With apologies to Madeline Kahn, in this case, it indeed is twu, it’s twu! The CRE CLO technology is maturing and evolving into the stable, match term, non-recourse, non-marked to market, dynamic portfolio lender lever technology that its fans (me among them) always thought that it could be. It’s just taken some time.
Tainted by the wildly different, and in hindsight entirely zany, CRE CDO securitization from before the Great Recession (most, but not all, of which died ingloriously before that recession was over) and after having creeped back into usage in the marketplace between 2012 and 2016, the CRE CLO as a technology to securitize whole mortgage loans is finally maturing into a stable and useful tool in the toolbox of the portfolio lender. Growing from a handful of deals in the period 2012 through 2016, total CRE CLO production was around $15 billion; in 2017 it was $7.7 billion; in 2018 it was $14 billion; and in 2019 it would appear to be on track to perhaps be a $20 billion securitization market. Ignoring for the moment black swans, orange swans, dictators, Brexiteers and sundry other loons on a mission to derail our economy or the modern world writ large, the CRE CLO market sector should continue to grow at a respectable pace with only the obligatory brief respite shared by all structured products, during the next recession, whenever it might occur.
For the uninitiated or those with PTSD from the Great Recession who flee to a safe space after hearing the mention of CRE CLO, a CRE CLO is a form of securitization which generally is used to provide match term lever to portfolio lenders. Whole mortgage loans, pari passu or senior participations and notes are legally isolated in an issuer vehicle which sells rated and unrated debt securities backed by the cash flows of the mortgage loans. This is a storage device providing lever to a portfolio lender and not a moving device, such as conduit CMBS. Typically, the sponsor of the transaction retains a significant amount of the bottom of the capital stack, composed of equity and below investment grade bonds, to which the offered securities effectively constitute leverage. The structures are essentially match termed and devoid of the mark to market horribles which characterizes the modern repo market and carries no form of principal guarantee.
The downside of the structures; and all good ideas have downside, is that it can be expensive in treasure and blood to put in place, and unless structured correctly, prepayments can rapidly erode the cost of funds advantages to the structure. Finally, investor appetite for the bonds has always been limited.
Here in the late summer of 2019, investor appetite seems to be firming and enhanced functionality of the securitization is making the transactions more cost effective.
So here’s a report from the front lines of creating a broad and deep CRE CLO market which will provide efficient and effective leverage to portfolio lenders:
- Deals no longer have to be static. When the CRE CLO first showed up several years ago, most or all the transactions were static. The investors were CMBS types and the notion was that you had to show the buyers all the goods in order to get the ticket. When active management of the portfolio began to tiptoe back into the space, there was a substantial pricing delta between static and actively managed deals. That premium, while it still exists, has faded considerably. Recently, bankers have suggested that the premium is down to the 20 bps range.
- Static isn’t static anymore. Even the notion of a static pool has been stretched considerably. Pools that are still characterized as static by the market regularly accommodate loans with significant non-pooled participations, with future funding permitted with respect to the non-pooled portions of these loans. Future funding has always been a bit of kabuki theatre, and if a sponsor cannot make that work, she ought to hang up her Bloomberg. Increasingly, these deals called “static” also permit the recycling of principal proceeds to buy additional bits of non-pooled portions of participated loans. Static? Sort of.
- Active management is increasingly active. Principal can be redeployed to buy in wholly new loans, as long as these new loans meet specified eligibility criteria. Of course we all know that in conduit securitization, which is exclusively a REMIC-based securitization structure, the static pool’s straight jacket makes this impossible. The CRE CLO space is largely non-REMIC and uses a qualified REIT subsidiary (QRS) structure to avoid adverse tax consequences while allowing sponsors considerable flexibility in modifying loans at the request of the borrower and adding loans to the structure. Reinvestment criteria in the CRE CLO space, while still embracing a considerable amount of underwriting discipline, are broad enough to permit most multi-strategy lending programs to conduct business in the ordinary course and keep its collateral pool replenished. This ability to replenish militates against the adverse consequences of a sequential pay structure which results in a sponsor’s liabilities getting more expensive as prepayments occur. Reinvestment periods are typically two years, albeit there have been some longer. We are tacking on a “replenishment period” to the reinvestment period. During the replenishment period, we can continue to buy in portions of non-pooled participations. Get ready for a real pro rata pay feature coming to a theatre near you very soon!
- Real active management II. Sponsors using the CRE CLO as leverage for their portfolio expect and need the ability to actively manage underlying loans. The inability to do so is one of the principal drawbacks of the conduit business model.
Nonetheless, in CRE CLO 2.0 there were still significant limitations on active loan management tied to the need to obtain servicer consent and the peculiarities of the capital markets servicing standard which creates some artificial barriers to good portfolio management. Frankly, it’s not really reflective of what a portfolio lender would do for its own account and that’s what we really want from our CRE CLO managers, isn’t it? The capital markets servicing standard is a blunt instrument and focuses almost exclusively on maximizing returns to the investors (and avoiding liability for the servicers!) and does not encourage a nuanced balance of benefits and burdens associated with a potential manager action. Can it take into account the possibility that investors might appreciate earning a return for a longer period of time from a well-managed structure? No. Does it take into account tradeoffs that may, at a business level, be good for the loan in the long run, but also have short term negative externalities that have to be weighed? Not well. Here’s one example. What happens if the borrower wants more money because it has a good use for that money? The loan is performing supremely well and the extra leverage wouldn’t hurt credit quality. If the current lender doesn’t give it, it will prepay the loan and get it elsewhere. Under our current servicing standard, the transaction is not happening. Under these new structures, a lender can add dollars to a non-pooled pari passu participation and the loan stays in the deal. These are things that a portfolio lender does in the ordinary course of its business. A portfolio lender doesn’t want to lose a loan to refinancing because it can’t accommodate a reasonably credit neutral or even credit positive borrower request. But in many cases, these type of requests simply would not get done under our servicing standard.
