The market for commercial mortgage backed securities has grown rapidly in recent years and has become the second largest source of financing for commercial real estate. Recent turmoil in mortgage markets has made it more imperative to understand sources of inefficiency and agency conflicts in the industry.
Commercial Mortgage Backed Securities (CMBS), securities backed by pools of mortgage loans on commercial real estate properties, are structured such that a master servicer oversees the administration of the underlying loans and the distribution of the cash flows to the tranche investors. One of these functions involves the administration, monitoring, and disposition of the loans. When a loan in a CMBS deal fails to perform as expected, the master servicer sends the loan to a “special servicer.” The special servicer has wide latitude to foreclose on the loan or modify the loan terms in an effort to maximize the cash flows to the CMBS investors. Typically, the special servicer’s activities are detailed in a Pooling and Servicing Agreement (PSA).
Since the first-loss investors have the most at stake when a loan fails to perform, investors often control the appointment of the special servicer. In fact, the special servicer often holds a portion of the first-loss piece, in order to properly align the incentives of the investors and the special servicer. The special servicers may undertake actions (modification, foreclosure, etc.) that maximize the position of the first-loss investor and guarantee the timely cash flow payments to the senior investor. If a loan does fail to perform as expected, the borrower may be able to negotiate an outcome other than foreclosure. However, there have been instances where the special servicer has purchased the “B” tranches in a deal, giving them an incentive to call performing loans, since it would increase the value of their positions.
I worked with my colleagues Brent Ambrose of Penn State University and Anthony Sanders of George Mason University to determine whether the default outcome of a pool is correlated to whether or not the master and special servicing rights of that pool are held by the same firm. We studied the conflicting incentives of the master and special servicers in handling troubled loans in a CMBS deal and how the friction between the interests of the two servicers might be diminished if the master and special servicing rights were held by the same firm.
After examining more than 46,000 securitized commercial real estate loans, we found that the foreclosure probability is smaller when the two servicing rights are concentrated in one firm than when they are held by different firms.
In light of the current economic crisis, identifying the determinants of foreclosure outcome in mortgage markets has become critical. As far as we know, our study offers the first analysis of the correlation between the foreclosure probability and whether or not the two servicing rights are held by the same firm.
Given the evidence presented in this paper concerning the impact that concentrated servicing rights have on commercial mortgage foreclosure outcomes, one would expect that investors in CMBS tranches would price these conflicts of interest at the deal origination. As the CMBS industry matures, and pricing data on senior/subordinate tranches become available, a fruitful avenue for future research would be to empirically test whether these conflicts of interest are priced at origination and ultimately whether expectations of such conflicts appear in the underlying mortgage interest rates.