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Best Practices for CMBS Risk
Management: An Information-
Based Perspective
“The difference between the
most dissimilar characters, between a
philosopher and a common street
porter, for example, seems to arise
not so much from nature, as from
habit, custom, and education.”
Clancy — Adam Smith, “The Wealth of Nations”
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If Adam Smith had attended the 2001 CMSA Seventh
Annual Convention, he might have been compelled to
substitute Wal-Mart and Caldor for philosopher and street
porter, but otherwise his sentiments would have had great
relevance to the commercial mortgage-backed securities
(CMBS) market. With delinquencies rising in 2001 and
many AAA rated bonds trading at high premiums, the
importance of deploying a rational and efficient risk
management process is greater than in years past. Applying
“best practices” to the portfolio management surveillance
process can be the difference between outperforming and
underperforming the market. In addition, as the CMBS
market continues to grow and the number of bonds under
management increase, the need for efficiency takes on
greater significance. This article outlines some key
elements of an information-based approach toward
managing CMBS portfolio risk.
WHAT CONSTITUTES “BEST PRACTICES?”
Over time, we have learned anecdotally that our clients’
processes range from the highly rigorous and meticulous to
the unstructured and haphazard. One common complaint
from those in the latter category is that they have “no place
to start” or “no particular process.” As a result, the process
that emerges is an ad hoc one of reviewing a mountain of
remittance reports and hopping from servicer website to
servicer website without any regard for prioritization. For
those in the highly rigorous category, we have learned that
these clients use a host of information tools and processes
to ensure that surveillance can be done in the most
efficient manner. In short, best practices can be defined as
the adoption of and adherence to processes that make
optimal use of data and technologies to maximize
knowledge and minimize effort and risk.
14 CMBS WORLD™
Manus Clancy
Not all of our experience with regard to best practices is
anecdotal. In 1999, Trepp, LLC began a CMBS pricing
service and soon was pricing hundreds of bonds daily
including many IOs (interest only). We learned that, just
like the portfolio manager with dozens of tranches under
management, we needed a way of quickly identifying
potentially significant bond specific changes to the
collateral so as to properly reflect these changes in the
value of the bonds. With that in mind, we set out to build
information-based tools and processes to ensure that we
could review changes to collateral performance with
minimal cost and maximum efficiency.
WHY IS THE PROCESS SO HAPHAZARD?
Given the nature of commercial real estate and CMBS,
building procedures that manage risk effectively might not
seem like rocket science. However, relative to residential
mortgage-backed securities (MBS), the performance of
CMBS is subject to a significantly higher level of “event”
risk and at times CMBS event behavior might appear to be
a “random walk.” Some recent examples underscore this
point:
• The California Power Crisis. The California power crisis
heightened concern that the increased cost of energy
might erode the debt service coverage ratios (DSCRs) of
properties in that state and subsequently impact CMBS
with high concentrations in California.
• Telecom and Dot.com Meltdowns. The credit concerns
surrounding the telecom and dot.com industries led to
concern over exposure in real estate and correspondingly
in CMBS to these industries.
• Bankruptcies. A number of companies that occupy space
in properties collateralizing CMBS have filed for
bankruptcy and, in some cases, have been liquidated.
• Store Closings. Frequently “anchor” tenants announce
the closing of unprofitable stores that back CMBS.
• Retail Exposure. Two years ago, there was concern
that the Internet would put traditional retail
Best Practices for CMBS Risk Management (cont.)
businesses under great pressure. Today the concern is
a fall-off in consumer spending.
• Movie Theaters. A series of theater chain
bankruptcies have led to concerns about CMBS with
movie theaters collateralizing loans.
Complicating risk management efforts is the fact that
the underlying sources of information are highly
fragmented. There are both multiple sources and multiple
mediums for uncovering this information. Rationalizing
the risk management process involves taking maximum
advantage of the data by “taming” the information flow.
