The CRE CLO Is Back…and That’s Good

We have been writing off and on about the restoration to good graces of the commercial real estate CLO since the early days of this current recovery, and it’s important to keep the conversation going.  Hey, if Pete Rose can get into the Hall of Fame (and as MLB is embracing gambling, that cannot but happen, right?), the full restoration of the reputation of the CRE CLO cannot be far behind.

First, let’s just stop and get some definitional clarity here for those of you who actually have a life.  Fundamentally, the CRE CLO is a device that provides match-term leverage for a portfolio lender, though the technology can be used for other purposes.  Loans are pooled, investment-grade securities are sold to investors, and the loans are repaid from debt service payments.  Customarily, the sponsor retains all of the equity and junior debt, creating structural leverage to enhance returns on the dollars invested in the structure.

It’s really a warehouse funded by the capital markets. As such, it provides for an excellent alignment of interests between investors and the sponsor, who holds the bottom of the capital stack.  The sponsor is in it for the long haul, managing financial assets for its benefit and the benefit of the investors alike. Continue Reading

2018 Golden Turkey Awards

It’s that time again for Dechert’s CrunchedCredit Annual Golden Turkey Awards. In a year made most remarkable by the extraordinary performance of the US economy, idiocy, silliness, pigheadedness and stupidity have tended to be somewhat obscured by the economic good news machine. At the other end of the spectrum, the continued high volume of outrage over almost everything from both the left and right (and I’m sure the middle would do their fair share here if there was anyone at home) makes it harder to suss out the truly memorable and award-winning, but it’s our job to try. As we have said in the past, this would be really hard if the world actually behaved in a predictable, rational, Newtonian universe sort of way, but blessedly it does not.

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Do I Have to Talk About Brexit?

We haven’t written much about Brexit…largely because, for the life of me, I have been unable to embrace, with any conviction, a view as to whether the Europeans will dodge this bullet, as they have dodged so many in the past, or whether chaos will finally ensue.  Then, if chaos ensues, I’m equally clueless about what the contours of the chaos will be; what a hard Brexit will look like.  I am baffled.  And while it is demonstrably true that cluelessness and bloviation are not mutually exclusive, I, perhaps more thin-skinned than most of the chattering class, have been waiting for some sort of an epiphany before I wrote on the topic.

But birds gotta fly, fish gotta swim and us members in good standing of the commentariat gotta prattle on.  Since I’m not convinced I’m going to get any smarter and since this is likely to be one of the seminal economic events of 2019.  I’m diving in.  Might be ugly.  Hide the children.

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The Next Recession: Something…Perhaps Not Really Wicked… But Certainly Annoying…This Way Comes

With full and complete credit to the Bard (Macbeth), and to Mr. Ray Bradbury who repurposed this line as the title for his 1962 dark fantasy (of which I was and still am a huge fan), there is just not a better title for this note. Trust me. A few weeks ago, I inked a note about whether the current expansion was soon coming to an end and whether it made sense to begin to “get the distressed debt band back together again.” Tongue slightly in cheek then because things seemed awfully good, I made the argument that we are not really all that far away from an abrupt right turn off the highway of good times onto the dirt road of distress. It apparently resonated (or at least there’s lots of people who think like me). Dechert is hosting a distressed debt conference on October 18, 2018 in New York which will touch on a wider range of issues but will include a distressed debt panel and we now have almost 400 RSVPs. We’ll report on that next week. That’s either 400 people with nothing better to do, or 400 folks who think it might just as well be time to start thinking about the end of days. Continue Reading

IMN 2018 ABS East Conference

Last week, an estimated gathering of over 4,700 of the industry’s finest descended on Miami for IMN’s ABS East conference. The mood was upbeat and the meeting rooms (and the lobby bar) were crowded, as participants raced to fit in as many meetings as possible. If there was one overall takeaway from the conference, it was that there is a lot of money looking to invest in the ABS sector, which continues to enjoy strong fundamentals and a hearty appetite for deal making. We are excited to see all the term sheets that come out of this conference and help get some of those deals closed. Continue Reading

Proposed Rule Regarding HVCRE ADC Open for Comment

Are you ready? The proposed rule regarding HVCRE ADC has been published in the Federal Register today and is open for comment. You know the drill, comments are due in 60 days (by November 27, 2018). Give us a ring for more background on HVCRE ADC and the proposed rule. We’re always happy to discuss the questions posed by the regulators and consider potential responses. And be sure to check in to Crunched Credit in the coming weeks as we do a deep dive into the whole new world of HVCRE ADC as a result of the recent amendment.

Are you there FDIC, OCC and Fed Res? It’s us, Crunched Credit: Regulators Request Feedback on HVCRE ADC

On September 18, 2018, the Federal Reserve, FDIC and OCC released a Notice of Proposed Rulemaking (NPR) regarding HVCRE. The good news is that the stated intent is not to alter any of the improvements made by EGRRCPA, instead the agencies describe the proposed rulemaking as conforming the regulatory capital rule to the new statutory definition of HVCRE ADC and providing interpretations of certain terms consistent with their usage in other regulations. This is good news indeed.  We were somewhat concerned that the regulatory state in full might try to steal some back here, but they seem to have gotten the message.

