The tranching and splicing of debt secured by commercial real estate (CRE) is likely to become an increasingly important part of the CRE lending market as it begins to grapple with the sobering reality of a breaking wave of refinancings coupled with a serious deterioration in valuations.

Continue Reading Tranching of debt is critical for the breaking wave of CRE refinancings

Firms regulated by the Financial Conduct Authority (FCA) are expected to take on a stewardship role in delivering sustainable economic growth, which will benefit UK consumers and businesses in all regions. Both the UK government’s Transition Plan Taskforce and the FCA have recently shared content on putting together a blueprint to ensure this happens. It is a given that if the UK is  to become a more sustainable society and transition to a net zero greenhouse gas emissions economy by 2050, the financial industry must work alongside policymakers to actualise sustainable change in the medium to long term.

The FCA has also recently published a discussion paper to help the financial industry deliver on its potential to drive positive sustainable change. The discussion paper is part of the FCA’s commitment to deliver on its environmental, social and governance (ESG) strategy and it seeks to kick-off stakeholder engagement with the regulator’s ESG monitoring, remuneration, incentives and training/certification for regulated firms.

Stakeholders are to respond to the Q&A in the discussion paper by 10 May 2023, following which, the FCA will use the findings in determining the direction of its regulatory approach, including in relation to its supervisory engagement with firms on its ESG and stewardship strategy, as highlighted in the recent ‘Dear CEO’ letter on the regulator’s asset management supervision strategy. Some of the key considerations outlined in the discussion paper include: capability building, embedding sustainability related considerations across a regulated firm’s operations, the lack of clarity faced by oversight functions in relation to sustainable investment products, and adopting transition plans that demonstrate milestones and track short‑term actions to achieve long-term net zero aims. While these considerations are no doubt a good steer, there nevertheless remains the challenge of coherently transforming well-meaning commitments into concrete policies to achieve those aims and reflect  firms’  awareness of the risks and opportunities presented by climate change and sustainability‑related matters (and their impact on profitability in the long term).

It is expected that the FCA’s sustainability standards would draw on various sources and industry initiatives, such as the UK’s Transition Plan Taskforce, the Glasgow Financial Alliance for Net Zero, the Taskforce on Climate‑related Financial Disclosures, the International Sustainability Standards Board, the International Organization of Securities Commissions, and relevant corporate governance codes, as well as any future international developments.

The UK’s financial industry should welcome the opportunity presented by the discussion paper and contribute to the dialogue to explore how best it can deliver on sustainability objectives and achieve a uniform outlook across the sector. It is important the industry does so because, although many firms are taking steps to implement ESG policies unilaterally, the impact of such actions is increasingly being scrutinised both by investors and society at large. Consequently, it is essential to have a common set of standards to serve as a benchmark against which to measure progress, build credibility and tackle potential liability risks, such as assertions of  greenwashing or other sustainability related misconduct. Engaging the financial industry in dialogue prior to crafting industry-wide standards in the quest to achieve sustainable economic growth seems a good indication that the FCA is positioning itself to translate into action the government’s ambitions for the provision of sustainable finance and for the UK to become the world’s first net zero aligned financial centre. Overall, collective responsibility and involvement combined with proactive leadership, stewarding and accountability will be key to the financial industry achieving the climate and sustainability objectives set out by the government and the FCA.  

On January 25, 2023, the Government of India launched and sold its first-ever Sovereign Green Bond issuance for Rs80 billion ($1 billion); with half in five-year bonds at a coupon rate of 7.1% and the other half in 10-year bonds at a coupon rate of 7.29%. The auction for the second issuance took place on February 9, 2022, and raised an equivalent amount, for a total of Rs160 billion, or $2 billion.

Sovereign green bonds are issued by state governments, using money from investors in climate-related projects. Through this first for the Indian market, the Indian Government has established a new means of facilitating high-value investments to accomplish its climate targets.

The Sovereign Green Bond Framework, launched by the Indian Government on November 9, 2022, discusses and specifies the project categories for which the proceeds of green investments will be used. This framework has received a medium green rating by Cicero (the Second Party Opinion). The funds raised from the recent Sovereign Green Bond issuances will be applied in accordance with this framework. Project categories under the framework include: a) increasing energy efficiency; b) clean transport; c) reduction in carbon emissions and greenhouses; d) promoting climate change adaptation; e) improving natural biodiversity; and f) water and waste management. Financing such projects will help massively reduce the economy’s carbon footprint.

The five-year sovereign bonds went to 32 investors and the 10-year sovereign bonds went to 57 investors, who collectively offered bids worth more than four times the amount of bonds on offer. After engaging with international and domestic investors, the regulatory authorities procured some key steps with the aim of attracting a strong market response before the issuance took place. International ESG investors are currently subject to a foreign participation investment cap for specified securities. The Reserve Bank of India (RBI) has provided an exemption from this cap in the case of the green bonds, as an incentive for such international investors.