BEGINNING TO SORT THROUGH THE CHAOS
One way to begin taming the information flow is to
adopt a strict discipline for processing this information,
even if the events themselves are random. There are a
number of reliable and consistent sources of information
that can be used to uncover potential trouble spots long
before the problems show up in a loan becoming
delinquent or a DSCR dropping off. It is important,
however, that these additional tools be used in a
structured, disciplined and regular manner in order to
make the greatest use of them. Among the resources used
by Trepp and/or our clients are the following:
• General Business News. Due to the vast number of
publications and websites, this source of information is
the most difficult to process. However, by selectively
identifying useful and reliable sources of news, risk
managers can greatly enhance the likelihood of
identifying events or trends that may impact CMBS in
the future. At Trepp, there are two very specific types of
news that we track on behalf of our clients: corporate
bankruptcies and retail store closings. We have
assembled a small set of news sources and websites that
steer us toward these news stories and use these
resources on a regular basis to gather information that
may impact CMBS. Using the data and information
available through these outlets, we map exposure to the
event that has taken place back to our collateral database
and ultimately to the bonds that may be effected.
• Government Agency Reports. Government agency
reports can be useful for identifying potential trends in
the commercial real estate market. For example, in
October, 2000, the FDIC published a report suggesting
that 13 markets were at risk of overbuilding. At Trepp,
we used this information to map the exposure of CMBS
conduit deals to these cities.
• Corporate Desks. By looking for research from
corporate bond desks, potential future risks can be
uncovered by mapping troubled corporate entities to
the tenants that occupy space in properties backing
CMBS loans.
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• Rating Agencies. Rating agencies can be useful in two
ways. First, the agencies regularly write surveillance
reports on issues and report on trends in the CMBS
market in general. Second, the surveillance of the rating
agencies can be leveraged in the same way that
corporate desk research can be used.
• Real Estate and CMBS Specific Research. Most of the
large investment banks regularly issue real estate and
CMBS-specific research reports.
“
Applying ‘best practices’ to the portfolio
management surveillance process can be
the difference between outperforming and
underperforming the market.
”
• Real Estate-Related Service Firms. A number of firms
specialize in real estate research and data. We find it
particularly useful to review trends in property types
performance. For example, in recent months the
healthcare and limited service hotel sectors have seen
increases in their delinquency levels. For savvy portfolio
managers who were able to identify this trend early, the
opportunity to trade out of bonds with heavy exposure
to these sectors was available. It may also be useful to
compare overall pool level delinquency rates, property
concentrations and geographic concentrations against
the market as a whole or against a major index. Because
a collateral pool has not undergone a new negative credit
event does not mean it is not underperforming the
market. In an improving real estate market, a collateral
pool that does not show improving loan performance
may not be performing as well as other similar collateral
pools.
Our experience has shown that those portfolio
managers with the most advanced processes are those that
have found useful data sources and have instituted strict
procedures for identifying potential risks to CMBS bonds.
Once these processes or metrics have been identified,
steering clear of potential minefields becomes a function
of how meticulously the procedures are applied.
Understanding the data and trends can provide reasonable
advanced notice of events that may take place. Even for
the most disciplined of portfolio managers, however, this
method of managing risk is, at best, a cumbersome
process. Moreover, for the undisciplined, the combination
of unanticipated events along with highly scattered data
can result in risk management “procedures” which are no
more than specific responses to each event as they unfold.
UNDERSTANDING THE FLOW OF DEAL INFORMATION
To establish another alternative source of information
that may used as a key element of a CMBS risk
FALL 2001 15
SM Best Practices for CMBS Risk Management (cont.)
management system, let us trace the flow of information
from deal inception.
When a new CMBS is issued, the offering document
contains a host of information about the properties
backing each loan in the deal. This data provides a
useful baseline for measuring and understanding future
loan performance. The data – generally known as the
“Annex A” – is typically contained on a diskette
accompanying the prospectus. Among the data that can
be found on the Annex A:
• Property type (suburban office, limited service
hotel, skilled nursing facility, etc.),
• Debt service coverage ratio (DSCR),
• Loan to value ratio (LTV),
• Occupancy,
• Largest tenants (and the percent of space they
occupy),
• Lock-out and prepayment penalty data, and
• Geographic data.
