only the special servicer can restructure, modify or extend the loan.

The master servicer, meanwhile, is responsible for collecting payments from the borrower, as well as holding and making disbursements from escrows. In the CMBS world, borrowers have fallen into the habit of contacting their master servicer to ask if they can pay off loans early, extend maturity dates or write down part of the principal. “The answer is ‘no’ because master servicers are essentially the cops of the deal,” says Hambly.

A better approach, she says, is for a borrower with a financial hardship to inform the master servicer why he is likely to default and to provide evidence. Only after gaining a full understanding of the borrower's predicament will the master servicer turn the matter over to the special servicer for a possible workout.

Second act for CMBS?

Securitized lending will eventually emerge from hibernation, Hambly says, but the financing model has lost its clout. After more than $230 billion in domestic issuance in 2007, CMBS volume dipped to just over $12 billion in 2008.

“When it comes back, I'm not so sure that it is going to be able to compete with life companies and other products because borrowers have got a really bad taste in their mouth for CMBS. That's partly because there are so many players and roles in the process,” says Hambly.

Historically, borrowers have put up with the many hassles of securitized lending in exchange for high loan proceeds and low interest rates. But that was before the credit crunch leveled the bond market and investors lost faith in the rating agencies.

“When CMBS starts up again it has to be with low proceeds and highly scrutinized,” says Hambly. “It will be conservative.” Translation: no more 80% loan-to-value, non-recourse deals.

The lesson learned from today's saga is that high loan-to-values shouldn't be based on anticipated cash flows, says Hambly. As the lending bubble got bigger, CMBS deals were increasingly based on projected rents. “Everybody got real competitive. They wanted more and more market share, and it wasn't their balance sheet at risk.”