Leslie Hayton, Managing Director, Wells Fargo Bank, N.A.
Stacy Ackerman, Partner, K & L Gates LLP
One of the outcomes of the market downturn in 2007 was an increased focus on advances. Master servicers saw exponential growth in the liquidity needs of the CMBS trust, and as obligated by the Pooling and Servicing Agreements (“PSA”), master servicers advanced funds accordingly. According to Trepp, the aggregate amount of outstanding advances increased from approximately $426 million in the first quarter of 2006 to approximately $617 million in the first quarter of 2008.  Declining collateral values during the downturn created a surge in the use of the Appraisal Reduction Amount (“ARA”) and Appraisal Subordinate Entitlement Reduction (“ASER”) mechanics in PSAs. The use of ARAs and ASERs is described in further detail below but ultimately may result in a reduction of the amount of interest a master servicer advances as part of a principal and interest advance (“P&I Advance”). Between CMBS 1.0 and 2.0 there was a change in the priority of ASER recoveries such that in most CMBS 2.0 PSAs, certain loan recoveries (primarily liquidation proceeds) are allocated in those deals to unpaid principal instead of being allocated as a recovery of prior interest shortfalls to subordinate certificate holders. We as an industry need to be prepared for the practical application of this waterfall change and the implications thereof.
The calculations of both an ARA and subsequent ASER are defined in most PSAs and are tied to the decline in the value of the underlying collateral. An ARA is triggered when a certain specified event (“Appraisal Reduction Event”) occurs. An Appraisal Reduction Event typically includes certain modifications, a transfer to special servicing, bankruptcy and payment defaults. Following the occurrence of an Appraisal Reduction Event, a new appraisal is ordered and any ARA is recalculated as prescribed in the PSA. In its simplest form, an ARA is calculated as follows: (outstanding principal balance plus outstanding advances and interest on advances) minus (90% of the appraised value + escrows). If a new appraisal is not obtained within a specified period of time, most PSAs allow for an assumed ARA of 25% of the outstanding principal balance of the loan. If the outcome of this exercise is positive, it indicates that the value of the underlying property does not currently support the debt outstanding. Each monthly P&I Advance will therefore be reduced by the shortfall as calculated by the ASER. The ASER is typically calculated as (ARA/Scheduled Principal Balance) * Net Scheduled Interest. This reduced P&I Advance results in less cash flow being sent to subordinate tranches during the normal monthly remittance cycle in recognition of the decline in collateral value and potential future loss.
It is important to understand the cash flows of the CMBS transaction and the implications of an ASER on the deal cash flows prior to liquidation. The bond waterfall calculations allow for the shorted interest due to the ASER to reduce the cash flows to the most subordinate bond classes. It should also be noted that once a master servicer deems a loan non-recoverable, the point is moot since the master servicer has stopped making P&I Advances. There were no changes to the calculation and impact of the ASER in the ongoing cash flows of a deal in CMBS 2.0 versus CMBS 1.0.
Once a loan with an ASER is liquidated, most CMBS 1.0 deals provide for the recapture of the ASERs prior to the allocation of proceeds to principal repayment but after the recovery of servicer advances, liquidation fees and other holdbacks. The outcome of this basically wiped out everything that was intended to happen with the ASER. Subordinate classes which previously absorbed shortfalls are then reimbursed for their shortfalls as opposed to directing the funds to senior classes as principal. In addition to delaying the principal repayment to senior classes, this increases realized losses to subordinate classes, thus reducing the credit support across the structure and potentially affecting controlling class rights.
If the goal of the ASER was to account for expected losses due to the declining value of the collateral and prevent enrichment to the subordinate classes at the expense of principal bond holders higher in the capital stack, this ASER/ARA mechanism in CMBS 1.0 deals (combined with the liquidation proceeds definitions within the PSAs) has failed its goal.
The CMBS industry is constantly evolving to meet the demands of investors and adjust for the changing marketplace. PSAs, while individual to each issuer, all typically contain certain industry-wide concepts. When an adjustment is needed, all PSAs will eventually conform to the new market standard. We saw this with the introduction of Work-Out Delayed Reimbursement Amounts (“WODRA”) to the PSA in late 2003. WODRA provided a mechanism for master servicers to recover advances from principal collections first as the result of workouts in which the applicable borrowers were specifically obligated to pay such advances. In CMBS 2.0 PSAs (mostly PSAs issued 2010 or later), the industry adjusted the waterfall for liquidation proceeds to properly account for the intentions of the ASER. In the new PSAs, recoveries of ASERs are after principal repayments, allowing for higher rated bonds to recover their principal before subordinate classes recapture interest.
Whereas CMBS 1.0 PSAs generally directed that recoveries on any loan be allocated to unpaid interest prior to being allocated to unpaid principal, CMBS 2.0 PSAs generally (and particularly with respect to liquidation proceeds) direct that recoveries on any loan be allocated to unpaid interest less the portion of any interest that was not advanced due to an Appraisal Reduction Amount (Appraisal Reduced Interest) prior to being allocated to unpaid principal and then only allow for allocations to recover Appraisal Reduced Interest once unpaid principal has been recovered in full. The impact of this change is illustrated below in the comparison of the hypothetical liquidation waterfall with outstanding ASERs in CMBS 1.0 and CMBS 2.0 deals.
As illustrated above, in CMBS 2.0, the principal loss to the trust is less than in CMBS 1.0 due to the ASER recovery mechanics. In CMBS 1.0, the ASER recovery would have been passed through to the subordinate bond holders instead of the more senior bond holders. Allocating the first loss to the most subordinate bondholders is the true intention of the ASER concept.
This change to waterfall calculations will have a substantial impact on many different CMBS constituents. We have not yet seen any post-CMBS 2.0 losses that would follow this new waterfall convention; however as an industry it is time for us to be prepared for the first one. Master servicers, special servicers, trustees, and certificate administrators should be training their staff on what to look for in the PSA to make sure they are following the proper conventions. The CREFC IRP committee needs to revisit the current Realized Loss Templates to determine if adjustments are required to handle the reporting for this allocation. Rating agencies must make sure their models are aligned with the PSA waterfall definitions to properly account for the potential impacts. Lastly, investors need to be aware of which of their holdings could potentially be impacted by these changes. Proactively addressing this change will prevent us from marketplace surprises, something no one in the CMBS industry wants to see.
 See Trepp Outstanding Advances. Excel Spreadsheet (Trepp, LLC, New York, N.Y.), March 24, 2015.
 According to Trepp, LLC data the total amount of ARAs (in 000s) for (1) loans originated in 2006 is $2,232,505, (2) loans originated in 2008 is $2,484 and (3) loans originated in 2010 is $570. See Origination Year by Appraisal Reduction Stratification Matrix. Excel Spreadsheet (Trepp, LLC, New York, N.Y.), March 24, 2015.