Servicers may face conflict of interest if their parent firms are also loan buyers, writes Lauren Parr
As the fallout from the financial crisis goes on, the number of unpaid matured loans in the CMBS sector is spiralling. Many will be restructured, but there are signs lately of a trend for investors agreeing loan sales, rather than face protracted work-outs or having to enforce and sell assets.
One example is special servicer Hatfield Philips’ sale of €129m of debt secured against the Velvet portfolio of distressed German residential assets.
This trend is turning the spotlight on special servicers – the companies that work out problem securitised loans. As their remit has broadened into all aspects of real estate loans, including conducting loan sales, their corporate structures have come under scrutiny.
At the same time, new operations are being set up and several loan servicers are changing ownership; Hatfield Philips’ US parent LNR is up for sale, while Situs Group acquired Deutsche Bank’s European loan servicing business last month (see panel).
Questions have been raised over the implications of a special servicer being owned by or affiliated with a group that is involved in, or trying to become involved in, secondary loan purchases.
As one former special servicer points out, “special servicers selling loans is not a de facto conflict in itself”. But he adds: “It does provide opportunities for conflict.”
Affiliates may gain bidding advantage
One point of contention is the prospect that inside information on assets could be shared between a selling party and a con-nected bidder. This would give that bidder an advantage over what loan sale adviser The Debt Exchange called ‘arms-length’ buyers, in a recent study about maximising proceeds for non-performing loans.
For CMBS loan sales where bondholders are not capable of bidding to protect their economic interests, because they are many, often divided and not set up to act in such a manner anyway, the special servicer will have “virtually unfettered access to the best information possible on each and every asset”, DebtX says. Affiliated companies could tap into this knowledge to potentially underwrite every loan.
“Even if a servicer runs it fairly, a related party might have better access to information than anyone else,” adds one rating agent.
Special servicers insist that, as elsewhere in the financial world, Chinese walls stop this from happening and restrict the flow of information. Traders are physically separated from their company’s in-house servicing division, for example.
However, there is always a common reporting line somewhere along the way. “How high are the walls?” asks the rating agent. “Ultimately, someone sitting at the top knows both sides of the story.”
Not only could information be shared, but bargains could be cherry picked by a related entity bidding slightly higher than the observable cover bid. DebtX says any asset achieving a favourable price for owner(s) would be sold in the open market, effec-tively restricting arms-length buyers to higher-priced assets.
For special servicers, “there is less reward to maximise selling proceeds for bondhold-ers if [their parent company] is a buyer”, says the former special servicer. “They may not necessarily do the greatest sales job because there is an arbitrage for them to be able to buy an asset the market has underpriced.”
He sees a myriad of potential conflicts of interest and ways to make money in servicing that don’t necessarily optimise recoveries for the first loss piece. Cynics say special servic-ers delay making decisions due to their personal liabilities; others say it is in special servicers’ financial interest to extend a loan and keep it in special servicing, as they get paid handsomely for this.
“The problem is how special servicers are structured and compensated,” says the ex-servicer. Conflict tends to surround lack of transparency and financial motivation for a sale – a special servicer has an income stream for working out loans and one from selling the loans: “This may or may not lead to a different conclusion,” he says.
Another criticism is that servicers are not doing a good job of policing values when it comes to discounted payoffs – sales of assets backing underwater loans back to borrowers, or their affiliates, at discounts to the outstanding debt.
Bondholders pile on the pressure
However, one legal expert says special servicers have been “bad mouthed” partly because bondholders are seeking ways to put pressure on servicers. This has led to some special servicers being replaced, driven by controlling noteholders acting in their own interests.
While understandable, this is a further point of dispute, given that special servicers have been known to tempt bondholders by offering to share fees if they get appointed.
The legal expert adds that special servicers must act independently so as not to put themselves at risk of liability – some-thing they are known to be particularly cautious about. A servicer would have to prove that a loan sale was a fair trade, he reckons, by going out for bids and showing its affiliate had put in the best bid, if that were the case.
“This is too obvious a conflict not to have compliance procedures in place,” agrees a private equity investor. Additional conflict could arise if, for example, a third-party servicer were backed by a private equity group that was the loan’s borrower, or the junior B note holder.
A recent trend has been for private equity firms to buy servicing platforms to better manage portfolios they buy, following the model set up by Lone Star years ago.
A separate issue is high-return-driven firms with no experience in the non- performing loan market taking an interest in the labour-intensive, low-margin business of loan servicing.
“My suspicion is they want to call the portfolio for recapitalisation opportunities, or buy properties from distressed borrow-ers,” says the rating agent. “Basically, they’re looking to make money on the other side.”
Whose interests the servicer would truly represent if third-party investors were involved alongside their parent group or affiliate is debatable, says a person involved in restructurings. But this is what the servicing standard is for – to protect all noteholders – albeit not a definitive guide.
“A servicer would try to manage those things very delicately because of perception in the market, but it should be disclosed so noteholders can have their say,” the rating agent says.
Crucially, without disclosure, speculation concerning ‘fair play’ or the lack of it, often based on anecdotal evidence, dominates market opinion. One financial adviser says: “Inevitably, servicers face inherent conflicts; ultimately it’s about how they’re managed.”