As outlined in our previous blog, X-tra, X-tra, Real All About It! published on Friday 8 April, Mr Justice Snowden handed down judgment of the High Court in the much anticipated Windermere VII Class X Notes dispute (Hayfin Opal Luxco 3 S.a.r.l. & another v Windermere VII CMBS plc & others). Continue Reading
Fuelled by continued macro-economic uncertainty, the European CMBS market is currently experiencing a prolonged period of malaise. Meanwhile the Italian legislative cogs have continued to turn. The news last week that the Italian government has finally approved a decree on NPL securitisations, which comes hot off the heels of the proposals to establish a private sector bail-out for banks and the promise of insolvency law reform, once again demonstrates that Italy is the jurisdiction to watch in 2016.
In my view Italy has the potential to play an integral role in not only kick-starting, but revolutionising the European CMBS market – a topic that I explore in greater detail in this week’s edition of Financial News (Leading a renaissance? It’s just what Italians do).
Therefore, as we continue to canter through 2016, I for one, will be watching and waiting to see if Italy begins to deliver on this latent potential…
Mr Justice Snowden has handed down judgment of the High Court in the much anticipated Windermere VII Class X Notes dispute.
For those of you who haven’t been following it, the dispute relates to the Windermere VII Pan European CMBS in which the holder of the Class X Notes and a holder of the Class B Notes commenced proceedings in the English High Court seeking a number declarations as to the proper construction of the transaction documents. Broadly speaking, these declarations were with respect to the basis on which payments of Class X interest had been made historically (specifically, as a result of the application of the intercreditor agreements), whether this underpayment constitutes an Event of Default and whether or not any underpayments accrue interest at the Class X Interest Rate. The holders of the Class X Notes and a holder of the Class B Notes asserted that there had been historical underpayments of Class X interest, that there had been an Event of Default and that these unpaid amounts should accrue interest at the Class X Interest Rate, which at various points in the life of the transaction had been as much as 6,001%.
The judgment can be found here.
In a nutshell, Mr Justice Snowden dismissed the Class X Noteholder’s arguments and confirmed:
“I do not consider that there has been an underpayment of the Class X Interest Amount for the January 2015 or October 2015 Payment Dates, or that any further interest at the Class X Interest Rate would have accrued thereon under Condition 5(i), or that any Note Event of Default has occurred as a consequence.”
The judgment will likely be welcomed by other Noteholders in the structure and makes for interesting reading for anyone involved in CMBS or structured finance generally. Reed Smith advised the successful issuer, Windermere VII on this dispute. A further detailed analysis of the case will follow.
Almost a year ago to the day, I posted a blog questioning whether CMBS was the answer to Italian bank deleveraging woes. One year on, I am pleased to say that the Italian government (clearly channelling me!) has just reached an agreement with the European Commission to provide for a guarantee mechanism for the securitisation of Italian non-performing loans (NPLs). In effect, the European legislature has given the green light to the deployment of securitisation as a tool to clean up Italian bank balance sheets. In other words, the answer to my question was YES!
This news is a hugely significant, positive sign for European securitisation markets. Hot off the heels of the proposed Securitisation Regulation, by agreeing to this securitisation proposal, the European legislature has once again acknowledged the vital role that securitisation can play for the European economy. Turning more specifically to CMBS issuance, the magnitude of this development will largely depend on the extent to which Italian banks deploy securitisation as a means of off-loading NPL’s secured by commercial real estate (CRE). However given the suggested volume of Italian CRE NPLs, the issuance backed by such loans has the potential to be sizeable.
Since the European CMBS market re-opened in June 2011, Italy has been one of the jurisdictional bedrocks of CMBS 2.0 being one of a few countries where there has been a steady flow of deals. The primary driver for this has, to date, largely been attributable to CMBS being used as a means of overcoming those Italian domestic regulations which require institutions purchasing syndicated loans to have a banking licence. With this in mind, the news that the European legislature has given the thumbs up to using securitisation as a means of cleaning up the balance sheet of Italian banks will have the metaphoric effect of throwing fuel on the Italian CMBS fire and thus in the coming year it is likely that we will witness a surge in the levels of primary issuance.
Indeed, such an uptick in Italian issuance should promote increased evolutionary change in the CMBS product, spurred on by a need for structures to accommodate a greater variety and number of non-performing CRE loans. A further consequence of this legislative measure is likely to be the deepening and strengthening of the investor base required to absorb and competitively price CMBS deals. Similarly investors that are already in this space should finally have the justification to put in place the internal resources and infrastructure required to invest in this asset class in real volume. Finally, we may also start to see a contagion effect in the European CMBS market, caused by those investors in these deals also demanding product backed by CRE located in jurisdictions other than Italy.