Beginning on the first payment date after a deal
closes, the trustee and/or servicer make a number of files
available that contain updated information on each loan.
The information contains specific data indicating a
loan’s most recent DSCR, whether the loan has been
paying timely, whether or not the loan is with the special
servicer, and so on. This data is updated monthly on the
bond payment date.
Critical to any risk management procedure is
obtaining, processing and reviewing this data at the
earliest possible point. (Updated data is typically
contained in a standard electronic format known as the
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CMSA Loan Periodic Update File or CMSA 100 file).
One way of doing this is to aggregate the information
directly. Unfortunately, this involves utilizing multiple
sources. Multiple trustees, servicers, and special
servicers serve the CMBS market. Navigating their
disparate and disconnected websites requires expending
a great deal of time and resources on data collection and
leaving less time for actual portfolio management. This
navigation expense makes building an efficient risk
management process extremely difficult.
In addition to the data collection expense, because
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each CMSA 100 file contains so much data
(approximately 100 fields of data on potentially
hundreds of loans), processing the data itself can be a
daunting task. A portfolio of 30 bonds might require
16 CMBS WORLD™
processing 30 separate 100 by 300 files (or 900,000 pieces
of data) each month.
To summarize, there are three significant roadblocks
that complicate the rationalization of an information-based
risk management process: (1) random event risk, (2)
fragmented data and information sources/mediums, and
(3) large amounts of data to process.
Given this, it is logical to ask, is there a way to manage
CMBS rationally? At Trepp, we asked ourselves: if all this
data could be viewed comprehensively in terms of current
changes in collateral performance all in one place, wouldn’t
that be better?
A NEW PARADIGM
In response to this question, we began assembling our
own information-based process by building a tool that
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would allow us to reduce the CMSA 100 Loan Periodic
files provided each day to a single list of loans that
indicated potentially meaningful collateral changes from
the prior month. Specifically, some of the events we looked
for included new appraisal reductions, new bankruptcies,
new defeasances, loans where the status of loan was
deteriorating or improving, loans with a newly reported
NOI (net operating income), DSCR or NCF (net
cashflow), DSCR less than 1, or loans newly in special
servicing.
Clearly some of the fields that are reviewed will only
indicate loan deterioration after the fact. If a loan has
undergone an appraisal reduction, it is likely the loan has
been with the special servicer for some time and has
already been delinquent. However, many of the other
fields that we review can indicate potential problems long
before they manifest themselves through transfer to the
special servicer or foreclosure. For example, by identifying
a loan as soon as its DSCR drops below one instead of once
it appears on the special servicer Watchlist, a potential
problem can be foreseen and avoided. A similar argument
can be made for focusing on loans that have gone from
being current to 30 days delinquent. It is important to
realize that loans do not go into default overnight. Loans
that ultimately go into foreclosure are generally stories that
have unfolded over the course of many months. By looking
for clues early, the candidates for future loan defaults can
be identified and risk management rationalized.
Once we have identified loans that have undergone
changes, we take a snapshot of data which combines some
of the static or relatively static data from the Annex A (top
three tenants, securitization DSCR and appraised value,
property type, etc.) with updated data provided by the
trustee or servicer (updated DSCR, paid through date, loan
status code, and so on). By reducing the data to a
manageable subset, the haphazard nature of the risk
management process can be minimized.
Best Practices for CMBS Risk Management (cont.)
Because we are most concerned about the impact on
IOs, we generally begin our internal surveillance by
extracting the bond specific data for those deals for
which we are pricing the IO. Within that category, we
proceed from deal to deal beginning with the largest
changes to the collateral in terms of percentage by
collateral balance.
