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

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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

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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

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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.

European CRE CLO – dynamism during a storm of escalating interest rates

Read time: 3 minutes

It is fair to say that there is not only a lot excitement about the arrival of CRE CLO technology in Europe, but also a heightened level of interest when it comes to some of the structural features that this new asset class could embrace.  In this vein, it is fair to say that one of the marquee features of a CRE CLO is that the underlying collateral is not necessarily confined to a static pool of loans (as is the case with CMBS), but instead can comprise a dynamic pool of loans, the composition of which evolves as new loans are acquired and existing loans are sold or redeemed. In order to finance this churning of loans, capital will take the form of either recycled funds from prepaid or sold loans, or fresh capital accessed from either a day one reserve or a tap issuance taking place later down the line.

Ostensibly having a dynamic pool of collateral makes a lot of sense in situations where you have loans that are prone to early prepayment or simply of a short term nature. When it comes to CMBS and CRE CLOs, prepayments are rarely regarded as a positive thing for the structure. From an investor’s perspective prepayments are certainly not welcome, especially if they lead to redemptions taking place soon after issuance. Equally, from a structurers point of view, prepayments can create a structural nightmare in terms of devising how principal should be applied. This is especially true if a securitisation features multiple loans of varying quality, a difference in interest rates and a wide geographical spread of underlying properties. Certainly in European CMBS 1.0, the modified pro-rata application of principal repayments really went through the structuring mill, which manifested itself with some hugely complex CMBS structures as the structurer sought to ensure that principal was applied in such a way to ensure that credit enhancement erosion for the senior notes was limited, that the weighted average rate on the notes was kept in check whilst at the same time ensuring that the class X would not be adversely impacted.

A neat solution to alleviate prepayment pain from investors and structurers alike, is to have a dynamic pool of loans where prepayment amounts are recycled with the acquisition of new CRE credit. Investors, instead of receiving early redemption proceeds, will be instilling confidence in a collateral manager who will be responsible for managing the collateral pool over the passage of time, and more specifically charged with the task of managing the constant risk of credit quality drift as the nature and type of underlying collateral changes as a result of prepayments and the acquisition of new loans.

The existence of a dynamic pool of loans can be considered a desirable and immensely flexible feature that would be greatly welcomed by sponsors of CRE CLO’s, which will be especially true if this technological feature actually enables them to use the CRE CLO to fund the origination of fresh loans following issuance. Investors will welcome it if it means that they are not suddenly subject to an early redemption. As for underlying borrowers, if this structure will ensure that they receive less arduous prepayment fees then this can be construed as a clear positive of having a lender house their loans in a CRE CLO.

Ultimately, having a CRE CLO product that is collateralised by a dynamic pool of loans can only be a good thing and in many respects a “must have” as the European market not only grows and develops, but does so in the face of a storm of rising interest rates and with it the inevitable risk of heightened loan prepayments.

European CRE CLO – a catalyst for multi-loan CMBS

Read time: 4 minutes

For the erstwhile market observer, when you compare CMBS 2.0 against the backdrop of the pre Global Financial Crisis (GFC) crop of deals, one resounding observation is that the latter had a significant number of so called “conduit” deals, where transactions featuring eight or more loans were in plentiful supply.  This “heyday” of European CMBS can be exemplified by one primary issuance that took place in the final weeks before the onset of the GFC that was comprised of thirty two loans secured by commercial real estate (CRE) located in five jurisdictions. In sharp contrast, CMBS 2.0 has been largely confined to the securitisation by a handful of banks of large balance sheet loans.

With Starz Real Estate bringing Europe’s first ever CRE CLO to market, a groundbreaking transaction that featured the securitisation of nine loans secured by CRE located in a number of European jurisdictions, questions are rightfully being raised as to whether the European market will once again start to witness the emergence of more CMBS deals comprised of a large number of loans.

Since the GFC, it is understandable that the CMBS market has shied away for the old school conduit multi-loan deals, with arrangers favouring more simplified structures which have largely been achieved by confining deals to the securitisation of one to three large loans. Indeed, the use of these structures has proved invaluable in the rehabilitation of the product, as these transactions have allowed confidence in the CMBS market to return as well as enabled a number of arrangers to re-launch their CMBS platforms.

Although simplified CMBS structures have been en vogue, it is questionable whether this status quo is likely to subsist in the coming years. Given the limited availability of sizeable CRE loans that are suitable for a large loan securitisation, the inevitable next step for the European market is the structuring of securitisations that are capable of accommodating a greater number of smaller loans.  Assuming that this does happen, this would have a profound impact on the European CRE securitisation market as it would not only hugely increase the universe of borrowers that could benefit from loans destined for a securitisation, but would also open up the floodgates for the level of primary issuance given the large number of loans that could be potentially originated with a structured exit in mind.  As borrowers prepare themselves to face a sustained period of escalating interest rates, the opening up of securitisation to smaller CRE loans, and with it the opportunity of obtaining cheaper debt, will be a welcome development.

