In the second of a series of blogs, in which we address the evolution of CMBS structural features, we will consider the most (arguably) integral form of credit enhancement for any CMBS deal, the liquidity facility.
Liquidity facilities are structured as 364 day committed revolving credit lines that can be drawn by a CMBS issuer to satisfy the payment of any shortfall in expenses, the payment of any shortfall in interest on notes, as well as the payment of any amount owed to a third party that directly relates to the underlying commercial real estate (a so called property protection drawing). Anyone that is familiar with the 1.0 vintage of deals will testify that such transactions exhibited a huge degree of variance when it came to the structuring of the liquidity facility, which can largely be attributable to the myriad of different CMBS 1.0 structures as well as the need to accommodate individual liquidity facility provider requirements.
With the emergence of CMBS 2.0 many market participants had hoped that there would be greater standardisation of these facilities and a higher degree of uniformity adopted between individual deals. In that vein, market participants will no doubt welcome the vastly improved documentation which includes fixes for many of the mechanical shortcomings that were endemic in CMBS 1.0. However, when it comes to actually creating uniformity with respect to key structural features relating to liquidity facilities, the new deals continue to be plagued with a similar level of heterogeneity as was the case with the previous deals.
Indeed, a structural vagary that was rife in CMBS 1.0 was the fee structure associated with a standby drawing. Historically these fees were structured in such a way that following a standby drawing either: (i) the liquidity provider received the same commitment fee as well as any income derived from the investment of the standby loan in eligible securities; or (ii) the standby loan was treated as if it was a normal liquidity drawing and thus the provider received a full amount of interest (although typically that portion of interest that exceeded the commitment fee was subordinated to payment of interest on notes). The new deals in the market reveal that this vagary is still rife with a compendium of different interest payment structures currently being employed which not only constitute a variance of the two structures outlined above but also new structures which include in one instance a structure whereby interest on standby drawings ratchet upwards over time.
Similarly with regard to appraisal reduction, there continues to be a range of mechanisms which mitigate liquidity provider concerns stemming from underlying stress in real estate values. In this context it is noted that a number of deals continue to follow the traditional “appraisal reduction” approach, where the amount of a liquidity facility is reduced by an appraisal reduction factor that is calculated by applying a haircut to the underlying value of the real estate. Other deals have adopted a more binary mechanism with the inclusion of a complete drawstop that is triggered when the underlying commercial real estate is determined to be insufficient to cover all amounts payable to the liquidity facility provider as well as all liabilities (including indemnified losses) that rank senior. Although both approaches have their merits, nevertheless this again demonstrates that a modicum of variation continues to be present in the new era of deals.
However despite this continued trend of variation, when it comes to drawings to cover interest shortfalls, the new transactions are (not surprisingly) consistent on this point. As market observers are aware, one of the most striking nuances of CMBS 1.0 compared to other structured products relates to a draw on a liquidity facility to cover an interest shortfall. Unlike other asset classes where the draw on a liquidity line was limited to the amount necessary to keep various classes of notes current, in the case of CMBS, drawings were instead dependent on whether there was likely to be a shortfall in the amount of interest received on an underlying loan. The corollary of this is that despite there being sufficient interest received on the underlying loans to service the payment of coupon on notes, nevertheless there could still be drawing on the liquidity facility if there had been a shortfall in the payment of interest on a loan, thus a welcome feature for anyone entitled to receive excess spread from the deal. Given the inequitable position of such structures, this nuance has now been eradicated and all new deals only allow interest shortfall drawings to cover the shortfall in the payment of interest on notes. In effect the new vintage of deals has removed the ability for there to be excessive liquidity drawings to meet loan interest shortfalls and thus the beneficiaries of excess spread are now only entitled to receive “true” excess spread (see CMBS 2.0 IN FOCUS: Class X – a Class Act!).
It would therefore appear that when it comes to the structuring of liquidity facilities these can be considered the wild child of CMBS 2.0. Although the structuring of liquidity facilities has definitely changed for the better, certainly one feature that has not changed is that it in today’s market there is still a great deal of variety between different liquidity facility structures. In an ideal world, CMBS 2.0 would have heralded in a new dawn of deals where standardisation of this important credit enhancement tool would have been the norm, however instead we are confronted with a market where one size certainly does not fit all.
Although critics of the CMBS product could readily cite the failure to standardise these liquidity facilities as a flaw in the new vintage of deals and an opportunity missed by the architects of CMBS 2.0, the reality is that this heterogeneity can be firmly attributable to the regulatory cost of the liquidity facility provider of providing these credit lines. Under Basel III (European Regulation (EU) No 575/2013, 26 June 2013) liquidity facilities have become incredibly expensive for CMBS structures and therefore arrangers of pretty much all new rated CMBS 2.0 deals have had little choice but to provide the credit line themselves or via an affiliated company. In effect, by forcing the arrangers to keep liquidity facilities “in-house”, the regulators have inadvertently removed the commercial tension and cross pollination that is essential to create a standardised credit enhancement tool and with it the opportunity to further standardise the CMBS product.