The forward recoverability test worked month by month on a defaulted loan, with and without an appraisal reduction, and what it means for the bonds.
A CMBS servicer declares an advance nonrecoverable when the advances already made, the interest owed on them, the fees and the advances it still expects to make before the property is sold would exceed what the sale is expected to bring in. On an illustrative $60.0M defaulted mall loan reappraised at $12.0M, with $10.93M of expected net proceeds, that point arrives in month 16 if the servicer advances full interest, and in month 54 once an appraisal reduction cuts the interest advance to $0.045M a month.
Worked in full in CMBS and CRE CLOs by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The determination matters to every bondholder because advances are repaid ahead of the certificates. While the servicer advances, the bonds are paid as if the loan were current. Once it stops, the shortfall moves up the stack, and the advances already made are reimbursed out of collections the bonds were expecting.
| Input | Value |
|---|---|
| Loan balance | 60.0 |
| Coupon | 5.0% |
| New appraisal | 12.0 |
| Costs of sale | 8% |
| Liquidation fee, share of net proceeds | 1% |
| Special servicing fee, per year on balance | 0.25% |
| Protective advances a month (taxes, insurance, repairs) | 0.10 |
| Interest on advances, per year | 7.5% |
| Months still expected to liquidation, at each test | 12 |
All figures are illustrative. The exact test, the rate on advances and who decides are set in each deal's pooling and servicing agreement; the structure below is the common one.
Step 1: what the property will repay. The appraisal of 12.0 less 8 per cent costs of sale is 11.04. The liquidation fee takes 1 per cent, 0.11, leaving 10.93 to repay advances, interest on advances and fees before anything reaches the bonds.
Step 2: what the servicer advances each month. Full interest on 60.0 at 5.0 per cent is 0.25 a month. Add 0.10 of protective advances and the servicer is putting in 0.350 a month, 4.2 a year. The special servicing fee accrues at 0.012 a month.
Step 3: the forward test. At each month the servicer asks whether everything it will have to recover by the expected sale date fits inside the expected proceeds.
Nonrecoverable when: advances outstanding + interest on advances + accrued fees + projected advances, interest and fees to the sale date > expected net proceeds
In Excel, per month: =IF(Adv+AdvInt+Fees+Proj>NetProceeds,"Stop","Advance")
| Month | Advances made | Interest on advances | Fees accrued | Projected claims | Net proceeds |
|---|---|---|---|---|---|
| 0 | 0.00 | 0.00 | 0.00 | 4.52 | 10.93 |
| 6 | 2.10 | 0.03 | 0.07 | 6.89 | 10.93 |
| 12 | 4.20 | 0.14 | 0.15 | 9.33 | 10.93 |
| 16 | 5.60 | 0.26 | 0.20 | 11.00 | 10.93 |
In month 16 projected claims of 11.00 exceed the 10.93 the property can repay, and the servicer stops advancing.
An appraisal reduction lowers the interest the servicer must advance in proportion to the reduced balance. Here it is the balance plus advances outstanding, less 90 per cent of the appraisal: on day one 60.0 − 10.8 = 49.2, so interest is advanced on 10.8 of the 60.0, 18 per cent, and the interest advance falls from 0.25 to 0.045 a month. The mechanics are in how an appraisal reduction amount is calculated.
| Month | Advances made | Monthly advance | Projected claims |
|---|---|---|---|
| 0 | 0.00 | 0.145 | 1.96 |
| 12 | 1.70 | 0.138 | 3.91 |
| 24 | 3.32 | 0.131 | 5.90 |
| 48 | 6.32 | 0.119 | 9.99 |
| 54 | 7.02 | 0.116 | 11.03 |
With the reduction the servicer can keep advancing protective costs and a reduced coupon for 54 months, more than three times as long. The bonds at the bottom of the stack stop receiving full interest from the first month, but the deal is not forced into a nonrecoverability determination early in the workout.
| Appraisal | Net proceeds | Without ARA | With ARA |
|---|---|---|---|
| 8.0 | 7.29 | 7 | 37 |
| 12.0 | 10.93 | 16 | 54 |
| 16.0 | 14.57 | 25 | 67 |
| 20.0 | 18.22 | 33 | 78 |
| 30.0 | 27.32 | 52 | 99 |
The deeper the value loss, the sooner the stop. On an 8.0 appraisal, 13.3 per cent of the loan, a servicer advancing full interest would reach its limit in seven months, before most workouts are even underway.
If the loan is sold in month 16, the month the full-interest servicer would stop, advances of 5.60, 0.26 of interest on them and 0.20 of fees come out of the 10.93 first, leaving 4.87 for principal: a loss of 55.13, a severity of 91.9 per cent. With the reduction, advances are 2.25 and the principal loss 51.63. The bonds received 4.00 of advanced interest in the first case and 0.65 in the second. Net, they are down 51.13 against 50.98: almost the same cost, paid at different times and by different classes. The gap between the two is the interest charged on the larger advances. The companion files make the same point on the book's Marlowe Tower loan, and why realised severity exceeds appraisal severity walks the bridge.
The common mistake is to test recoverability against the appraisal itself, or against the loan balance, rather than against net proceeds after costs and fees, and to forget the interest on advances and the advances still to come. Tested on the 12.0 appraisal against advances made to date, the servicer would keep going for years. A second mistake is to read a nonrecoverability determination as the loss: it is the moment the timing changes: new advances stop, the shortfall reaches classes that thought they were safe, and any advance already made that the sale cannot repay is reimbursed out of the pool's general collections.
Take the appraisal less costs and the liquidation fee, project advances, interest on advances and fees to the expected sale date, and stop when they no longer fit. Here: month 16 without an appraisal reduction, month 54 with one, and roughly the same total cost to the bonds either way. The appraisal reductions, the monthly shortfall and the spill into the class above are modelled in the free workbook for this case.
The servicer stops making new advances on that loan. Advances already made, with interest, are repaid first from the sale proceeds, and any part the sale cannot cover is reimbursed out of the pool's general collections, usually principal first. In the illustrative case the 5.60 outstanding at the month-16 determination, with 0.26 of interest and 0.20 of fees, still fits inside the 10.93 of net proceeds; what stops is the next 0.35 a month. The bonds lose the advanced interest on that loan from the lowest class up.
It reduces the interest advance in proportion to the reduced balance. On a $60.0M loan appraised at $12.0M the reduction is 49.2, so interest is advanced on 10.8 only: 0.045 a month instead of 0.25. That keeps the advances recoverable for 54 months instead of 16, at the cost of interest shortfalls to the junior classes from the start.
The trust, through the loan's recovery. Advances and interest on them are repaid before the bonds from liquidation proceeds. Sold in month 16, the example loan repays 5.60 of advances, 0.26 of interest and 0.20 of fees out of 10.93, leaving 4.87 for principal. With an appraisal reduction the bonds end down 50.98 rather than 51.13: nearly the same cost, differently timed.
This article is one calculation from CMBS and CRE CLOs. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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