Slicing and dicing CRE Debt for the greater good of all

In the wake of the Global Financial Crisis (GFC), highly structured CRE debt transactions featuring multiple lenders and including a securitisation received a lot of criticism. There are myriad of justifiable reasons for this, but the chief complaint generally centred around the fact that at times of distress and a need for urgent action to be taken, these structures were simply not up for the job. A decade or so ago, there was no shortage of evidence to support this proposition as subordinate lenders that were out-of the money flexed their muscles to extract any value that they could, distressed borrowers found it cumbersome, time consuming and expensive to reach consensus with their lenders,  whilst at the same time those charged with policing these structures (namely facility agents and servicers) more often than not found themselves between a rock and a hard place as they tried to break the deadlock. In some instances, distressed borrowers were able to exploit structural flaws to significantly strengthen their bargaining position to the detriment of lenders as a whole.

Against this chaotic backdrop it was no surprise that high profile disputes and litigation subsequently ensued, and the knee jerk reaction was a conscious move by the market to simplify CRE debt structures as a means of once again instilling trust and confidence so that CRE lending could resume at scale. However admirable this position is, the truth is that the slicing and dicing of debt secured by one or more CRE assets is not only essential but also makes a lot of sense. From a lenders perspective, it enables them to be able to invest in a CRE debt instrument that will deliver a  return that is capable of quenching their risk/return appetite. For senior lenders, they also have the benefit of not only lower leverage but also take comfort from the fact that sitting behind them is a subordinate investor that is not only likely to be sophisticated with serious CRE expertise, but an investor that is strongly incentivised to take appropriate action for the greater good of the capital stack as a whole including the ability to step into the shoes of the borrower. 

Assuming that tranching and potentially securitisation creates a cheaper form of debt for borrowers,  then they will almost certainly welcome these structures, especially now as global economies are battered by a storm of high inflation and escalating interest rates. These techniques also have the added advantage of establishing a deeper and wider investor base to invest in CRE debt, thus removing a potential systematic risk by having too few CRE lenders channelling debt into the CRE sector.

Ironically, over the past few years, the exercise of tranching has proven itself as an essential financing tool thanks to the retraction of banks from high LTV lending, and accordingly the presence of structural mezzanine debt has become staple for highly leveraged CRE finance transactions involving banks. Equally, with the emergence of alternate lenders that are reliant on loan-on-loan financing, we have witnessed the use of structures which effectively mimic the economics and legal rights of tranching albeit under a different guise.

Fifteen years on from the GFC, it is time for highly evolved CRE debt structures to not be stigmatised, but instead actively embraced. Yes, the market has had some bad experiences, but any reservations that market participants may have can be easily nullified by the presence of a servicer appointed by all lenders, a decent servicing standard and the ability to override certain lender positions for the greater good of all. Equally, the presence of a control valuation event has always been an important test as it ensures that whilst a junior lender has no economic interest in an asset, then any rights they have burn away.

At this point in time we are at a critical juncture as we embark on a new era of higher interest rates, and with it borrowers are more receptive to more complex debt structures that will allow them a cheaper source of debt. Meanwhile, sophisticated CRE players who have focussed on CRE equity as part of their relentless search for yield during an era of super low interest rates, will have a renewed focus to invest in CRE debt given its relative returns compared to equity and the limited downside risk. It also means that a different lender base will enter the fold and with it they too will be more receptive to embrace some of these more involved finance structures in order to achieve the returns that they require. Either way you look at it, tranching has proven that despite a chequered past, it has an essential role to play in the European CRE financing market. As borrowers, lenders and investors alike grapple with high interest rates, when it comes to CRE debt structures then I would surmise that the time is ripe for CRE structures to embark on a period of rapid innovation for the greater good of all.

Bridge loans set to fuel the development of the European CRE CLO

Read time: 3 mins 40 seconds

One of the desirable features of a CRE CLO is the ability of the collateral manager to buy and sell loans at will or, going one step further, originate loans directly out of the securitisation structure itself. Although the economic merits of such a feature are emphatic, this feature was purposefully omitted from the one and only CRE CLO to grace the European market, and instead the Starz transaction was comprised of a static portfolio of loans with principal proceeds applied towards repaying the notes. The absence of this important and compelling feature has not gone unnoticed and questions have been raised in some quarters about if and when we will witness the arrival of CRE CLO backed by a dynamic pool of loans. Although conventional thinking would infer that we are someway off given that there has only been the Starz CRE CLO deal to date, I would suggest that we may witness the arrival of this feature sooner rather than later thanks to the inevitable demand for bridge financing and the abundance of transitional CRE.

