The aftermath of Hurricane Katrina has exposed both the strengths and weaknesses of the commercial mortgage-backed securities (CMBS) market, say industry experts. Since 9-11, the industry has become quite adept at minimizing the risk to bond buyers by shying away from single-asset deals such as the $1 billion loan on the twin towers of the World Trade Center. Today's securitization offerings increasingly mix large loans with hundreds of small loans to protect investors. But Hurricane Katrina also has brought to light the need for property owners to have adequate business interruption and flood insurance and for communication to improve between borrowers, conduit lenders and intermediaries.
“Katrina wasn't a huge event for the CMBS market, but it did highlight some of the market's shortcomings,” says Brian Lancaster, head of structured products at Wachovia Securities, one of the nation's largest CMBS servicers.
The full scope of Katrina's damage may not be known for months to come. In November, Fitch Ratings warned that it expects CMBS loan delinquencies in hurricane-ravaged areas to increase, as more owners go 60 days without making payments. Even so, the Fitch loan delinquency index was hovering near 0.93% at the end of October — below the January 2005 delinquency rate of 1.27%.
Surveying the damage
In the chaotic days that followed Katrina, insurance adjustors and CMBS servicers entered New Orleans to survey property damage. Many had already reviewed satellite photographs, but they soon learned that the story on the ground was one of triumph mixed with tragedy.
“It was simply amazing how indiscriminate much of the damage was between properties. The wind and water didn't affect even neighboring properties the same,” says Paul Smyth, managing director of capital markets at Irving, Texas-based ARCap, one of the largest buyers of high-yield CMBS in the nation.
The firm manages more than $2 billion in high-yield CMBS (rated BB or lower) and services more than $30 billion in commercial mortgages. In 2001, ARCap entered the special servicing business as a way to monitor and resolve problem loans. That, in short, is the role that special servicers play in the CMBS market.
Smyth's team headed to New Orleans expecting a total loss at one retail property near Canal Street in downtown New Orleans. They found it was unscathed by rising waters or heavy winds, even though nearby properties — including the 527-room Ritz Carlton — were in shambles and will need major renovations.
Wachovia Securities, the master servicer on the property, doesn't expect the hotel to reopen until late next year after as much as $50 million in repairs and renovations have been completed, which will be covered by insurance, according to Moody's Investors Service. The Ritz Carlton had 18 months of full business-interruption insurance and an additional 12 months of partial coverage. The loan matures in April 2006 and the borrower has three, one-year extension options.
Smyth was relieved to find that many other ARCap properties had fared better than he thought. The outstanding loan balance on ARCap's CMBS portfolio in New Orleans was roughly $205 million as of mid-November, according to Smyth. Only two days after Hurricane Katrina roared through New Orleans, ARCap identified some $460 million in outstanding loans that were likely to be affected.
Within a few weeks, however, Smyth says that number fell to roughly $230 million. One reason: the Federal Emergency Management Agency (FEMA) disaster zone covered such a broad area that closer inspection showed many properties to be relatively unscathed.
“The FEMA definition really overstated the true exposure, but we had to get in there to figure that out,” says Smyth. He also learned that many borrowers in CMBS pools are paying their debt service through business-interruption insurance.
As a result, says Smyth, only seven of 80 pooled loans handled by ARCap were in special servicing as of mid-November. That means that special servicers were advancing funds to lenders on behalf of borrowers. Smyth expects that number to double over the next few weeks as many borrowers have trouble securing business interruption insurance.
On Sept. 2, Wachovia identified 839 properties with $4.2 billion in outstanding loans located within FEMA's designated disaster zone. The CMBS pools were supported by multiple properties scattered across many markets — so the loss of a few buildings in New Orleans could not wipe out an entire pool.
“The 9/11 attacks really slowed down the number of single-asset deals in the CMBS market,” says Wachovia's Lancaster, adding that diversification is one of the CMBS market's biggest selling points to investors and borrowers. A single-asset securitization is generally a large loan on a single property as opposed to a pool of loans across many different properties.
Still, there are rumblings from investors. By October, says Lancaster, holders of debt in the lower-rated tranches were growing antsy. Their concerns were warranted since investors in the lower-rated tranches are the last to get paid, if a CMBS pool goes sour.
“Some of the B-note holders urgently wanted to know if their loans were affected, but many servicers couldn't physically check on the situation in New Orleans for weeks,” adds Lancaster.
The situation has improved since mid-September as an increasing number of servicers and insurers have entered New Orleans several times and reported back to their bondholders, he says.
Among the many unresolved issues raised by Katrina are the limits of both federal and private flood insurance. Many properties located in high-risk zones that purchased flood insurance may be severely underinsured for damages. It's also too soon to tell how many properties will be adequately covered, but that number will likely be high.
There is a $500,000 cap on federal flood insurance, and similar limits exist on private flood insurance. “We certainly find that flood insurance on many New Orleans' properties is far too inadequate,” says Tad Philipp, managing director at Moody's Investors Service.
After serial hurricanes Charley, Frances, Ivan and Jeanne shined a light on windstorm coverage, Katrina put flood insurance squarely on the CMBS radar screen. According to Philipp, borrowers with many properties can obtain higher flood insurance limits through blanket policies that diversify an insurer's risk. But smaller borrowers with one or two large properties often cannot afford steep flood insurance premiums.