Considering all of the above, it is therefore quite possible that Italian and European legislators could have in fact hatched a plan that may not only prove integral to the rehabilitation of the Italian banking system, but also be positively revolutionary for the re-emergence of European CMBS issuance.
Earlier this month I set out my CMBS predictions for 2016 in the Investment Adviser (Broadening the scope of CMBS loan issuance), where I predicted that macro-economic conditions would continue to challenge the re-establishment of CMBS as financing tool for European commercial real estate (CRE). Indeed, the first few weeks of the year have done little to alleviate these residual concerns given the renewed and heightened volatility in the Chinese capital market, the continual slide in the price of oil as well as the raft of disappointing UK economic data. As was demonstrated during 2015, these factors have the potential to have a profound adverse impact on the pricing of CMBS bonds and with it, the ability to act as a metaphoric off-switch for primary issuance. Despite these warranted notes of caution, it is therefore essential that CMBS market participants do not get too carried away with the headwinds of the potential of another financial crisis, but instead concentrate on those positive tailwinds that have continued to move CMBS along from being a financing myth to potentially becoming an integral financing instrument for European CRE.
Indeed, the most encouraging tailwind for the securitisation product, is the fact that simple, standardised and transparent securitisation is considered by regulators as one of the building blocks of a European capital markets union. In order to achieve this, the European Commission has therefore published a legislative proposal for creating a European framework for simple, transparent and standardised securitisation (the so called Securitisation Regulation) which is currently making its way through the European consultation mill. However for this to go from being a headwind to a tailwind, it is important that many of the structural nuances associated with CMBS as an asset class are addressed as currently this regulation does follow a similar direction as other well meant legislation such as Solvency II which has had the unwelcome effect of inadvertently penalising CMBS as an asset class.
Other encouraging CMBS tailwinds to be aware of include the fact that the geographical net of CRE assets financed by CMBS has greatly expanded in recent years, as has the complexity of the deal structures to include multiple loans in different jurisdictions. Indeed, last year we saw the first Pan-European CMBS deals since the financial crisis which is an important milestone in the evolution of CMBS 2.0.
Taking into account these positive tailwinds, I therefore have four wishes for the European CMBS market in 2016. Firstly, I wish that European primary CMBS issuance will shortly resume and that unlike 2015, we will witness a steady flow of deals throughout the year. Secondly, although I acknowledge that this year will be challenging for the financial markets, it is nevertheless my wish that market participants do not get too carried away with those adverse macro-economic reports that are currently monopolising the global financial press. Thirdly, I wish that the European regulators will appreciate the structural idiosyncrasies of CMBS as an asset class and therefore do not introduce measures that have the unintended consequences of penalising CMBS vis-à-vis other asset classes. Finally, I wish that the European market experiences an exponential “boom” in CMBS issuance involving multiple loans, multiple jurisdictions and multiple arrangers.
Clearly only time will tell, whether any of these wishes will become true and indeed my fourth and final wish can justifiably considered rather fanciful, but that said, if the other three wishes materialise, then there is no reason why my fourth and final wish cannot become a CMBS reality…….
The green bond market is currently one of the fastest-growing fixed-income segments, with issuances tripling between 2013 and 2014. There is a sense of excitement and optimism surrounding the market – initially led and developed by the multilateral development banks (MDBs) and international financial institutions (IFIs), but now actively promoted, sponsored and supported by the private sector.
For more information, read our Client Alert on reedsmith.com.
Given that it is coming up to a year since I posted a blog (CMBS – it’s time to dance to the beat!) in which I surmised that “I don’t just want to see CMBS hit the dance floor – I want to see it win a contest!”, now would seem an opportune time to reflect on whether CMBS has lived up to any semblance of this hype.
Indeed, if we extended this metaphor for the purposes of considering the products achievements for 2015, it would be fair to say that although CMBS did not win any contest, it definitely began to dance. In fact, not only did CMBS hit the lyrical dance floor and bust some moves, it actually began to break dance before the music was rudely turned off and the lights switched on.
Given the burgeoning confidence displayed by CMBS, the August flicking of the metaphoric switch could not have come at a worse time. At this point of the year, CMBS was in a great place, given that with at least a third of the year still to run (which historically is also the busiest period) the volume of primary issuance had already equalled that of 2014. Furthermore, major structural innovation had also been achieved, the most pertinent of which was the emergence of the inaugural pan-European deals since the global financial crisis (GFC). Finally, further confidence was engendered by the fact that the market saw the first deals since the GFC that were backed by assets located in Ireland and Belgium as well as the launch of JPMorgan’s maiden CMBS 2.0 deal.