Indeed, at the present moment, bridge financing is receiving a heightened level of attention with a number of factors contributing to this. Chief amongst these is the fact that the loan origination market continues to be challenging and is clearly demonstrating that it is not immune to market turbulence. Compared to the position over the past few years, there has been a marked increase in the cost of credit which can be attributed to market volatility, a heightened level of uncertainty as well as some lenders closing their lending books until conditions improve. To add insult to injury, the exorbitant price of interest rate caps has added to these financing costs, and with it borrowers are once again embracing interest rate swaps as an interest rate hedging strategy. Furthermore, on the equity side a combination of rising cap rates and looming concerns over a significant economic downturn has had a negative impact on property valuations, which in turn has had a direct impact on the amount of debt that a lender is willing to lend but also the purchase price that a seller can command as part of any sales process.

The corollary of all of these woes is that there is little impetus for Borrowers to tie themselves into expensive term debt which is difficult to extricate themselves from, without being burdened by prepayment penalties and potential close-out payments under a swap. Bridge financing would appear to be the perfect solution for those borrowers that are in the unenviable position of being forced to raise fresh debt whilst at the same time looking to ride-out the current wave of volatility. Bridge financing also has the added advantage of affording borrowers the breathing room to reposition and stabilise transitional assets, and thus enable them to qualify for a cheaper form of long term debt. In this regard there is no shortage of transitional properties and volumes are likely to increase further as a consequence of landlords embracing best practices of ESG, re-positioning properties following the fallout of Covid, the eradication of voids as tenants succumb to the macro-economic stress as well as repurposing properties to meet ever changing consumer patterns and behaviours.

The inescapable fact is that bridge finance has an integral role to play in being able to provide borrowers with the space required to execute their business plans and somehow stave-off being burnt by market volatility. These stark facts will reverberate for proponents (like myself) of CRE CLO technology; after all, it is the financing of transitional assets and bridge loans that has fuelled the exponential growth of the US CRE CLO market. With the European market exhibiting a bountiful supply of transitional assets alongside what promises to be huge demand for bridge loans, then there is no reason why European CRE CLOs will not follow the same trajectory of growth experienced by its American cousin. The ramifications of this could be massive; not only will the flood gates be opened for a significant volume of CRE CLO issuance, but the market will also witness an unprecedented level of evolution of the product as it is finessed to cater for short-term loans, and with it a staple feature will be the ability of the collateral manager to re-invest loan principal proceeds in originating and buying new loans.

Although market conditions have clearly created a bedrock of challenge, the fact is that these are prime conditions for innovation to thrive and with it I would surmise that when the CRE CLO market does take-off (which it will!!), not only will bridge loans be a major part of this, but the presence of a dynamic pool of loans will become a mainstay of the European CRE CLO.

Securitisation – time to put on its hero cape!

The last few weeks have proven to be a tumultuous period for the capital markets, and with it a stark (and painful) reminder has been duly delivered on the impact that they have on all aspects of business and the wider economy. Securitisation has also shown that it is not immune to this turmoil demonstrated by a cessation of primary issuance and a blowout in bond spreads. Amidst this volatility, it is not surprising that parallels are being drawn with the onset of the so-called credit crunch (summer 2007) which later led to the global financial crisis (GFC).

As was the case in the summer of 2007, we are currently experiencing a primary issuance hiatus thanks to the fact that market volatility (namely the sudden increase in yields) has made it near impossible to viably price new primary issuances, which in turn has been exacerbated by a material uptick in the trading of highly rated securitisation paper as investors have been forced to liquidate some of their positions. Securitisation has shown that (unsurprisingly) it is not immune to the ebbs and flows that plague the capital markets, however this is where parallels with 2007 should end, as the markets will inevitably stabilise, and when they do there is no reason why securitisation will not expose its mettle and demonstrate that it has an integral role to play for the greater good of the economy as a whole.

Taking a step back it is important to appreciate that the GFC dealt securitisation a hammer blow, tarring it with the brush of being one of the chief architects that precipitated the GFC. Although a harsh characterisation, it does have some merit given that this vintage of securitisation structures were generally not always fit for purpose. Such a remark should not be considered a surprise given that securitisation technology exploded into life in the noughties fuelled by a favourable regulatory environment and an abundance of cheap debt. Against this backdrop, there was an impressive amount of creativity and innovation which manifested itself with increasing levels of complexity and ingenuity, culminating in the emergence of some hugely impressive structures. Alarmingly, thanks to the overwhelmingly favourable market conditions, securitisation evolved in a vacuum and was not subject to the tests, challenges and scrutiny that a product of this magnitude rightfully requires.  In effect, securitisation managed “to run before it could walk”, the corollary of which was that a number of unknown structural issues soon became endemic.  With the onset of the GFC, securitised products were subjected to a long awaited litmus test and with it many of the structural shortcomings were soon exposed.