PROCESSING THE INFORMATION
The framework we use for processing the data
revealed by our new tool can be seen in Exhibit A. We
have learned over time that this tool represents only the
start of the surveillance process. It has become one part
of our internal best practices repertoire, but certainly not
the final word. It has served as a starting point for
managing our “pricing portfolio.” There are a number of
other procedures we take to complete the process.
Exhibit A: Processing the Information
Scan the Data for Significance
Scan the Data for Reasonableness
Review the Characteristics of the Loan
Use Other Data Available
Gauge the Impact
We begin by scanning the data for the significance of
the event and the size of the loan—a large loan that goes
from 60 to 90 days delinquent is of much greater concern
than one that has been defeased. A large loan with a
bankrupt tenant is of greater significance than one with
an investment-grade tenant. Priorities should be
established by processing the most onerous events first
in descending order by the percentage that the loan
represents of the deal it collateralizes.
Next, we scan the data for reasonableness. For
example, periodically we find inconsistencies between a
loan’s reported status and a loan’s paid-through date.
Checking the reasonableness of the data is an important
part of the surveillance process. If data anomalies are
found it is important to confirm and/or correct the data
by conferring with other sources.
Once the priorities have been established and the data
has been scanned for errors, we begin to review the
characteristics of the property collateralizing the loan.
Our examination of the loan characteristics encompasses
over 50 separate fields of data. Among the fields we
review are the loan status and workout code in the
current month and previous month, the top three tenants
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and the percentage of space they occupy, and the
continuum of DSCRs from securitization to second prior
fiscal year to prior fiscal year to the most recent period.
We realize that the data itself is only part of the story.
As a result, we review a number of other sources of data
including the trustee remittance report. Specifically
we look for special servicer notes, modified loan notes
and appraisal reductions. In addition, if warranted,
we look to the servicer Watchlist, Delinquent Loan
Status Report, REO Status Report, and Comparative
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Financial Status Report—all part of the CMSA
Investor Reporting Package. Lastly, as our case study
demonstrates below, it can be useful to review a
loan’s operating statement for additional clues to
understanding a loan’s performance.
Once the potential “at risk” loans have been
identified, the next goal is gauging the impact of the
event on the performance of the bond under various
stress cases. This involves isolating the loan(s) identified
through the processes described earlier and making loan
specific assumptions or “overrides” on those loans.
For traders, the desire is to run a bond to the worst
possible outcome. Running a bond “to worst” does not
necessarily imply running a default scenario. The
subordination level of a bond as well as the price of the
bond needs to be taken into consideration before one
determines the most stressful scenario.
For example, assume a deal has a $25 million dollar
office tower whose main tenant has gone bankrupt. If
offered the first pay AAA class at a price above par, a
logical step might be to assume that that loan defaults in
six months with a loss of 40% in order to measure
downside risk. A similar scenario might be to run the
BBB minus tranche with an eye on how much
subordination would be left after the default. If the first
pay AAA class was a discount bond however, the logical
scenario might be one in which the loan extended for two
years.
From an overall portfolio risk management
perspective, beyond establishing the impact of a single
loan default or extension, it is important to establish a
consistent set of scenarios to allow for bonds of similar
ratings and average lives to be compared to one another.
In residential collateralized mortgage obligations
(CMOs) and MBS, running OAS (option adjusted
spreads) on a set of bonds is a common practice. An OAS
is the expected spread of a bond calculated by running a
Monte Carlo simulation of hundreds of prepayment and
interest rate scenarios. In the CMBS world, there is no
universally accepted equivalent of the residential OAS.
However, by establishing a well thought out set of
scenarios, risk managers can reach similar conclusions
FALL 2001 17
SM Best Practices for CMBS Risk Management (cont.)
regarding the value of some bonds versus others. To start,
we suggest running each bond:
• At a number of constant prepayment (CPY) speeds.
• At a number of CPY speeds assuming interest
rates increase and decrease 100 basis points.