In light of these achievements, it is hugely frustrating that those adverse macro-economic factors caused by concerns over a Grexit and the Chinese financial crisis brought about the premature shutdown of primary CMBS issuance for the year. Indeed, had the CMBS product been allowed to continue to party, there is every chance that we would have witnessed some pretty impressive innovation. The hard reality, though, is that the idiosyncrasies of investing in a capital markets instrument such as CMBS prevailed and with it, we learnt that there is clearly some way to go until CMBS 2.0 can be considered a strong, robust and reliable financing instrument that is capable of weathering a capital markets storm.
Turning the spotlight to 2016, it would be fantastic to see the resumption of primary issuance and a return to continued innovation, with a particular emphasis on the emergence of those structures that are capable of featuring a greater number of loans (see The renaissance of European multi-loan CMBS). Having said all that, given the lack of issuance over the past few months, in the immediate term I would just be happy to see CMBS dance and if that means that CMBS 2.0 is merely throwing some groovy shapes on the dancefloor – with no contests in sight – then so be it!
The European CMBS 2.0 market was launched in June 2011 and in the years that have since followed, twenty four public rated deals have so far hit the market. Given that only seven of these deals have featured multiple loans and the smallest loan securitised prior to November 2015 had a balance of €55 million, the European market appears to be largely confined to the securitisation of large balance sheet loans. This is a stark contrast to the position immediately prior to the global financial crisis (GFC) when CMBS deals featuring eight or more loans were in plentiful supply. Indeed this “heyday” of European CMBS can be exemplified by one primary issuance that took place in March 2007 that was comprised of thirty two loans secured by commercial real estate (CRE) located in five different jurisdictions. Now that we are more than four years into this new era, many market observers are beginning to question whether the European market will once again reach the dizzy heights of CMBS 1.0 or whether deals featuring one or two large loans is in fact the new market norm.
In order to understand what direction the market is heading, it is essential to consider the evolution of deals prior to the GFC. CMBS 1.0 exploded into life in the middle of the last decade and with it multi-loan transactions were a common feature from the very outset. Fuelled by a favourable regulatory environment and an abundance of cheap debt, CMBS was able to flourish as an off-balance sheet tool for funding CRE. Against this backdrop, there was a huge amount of innovation in the market with deals featuring increasing levels of complexity and ingenuity culminating in some notable multi-loan deals, such as the thirty two loan transaction mentioned above.
Given the overwhelmingly favourable market conditions the CMBS 1.0 product evolved in a vacuum and was not subject to the tests, challenges and scrutiny that a product of this magnitude generally receives and requires. In effect CMBS 1.0 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 1.0 product was subjected to a long awaited litmus test and with it many of the structural shortcomings were soon exposed. Indeed, a review of the new CMBS deals in the market reveal that the structural concerns raised by CMBS 1.0 have largely been addressed in the structuring of this new vintage of notes.
Since June 2011 we have now entered into a new era for the CMBS product. Given that so many market participants were adversely impacted by CMBS 1.0’s structural flaws, the fragility of the global economic market as well as the high level of regulatory uncertainty, the new deals have so far evolved and developed at a much more measured rate than their predecessors. The trend for CMBS 2.0 has therefore been the utilisation of simplified structures which has largely been achieved by confining deals to the securitisation of single large loans. The use of these structures has proved invaluable in the rehabilitation of the product as these transactions have allowed confidence to once again return to the CMBS market as well as enabled an increasing number of arrangers to re-launch their CMBS platforms.
Although simplified CMBS structures are currently en vogue, this status quo is unlikely to subsist in the coming years. Given the limited availability of sizeable CRE loans that are suitable for a CMBS, the inevitable next step for the European market is the structuring of deals that are capable of accommodating the securitisation of a greater number of smaller loans. Assuming that this does happen (and there is every sign that it will), this would have a profound impact on the European CMBS market as it would not only hugely increase the universe of borrowers that could benefit from loans destined for CMBS 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 CMBS exit in mind. Indeed as borrowers prepare themselves to face a sustained period of escalating interest rates, the opening up of CMBS to smaller CRE loans and with it the opportunity of obtaining cheaper debt will be a greatly welcome development.