There are a few immediate takeaways from the NPR – namely, HVADC is dead and that the test for whether a loan qualifies as an HVCRE ADC exposure occurs only once – at origination. So, after origination, you can fall out of HVCRE ADC (with the new reclassification provisions) but you can’t fall into HVCRE ADC.

Embracing hubris, perhaps, we’d like to think the agencies are readers of Crunched Credit.  They certainly address many of the provisions we highlighted in our prior commentary. Here are some of the highlights:

Crunched Credit: What does “primarily finances” mean?
NPR: The agencies request comment on whether the term[] … “primarily finances,” … [is] clear or whether further discussion or interpretation would be needed.

Crunched Credit: When is development “substantially” complete?
NPR: The agencies invite comment on whether [substantial completion of construction] is ambiguous or needs interpretation? The agencies invite comment on what, if any, operational challenges would banking organizations generally expect when determining whether an HVCRE exposure under the proposed revised definition can be reclassified as a non-HVCRE  exposure?

Crunched Credit: What is the “cash flow” test?
NPR: The agencies invite comment on what, if any, operational challenges would banking organizations generally expect when determining whether an HVCRE  exposure under the proposed revised definition can be reclassified as a non-HVCRE exposure?

Crunched Credit: It’s clear that HVCRE ADC supersedes the old rule for loans made after May 24, 2018 (and provides grandfathering for loans made prior to January 1, 2015), but it’s unclear what it does to loans made from January 1, 2015 – May 24, 2018. Are these loans now subject to HVCRE ADC for re-classification? We would like for clarity (although maybe we already have it) that the new HVCRE ADC applies to those loans as well.
NPR: For ADC exposures issued on or after January 1, 2015, banking organizations would follow the interagency statement that permits them to either apply the statute on a best efforts basis or classify HVCRE  ADC exposures according to the superseded definition until the final rule is effective. The agencies invite comment as to whether the final rule should require reevaluation of ADC loans originated on or after January 1, 2015 under the revised HVCRE exposure definition. What are the advantages and disadvantages of requiring reevaluation? What alternative treatments, if any, should the agencies consider?

Crunched Credit: Can mezzanine debt and preferred equity count for the 15% Borrower equity contribution test?
NPR: The agencies invite comment on whether their proposed interpretation of the 15 percent contributed capital exclusion is appropriate and clear or whether further discussion or interpretation would be appropriate. What other issues, if any, relating to the contributed capital exclusion require interpretation?

Well, glad you asked!  As with the last rodeo, the public will have 60 days from the date the rule is published in the Federal Register to comment. It has not been published yet, but rest assured readers, we are watching the FedReg for it and will post an update once the comment period begins.

Review our archive of commentary for more background on HVCRE ADC and EGRRCPA. Better yet – we make house calls! We would be happy to do a teach-in or host a Q&A session on the changes. Please let us know if that would be helpful and we’d be happy to set up a time! And- stay tuned for further commentary as we digest the posed questions and consider potential responses.

HVCRE (The Reformed Loan): Musings and Next Steps

Since my last post, the Economic Growth, Regulatory Relief, and Consumer Protection Act (which some are referring to as EGRRCPA – oof.) was signed into law by President Trump on May 24th. Section 214, titled, “Promoting Construction and Development on Main Street,” amends the Federal Deposit Insurance Act to clarify what loans are subject to HVCRE, when loans are measured for HVCRE exposure and what we call loans subject to HVCRE (spoiler alert: it’s not HVCRE!). Long story short, despite all the grumblings about this reform, Dodd-Frank has not gone the way of the Dodo. Here’s what we know, what we think we know and what we think you may be able to do.

What We Know

  1. (For loans made after May 24th) HVADC is out – HVCRE ADC is in.

Under Public Law 115-174, regulators “may only require a depository institution to assign a heightened risk weight to a high volatility commercial real estate (HVCRE) exposure (as defined in 12 C.F.R. 324.2) under any risk-based capital requirement if such exposure is an HVCRE ADC loan”. So, after all the back and forth with HVCRE and HVADC, it is finally settled: only those loans classified as “HVCRE ADC” can be subject to HVCRE. Wait, what?? (We hope this means that the regulators will abandon HVADC…).

So, what is an HVCRE ADC loan? An HVCRE ADC loan is a credit facility secured by land or improved real property that (A) primarily finances, has financed, or refinances the acquisition, development, or construction of real property; (B) has the purpose of providing financing to acquire, develop, or improve such real property into income-producing real property; and (C) is dependent upon future income or sales proceeds from, or refinancing of, such real property for the repayment of such credit facility.