Recently, a concept of “modification” has been added to deal documents. These are decisions which can be made by the collateral manager without the special servicer consent. There are significant constraints on this type of active management and these types of modifications are limited in number and structure, but have gone a long way to making the CRE CLO much better aligned with your classic portfolio lender strategy. Are investors at peace with the structure? Perhaps not entirely and certainly in some cases, not entirely, but the CRE CLO is increasingly understood as an actively managed strategic leveraged structure and the need for sponsors to actively manage their portfolio is apparent to everyone. If it’s a good structure, with a good return, with a good manager, investors should want to facilitate a portfolio lender’s performance from the manager and not torque that performance to meet an artificial construct.
Protecting investor expectations. Responding to investor comments, the deemed consent mechanic for making significant changes to the indenture is going and will soon be gone. Investor expectations regarding the quality and criteria for loans in the pool is now better protected. This is a great example of the market listening both to the investors and the issuers, working together to make this structure better.
- Bond structural flexibility. Recently, a couple of things have entered the space that represent potentially useful structural features. The first is exchangeable classes that allow the sponsor retaining securities to strip premiums out of bonds to sell near par and retain the extra coupon in IO. Also, some technologies have developed to facilitate the monetization of certificates that need to be retained by the QRS sponsor for either REIT or risk retention purposes.
- Pesky excess inclusion income. Structures are developing around the CRE CLO to minimize, if not eliminate, excess inclusion income that were not available in the early days of CRE CLO 2.0. While still not a non-event, it’s becoming more of a non-problem.
- Buying dodgy assets out of the pool. Most modern CRE CLOs permit the collateral manager to purchase both defaulted and credit risk assets out of the pool. Because of concern of over adverse selection, investors have been vigilant to insure that these structures make sense and guardrails and criteria have been built around the structures to insure that adverse selection does not occur. When well-constructed and well- managed though, it allows a collateral manager to pull assets out of a vehicle that need more than the sort of intervention that can be done inside a structure, which is advantageous to all the parties involved (although I am sure I will hear from some reader telling me that that’s wildly wrong).
- Deals retain tight par value and interest coverage tests. That good. If a pool deteriorates, the structure turbos the senior bonds.
- Still (always) first lien mortgage loans. Nothing gets into these deals except first mortgage loans and there is essentially no bid by anyone in the space to change that.
- Information flow is good. Data sites are open to privileged persons and include ASRs and increasingly include updates on the underlying borrower’s business plans. CREFC is working on an improved, bespoke CRE CLO reporting package which will facilitate the integration of collateral manager information and servicer information. It’s not that the information would be new, but that it would be easier to use and manipulate. Stand by for that. For those who want to pay attention, there’s a lot a grist for the mill.
- US and EU risk retention. CRE CLO has always been the one securitization structure without significant tension with the US risk retention rules, as most of our vehicles are Qualified REIT Subsidiaries that must, for tax purposes, continue to hold all the non-investment grade securities and equity issued by the vehicle. If you’re doing that, risk retention is not a problem. But now there’s European risk retention and for that matter, Japanese risk retention, to deal with. Generally, the structures meet the fundamental hold requirements of the European risk retention regime, but do not meet the reporting and transparency provisions that may or may not be applicable to these US based deals under the European risk retention regime. We are taking the view that what we are able to do is a dam fine shot at meeting the European rules and European investors are free to make their own decisions. Japan? We are doing our best, but who knows, and the Japanese aren’t buying.
- Killing LIBOR. As those of you who read this column regularly, or otherwise pay attention, LIBOR is going away in less than 30 months. We all know we are going to have to deal with the transition, but the CRE CLO bond market is moving aggressively right now toward the ARRC’s SOFR based alternate rate structure and in the past several months, we’ve been adding it to deal documents. Now, to be clear, none of the underlying loans easily facilitate a SOFR transition and right now, there is a lot of variability in the alternate rate structure of the underlying loans. Are we making mismatches? Probably. Are we disclosing the hell out of it? You betcha.
I’ve always been of the view that our market knows how to rate mortgages and also knows how to rate managers. The broadly syndicated middle market CLO business is all about the managers, as the assets are short lived and pool composition rapidly changes. Investors have been okay with that. So there’s no reason that the CRE CLO business can’t continue to grow as a robust and highly functional part of the portfolio lender’s toolbox and I think it will.
Are there risks? There’s always risks. Could the market lose its mind? Heaven forfend, we’ve never done that before, right? But for the moment, the structures are disciplined and continue to balance functionality and safety. All market participants seem to be onboard. So here’s to the CRE CLO finally earning its place in the sun as an important part of the lender’s leverage strategy.