It is not just borrowers that will herald in such a structural shift, but fixed income investors will also welcome such a development given their increasing appetite for investment in CMBS that has been spurred on by the continued low interest rate environment, the ECB’s introduction of large scale quantitative easing as well as their own relentless search for yield. Accordingly on the basis that the securitisation of a greater volume of smaller loans will lead to an increased amount of primary issuance and a smoother flow of deals, this is likely to 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 that in the sixteen months that followed the launch of Europe’s first CMBS 2.0 multi-loan deal in July 2014, seven of the fifteen public rated deals that have been brought to market were multi-loan deals, then the European market is already displaying a structural shift towards transactions featuring a larger number of smaller loans. This is a huge step forward for CMBS 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 CMBS structures that are required to be put in place for such deals. Building on the success of these transactions 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 such 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 with the renaissance of multi-loan deals, the market has taken its first steps towards this CMBS 1.0 myth becoming a CMBS 2.0 reality and with it confining a market monopolised by the securitisation of large balance sheet loans to the evolutionary history books of CMBS 2.0.
The recent below par pricing of two Goldman Sachs arranged CMBS deals demonstrate the potential perils of CMBS as a distribution tool for CRE debt. Indeed, these two deals bring into stark focus the pricing quandary that currently confront many conduit lenders. On the one hand, lenders are having to competitively price loans in a debt market that is awash with a plentiful supply of liquidity leading to increasingly tighter margins, meanwhile the capital markets have proved themselves to be anything but predictable. A balance sheet lender (or a lender seeking to distribute a loan via the syndication market) can be largely indifferent to short term volatility in the capital markets which is subsequently corrected, however, as demonstrated by the impact of a potential Grexit and the Chinese stock market crisis on the below par pricing of the Logistics UK 2015 CMBS and the Reitaly Finance CMBS, short term market turbulence has the potential to have a profound impact on lenders with a CMBS exit in mind.
With the continued fallout from the global financial crisis, uncertainty regarding the Eurozone, falling oil prices, increasing instability in the Middle East as well as the unknown impact of rising interest rates, it is likely that we will increasingly be confronted with periods of extreme volatility in the capital markets. Although market turbulence will certainly not be welcomed by CMBS lenders, it is nevertheless one of the endemic risks of employing an originate-to-distribute business model with CMBS at its heart. Despite the fact that this risk cannot be entirely eradicated, there are certain mitigants that lenders can use to limit pricing risk such as ensuring the temporal period between pricing of a loan and distribution is kept to an absolute minimum. Equally a lender could ensure that its exposure to a large loan is reduced by syndicating an amount of the loan contemporaneously with origination. Finally (and it is noted that this is easier said than done), a bank can avoid being placed in the unenviable position where it is forced to launch a CMBS deal amidst tumultuous capital market conditions in order to free up balance sheet or meet investor demand for product.
When it comes to the origination of large loans, this pricing risk is magnified and further compounded if there is little or no appetite to distribute any amount of this loan in the syndication market. In these circumstances, a lender should be mindful of another weapon up their sleeve and that is the arrangement of an agency CMBS deal pursuant to which the borrower can directly tap the capital markets to raise debt (see Agency CMBS – the sophisticated tool for raising cheaper commercial real estate debt!). Although such structures will not afford originators the right to receive excess spread, they will at least allow banks to meet both borrower and investor demands whilst at the same time not having to deploy any of their balance sheet. At a time when the capital markets are likely to be prone to periods of heightened volatility and lenders are reluctant to assume significant pricing arbitrage risk, when it comes to the origination of large loans we could therefore yet see the renaissance of agency CMBS technology with renewed vigour as a means of satisfying borrower, investor and lender requirements alike.
As was the case prior to the global financial crisis, the current driver for all new European CMBS deals stems from the adoption by investment banks of the originate-to-distribute business model for financing commercial real estate assets. This trend is showing no sign of abating in the CMBS 2.0 era with twenty of the twenty seven public CMBS deals that have so far hit the market since June 2011 being attributable to this lending model. Although this is a proven and effective mechanism for producing much needed CMBS product, it is important for market participants to be aware that these conduit deals are not the only CMBS structures in the market and that agency deals could potentially be an invaluable tool for any sophisticated borrower that is looking to directly tap the capital markets to raise cheaper finance.