In the aftermath of the GFC, securitisation had not only been tarnished as a financing tool but also it was readily apparent that many of these structures were in desperate need of rehabilitation. In other words despite the need for a financing tool that could plug the funding gap created by the retraction of the banks, securitisation in its then form had little role to play until a number of its structural shortcomings had been resolved. Securitisation products were therefore subject to a period of much needed reform through the implementation of new regulation, best practice principles proposed by trade bodies and investor structural requirements. Indeed, the fact that this new crop of deals managed to weather the COVID storm is testament to the adaptability of the market and the true success of the implementation of these reforms.

Not only the ABS markets, but the wider economy, should take solace that against a backdrop of market volatility and the widespread talk of recession, we today have a new and improved securitisation product that has demonstrated that it is more than capable of weathering an economic storm. The importance of this cannot be under played, as all economies (although maybe not Turkey….) embark on an escalator of increasing interest rates as central banks have the unenviable task of tackling inflation. At least for now, the era of ultra low interest rates is over, and with it borrowers of debt will have no choice but to embrace racier forms of finance in order to boost their returns.

Given its myriad of positive characteristics, it is definitely time for securitisation to step-up and assume an integral role as a financing tool during this new period of escalating interest rates. After all, on a macro-economic level, securitisation is a great way of spreading and diversifying risk whilst at the same time promoting much needed openness and transparency to the financial markets. From an investors perspective, the resultant product not only enables investment in a (relatively) liquid product that satisfies their risk/reward appetite, but also a product that offers a return that will fluctuate in line with interest rates. Finally, from an underlying borrowers perspective, debt that is ultimately financed through a securitisation (either on day one or down the line) will invariably enable them to obtain a cheaper form of debt compared to other more traditional sources of finance. It is this latter characteristic that is the crucial point,; as interest rates rise there will be strong demand for these cheaper forms of finance and financiers, whether in the form of traditional banks or alternate lenders, will have little choice but to embrace securitisation to deliver on these needs in order to remain competitive.

In the immediate wake of the GFC, securitisation was very much in the doldrums with it not only being lambasted for precipitating the GFC but also the exposure of serious structural flaws. Securitisation is now in a very different place, and this is one of the distinguishing features as we look to ride out the impending economic downturn and beyond. The inescapable reality is that interest rates are on the rise there will undoubtably be a demand for cheaper forms of debt, and securitisation has the unique ability satisfy this requirement. Indeed, if securitisation can deliver on this potential then the repentant villain of the GFC has all the hallmarks of being a genuine hero of the future;   now is the time for it to put on its hero cape!  

Securitisation type technology showing a glimpse of its mettle

Estimated read time: 2 minutes 45 seconds

It would be fair to say that when it comes to securitisation, I have always been very upbeat about the huge potential of this technology and the integral role that it can play. This is not only in providing a cheaper form of credit for borrowers but also that the resultant investment for fixed income investors is hugely desirable given that they will be able to invest in a product that not only satisfies their risk/return appetite but also an instrument that already has built-in protections for fluctuating interest rates. Ultimately, securitisation provides a vital role of funnelling debt raised via the capital markets to areas of the real economy in an extremely efficient manner.

Last week I wrote a piece (CMBS & CRE CLO – Heroes of the Future) which made the case that despite the challenging economic environment, securitisation could prove itself to be the unlikely hero given many of its favourable attributes. With this piece very much in my mind, I was delighted to hear that Perenna (UK based specialist lender) has recently been granted a licence to offer to residential borrowers a mortgage product that offers a fixed interest rate for the life of that mortgage. This is a hugely desirable product for owners of residential property that do not want to be at the whim of interest rate fluctuations and one of the chief reasons why Perenna can offer this is the fact that ultimate finance for this product will be funds raised in the capital markets in the form of a covered bond issuance.

A covered bond issuance has many of the same attributes and features as a securitisation, although the products are technically distinct given that in the case of the former the underlying loans reside on the balance sheet of the lender as opposed to being transferred to a special purpose vehicle. Fundamentally though in both products the underlying collateral are mortgage loans and the resultant investment instrument are bonds tied to the performance of this collateral. Indeed, in some quarters given the similarities between the two products, then covered bonds have been known to fall under the securitisation umbrella. Semantics and technicalities aside, the news about Perenna is an important development, as first and foremost borrowers are being given the opportunity to obtain a mortgage on terms that would not be viable from traditional residential mortgage lenders, but secondly, this is real life example of how the versatility and application of securitisation technology (although not securitisation in a true sense) can be used to make a real difference.

As the economy and the markets continue to evolve and adapt to a new world of shifting macro-economic themes and the new risks and challenges that they present, I am confident that securitisation will continue to be an important tool in ensuring the more efficient deployment of capital and that despite the subdued nature of the financial press, I continue to be buoyed and excited by the role that securitisation can play in the new economy. Returning to the news about Perenna, then metaphorically speaking securitisation type technology has already demonstrated heroic qualities by making this residential mortgage product viable and with it a positive endorsement of my base case scenario that securitisation will prove to be a hero of the future.

