Having written hundreds of thousands of words of CrunchedCredit over the years, it’s possible I’m about to cross a bridge I already crossed long ago, but I thought it was a worthwhile topic in this time and place.
It’s time we develop a structured warehouse facility for commercial real estate mortgages. Structured warehouses could provide current back leverage providers with an opportunity to deliver a higher LTV product. It could also allow non-bank lenders to compete to provide back leverage.
The commercial real estate warehouse has been with us for a very long time but with very different levels of uptake from the grandees of the banking world. Now, for reasons I’ll get into in a moment, pretty much everybody is on board.
Just to level set this conversation, the paradynamic commercial real estate warehouse is a repurchase structured facility where the seller (the borrower in most material respects) “sells” mortgage loans to a buyer (lender) which buys these loans at a purchase price which is typically in the 60-70% OPB (assuming that to be fair value). Under the relevant transaction documents, the buyer has a contractual obligation to resell the mortgage loans to the seller at the purchase price (plus outstanding interest and costs) and the seller has an obligation to repurchase the mortgage loans at that price on a date certain. The seller pays interest to the buyer on the outstandings.
These facilities have a term certain at which point the seller is required to repurchase the assets. The transaction might include an initial repurchase date and an extension repurchase rate, just like any in any other loan-on-loan transaction.
Repos typically have some sort of margin mechanic by which the seller is obligated to repurchase loans which are in default or after credit event (or, in some cases, if the market value of a mortgage loan deteriorates). A margin call could also be satisfied by adding collateral or paying down the facility to achieve the initial LTV of the deal. There’s typically a bad boy guarantee and a limited P&I guarantee (with respect to limitation, keep reading).
The financing documents will set out a “credit box” for acceptable collateral. Typically, the decision to advance, the amount of the advance and the interest rate, are in the discretion of the buyer. The documentation for these facilities share 95% of the DNA of a typical loan-on-loan transaction (sort of like pigs and people). The reps, warranties, covenants, reporting obligations and the like are very similar across the two sectors.
If there is a secret sauce to a repurchase transaction, it is that we call things by funny names. Does it make this seem more arcane and the purveyors of this product more important? Well, for whatever reason, the buyer is the lender, the seller is the borrower, and the interest rate is the price differential. Kind of makes perfect sense, doesn’t it? You are now amongst the camarilla.
Repurchase transactions have a special advantages under the Bankruptcy Code, which is one of the reasons these transactions are so attractive. Under the Code, a repurchase transaction is not subject to the automatic stay and the buyer is free to sell the assets in the event of a default under the facility without regard to whether the buyer has filed a petition in bankruptcy. We get there analytically by thinking of the transaction as a “true sale” for bankruptcy purposes. This is the reason that while a P&I guarantee is common in the space, it is generally limited to not more than 20% of OPB (or whatever higher amount opinion counsel is prepared to stomach to give a true sale opinion).
The factor that has turned the warehouse business from a bit of a boutique-y enterprise, with only a handful of lenders regularly participating into the booming business it is today, was a determination by the bank regulators that a repo-style warehouse, if properly structured, would be treated as a securitization for risk based capital (RBC) purposes. That characterization will reduce the risk based capital quantum of a warehouse by almost 80% (and it may go down even more depending on the result of the final Basel III Endgame Proposal). This factor is huge for the regulated banking community.
For years, and long before the RBC changes, I had thought that the warehouse was the most overlooked and terrific business a bank could be in. The average advance rate of 60% or 70% provides an attachment point against the underlying assets in the low 40s. The facility is cross collateralized and cross defaulted and it benefits from some level of guarantee. Moreover, lenders have a get-out-of-jail-free card under the Bankruptcy Code that allows the immediate sale of collateral and reduces the risk of severe losses. For all this, the banks were earning a spread that was as much as two thirds of the spread they could earn on the whole loan, if they had made it themselves. That’s a great deal for a lender, particularly in a high coupon environment. Once the attractiveness of this trade was turbocharged by the RBC changes, this business has exploded.
The availability of warehouse money in the market today is crucial to the business plan of most private credit enterprises which are lending to the commercial real estate industry. Without leverage, given their relatively high cost of funds, private credit would not be competitive. As non-bank lending has become an essential part of the commercial real estate landscape this back leverage is, in fact, in a concomitant sort of way, critical to the health of the commercial real estate market writ large.
