Trading Is Not a Dirty Word and Other Thoughts on a More Manageable CRE CLO

As we begin to reflate the CRE CLO business this year with shrinking spreads and hopefully shrinking SOFR, we need to think of this as CRE CLO 3.0. This business, this technology, which is truly a brilliant way to deliver leverage to portfolios of commercial real estate loans has been, shall we say, somewhat moribund, almost having cooled to room temperature over the past two years.

It's coming back and it’s time for us to make it even better.

First, a short advert for the CRE CLO. The CRE CLO is the absolutely best technology to provide leverage to commercial mortgage loan portfolios. Across the securitization business, it represents the best alignment of issuer and investor (with the investor holding a significant part of the first lost risk of the pool), with the capacity to provide match term stability across the life of the transaction without the margin mechanics of warehouse lending.

It’s coming back in 2024 and will do nothing but grow thereafter. (In the spirit of full disclosure, I’m talking my book here, as I predicted a robust $25 billion issuance level for 2024…FanDuel has me at 15:1.)

We’ve been compiling a list of fixes, improvements, adjustments and clarifications for these past couple of years as we’ve developed operating experience with the technology in the crucible of once-in-a-lifetime interest rate stress. While the bolts haven’t blown off the door, our technology also has a certain built-while-flying-it vibe. Now, several years of operational experience has taught us about the things that need improving, that need clarifying, and that will make the vehicle more operationally efficient. We’ll return to the small-bore fixes at the end.

A couple of other perhaps wider bore changes that the market might want to consider: Let’s talk about a trading bucket; let’s talk about repricing outstanding securities.

The trading bucket is one bit of technology that hasn’t darkened our door since it was merrily marched out of the fort with saber broken and shoulder patches ripped off (obscure Chuck Connors 1960s tv show reference). I frankly never thought that a trading bucket was a terrible idea. In the day, usually subject to a relatively tight cap, collateral managers were allowed to sell or exchange performing assets where doing so was in the best interests of the certificate holders and helped shape, in a positive way, the collateral pool. Then, as we buried the late, lamented CRE CDO, the trading bucket was buried with it (like pharaoh’s concubines and hunting dogs). A shame (particularly for them).

Why not have a collateral manager have a right to exchange performing assets that might have some concerning attributes, yet where the asset has not risen to the level of a credit impaired asset? Why not allow a collateral manager to trade, at a premium, an asset and reinvest proceeds consistent with a credit profile of the pool and grow the collateral cushion?

If there was ever a time to think about that, now is that time. First, we know that it is certainly possible to see trouble on the horizon long before it would be determined that something was credit impaired. Get out while the getting’s good. It’s net positive for investors. Second, with interest rates coming in (my lips to God’s ear) spreads are likely to trend lower as SOFR follows Fed funds. When this happens loans, particularly those not yet out of make-wholes, may trade at a premium. If a loan could be sold at 101 or 102 or 103 of OPB, why not harvest the upside? If exchange properties are purchased with the proceeds, collateral cushions could improve. If no exchange assets could be acquired, the premium would flow through the waterfall.

How about considering a repricing mechanism that could allow repricing of an existing capital stack without the full cost and expense of a windup of a deal and issuance of a new deal. Once again, as spreads come in, it could be an effective strategy. This so-called Refinancing Redemption (or at least that’s what we called it) could be triggered after the non-call period expires. Yes, it sounds odd in the CRE space, but this is not an entirely novel feature in the corporate CLO arena. Obviously, we haven’t seen this done in a rising interest rate environment, but now with a possibility that spreads might come in on the horizon, this deal feature could be extremely valuable for certain sponsors The trick, of course, is to do it without full redo of the book and disclosures. The issuer would undertake to redeem the notes and where investors agreed to redemption, exchange the old notes for replacement notes at lower coupons. If some investors choose not to participate, they would be paid out in cash. To avoid a new offering, this would probably have to be done inside the existing investor population, but that certainly is a possibility. Could be engineered. Note that in connection with any such refinancing, things such as caps on criteria modifications, caps on replenishment buckets and the like, could be achieved. The result would be an effectively a new issuance at a significant cost savings. Hmm. Worth a thought.

As I mentioned at the outset, there is a host of smaller bore fixes which should be considered. Just for a taste of these cleanups:

• To make sure we get better alignment between payment dates at the loan level and bond level.
• Clean up dissonance around appraisal reduction events, special servicing transfer events and default loan definitions.
• Rationalize for RAC on due on encumbrance and due on sale waivers.
• Clarify treatment on deferred interest in certain calculations,
• Clarify how the modified loan definitions work (or not).
• Give credit for rate cap payments in debt service definitions.
• Make sure the investor Q&A form works in a way that allows broad distribution of information which could be MNPI;
• Add some clarity around the stabilized value concept for all the future fundings.
• Add some additional clarity around the tension between servicing and the best interests for the investors and servicing with a view to timely recovery of payments.

You get the idea, there are a lot of these and it’s a reverse of “death by a thousand paper cuts.” Addressing these operational issues will make the vehicle more responsive and efficient.

The point here is to at least think outside of the box a bit as we get ready to reflate our business. Retest our assumptions, think about things afresh. I’ve already addressed in other commentaries about the possibility of two sponsors buddying up (yes, it can be done) and re-purposing these vehicles as a CRT modality. We have a chance to expand the use and functionality of the CRE CLO and we should do so. A definition of insanity is to do the same thing over and over and expect a different outcome. We’d like a different outcome this time. Doing the same thing over and over for lack of imagination is equally problematic.

Yes, I get it that our industry, like all capital market silos has a natural conservatism about it. If it’s new, it’s suspect. But that doesn’t mean we shouldn’t try. That doesn’t mean we shouldn’t try to educate the investor cadres about building a better mousetrap that still functions in the best interest of the investors but also provides opportunities to grow the asset class, thereby providing additional liquidity in the space by making the CRE CLO a better machine for the portfolio lenders that’s good for investors too.