It is not just borrowers that will herald such a structural shift, but fixed income investors will also welcome such a development, especially if the securitisation of a greater volume of smaller loans will lead to an increased amount of primary issuance and a smoother flow of deals, which in turn will precipitate the deeper and stronger investor base required to absorb and competitively price such an increased volume of deals.  Similarly investors that are already in this space would finally have the justification to put in place the internal resources and infrastructure required to invest in this asset class with any real volume.

Given the emergence of a European CRE CLO product which at its core involves the securitisation of pools of loans, there are already signs that the European market is poised for a structural shift towards CMBS 2.0 transactions featuring a larger number of smaller loans.  This is a huge step forward for securitisation as a financing tool, as this development not only signifies that investors have appetite for the product but also that they are comfortable with the more complicated securitisation structures and analysis that are endemic in this type of structure.  Building on the success of the CRE CLO and fuelled by the increasing levels of demand from borrowers seeking cheaper CRE debt, it is highly likely that the European market will witness a marked increase in the number of multi-loan deals along with a trend towards a larger number of loans being securitised in these structures.

Although at this juncture in the market it is hard to say whether the new vintage of deals will ever reach the dizzy heights of a thirty two loan transaction, what is apparent is that the renaissance of multi-loan CMBS deals is a natural evolutionary step that has been catalysed by the emergence of CRE CLOs in Europe. Given that in recent years it has been the debt funds that have stepped into the shoes of the banks in the CRE lending space, then not only will they be the true architects of CRE CLOs, but these funds will be the chief protagonists when it comes to multi-loan CMBS.

NPL Securitisation – time for NPL Investors to pick up the mantle from GACs and HAPs

Read time: 4 minutes

Nearly eight years ago I penned a piece about the hugely important role that securitisation can play in alleviating the pain suffered by banks on account of the large volumes of non-core assets and non-performing loans residing on their balance sheets. The deployment of securitisation technology certainly made a lot of sense; after all it ultimately involves distilling problematic credit from the banking sector and transferring this risk to the capital markets where there is a deep and diverse pool of capital as well as appetite to absorb this risk. In addition, unlike the highly regulated banks and also thanks to the discounted purchase price paid for these assets, the securitisation structure had the much needed freedom and flexibility to work through the book and resolve these NPLs one way or another.

Given these positive attributes (and there are many others) it is no surprise that the European NPL securitisation market is truly flourishing. The volumes of issuance that have taken place over recent years is certainly impressive, and NPL securitisation has certainly delivered on its promise of alleviating some of the NPL pain in the banking sector. The chief proponents of this technology have been Garanzia Cartolarizzazione Sofferenze (GACs) in Italy and the Hellenic Asset Protection Scheme (HAPs) in Greece, and these can largely be attributable to not only delivering impressive figures when it comes to the volumes of NPL Securitisation issuance but these schemes have also been instrumental in ensuring that Europe has the infrastructure to ensure that NPL securitisation transactions can properly take place at scale.

It is important to appreciate though that as impressive as GACs and HAPs have been, these are NPL securitisations that are reliant on the support of the Greek and Italian governments respectively. These schemes are also not a long-term proposition, but a short-term fix for their banking woes which is subject to permission to renew from the European Commission every year or so. Given the significant volumes of NPLs that were residing on the balance sheets of the Italian and Greek banks embracing this technology with sovereign support certainly made a lot of sense. However as the levels of NPLs residing in these banks are reduced to more palatable levels, the need for the these programs will wane and with it their contribution to the remarkable volumes of NPL issuances that we have enjoyed to date.

It is inevitable that the next evolutionary step for the market is for those funds and special situations desks that have been active in acquiring NPLs, to start embracing securitisation technology in order to maximise their returns. Already some funds have done exactly this, with a handful of transactions that have graced the European market which have ranged from NPL securitisations in the purest sense to securitisation of portfolios of re-performing loans. The reality is that embracing NPL securitisation technology should not be dismissed by investors as they are already reliant on leverage in the form of loan-on-loan facilities in order to super-charge their investments and achieve the internal rate of returns demanded by their stakeholders. In simple terms, for these investors embracing NPL securitisation would mean substituting their current debt financing with a securitisation structure that features rated, listed notes that are sold to third party investors in the capital markets.

Admittedly structuring a securitisation is an involved process, but investors that are willing to roll up their sleeves and embrace this technology will be richly rewarded with a number of immediate economic advantages. including:

  • Cost of funds will be appealing as the weighted average interest rate on a securitisation is likely to be less than a loan-on-loan financing.
  • The level of leverage will be higher on a securitisation than compared to a loan-on-loan, thus improving their internal rate of return.
  • Significantly longer maturity date on a securitisation, thus affording the securitisation structure the requisite period of time to work through the portfolio and free the sponsor up from having to refinance a portfolio every few years.

