Few trials pick up as much interest as that of FTX’s founder and ex-CEO, Sam Bankman-Fried (“Bankman-Fried”). Once the leader of a cryptocurrency exchange platform valued at its peak at around $32 billion[1], Bankman-Fried has spent the past month in a Manhattan federal courthouse facing charges of fraud, conspiracy, and money laundering. Last week, after less than five hours of deliberations, the jury delivered its verdict: guilty on all charges[2]. We thought it a pertinent time to consider ten things that we learnt about Bankman-Fried and FTX.

1. Who’s Who

To understand Bankman-Fried’s trial, you need only know the names of three companies: FTX, Alameda Research (“Alameda”), and Binance. FTX was a cryptocurrency exchange. Founded in May 2019 by MIT-graduate Bankman-Fried, FTX would go on to host 1 million users and become one of the largest cryptocurrency exchanges on the planet. Binance, an investor in FTX, ranks amongst the largest cryptocurrency exchangers[1]. Alameda was a private cryptocurrency trading firm run by Caroline Ellison, and part-owned by Bankman-Fried. Alameda and FTX, despite what Bankman-Fried may have espoused as his fortunes turned, were inextricably linked.

2. What set off the chain reaction that led to the collapse of FTX?

In November 2022, CoinDesk, a crypto-based news site, posted a report that Alameda Research held a position valued at $5 billion in FTX Token (“FTT”). As it transpired, Alameda’s investment foundation was also in FTT[2]. If the currency failed, both of Bankman-Fried’s firms would pay the price. Over the ten days after CoinDesk published its report, FTX would collapse. This is largely because the report not only highlighted the potential risks posed by tying two companies to the same cryptocurrency, but more importantly, also revealed that Alameda would routinely borrow from FTX. The source of these funds is a key point in Bankman-Fried’s trial.

A leaked FTX balance sheet dated 10 November 2022 also showed that the company had roughly $9 billion in liabilities, with only $900 million in easily saleable assets[3]. This resulted in Binance announcing on 6 November 2022 that it would sell roughly $580 million dollars’ worth of FTT[4]. By 7 November, FTX was experiencing a vast liquidity crisis as customers made a run on the exchange. Soon after, FTT’s value had plummeted by 80%[5], and both FTX and Alameda filed for bankruptcy.

3. What was the problem?

The crux of the matter in Bankman-Fried’s trial was simply whether Bankman-Fried ordered his employees to mishandle FTX customers’ money to fund the loans to Alameda. Prosecutors argued that Bankman-Fried had conspired to move billions of dollars’ worth of customer deposits from FTX to Alameda, which he then used to pay for items unrelated to FTX operations[6]. Bankman-Fried’s former employees and friends took to the stand, largely to vilify him. By his own account, however, he was unaware of the mishandled funds until it was too late.

4. Recollections vary between friends  

Gary Wang, Bankman-Fried’s university friend and right-hand man, and Caroline Ellison, CEO of Alameda and Bankman-Fried’s ex-girlfriend, both pleaded guilty to fraud and cooperated with the prosecution. They both stated that they warned Bankman-Fried that Alameda owed more than $10 billion to FTX. They also testified that they committed financial crimes under his direction. Mr Bankman-Fried responded “I don’t recall giving any direction”[7]. In fact, this was a running theme. On the witness stand, as he was being questioned, Bankman-Fried responded with “I do not recall” more than 140 times[8]. The prosecution often countered this with a statement given by him to journalists at the time which featured exactly what he had been asked[9].

5. Money is “fungible anyway”

Bankman-Fried ran Alameda until 2021. When asked about how $8 billion of FTX customer money had been spent, Bankman-Fried claimed that he only discovered this fact months before FTX collapsed. The prosecution alleged, however, that Bankman-Fried had set up special lines of credit between the companies allowing Alameda unlimited borrowing privileges[10]. After being questioned on how he could have been unaware that $8 billion dollars had been spent, Bankman-Fried responded that he was not “interested in doling out blame”[11] and that “money is fungible anyway”[12]. Unsurprisingly, FTX’s customers did not feel the same way.