For local investors, the Insurance Regulator and Development Authority of India allowed the investments to be treated as infrastructure investments, which is an investment category required for insurers. For banks, the RBI has allowed investments in these bonds to constitute part of the mandatory holding of liquid assets such as government securities.

As local investors and banks have been the majority of investors in this issuance, there has been some curiosity over why more foreign investors did not take part. A possible reason could be the fact that foreign ESG bond investors generally have a preference for dollar debt and may have been sceptical on a rupee-designated debt. Although there are currently no investment funds in India with a dedicated green mandate, international investors who do may wait to review the outcome of the first few auctions of the sovereign green bonds. In general, market commentators say that global investors are interested in India’s green bonds, but perhaps want to see how the markets react to such issuances before making key investment decisions. Measures such as the RBI’s exemption will do much to encourage international ESG investors. As India’s commitments at recent COP summits have made clear, large-scale funding is required in order to meet its stated objectives. The issuance of these sovereign green bonds, along with other investment in green technology and renewable energy from both the public and private sectors, will go some way to help India fund these ambitious but critically important plans.

Wow, what a year 2022 has been! Typically when I reflect on all things structured CRE related, I have more often than not found myself applying a metaphor of a roller coaster, which is suitably apt given the huge swings in market activity experienced over the past twenty years or so. 2022 has proven to be no exception, although the track itself has resembled a downward spiral rather than a thrilling ride of highs and lows. Either way you look at it, the fact is that the 2022 roller coaster ride has proven to be very different to what was promised a year ago.

Looking back at this time last year there was a palpable sense of excitement for the European structured CRE market, thanks to the fact that 2021 not only had delivered a record volume of CMBS issuance, but more excitingly, had successfully imported CRE CLO technology from the United States. Unfortunately, 2022 failed to deliver on all this promise, with CMBS issuance hitting an unprecedented low, and as for the CRE CLO product, the Starz transaction that closed in November 2021 still remains the one and only deal to have graced the European market.  Although the industry (once again) could be forgiven for wallowing in pity, I would profer the view that despite a disappointing level of deal activity, 2022 has nevertheless laid the foundation that the market will reap the benefits from in the years ahead.

What I have witnessed first hand is that there is tremendous appetite for CRE CLO technology thanks to its many positive characteristics. After all the CRE CLO product, when compared to loan-on-loan financings, offers a lower weighted average interest rate, higher advance rates as well as a fair level of flexibility when dealing with the underlying loans. With the abrupt halt to the era of ridiculously cheap debt, we now enter (or should I say return) to an environment where higher interest rates are the new norm. This will not only improve profitability for the banks, but also means that alternate lenders can no longer afford to simply rely on loan-on-loan facilities and repo lines to fund their CRE lending activity in a market where CRE CLO technology offers more favourable economics. For those alternate lenders that want to remain competitive, they risk failing to embrace (or at the very least consider) this technology at their peril.  

Buoyed by the success of CRE CLO’s in the United States, 2022 has been an educational journey as market participants have sought to understand more about the intricacies of how CRE CLOs work, how they differ from their CMBS cousin, and figure out in what way they can be properly used as a funding tool for their business. The huge interest in the CREFC Europe conference in May (CMBS & Beyond) was testament to this, as well as the plethora of thought leadership pieces that have been published throughout the year. Similarly, thanks to a blow-out in capital market spreads, banks and alternate lenders alike have been delivered a stark reminder of the perils of holding loans on their balance sheets without the potential of having structured takeout embedded as an important exit strategy.  

As for underlying collateral level, we are witnessing bridge financing 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. 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 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 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.

Taking all these factors together, as we look ahead to 2023 and beyond, although the capital markets look like they will continue to be challenging in the coming months, in the medium to long-term, I would profer that 2022 has shown us that there is a genuine need to embrace CRE CLO technology at scale, and there is a willing market to do this. Ultimately, just over a year on from Europe’s first CRE CLO, the market cannot only be said to be wiser and smarter about the product, but the anecdotal evidence points to the fact that there is a genuine need for this type of structured product to play an integral role for financing European CRE CLO.

As for my personal hopes and predictions, I hope that I never again find myself comparing the structured CRE market to a roller coaster ride, but instead find myself using metaphors more akin to supersonic space travel. In terms of my predictions, well the resounding fundamentals of the CRE CLO product continue to make absolute sense (a point that has been brought into sharp focus and magnified by the current macro-economic environment) and the US market continues to be a shining example of the hugely important role that CRE CLO technology can play in financing CRE. and therefore My prediction therefore, is that it is now time for the European CRE CLO market to take its seat and brace for lift-off.

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.

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.

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!  

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.

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.

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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.

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