It has always struck me as odd that no one has come up with a securitized warehouse product[1] because the capital stack of such a product will be more efficient than the current single tranche warehouse (okay, for RBC purposes, we treat the borrower’s redemption equity as a second tranche, but that’s both irrelevant and sort of silly). Why tolerate a more expensive capital stack during the asset accumulation period when we could pull back into the warehouse some of the benefits of the capital stack of an anticipated future securitization?
Here’s how I think it ought to work. The bank, with experience in the sector, will face the borrower counterparty with an SPV vehicle. The vehicle will issue variable funding credit tranched securities. As the seller sells additional mortgage loans to the buyer, the securities holders would fund up to allow the buyer to buy at a fixed ratio agreed to by the parties at the outset in connection with the initial underwriting (and in connection with agreement as to the size and specificity of the credit box) and how assets would be added to the structure. They would fund at a fixed ratio agreed to by the parties as part of the initial underwriting. As in any other structured vehicle, the senior security would carry a lower interest rate while the junior security would carry a higher interest rate representing the higher risk associated with its first loss status.
To the extent a bank was a participant in the transaction, its exposure should continue to constitute a securitization exposure delivering securitization-type RBC treatment. As long as a “financial participant” is in the structure (perhaps as an agent) the bankruptcy benefits of a securities contract (the technical characterization of most repos in the space for bankruptcy purposes), would be available.
Probably as this rolled out, it would be a bank which would take down the senior security and one of our more traditional high yield lenders stepping in to take the junior piece. Given the relatively low attachment point of these transactions, even if the advance rate moved up to over 80%, this should continue to be an attractive risk-adjusted return for the subordinated security holders.
Obviously, the structure would confront us with some complex issues. While the commercial real estate borrowing community has gotten comfortable with the CRE CLO securitization structures (of course, for an attractive lending product), this is different. Can a facility borrower manage its concern that a first loss player could exercise control over things like asset acquisition, pricing and proceeds? Good heavens, first loss buyer with control over margin mechanics? It will be challenging (as Captain Obvious might say). These issues will be difficult to resolve; however, faced with a compelling need and some innovative thinking, we can make it work. Maybe, and I’m spit balling here, we break up things like asset acquisition and pricing and servicing decisions so that both junior and senior participants will have a say. Maybe, if a bank is holding the senior securities, they will provide a backstop facility (at fair value) at some level to protect against margin hits. We, as an industry, are endlessly creative. We’ll figure it out.
How might this be used? It would be a terrific marketing opportunity for the banks who could offer a significantly higher attachment points for their product. That would, in many cases, appeal to the users of capital.
It also could be used by non-bank participants to build out a structured warehouse product. This could bring more capital into the space. Given the Feds’ current heightened concern about the whole back lever business, we might see the banks in the next few years (maybe particularly under a new administration) reducing their level of support of the product. At that point, a structured warehouse which can access funding from a broader investor community would become a critical part of the capital structure for commercial real estate. Need is the mother of invention. If that were to happen, there would be an overwhelming need.
If the warehouses could be structured in a way that looks an awful lot like an accumulating CRE CLO (more, obviously, than the puny little ramp-up features and delayed closing features that are currently extant in our market), it could provide a true bridge to a broadly held securitization. These transactions could be structured with a homogeneous accumulation and term period where the structure would toggle into a more broadly distributed CRE CLO type structure when it would term out. It would, of course, be terrific, if we could convince our ratings agency friends to rate the accumulation period. Sadly, they have shown little enthusiasm for blind pools, but that doesn’t mean that conversations around this topic should not continue. In any event, with a traditional CRE CLO architecture, ratings could be had during the run-off period. If we could structure the transaction with a toggle so that the existing structure could morph into a CRE CLO, we could eschew some of the brain damage and inefficiencies of terminating a warehouse facility and building out an entirely new structure (with apologies to those of us who would earn delightfully large fees in doing so).
Look, I’m blue skying here and like certainly haven’t thought through everything. The servicing mechanics, the toggle into a CRE CLO, the REIT issues and the like, are complicated…but it would make a fascinating conversation, wouldn’t it?
Particularly in light of the fact that back leverage is absolutely critical to the private credit market these days, and private credit is absolutely critical to meet the liquidity needs of commercial real estate, it’s time we think about it. The bank regulators could get twitchy at any time resulting in a diminution of existing warehouse liquidity. If the banks are required to pull in their horns and we don’t have an alternative, significant damage to the CRE market would occur. Wouldn’t it be a good idea to think about a solution to this before the need for a solution becomes of paramount importance?
[1] I’m sure someone has and will be delighted, I’m sure, to tell me about it. Don’t worry, I have thick skin; just ping me.