6. Tweet with caution

The jury’s attention was often brought to several of Bankman-Fried’s posts on the social media website X, formerly Twitter. Prosecutors showed them a tweet from July 2019, in which Bankman-Fried stated that Alameda’s account on FTX was “just like everyone else’s”. Gary Wang, a close friend of Bankman-Fried, testified that FTX had on the very same day implemented the code that allowed Alameda unlimited rights to borrow from FTX[13]. 

7. “This kind of fraud is as old as time”

Many of the problems at FTX arose because of the business decisions made by Bankman-Fried himself. As such, the prosecution presented their case as one of fraud rather than a complex crypto currency case. “The crypto industry might be new, the players like Sam Bankman-Fried may be new, but this kind of fraud is as old as time” said Damian Williams, the lead federal prosecutor[14]. The U.S. Justice Department seems keen to use the conviction as a reminder to the crypto industry that they are not immune from the law. Where customer funds are involved, fiduciary duties and AML rules still apply.

8. How has the regulatory landscape changed since FTX’s collapse?

Regulators around the world have also begun to make moves to shore up their crypto frameworks. The UK Treasury last week announced its response to a consultation on the future of crypto regulation. They published their initial plans, which would bring several cryptoassets under regulatory oversight. They specified that this was partly in response to the collapse of FTX[15]. The UK has also, through the Financial Services and Markets Act 2023, now enabled the regulation of cryptoassets and established sandboxes in which market participants can use new technologies such as blockchain in financial markets[16]. The EU has made further advances in its Markets in Crypto-Asset Regulation (MiCA), which entered into force in June of this year. In the US, July saw a bipartisan bill introduced in the Senate to grant the Commodity Futures Trading Commission oversight over most forms of cryptocurrency[17]. We expect to see more regulatory impact in 2024.

9. Is DeFi the future?

The FTX collapse was a failure of business models and practices rather than the blockchain technology, so now the question is whether the conviction last week will finally pave the way to a decentralised finance (“DeFi”) future?

One of the biggest benefits of DeFi frameworks is that they are transparent. Transactions conducted on the blockchain, whilst anonymous, are public, so all activity can be audited and fraudulent activity can be traced. However, DeFi is constantly evolving, so it will be interesting to see how the innovative DeFi community further develops the infrastructure.

10. What’s next for Bankman-Fried?

Following the jury’s guilty verdict, Bankman-Fried will return to court for sentencing on 28 March 2024. He faces a maximum of 115 years in prison for the 7 convictions[18]. His lawyer released a statement following the verdict: “We respect the jury’s decision. But we are disappointed with the result. Mr Bankman Fried maintains his innocence and will continue to vigorously fight the charges against him”[19].

[1] https://www.statista.com

[2] https://www.investopedia.com

[3] https://www.ft.com

[4] https://www.theguardian.com

[5] https://www.cnbc.com

[6] https://www.law360.com

[7] https://www.theguardian.com

[8] https://www.nbcnews.com

[9] https://www.theguardian.com

[10] https://www.bbc.co.uk

[11] https://www.bbc.co.uk

[12] https://www.ft.com

[13] https://www.ft.com

[14] https://www.reuters.com

[15] https://www.ft.com

[16] https://www.reuters.com

[17] https://www.ft.com

[18] https://www.cnbc.com

[19] https://cointelegraph.com

The Bank – who they are    

Initially operating from the small town of Varanasi in Uttar Pradesh, India, Utkarsh was established in 2009 as a Micro Finance Institution. Over the years it has evolved into a Small Finance Bank with the objective of creating “umeed” (hope) amongst the unbanked population by providing micro, small and medium enterprise (MSME) loans, housing loans (with a specific focus on affordable housing), savings accounts and other essential financial services to the under-served low-income rural and semi-urban population in north and east India. The micro-banking segment accounts for about 66 per cent. of the bank’s gross loan portfolio.