CMBS & CRE CLO – Heroes of the Future

Estimated reading time: 5 minutes

If the latest forecasts are true, then we will imminently be subjected to a long and deep recession and therefore now is the opportune time to draw comparisons against previous downturns and lessons learned. Indeed, given the nature of these beasts, there is always a chief protagonist or metaphorically speaking a pantomime villain that shoulders responsibility for the recession (albeit this can be construed as an oversimplification given the complex network of interconnected variables at play). In the case of the recession of 1973, the oil crisis was the main proponent, in the early 1990s it was Great Britain’s membership of the Exchange Rate Mechanism and in the case of the global financial crisis (GFC), the interplay of securitisation and sub-prime mortgages proved itself to be a worthy contender as pantomime villain. Although securitisation certainly played a role in precipitating the GFC, it is quite possible that it has an integral positive role to play when its comes to financing European commercial real estate (CRE).

As was clearly evident from the fallout of the GFC, historically CMBS structures were deeply flawed and there should be no surprise with such a remark given that the product exploded into life fuelled by a favourable (i.e. limited) regulatory environment and an abundance of cheap debt. Given these overwhelmingly positive market conditions, the CMBS product evolved in a vacuum and accordingly was not subject to the tests, challenges and scrutiny that a product of this magnitude generally receives and requires.  In effect CMBS had managed “to run before it could walk”, the corollary of which was that a number of unknown structural issues soon became endemic.  With the onset of the GFC, the CMBS product was subjected to a long awaited litmus test and with it many of the structural shortcomings were soon exposed.

Given that so many market participants were adversely impacted by CMBS structural flaws, the fragility of the global economic market as well as the high level of regulatory uncertainty, the post GFC deals evolved and developed at a much more measured rate than their predecessors. These structures also embraced those structural reforms that emanated from the CREFC guidelines issued in November 2012 (Market Principles for Issuing European CMBS 2.0) and the investor principles of March 2013. Through adopting such a measured approach, it enabled not only CMBS structural flaws to be fixed but also created the ideal foundations for new CRE securitisation products to emerge such as Europe’s first ever CRE CLO (Starz Mortgage Securities 2021-1).

The onset of the pandemic in 2020 imposed a much needed acid test on these newly improved structures and the results were overwhelmingly positive with many of the mitigants for macro-economic risks (e.g. longer tail periods, existence of special servicers, loan level caps, cleaner loan structures) proving that they are more than capable of withstanding economic distress. Securitisation structures can in many respects be considered a reformed villain and accordingly the villain of the noughties could be credibly recast as a potential hero of the future given the following important attributes:

  • it provides an efficient mechanism to transfer CRE loan risk away from both the banking sector and the shadow banks;
  • it provides investors with a more liquid alternative to the CRE loan syndication market;
  • it is an instrument that not only allows investors to invest at a level of risk and reward that satisfies their investment appetite but also an instrument that has floating rate element pegged to SONIA or EURIBOR thus providing a perfect insulation to interest rate risk;
  • it brings about much needed openness and transparency to the CRE lending market;
  • when compared to banks hampered by provisioning and regulatory pressure, securitisation affords special servicers and collateral manager a fair amount of flexibility to work-out and enforce loans over an extended period of time.

Taking all these attributes together, it is clear that securitisation exhibits a number of hugely positive features, which is especially true when it is compared against balance sheet lenders. Also, given the public commentary on the performance of securitised CRE loans (to satisfy ongoing public issuance disclosure obligations), the asset class has the potential to play a role in educating the wider market on what actions are being taken to resolve and address issues on problematic loans. Indeed, in light of the unprecedented and dynamic nature of the current macro-economic environment, this active flow of real-time market information could prove to be invaluable to the CRE lending industry as a whole.

Given that ultimately securitisation enables underlying borrowers to source a cheaper form of debt, then against a revolving script of rising financing costs as well as the increased cost of owning property, securitisation technology will certainly be greatly welcome and provide some much needed respite to borrowers hampered by these increasing costs. There are of course a number of residual challenges such as the current uncertainty and volatility around pricing which goes to the very core of considering the feasibility of a securitisation from the outset. In addition, interest rate hedging having been a relatively contentious feature of CMBS in the past has been relatively benign for the past decade thanks to ultra-low interest rates that have enabled the more straightforward interest rate caps to prevail. This though is all set for change, given the exorbitant price of interest rate caps which has led to a renewed emergence of interest rate swaps on the origination of fresh loans and with it an additional layer of complexity that needs to be contended with when it comes to structuring a securitisation.

Ultimately, securitisation has demonstrated that it has an integral role to play in financing CRE for the benefit of underlying borrowers, investors and the market as a whole. Indeed, if securitisation technology can be embraced whether in the form of CMBS or CRE CLO and the product can start to deliver on its true latent potential, then securitisation could cement itself as not only a reformed pantomime villain but a true hero.