• Assuming each loan that is 60 or more days delinquent or
with the special servicer defaults.
• At a number of constant default rate (CDR) speeds.
• Assuming all balloon loans extend 12 months.
• Assuming the top three loans default.
At various times we have done research pieces that
compare various similar bond types to one another using a
number of scenarios to show relative performance of similar
bonds. Of recent interest were analyses comparing IOs to
one another as well as to AAA rated premium bonds.
It should be noted that the scenarios listed above
represent a baseline set of scenarios. Other scenarios which
isolate the effect of defaulting loans with specific property
types, loans with low DSCRs, loans with appraisal
reductions, loans in certain regions, or loans with certain
tenant exposure should also be implemented to
supplement the analysis. It is also important to compare the
performance of one’s portfolio to the performance of bonds
from one of the industry indices under the same set of
scenarios.
CASE STUDY
Recently, an example of Trepp’s best practices was
applied in the following manner. Based upon our daily
review of data changes, we learned that a large office loan
began reporting a most recent DSCR of .58 for the period
from January 1, 2001 to March 31, 2001. The prior fiscal year
DSCR had been 2.00. The loan’s balance was over $40
million and represented over 4% of the issue. The loan was
current and not with the special servicer according to the
latest data from the trustee.
The tenant information gathered from our surveillance
indicated that the listed lead tenant occupied 54.3% of the
space. Based upon other information sources, this lead
tenant was known to have had recently filed for bankruptcy
offering a potential explanation for the apparent drop in
DSCR.
Following a best practices paradigm that we would
advocate, we took the following additional steps:
1. We pulled up the trustee remittance report. It did not
give any additional color on the loan.
18 CMBS WORLD™
2. Next, we pulled up the servicer website. According
to the operating statement on the servicer website,
rental income had fallen from $17.3 million (2000
annual) to $1.44 million in the first quarter of the year
($5.8 annualized). This seemed plausible given the
status of the lead tenant.
3. From there, we called the servicer and lead
underwriter seeking their input on the matter.
4. Next, we went to the prospectus for the deal in
question to see if the loan was cross-collateralized or
cross-defaulted with any other loan or if the loan was
footnoted in any way. We learned that the loan was
not crossed with any other loan.
5. Lastly, we searched the web for information about
the building (we used the Google search engine). It
was here that we learned that the story surrounding
this loan was likely not as dire as the servicer data
might have indicated. A search of the web turned up
information from a real estate broker’s site that
indicated that the space had been re-leased.
6. Later, the servicer confirmed that a highly-rated
financial institution had taken the space in the
building.
Had the story turned out differently, and had we
owned the bond in question, we would have taken a
number of additional measures. We would have:
1. Tried to determine the potential for re-leasing the
space and the price per square foot a new lease might
be offered at using alternative sources. If this data
were available, we would have used it to gauge the
impact on the DSCR of the new lease.
2. Based upon the findings of our research, we would
have determined whether the loan was a likely
candidate for a default or modification.
3. Once making a prediction on the likely fate of the
loan, we would have run the bond through a number
of stress cases to determine a best, worst and
expected case for the bond.
CONCLUSIONS
In 1999, Alan Greenspan made the following remarks
with regard to the contributions to the economy of new
technologies:
“The use of information in business decision-making
can be best described as an effort to reduce the fog
surrounding the future outcomes of current decisions.”
He went on to add:
(continued on p. 80)
SM Best Practices for CMBS Risk Management (continued from p. 18)
“In short, information technology raises output per
hour…by reducing hours worked on activities needed to
guard productive processes against the unknown and the
unanticipated. Narrowing the uncertainties reduces the
number of hours required to maintain any given level of
readiness.”
These sentiments can easily be applied to the CMBS
industry. As portfolios grow and the delinquencies rise,
there will emerge an increasing need to process more
and more data quickly. Analyzing the abundance of
SFAS 140 Implementation Guidance Impacts CMBS Industry (continued from p. 23)
record that loan asset (along with its related liability) on its
books, even if the option is not exercised. Should that option
later expire or terminate, the asset then would be removed
from the option holder’s financial statement, assuming the
holder is not considered to have maintained effective control
over the asset by some other means.
