Recently, a few well-capitalized borrowers in commercial mortgage-backed securities deals threw in the towel on some assets and handed back the keys. Does this make them a bad borrower? Not necessarily. A strong sponsor is one that is financially capable of doing that which is economically advisable and structured in a way that does not preclude or diminish the likelihood of capital contributions in the event of economic stress. Although financial capability does not suggest that borrowers will cover debt service payment shortfalls unless there is significant equity to protect, it does suggest that strong sponsors are less likely to default because of a short-term cash flow shortfall and are less likely to exacerbate losses in the event their equity has eroded.
Well-capitalized or not, borrowers will do what is economically advisable for them or their shareholders, including giving back the keys. In a non-recourse lending environment, it is incumbent on the lenders to size loans appropriately, applying structures that amortize principal balances sufficiently to facilitate refinancing in a less favourable economic environment. It is insufficient analysis to rely solely upon a strong borrower to cover the shortfalls resulting from overly aggressive lending practices.
We recognize that a fiduciary responsibility to minimize losses supersedes the financial obligations of a non-recourse loan. In defining a strong sponsor, we would be remiss to assume that a strong sponsor, or any borrower for that matter, will continue to throw good money after bad to feed or recapitalize an over-leveraged asset.
There are some benefits to the trust of a borrower recognizing impairment early and giving back the keys. First, it saves the trust some money by eliminating the expenses of a drawn out foreclosure process. Once the deed to the property is obtained by the trust, the special servicer may sell the asset, which leads to the second benefit allowing the special servicer to get involved much earlier in the process and potentially mitigates losses.
Refinancing risk is a concern given the historically low interest rate environment may be less favorable at maturity. Amortization would help to recreate equity that may have been refinanced away, keep the borrower's skin in the game, and lessen the chance of a put. However, with the proliferation of interest-only loans, any equity to be gained through amortization is also lost. Thus, the borrower has no equity to protect at refinance, and if the asset is not readily able to support the debt on the property at maturity, DBRS expects a lot more keys to be handed back.
Erin Stafford is a senior v.p.-CMBS at Dominion Bond Ratings Service in Chicago.