India’s ECB market: long term downturn or short term blip?

Read time: 4 minutes

India's ECB market: long term downturn or short term blip?

External Commercial Borrowings (ECBs) are commercial loans advanced to Indian borrowers in a foreign currency by non-India resident Lenders. Following the gradual relaxation of India’s tight external debt controls in the mid-1990s and early 2000s, ECBs have emerged as an important source of funding for eligible Indian entities, particularly in the financial services, petro-chemical and energy sectors which make up nearly two-thirds of India’s ECBs. Certain parameters continue to limit the availability of ECBs to domestic borrowers, including minimum maturity, non-permitted end-uses and a maximum all-in-cost ceiling, but providing a means to access the cost advantages of the last-ten-year trend of low global interest rates during a period of unprecedented growth for the Indian markets has resulted in ECBs now consisting of over 35% of India’s external total debt.

Figure 1. Source: RBI via Financial Express

While yearly RBI data shows an increase in ECB inflows to $38.2 billion in FY22 (see Figure 1), a closer look at both the commercial context and RBI statistics suggests that ECBs may be facing significant headwinds.

First, reviewing monthly figures provide a more accurate picture. In April 2021, for example, Indian entities raised US$2.4 billion via ECBs. In March 2022, this figure was US$5 billion. In April 2022, which is the most recent full month of data, this dropped to US$361 million, a 93% decrease from the month before. In terms of quantity, over 115 individual ECBs were included in RBI data for March 2022; in April 2022 this was only 64.

The RBI also provides details on the ‘purpose’ of these ECBs. In March 2022, 13 ECBs were advanced with the purpose of refinancing either an earlier ECB or a pre-existing Rupee loan, with an aggregate equivalent value of US$938,647,275. In April 2022, only a single ECB was used for refinancing, with an equivalent value of only US$8,927,653. This data signposts a rapid drop-off for ECBs in terms of both value and quantity, as well as in the appetite of Indian corporates to take on new ECB exposures in place of existing debt.

As mentioned above, the uptake of the ECB regime was driven by Indian corporates seeking to reduce their cost of funds by accessing the lower interest rates available in global debt markets, and thereby avoiding the relatively high interest rates which have been a constant staple of the Indian domestic market. Similarly, the recent decline in ECBs’ popularity seems to be attributable to borrowers deciding that their balance sheets would be better served without going overseas.

We are seeing the fastest rise in global interest rates in 30 years, with nearly four dozen central banks having raised rates in the last six months in an attempt to rein in the growing inflation resulting from increases in energy prices due to the war in Ukraine, as well as the continuing impact of Covid-19 on global supply chains. For example, the Federal Reserve US benchmark interest rate has increased from less than 0.1% at the beginning of the year to over 1.5% as of June 2022, including a single increase of 0.75% – the largest since 1994. In a similar vein, the Bank of England’s Monetary Policy Committee has voted for rate increases of 0.25% in every month since December 2021, with the bank rate now at its highest in 13 years.  Increased interest rates directly increase the cost of servicing loan interest obligations, but also affect the price of currency and interest rate hedging, which ECB borrowers will factor into their total cost of funds. The efforts of global central banks, in particular the US Fed, and the rise in crude oil prices given the ongoing war in Ukraine are also putting downward pressure on the Rupee, which makes it more expensive for Indian borrowers to service payments in foreign currencies and thereby makes ECBs less attractive.

In essence, the issues which are buffeting global markets more generally are having a more pronounced effect on ECBs in India.  In particular, rising interest rates in the Eurozone, the US and the UK, will potentially make ECBs less popular when juxtaposed with domestic lending.  However, rising inflation is a global trend and it remains to be seen whether increasing interest rates will counter this in India, especially against patterns of high growth over the last decade.  As we have discussed previously, Indian lenders are reticent to take a proactive role in negotiating with borrowers and we may yet see a marked increase in loan delinquency as a result.  The ECB market is critical to India’s finance markets, but is clearly in a state of flux for now.

If you are interested in learning more about Reed Smith’s India finance capabilities, please visit our India busines team page or contact Gautam BhattacharyyaSarah Caldwell or Nathan Menon.

CRE hedging – friend and foe

Read time: 5 minutes

For better or for worse, interest rate hedging instruments have an important role to play when it comes to financing commercial real estate (CRE). For the past decade or so, these products have enjoyed a relatively low profile following the excesses of the period leading up to the global financial crisis (GFC). This is all set to change thanks to our current macro-economic backdrop dominated by rising inflation and escalating interest rates. With this in mind, I thought it would be worth reminding ourselves of some of the lessons of the past as well as delving into what may be install for the future.