This situation is uncannily similar to the terrorism insurance market immediately after 9/11. With insurers raising premiums to astronomical levels, many borrowers could not take on the coverage.
“We are advising lenders and servicers to pay closer attention to flood insurance coverage. It's really a case-by-case survey of each property that they need to think about doing,” he says.
To Moody's Philipp, buying more flood insurance just makes sense after Katrina. But modeling the risk of flood exposure isn't totally reliable, and flood zone maps are often outdated.
That makes it even more important for lenders to require some form of flood insurance, say Philipp, especially when so many CMBS properties are at risk well beyond the Gulf region. According to Moody's Philipp, two of the largest CMBS servicers reported in late September that roughly 7% of their entire serviced portfolio is located in a government-designated flood zone.
Covering disruption time
Most borrowers don't buy flood insurance; those who do have usually been required to by their lenders. One legacy of Katrina may be that more borrowers in vulnerable areas of the country buy the insurance, say sources. Business interruption insurance, however, is boilerplate language in most loan documents. According to lender Clay Sublett, senior vice president of CMBS at Cleveland-based KeyBank, more borrowers are now asking him about this coverage.
“We require all of our borrowers to have some business interruption insurance, but it's always a negotiation to determine how much is necessary,” says Sublett, who will finance $2.5 billion in real estate this year, half in the CMBS market.
He says that Katrina has suggested disturbing new scenarios to lenders. It showed, for example, that a neighborhood or regional disaster — even one that leaves a borrower's property intact — can shut down business in the area for years, rather than just a few months.
“Then the issue becomes how long your business insurance will last, and believe me that's under the microscope in New Orleans,” says Sublett.
Understanding contract language
Assessing a property's flood exposure may be simple versus interpreting much of the insurance language that peppers loan documents. Some progress was made on this front after the 9/11 attacks, when insurance language played a pivotal role in a multi-billion dollar payout.
While the 9/11 property insurance claims were highly unique, the protracted litigation that followed served as a reminder to all borrowers that dense insurance language is best understood before the disaster.
“The insurance provisions in most loan documents are rarely clear, and many borrowers rarely assume a scenario whereby these provisions will be of paramount issue,” says attorney Gary Thompson, a managing director at Washington, D.C.-based Gilbert, Heinz & Randolph. Thompson leads the firm's commercial real estate practice, and much of his work involves the CMBS market.
He believes insurers should revise their insurance clauses and adopt a standard provision that would help eliminate much of the confusion. Thompson says that run-on clauses and jargon-choked paragraphs with fuzzy hedging terms make the insurance requirements vague at best, or downright indecipherable.
But Thompson also advises both servicers, lenders and borrowers to be more vigilant in working with their insurers before the disaster strikes rather than afterward.
Trade organizations such as the Mortgage Bankers Association (MBA) and the Commercial Mortgage Securities Association (CMSA) are working to ensure that servicers and insurers focus on standardizing claim forms.
Borrowers that either fail or refuse to follow the insurance demands made in their loan documents can't blame ignorance, either. According to Mark McCool, senior vice president and managing director at GMAC Commercial Mortgage, these are not flexible terms.
“If the loan documents require a specific type of insurance, the investors expect that borrower to have it,” he says, adding that GMAC is determined to “uphold the document.”
Hurricane Katrina has forced many borrowers to closely study their loan documents — and that's a healthy trend in McCool's opinion.
GMAC has an in-house insurance group that works with borrowers to interpret their loan documents. GMAC is the largest servicer of CMBS in the nation.
“From the servicer's perspective, the borrowers are better educated now than they were six years ago,” says McCool. “And the communication between servicers and borrowers has improved, which feeds into the transparency of the CMBS market.”
Parke Chapman is senior editor.
When Loans Sour, CMBS Specialists Act Swiftly
Disaster response is a many-layered enterprise for the CMBS market. A cast of players that includes trustees, lenders, rating agencies and servicers are required to sort out any problems with the underlying loans.
“It's important to remember that the CMBS market brings many different people together at various different points in the life of the loan,” says Brian Lancaster, head of structured products at Wachovia Securities. “And the income stream is getting sliced and diced by many of them along the way.”
Here's how it generally works: The master servicer contacts the borrower after a catastrophic event has affected the property. If the property has sustained serious damage, the master servicer will then report this news back to bondholders.
Even under normal circumstances, the master servicer is responsible for collecting payments each month and monitoring the property. The payments and monthly reports are given to the trustee, who then divides up that money among the various bondholders.
If the borrower cannot pay debt service for 60 days after the event, the loan is officially declared delinquent by rating agencies such as Fitch Ratings and Moody's Investors Service. Special servicers enjoy an elevated role when loans go bad.
With so many moving pieces, it's easy to see why many borrowers feel neglected. According to Clay Sublett, senior vice president of CMBS at Key Bank, many borrowers get frustrated by “the many nameless and faceless entities” they report to in the CMBS market. “There are so many people involved in the CMBS business that the borrower does become sort of anonymous,” he says.
The big advantages, however, are lower interest rates and non-recourse loans. Sublett says that the average CMBS loan carries interest rates that are 10 to 20 basis points lower than a conventional bank loan.
What's more, nearly 100% of all CMBS loans are non-recourse (meaning lenders have no recourse to a borrower's personal assets in the event of a default).
“There's also a huge amount of capital in the CMBS market,” says Sublett. “And that gives borrowers the advantage of having a massive capital source.”
— Parke M. Chapman