In fact it was not so long ago that agency deals were considered to be the only viable means of creating European CMBS product. Shortly following the onset of the global financial crisis, a whole raft of regulation was mooted which had the consequence of subjecting the originate-to-distribute business model to intense scrutiny. Pending clarity on whether the cost of such regulation would leave this business model bereft, agency deals were considered by many as the future of CMBS given that they could be structured without the involvement of banks and thus insulated from most of the regulation that was threatening to decimate this much used business model. In the years that ensued, there has been regulatory clarity and as demonstrated by the volume of conduit style deals that are currently being brought to the market by the likes of Deutsche Bank, Bank of America Merrill Lynch and Goldman Sachs, the originate-to-distribute model has clearly weathered the regulatory storm and is now back with a vengeance.
In terms of the structuring of agency and conduit deals, although both transactions ultimately result in the issuance of notes secured by commercial real estate, the structures employed to achieve this vary. In the case of the latter, the structure involves a bank advancing a loan to a borrower which then sits on the bank’s balance sheet prior to being distributed (either by itself or in a pool of other loans) via securitisation, syndication or a combination of the two methods. Given the bank owns the loan prior to the securitisation, conduit deals will also typically contain structures that allow the originating bank to extract “excess spread”, being the difference (after taking into account expenses) between the weighted average coupon on the notes and the weighted average interest received on the underlying loans. Agency deals on the other hand remove the role of the bank as an intermediate lender, thus are structured in such a way that the borrower through an affiliated entity (the note issuer) will directly raise finance by issuing CMBS notes into the capital markets.
Although we are now seeing a greatly welcomed resurgence of conduit deals, it is important to note that the originate-to-distribute business model, is not as compelling as it once was given the regulatory costs associated with holding commercial real estate loans on the balance sheet (prior to distribution), the balance sheet cost of retaining a material net economic interest of 5 per cent. of issued notes as well as the expense of meeting the exorbitant cost of a liquidity facility. However despite this drag on costs, the originate-to-distribute model has proven itself to be profitable and will increasingly become more profitable assuming that bond prices continue to tighten, there continues to be an increase in the volume of issuance and arrangers manage to keep the temporal period between origination and distribution to a minimum.
Meanwhile coupled with the rise of conduit deals to prominence, agency structures have once again fallen into their shadows. Although it is fair to say that both these structures have their merits and weaknesses, these credentials will vary depending on from which angle these transactions are viewed. From a borrower’s perspective the most appealing feature of an agency deal is that finance raised through these structures is greatly cheaper, as they only have to service the coupon on the notes and therefore not required to stump up additional amounts to cover the payment of excess spread and any regulatory costs of the lender incurred prior to distributing the loan and satisfying the 5 per cent. retention requirement. A further appeal of these structures, is that given a borrower has created the agency structure and therefore appointed individual transaction parties to their role, then these structures inherently give a borrower a greater level of control and influence than they would otherwise enjoy in a conduit deal. As demonstrated by the CMBS 1.0 vintage of agency deals, this has proven to be invaluable in the event that a borrower ever finds itself having to consensually restructure its debt (see the restructuring of London & Regional Debt Securitisation No.1 PLC).
Although from a borrower’s perspective, the economics of such a deal would appear to be a no brainer, the reality is that the structuring of these agency deals compared to a plain vanilla financing is certainly a more time and resource intensive process which carries with it a greater level of execution risk. These risks are particularly pertinent in the case of a maiden CMBS deal, however such concerns can be off-set by the fact that a borrower could potentially derive huge benefit from the economy and efficiencies of scale of putting in place repeat financing using a similar structure with the same parties. A further drawback with an agency deal is that the amount of financing required must be large enough (typically public rated CMBS deals are in excess of €200m) to make a public rated agency deal an attractive financing proposition. Although this is a difficult hurdle to overcome and in effect reduces the universe of potential borrowers that are able to put in place a public rated CMBS deal, borrowers should remember that these are not the only type of deals in the market and that CMBS technology is regularly used to implement a smaller note issuance through the issuance of privately placed unrated notes.
The re-emergence of the originate-to-distribute model and CMBS’s role as an integral part of this has got to be viewed as an extremely positive development for borrowers, lenders and investors alike. In particular, borrowers will no doubt hugely welcome the opportunity of obtaining cheaper debt that these conduit lenders are able to provide. However for those borrowers that demand and require ever cheaper financing, then such borrowers should definitely consider rolling up their sleeves and directly tapping the capital markets with an agency CMBS. Given that in today’s market we are currently awash with cheap credit, however, these agency deals may seem a fathom too far for even the most yield hungry borrower. That said, as borrowers prepare to join a conveyor of escalating interest rates, the sophisticated and commercially savvy amongst them would do well to embrace agency CMBS technology sooner rather than later.