One of the key features of European CRE lending is that there has always been a mismatch between lender and borrower requirements when it comes to income, given that the latter typically receives a fixed amount from their tenants, whist a lender requires a variable interest rate to match their back-to-back funding. To bridge this gap, typically a hedging instrument is used in the form of either an interest rate swap or an interest rate cap. Prior to the GFC the derivative of choice was the interest rate swap, but due to the ultra-low interest rate environment these have since been usurped by the interest rate cap.

Although interest rate swaps were the derivative of choice leading up to the GFC, it was this crisis that brought into sharp focus the perils of the instrument. Thanks to the demise of Lehman Brothers and the sobering message that hedge counterparties are not too big to fail, counterparty risk was promoted from a hypothetical risk to a genuine risk with profound negative consequences for impacted borrowers and lenders alike. In the case of the latter, not only were lenders also exposed (directly or indirectly) to counterparty risk, but in situations where loans turned sour they also found themselves in the unenviable position of being unable to instigate enforcement action in situations where this would mean terminating a swap and with it precipitating a significant close-out payment to the swap provider. This dire situation was exacerbated by highly leveraged loans and/or where long-dated swaps were involved which made it economically impossible to liquidate a loan given the eye-watering termination costs.

It is no surprise that in the wake of the GFC, market practice and regulation has sought to clean up these shortcomings in order to ensure that the risks of interest rate swap were carefully managed. Although these steps have been very much welcome, in many ways this has all been rather academic given that for the past decade or so, we have experienced record low interest rates and with it interest rate caps have dominated.

Just as interest rate swaps received their acid test in the wake of the GFC, now is the time for interest rate caps to be properly tested. The vast majority of CRE loans originated during the last decade have embedded the requirement of cap which must remain in place for the life of that loan. An increase in interest rates though will have a number of ramifications. First and foremost, counterparty risk becomes a real hot topic. Loan agreements typically provide that if certain ratings triggers are triggered then the cap needs to be novated to another cap provider and/or collateral posted. Given where interest rates are likely to go and the cost associated with these instruments it will be interesting to see how workable these replacement requirements are in practice. Similarly, when it’s comes to calculating financial covenants, the sincere hope is that interest covenants give credit to the strike rate under an interest rate cap. Failure to give credit to any interest rate cap could trigger a cash-sweep or worse, an event of default.

In circumstances where a loan is approaching maturity, the rise in rates is particularly acute. If a borrower is looking to exercise an extension option then that almost certainly will involve purchasing a new cap to cover the extension period and given where rates are at, this is likely to be at an eye-watering prospect compared to what was paid on origination. In a similar vein, if a borrower is looking to refinance existing assets, then borrowing costs will have risen significantly compared  to the previous financing. These exorbitant costs are likely to have a knock on effect, with a dampening of purchase prices that borrowers are prepared to pay to acquire assets and/or they may seek higher levels of leverage to fund these additional borrowing costs.

It is abundantly clear that the rising price of the interest rate cap will clearly have a serious impact on the CRE lending market, and although some borrowers may try to counteract this by trying to obtain a higher strike rate and/or a reduction of the notional, these approaches will not be hugely appetising for lenders given the heightened level of risk. Given the current interest rate environment, the appeal of the interest rate cap has somewhat diminished and with it the market is likely to witness the re-emergence of the interest rate swap as a more workable method of addressing interest rate risk. Ultimately, this is no bad thing given that interest rate swaps as a hedging product have been tried, tested and lessons learnt. Furthermore, compared to the period prior to the GFC, the levels of CRE leverage are at more workable levels and accordingly there is a greater capacity to absorb swap termination costs in situations where enforcement action is required.

The bottom line is that interest rate hedging is here to stay, and whether it takes the form of a cap or a swap will derive different benefits and headaches for borrowers and lenders alike. The key thing for the market to recognise is that regardless of which instrument is deployed, lessons are learnt from the past and that ultimately the chosen hedging product is structured in such a way that it proves to be friend and not foe to the lending structure. As a final thought, given the CRE lending market has proven itself to be a hotbed of innovation that has consistently learnt from the mistakes of the past and actively refined and finessed loan structures and documents to create a more robust loan product, I would not be surprised if the same applies to hedging, and who knows the binary choice of either a swap or a cap could be confined to the CRE lending doldrums. Either way this is definitely a hot topic to watch.

Russian Sanctions: Provision of corporate services and ‘indirect’ assistance

Read time: 2 minutes 30 seconds

On 8 May 2022, OFAC issued a determination (Determination) pursuant to Executive Order (E.O.) 14071 (issued on 8 April 2022), “Prohibitions Related to Certain Accounting, Trust and Corporate Formation, and Management Consulting Services,” prohibiting:

The exportation, reexportation, sale, or supply, directly or indirectly, from the United States, or by a United States person, wherever located, of accounting, trust and corporate formation, or management consulting services to any person located in the Russian Federation.”

