Commercial mortgage-backed securities (CMBS) capitalize on the non-residential real estate market. In light of an uncertain economic environment, the default rate on these mortgages has led to a sharp rise in CMBS defaults. The Internal Revenue Service (IRS) has since introduced a way of easing the investor pain associated with defaults by actually offering an attractive option: instrument modification.

Known by the IRS as Revenue Procedure 2009-45, this ruling enables loan servicers to choose securitized loan restructure and modification prior to the fiscal instruments’ actually arriving at a default state. Best of all, there are no tax penalties associated with the process. This empowerment places servicers on par with so-called balance-sheet lenders – like pension funds and regional banks — which have all along made frequent use of the practice to navigate through the credit crunch relatively unscathed.

Hailed as being instrumental to market integrity as a whole, the IRS sanctioning protects against the heavy tax penalties and associated burdens levied on investment trusts and real estate mortgage investment holders. Another upside is the fact that default is no longer considered to be a precondition for acceptance; instead, it suffices to recognize that CMBS loans may be inevitably headed into this direction for the IRS revenue procedure to take effect.

The impact of this ruling cannot be overlooked: with an average all-property CMBS default rate of approximately 3.04 percent, the multifamily element went far above this average with an estimated 5.4 percent. Most heavily impacted by the now infamously defaulted $195.1 million Babcock and Brown portfolio loan, the figure was slated to reach above and beyond the six percent mark. Restructuring and modifying the instruments is though to perhaps be the best option to not let matters progress in this direction.

Yet even here there is a fear that the law of unintended consequences might once again be at work. Citing that the main selling point of CMBS is the virtual guarantee of returns, the sudden introduction of a new probability factor – namely the potential for any kind of sudden, unanticipated restructure or modification of the loans that hold up the bonds – may leave the occasional investor uncertain. In fact, the very notion that default no longer serves as a trigger point upsets the rules of the fiscal tightrope walk and adds an element of insecurity to a previously cut and dried transaction.

Adding to the confusion is the treatment of senior and junior class investors. While the senior investors stand to benefit from a liquidation of the security, the junior investors lose out on the deal. They only have a chance of cashing in during a modification. Not surprisingly, investor interests are divided along fiscal lines. Attempting to provide a bit of leverage to both sides, servicers generally resolve not to modify the more aggressively underwritten loans but concentrate on those that foreshadow the most chance of financial long-term reward.