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CRE Finance World Summer 2015

30

O

ASERs 2.0: Who Gets the Short End of the Stick?

Leslie Hayton

Managing Director

Wells Fargo Bank, N.A

Stacy Ackernman

Partner

K & L Gates LLP

ne 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.

1

Declining collateral values during the downturn created a

surge in the use of the Appraisal Reduction Amount (“ARA”)

2

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 liquida-

tion proceeds) are allocated in those deals to unpaid principal

instead of being allocated as a recovery of prior interest shortfalls

to subordinate certificateholders. 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