The Determination is also applicable to transactions denominated in US Dollars but excludes (1) any service to an entity located in the Russian Federation that is owned or controlled, directly or indirectly, by a United States person; and (2) any service in connection with the wind down or divestiture of an entity located in the Russian Federation that is not owned or controlled, directly or indirectly, by a Russian person.

In particular “Trust and corporate formation services” includes “…services related to assisting persons in forming or structuring legal persons, such as trusts and corporations; acting or arranging for other persons to act as directors, secretaries, administrative trustees, trust fiduciaries, registered agents, or nominee shareholders of legal persons; providing a registered office, business address, correspondence address, or administrative address for legal persons; and providing administrative services for trusts”.  This is squarely aimed at the corporate services sector as OFAC itself acknowledges by stating  “please note that all of these activities are common activities of trust and corporate service providers (TCSPs), although they may be provided by other persons”.

The Determination does not only prohibit the setting up of new special purpose vehicles (SPVs) or trusts on behalf of Russian persons but “acting” implying that continuing to act for these and providing services to already established SPVs and/or trusts would also be prohibited.

However, what is currently unclear is how widely OFAC would construe the provision of ‘indirect’ services. For instance, if a TCSP is providing its services to an orphan SPV outside of Russia but the overall structure was set-up to allow funding to flow to or to otherwise benefit a Russian person, there appears to be a risk that this could also be prohibited by the Determination. Each structure and the role of the TCSP will need to be analysed individually to determine a course of action going forward.

In addition, other services provided by TCSPs could be captured as “Accounting services”  including “ ….services related to the measurement, processing, and evaluation of financial data about economic entities”, and “Management Consulting services”  “…includes strategic business advice; organizational and systems planning, evaluation, and selection…”. The broad nature of ‘management consulting services’ in particular means that careful thought should also be given to any discussions on exploring alternative solutions for existing transactions (such as restructuring existing payment mechanics) that may be subject to the Determination as these could themselves be prohibited.

The prohibition is to take effect from 7 June 2022. However, OFAC has issued under a General Licence 34    “….all transactions ordinarily incident and necessary to the wind down of the exportation, reexportation, sale, or supply, directly or indirectly, from the United States, or by a United States person, wherever located, of accounting, trust and corporate formation, and management consulting services to any person located in the Russian Federation” may be undertaken until 7 July 2022.

Even once a TCSP has decided to resign from its role, the basis for such action, its timing in light of relevant notice periods and the position of the directors of any SPV will itself need to be carefully considered.

CRE CLO versus the old and outdated brush

When speaking to market participants and commentators about Europe’s first ever CRE CLO, more frequently than not there is an inference that the Starz Real Estate CRE CLO is the first since the global financial crises (GFC). This is certainly a view that has merit, thanks to the fact that on the eve of the GFC, we did witness the arrival of CRE CDO technology on European shores which has a strikingly similar appearance to a CRE CLO. On a superficial level, this view can largely be attributable to both structures featuring loans secured by commercial real estate (CRE), the existence of a collateral manager (or equivalent) and the resultant investment piece is a rated debt instrument. If however you delve into the vagaries of these two different structures, it soon becomes apparent that CRE CLO technology is new to the European market and that the Starz deal is a true first of its kind.

Indeed, their chief distinguishing feature is the nature of the underlying collateral. In the case of CRE CLO, these structures are designed to house whole loans secured by commercial real estate that is transitional in nature. In the case of CRE CDOs, heterogeneity is the name of the game, with the collateral pool comprising a whole myriad of debt interests secured by CRE including whole loans, B-Notes, pari-passu tranches, mezzanine loans, tranches in mezzanine loans and of course CMBS notes.

These products also serve different purposes. Rather like CMBS, CRE CDOs can be considered an arbitrage tool where investors in this collateral or indeed the originating bank set up structures in order to off-load collateral from their balance sheet and reap the rewards of the excess spread derived from there being a lower weighted average interest rate on the securitisation compared to the return on the collateral. In other words these structures were ideal in absorbing all the high yield CMBS by-products. Conversely, CRE CLO technology has a seemingly more noble existence in the form of a balance sheet financing tool for debt funds that originate CRE loans.

On a more macro level, both structures have very different prospects. CRE CDO technology can be considered outdated, thanks to its short-lived existence in Europe with less than a handful of transactions taking place. This is largely due to the fact that the public issuance window was extremely small with the first deal of its kind in December 2006 and the onset of the GFC seven months later which precipitated an immediate cessation in primary activity. Punitive regulatory capital treatment for re-securitisations, a lack of suitable underlying collateral and no investor appetite for this product has meant that CRE CDO has been confined to the doldrums and unlikely to re-emerge anytime soon (if at all). As for the CRE CLO, this is very much the new kid on the block, which currently benefits from huge demand, decent set of tailwinds and a really promising blueprint in the form of the United States market which is currently witnessing exponential growth of the product.

