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 credibily 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.