CONCLUSION
During the last week in July, 2001, over $3 billion in
CMBS transactions from several major issuers came to
market, all using an option approach for the removal of
defaulted loans from the collateral pool. Pricing apparently
was not impacted by the change in how the special servicer
administers defaulted loans. Thus, by the time this article is
published, the industry’s focus should be back to where it
belongs, on the economics of these transactions, with
accountants providing guidance to help their clients achieve
their financial goals. ❑
Robyn C. Stern is Regional Director, Structured Finance with
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Ernst & Young in New York City and Chair of the CMSA
Regulatory Subcommittee. Portions of this article are reproduced
from the author’s article recently published in Journal of Taxation
of Financial Institutions. The author wishes to thank Paul
Hurdle of McKee Nelson LLP for his comments on “true sale” and
“substantive consolidation.”
1 Internal Revenue Code (IRC) Sec. 860D(b). In REMIC
Effective for transfers and servicing of financial assets and
extinguishments of liabilities occurring after March 31, 2001. The
Statement is also effective for recognition and reclassification of
collateral and for disclosures relating to securitization transactions
and collateral for fiscal years ending after December 15, 2000.
2 13
Statement of Financial Accounting Standards No. 125, “Accounting
for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities.”
3 IRC Sec. 860G(a)(3)(A).
Special Report, February 22, 2001, “A Guide to Implementation of
Statement 140 on Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities (“Special
Report”).
80 CMBS WORLD™
available data will require the adherence to a disciplined
set of procedures and technologies. How quickly
new procedures and technologies are embraced and
efficiencies implemented can be the difference between
a Wal-Mart and a Caldor. ❑
Manus Clancy is a Managing Director at Trepp, LLC.
4
See presentation, “Meeting Between Members and Staff of the FASB
and Representatives of The Bond Market Association, Commercial
Mortgage Securities Association, Mortgage Bankers Association of
America and The Real Estate Roundtable” posted on the CMSA SM
website, www.cmbs.org
5
The May Q&A, the CMSA response to the May Q&A and the July
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19th revised Q&A are posted on the CMSA website, www.cmbs.org.
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6
SFAS 125, ¶ 26.
7
Id.
8
EITF Topic No. D-66, “Effects of a Special Purpose Entity’s Powers
to Sell, Exchange, Repledge, or Distribute Transferred Financial
Assets under FASB Statement No. 125.”
9
Outside of SFAS 125, the consolidation guidance for non-qualified
SPEs was (and still is) indirect, which had led to accounting
uncertainty. See EITF Topic No. D-14, “Transactions Involving
Special Purpose Entities” (“Topic D-14”), and Issue No. 90-15,
“Impact of Nonsubstantive Lessors, Residual Value Guarantees, and
Other Provisions in Leasing Transactions” (“Issue 90-15”).
10
The securities issued by the QSPE, if not retained by the transferor,
are sold to different types of investors, depending on the grade. AAA
securities typically are sold to money managers, insurance companies,
banks, agencies, and commercial paper conduits. Lower investment
grade securities are sold to insurance companies and collateralized
debt obligation (CDO) buyers. Securities below investment-grade are
sold to a mix of high-yield investors, and some to insurance
companies.
11
transactions the trust is created through a pooling and servicing
agreement. Where REMIC status is not elected, a trust and servicing
agreement is used.
12
IRC Sec. 860A(a).
IRC Sec. 860B(a).
14
IRC Sec. 860G(a)(1)&(2).
15
16
Typically, securitization transactions restrict the trust’s ability to sell
or pledge its assets. With regard to REMICs, outside of a cleanup
call or a qualified liquidation, IRC Sec. 860F(a) generally imposes
(continued on p. 81)