In order to avoid burying the lead, let me tell you where I’m going here. The CRE securitization business is in trouble. We need to throw out what biologists call the punctuated equilibrium, where once a system initially stabilizes, it thereafter changes little and resists radical change. Elsewise, our business is at very material risk of irrelevance.
But to give you some time to mull all that over, let me set the table first. I’ve been worried…
A couple of weeks back, the meme of the CRE CLO annual meeting posse was generally upbeat, but stubbornly focused on thinking largely about the short term. There was a lurking, maybe even a subliminal underlying anxiety that if you dared look very far down the road, you might see something unpleasant, so let’s not. I sensed that we all feel a certain anxiety that we are confronted with insurmountable and existential structural problems which make real growth from this point almost impossible and the continued shrinkage of our business’ footprint more likely than not. Living in the moment is, of course, an alternative but the doom loop beckons.
Jack Cohen’s panel on the morning of the first day (see JackChat that was published 6-22-19) began to tease out this narrative of foreordained calamity (okay, in which I participated… but merely as a provocateur!). Borrowers don’t like securitization, volumes are down, liquidity is iffy, blah, blah, blah. The theme reverberated gently, sotto voce, throughout the meeting’s chatter. We know we are in trig bubble (Think about it. I love the Capitol Steps!), but we seem fatalistically certain that we are we are incapable of addressing the real structural problems in our industry, too hemmed in by balanced structural impediments to achieve any meaningful change. The challenges are too overwhelming. Are we the frog in the slowly boiled water?
Well, hold on a moment. A couple of weeks ago, S&P reported that the share of all credit financed through securitization was continuing to increase (the so-called Security Utilization Rate) which buttresses the notion that the US, and indeed the entire developed world, has decidedly and irrevocably moved away from the notion that only banks can extend credit. But that’s not true in CRE, is it? Gone are the days of $200 billion of fevored CRE production, but are we really at the point where the last one out should turn out the lights and lock the door? Not hardly. Markets need us…right? So, let’s put paid to the notion that the CRE securitization business is moribund. The business has changed in remarkable ways since the Great Recession. For instance, we developed completely new SFR finance products which have seen and will continue to see significant growth. We adapted to Dodd-Frank and the new regulatory environment in which capital formation has to function. CMBS 2.0 and 3.0 represent real change making the CRE securitization execution better. While we were at it, we’ve rebooted the CRE CLO business which is now here to stay as an increasingly important part of the landscape of finance of transitional assets. Technology is better, transparency is better.
But, let’s face it, the conduit securitization business, which is the father of the feast, is not doing well. We have about $450 billion of bonds outstanding today (including SASBs). Hard to see it growing and it’s threatening to shrink.
SASB is healthy and indeed growing, but the same underlying problems that haunt conduit market are there and can only metastasize. (Note that the CRE CLO is actually showing real leadership here in providing much more flexibility for securitization sponsors to deal with structural deficiencies… but that’s still a work in progress).
We are at an inflection point. The need to innovate is imperative. To do so, we have to look in a clear eyes sort of way at some of the shibboleths or third rails in the structure of our industry.
Back when all this began in the early 1990s, CRE securitization was the shiny new thing. We were providing 10 year fixed rate money on a non-recourse basis to borrowers who couldn’t otherwise get it. We provided more money and at lower interest rates that was otherwise available. That was a pretty compelling value proposition. Hey, if our processes were clunky and our servicing was annoying, oh well, just show me the money!
But that was then and this is now. CMBS now competes across a wide variety of product types, chockablock with both prudentially regulated lenders, life insurance company lenders and a robust alternate lending market with a wide range of liability strategies. Today’s securitization is not the only place to find long term fixed rate gearing or indeed floating rate lever on non-stabilized assets. Shiny no more.
It’s time to think about the heretofore unthinkable. What was it that Sherlock Holmes said, “Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.”
We need an industry-wide white board session. One of those sessions where anyone would be free to toss out ideas and no one can say, “Yeah, but.” No nattering nabobs of negativism allowed.
When you get down to it, there’s only two things we can really do to fix the problem. We can create a new product that recapitulates the unique attractiveness of CMBS in the ‘90s, or make our existing offerings more competitive with existing alternatives.
So, please don’t shoot me, but here are some of the things that might – just might (depending on who’s invited into the room) – get scribbled on that white board:
- We have to return to being the finance solution to B and C borrowers in secondary and tertiary markets.
- We need to stop chasing the sub 60% LTV priced paradigm. CMBS need to do riskier loans (with higher coupons) and securitization products need to reprice to reflect that enhanced risk. Do you remember when B pieces in the mid-twenty percent yields because the operating assumption was loans would fail? Maybe that’s our sweet spot?
- We need to make it easier for borrowers to get out of fixed rate loans. Real estate is dynamic and 10 years is simply too long.
- It’s time to move more product to the 144A market so investors can have much more information about the deals in which they invest. The enhanced liquidity of the public deal is a construct and is largely illusory.
- We need to reduce the number of cooks in the kitchen on servicing decisions.
- We need to get rid of unanticipated fees.
- We need to increase the base compensation of servicers and strip away transaction specific compensation opportunities.
- The folks who will actually get to make the final decision on servicing matters have to be noticed of any borrower asks, day one.
- Get the lawyers out of servicing. Allow decisions to be made on practically available, as opposed to perfect information. Perfect information takes too long.
- Go from a negligence to a gross negligence standard for master and special servicers and other service providers.
- Move this servicing standard override mechanic out of the decisional process and into an audit function. As currently configured, it takes too long and is too complex. We still can bend the performance curve towards decisions that benefit the security holders as a collective whole through auditing decisions made after the fact. Discipline can be maintained and bad behavior can be penalized. Control rights could be stripped, a robust operating advisor signoff on the subsequent exercise of control rights could be imposed or monetary penalties assessed.
- In general, create a better communication process between investment grade investors and deal parties. Consider an actual mechanic to allow investment grade bondholders to seek redress from deal parties instead of the illusory right we have now, subject to labyrinthine voting and trustee interaction mechanics. Add an arbitration feature?
- Take a page from the CRE CLO structure and allow certain decisions to be driven by the control class outside the servicing standard.
- Skinny the servicer decision process by shortening timeframes and reducing information requirements to actually meet the lender consent requirements in your typical underlying loan documents.
At the end of the day, this is, in one way, simple. If it’s painful, it better be pretty and if it’s not pretty, it can’t be painful. If we don’t fix this, the gentle slope of the doom loop in which we already exist will just get worse. Less borrower demand producing less loans, less loans making for fewer deals, fewer deals making for more expensive execution, more expensive execution impairing bank business plans, thus further reducing the share of CMBS in the Barclays Index, reducing investor demand, reducing investor interest… and on and on, until someone has to shut the door and turn off the lights.
Can’t let that happen, can we? It’s time to embrace the improbable and think this through and restore CRE securitization as a critical and growing part of the commercial real estate finance landscape. Otherwise, we’re the frog.
Finally, you figure out if I really mean all this or this is just a provocateur at work. Got you thinking though, didn’t I?