CRE CLO is therefore a very exciting prospect for the European market and there is no reason why we will not witness an explosion of activity in the coming months and years ahead. Ultimately, time will only tell whether it can truly live up to this hype, but one thing that is abundantly clear is that CRE CLO and CRE CDO is not the same product and to suggest otherwise risks tarnishing this new and exciting technology with an old and outdated brush.

India’s bad debt – an international perspective

In January 2022, Dinesh Khara, the Chairman of the State Bank of India announced that the National Asset Reconstruction Company (“NARCL”) has received all approvals to commence its operations. NARCL is what is colloquially known as a bad bank, formed to acquire illiquid and risky assets, such as bad debt, from distressed financial institutions. NARCL is a state-owned bank that will receive assistance from India Debt Resolution Company Ltd, which is majority-owned by private banks, by way of an exclusive arrangement on a principal-agent basis with final approvals from NARCL as the principal. Thirty-eight accounts have already been earmarked to transfer to NARCL. It was planned that 15 distressed assets would be transferred to NARCL by the end of March 2022. However due diligence, procedural and valuation issues proved to take longer than expected and these transfers are still to take place.   On March 10, 2022 ICICI Bank signed an agreement to invest in NARCL, acquiring 5% equity in NARCL. Public sector banks will maintain a 51% ownership in NARCL.

India recorded a ratio of gross non-performing assets to total advances over 8% in the 2020 fiscal year and 7.5% as of September 2020. India’s state owned banks account for more than 60% of the bad debt, although the State Bank of India, Bank of Baroda and Punjab National Bank each reported declines in non-performing loans in the last quarter of 2021. The approval of NARCL will be a welcomed move for the banks, as the proceeds from the sale of the bad assets will help them to further recoup some of the money they have lent.

Lessons from around the world

India is the latest in the list of countries who have formed bad banks to look to clean up non-performing assets. In response to the Asian financial crisis, China set up bad banks for each of its big four state-owned banks with the intention that they would acquire non-performing loans from those banks. The goal was to resolve the non-performing loans within 10 years, however in 2009 their tenure was extended indefinitely. Although India’s model will not be based on that of China, there are clearly lessons to be learnt. An important take away is that NARCL should have finite tenure and a clear and specific mandate that is not altered. In contrast, the China Huarong Asset Management Co. Ltd. bank in China extended its tenure and broadened its mandate transforming into an investment bank and it has been argued that the change in timeline of the bank has led to financial instability.

We have learned from the Resolution Trust Corporation in the United States and Securum in Sweden that by sticking to mandates and setting timelines, bad banks can be successful. In the US and Sweden the bad banks were wound up within their predicated lifespans. Sweden’s was dissolved and had disposed of 98% of its assets. Similarly, here in the UK, UK Asset Resolution (“UKAR”) was created in response to the financial crisis and managed the assets of Northern Rock and Bradford & Bingley. Like the US and Sweden, UKAR was focused on meeting its 2021 deadline and therefore by 2019 it had fully repaid the government loans given to the companies and sold the companies together with their assets in 2021.  In Ireland, the National Asset Management Agency (“NAMA”) was set up to take over the Irish bank’s property debts after the financial crisis. NAMA was originally due to be wound up in 2021, however in 2019, like China Huarong Asset Management Co. Ltd, the deadline was extended, but only until 2025. Paschal Donohoe, the Minister of Finance in Ireland, explained that this was to allow NAMA to deal with a small number of remaining loans. It has been indicated that when NAMA is wound up it will return a surplus on its activities as it has made a profit each year since 2011, perhaps suggesting that extending deadlines is not always a cause for concern.

Looking to the future

The success of NARCL, as with other bad banks, is a combination of a variety of factors.  First, such an institution needs political will and backing from government. Support from political leaders provides the vision and incentive for bad banks to acquire distressed debt. This has to come from the top-down, governmentally speaking.  Further, the process for take-on and divestment of such debt must be clear and streamlined, which acts as a further factor to drive action by regulators and others to encourage action on bad debt. A final factor is a careful use of private sector expertise in well-developed financial markets who are able to acquire bad debt. In this respect, the agreement of ICICI Bank to acquire 5% equity in NARCL is a positive sign.

NARCL’s creation is undoubtedly a step in the right direction for the future of the Indian financial markets in respect of bad debt.  It provides a key opportunity for Indian banks (especially state-owned banks) to sell distressed loans and improve their balance sheets. If India can closely follow the success of other bad banks around the world, this could prove to be a seminal moment for Indian debt markets.

The Reed Smith team have advised a variety seller, purchasers, borrowers and financiers in respect of distressed debt transactions and debt restructurings. If you are interested in learning more about Reed Smith’s India finance capabilities, please visit our India page or contact Gautam Bhattacharyya, Sarah Caldwell or Nathan Menon.