On account of these positive features (and there are many more), there is absolutely no reason why NPL securitisation should not be baked into investor business plans as they go about the process of bidding for portfolios. At this point in time, it can be considered an ‘optional extra’, especially given the efficiencies and the well trodden path of loan-on-loan financings. However for those trail blazing funds that are looking to not only maximise returns on their investments but also secure a competitive advantage when it comes to pricing, they should be actively embracing NPL securitisation technology.

The huge strides made by HAPs and GACs mean they can largely be credited with establishing the infrastructure and solid foundations for the market to flourish. As the European NPL market continues to evolve and adapt, now is time for NPL investors to pick-up the mantle and not only be the true architects of NPL Securitisation but drive activity and spur growth in the years ahead.

CRE CLO versus CMBS – two peas in a pod?

Read time: 2 minutes

Commercial real estate

When speaking to market participants about the intricacies and benefits of CRE CLO technology, more frequently than not the first point that I have found myself explaining is the difference between a CRE CLO and CMBS. It is certainly a fair question, as ostensibly both products are the same given that they both feature loans secured by commercial real estate and the resultant investment piece is a rated debt instrument.

However if you peel off the label and take a more forensic analysis of the structure, it is clear that CRE CLO’s and CMBS are distinct products. For starters with the former, the sponsor of the securitisation retains a large percentage of the first-loss notes, where as in a CMBS this retention amount is likely to be limited to the bare minimum required to comply with the orginators regulatory requirements, and even then in lieu of the first loss piece they may elect to retain a vertical slice of the issued notes.

In terms of control, in a CRE CLO there is a day one operating adviser (or collateral manager) that not only has certain modification rights with respect to the collateral but also has extensive consultation rights when it comes to material actions. In the case of CMBS though such control is limited to consultation rights and the operating adviser is not a day one issuer appointment but instead a noteholder appointment which only really takes place at times of distress.

Finally (and quite literally), a further redeeming feature of CRE CLO is the existence of note protections tests. These are financial covenants which, if breached, cut-off distributions to the equity and sets off alarm bells signifying distress. CMBS has no equivalent early warning system, although payments to the Class X are switched off following the occurrence of certain credit events.

The upshot of these attributes is that CMBS is an ideal structure for the securitisation of loans backed by more stabilised assets, and therefore a perfect pricing arbitrage tool for those banks adopting the originate-to-distribute business model when it comes to financing CRE. On the other end of the spectrum, CRE CLO’s are better suited for loans backed by more challenging transitional types of CRE, and given that debt funds have colonised this lending space following the retrenchment of the banks, CRE CLO technology can be viewed as a balance sheet financing tool for such funds.

Although on a superficial level CMBS and CRE CLO’s could be two peas in a pod, when you sharpen the focus it becomes evident that they have very different and distinct personalities. As the European CRE CLO evolves, adapts and embraces some of the features of its more developed US cousin, the personalities of these two asset types will become increasingly apparent.

European CRE CLO technology cannot be ignored

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The European commercial real estate (CRE) lending market is currently awash with an oasis of interest when it comes to the deployment of CRE CLO’s as a means of financing loans secured by CRE. To date, debt funds that have financed CRE have been reliant on a myriad of sources of capital including pure equity, loan-on-loan facilities or repo lines. However news that Starz Real Estate successfully brought to market Europe’s first CRE CLO can be considered a game changer, as this is a financing tool that not only provides a better weighted average interest rate when compared to other forms of debt, but also much improved advance rates. Economics aside, if you consider that the debt fund will continue to have an active role in dealing with the borrower, including in relation to modifications and waivers as well as far reaching consultation rights with regard to material actions impacting the underlying collateral, then you can see the attractiveness of this technology.

CRE CLO’s are ideal for financing more transitional assets which, in today’s market, there is no shortage of supply given that property owners are faced with a once in a generation task of having to reposition and improve assets for a not only post pandemic world but also a world where ESG principles have become centre stage and are actively being embraced.

Given the outstanding fundamentals of this product for investors, property owners, debt funds and banks alike, it is safe to say that the emergence of a large bourgeoning CRE CLO market is not just “on the cards” but very much a fait accompli. Given the clear benefits (including the economics), then debt funds have little choice but to embrace CRE CLO’s to stay competitive in the CRE lending market. Ultimately, the arrival of the CRE CLO on European shores can be considered a truly positive disrupter which market participants risk ignoring at their peril.

On a personal level, I am very excited about CRE CLO’s and the vital role that this can play in the European market. To the extent that anybody has any questions or queries on any aspect of these structures then please do not hesitate to get in touch.

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