Continue Reading Utkarsh Small Finance Bank’s IPO: what it means and why it matters

One unassailable fact is that securitisation has a hugely important role to play when it comes to financing commercial real estate (CRE). Simply put, no other source of CRE finance can provide the high level of openness and transparency that can be afforded by securitisation. Indeed, as demonstrated by the recent financial turbulence, the ability to shine a spotlight on this traditionally opaque market yields dividends when it comes to assessing the true impact and ramifications that the challenging macro-economic outlook is likely to have on the performance of CRE.

At this point in time, it would be fair to say that the capital markets are jittery to say the least, thanks to the severe impact of interest rates rising at a relatively rapid rate and the unprecedented demise of a handful of banks. Although the health of the banking sector has been the primary focus in recent months, market observers have been keen to identify the next domino to fall amidst this turmoil and chief amongst the potential candidates has been CRE. This is a fair conclusion to reach given the tremendous headwinds that CRE is currently experiencing on account of cap rates, interest rates, operating costs (including fuel prices) and financial costs all following an upward trajectory. The corollary of which, is that existing financings are under greater stress and refinancing’s have become more of a challenge with an increasing need for fresh equity injections and/or higher leverage to make such transactions viable. Meanwhile these factors have had a cooling effect on the sales market with it becoming harder to price CRE.

This brief epilogue of the perils that CRE is currently facing is sobering and provides clear justification why many believe that CRE is in the firing line. However, those looking to draw parallels with the global financial crisis (GFC) will be sorely disappointed as the debt secured by CRE is a very different beast to what we saw being originated in the noughties. Generally speaking, loan structures are a lot cleaner and easier to enforce. Leverage levels are more conservative compared to the crazy levels reached prior to the GFC and sponsors have a lot more skin in the game and therefore less inclined to unceremoniously hand over the keys at times of distress. Despite the challenging headwinds, the CRE market should be confident with its ability to weather the current macro-economic storm given the more conservative underwriting and improved loan structures.

The crux of the issue is the inability to confidently determine the current state of the CRE market and, more importantly, whether it is managing to weather the macro-economic storm. This is an issue of profound frustration and denotes a major flaw in the European CRE lending market. In an ideal world this information should be readily available for all to digest and be used to form educated views on whether CRE is indeed the next domino to fall or otherwise. This lack of transparency is not only hugely unhelpful but allows market harbingers to provide negative speculation, which for an industry both buoyed and sunk by sentiment, is truly toxic.  This unjustifiable opaqueness is not only a flaw in the lending market but is also a major advertisement on the huge merit that securitisation can play as a tool for financing CRE.

Regardless of whether a public securitisation takes the form of CMBS or CRE CLO, the bottom line is that transparency and openness are in bountiful supply. After all, ahead of any note issuance, a prospectus is issued that provides comprehensive information about not only the loans but also the CRE that secures such loans. Following note issuance, ongoing reporting, in the form of quarterly reports, allows the market to regularly track performance. In addition there is a real time ongoing obligation on the securitisation issuer to make disclosures about any material events that are likely to have an impact on a loan and the underlying CRE.

When it comes to the tracking of performance of loans and the CRE that they finance, securitisation can act as a beacon of best practice and be an educator in its own right.  After all, securitisation through the public transmission of real time information has a role to play in educating the wider market on not only the performance of loans but also what actions are being taken to resolve and address issues when securitised loans become stressed. Indeed, in today’s market, had securitisation been more widely adopted, we would be in a far stronger position to make a reasoned assessment on the state of CRE.

I would argue that now is the moment to embrace securitisation at scale for a number of reasons, chief amongst which is that these structures create the much need openness and transparency currently severely lacking in the European CRE market. Indeed, if we were fortunate enough to have a significant amount of European CRE financed by securitisation, then a lot of the negative concerns and jitters currently embattling CRE would simply vaporise and in its stead be replaced with hard solid facts for the greater good of all.

As focus turns to the annual IMN Global ABS conference in Barcelona next month, there will be a real opportunity for the market to meet and consider how we can do better to embrace securitisation technology. Personally, I am very much looking forward to speaking on the panel about CRE CLO’s, which I believe will not only have an integral role for financing European CRE but this product has a massive role to play in shining a spotlight on CRE and, by doing so, alleviate many of the issues and concerns that the market is currently confronted with.

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!