Let’s start with the good: thankfully, the revised definition clarifies that only credit facilities secured by land or improved real property are subject to HVCRE ADC. One addition to the definition from the prior incarnation is that an HVCRE ADC loan “primarily finances” acquisition, development or construction. We have no idea what “primarily finances” means – 50%, 60%, 95%? But – maybe this ambiguity is good. Should we be racing to the regulators to fill in all of the “grey”? If we do that, we have no room to make calculated and reasonable decisions (that are good for the bank and the borrower) and ask forgiveness (if it ever comes to that!) later.

Another new addition to HVCRE ADC is the requirement that the loan “has the purpose” of providing financing for ADC. Again – what does this even mean? We are in new territory with the regulators being concerned about the “purpose” of a loan. How do you even figure this out? “Purpose” seems to be in the eye of the beholder. And, when is the “purpose” decided? At origination? Hopefully! Banks should not be required to continuously monitor the borrowers’ use of funds in order to be technically compliant.

We’re not thrilled that unimproved land (without any construction or development component) still falls under HVCRE ADC, especially where the loans are fully guaranteed (how much sense does that make?).

Further, we worry that now that any loan that “has financed” the acquisition, development or construction of real property could potentially fall under HVCRE ADC, does that mean that a loan made after January 1, 2015, that, “had financed” the acquisition of real property but wasn’t previously subject to HVCRE now would be? Practically, probably not, but well worth the thought exercise (at least to us dorky lawyers).

  1. HVCRE ADC loans are not:

    • Loans that are secured by one- to four-family residential properties, real property that would qualify as an investment in community development or agricultural land;
    • Loans to acquire, refinance or make improvements to existing income-producing properties with cash flow generated by the real property that can support its debt service and expenses (in accordance with the bank’s underwriting criteria for permanent financings);
    • Commercial loans with (i) an LTV less than or equal to current standards as determined by the regulators, (ii) a borrower contribution (in cash, marketable assets, out-of-pocket development expenses or real property and improvements) of at least 15% of the appraised “as completed” value and (iii) such contribution was made prior to any advance under the credit facility (and such contribution is required to remain in the project until the loan is reclassified as non-HVCRE ADC); and
    • Loans made prior to January 1, 2015.

It’s now clear (at least as clear as these things get) that ground-up construction is HVCRE ADC (Yup – makes sense…risky lending deserves some regulation) and already improved property (that IS cash flowing sufficiently to pay debt service and expense) is NOT HVCRE ADC. And that’s where banks find themselves with a lot more breathing room: now, the “construction-lite” loans where the property is improved, cash flowing and the loan is being made to finance some sort of renovation, face list or tenant improvements may NOT be HVCRE ADC (depends).

The above exemptions are substantially similar to the original HVCRE regime (so repurchase facilities and loan on loans are exempt, as is mezzanine debt secured by borrower equity with ADC), with a few important tweaks: first, the calculation of what counts as Borrower equity contributions is different and second, the div stopper is less onerous.

As we all know, to be exempt from HVCRE ADC, Borrower must have 15% equity in the deal. The equity contributed can come in the form of cash, development costs spent at the property, and the value of the land (based on a current appraisal). Note, under the old HVCRE regime, the value of the property was determined at acquisition, so no appreciation benefit was given. Now, the appraisal will be based on the “as completed” value of the property (so borrowers can get the benefit of an appreciation in land value making holding onto real property well worth it!).

In addition, under the new HVCRE ADC rules, if the property starts cash flowing, the cash can be distributed to the borrower’s equity holders so long as the 15% contributed capital described above stays in. Whereas under the old regime, no money could be leaked out during the life of the loan. Hooray! Gotta celebrate each victory!

  1. Loans that are made under the HVCRE ADC regime can be “reclassified” as a Non-HVCRE ADC loans.

Probably the biggest breakthrough in the reform is the ability to reclassify loans. This allows banks to reduce their capital stack once the loan is stabilized. Under the new regime, a loan can be converted to a “Non-HVCRE ADC Loan”:

  • Upon the substantial completion of the development or construction; or
  • Once the property generates enough cash flow to support the debt service and expenses in accordance with the bank’s underwriting criteria for permanent financings.

Going forward, loan documents for HVCRE ADC loans should build in mechanics (or not- the language seems to suggest the bank can reclassify on its own but borrowers may want some certainty built in) for reclassification (e.g., upon substantial completion, satisfaction of a DY/DSCR test, etc.) as this would remove the div stopper and allow internally generated cash flow (above the 15% required capital contribution) to be dispersed (mezzanine lenders rejoice!). We would expect to see, at a minimum, a spread step-down in the interest rate too…maybe? There are other ways too we can think of to handle the “cash flow” test which we will be discussing with our clients.

Giving borrower’s greater optionality may be one way to make “Main Street” like banks again.


The Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation issued a statement on July 6, 2018, clarifying that banks “may refine [estimates regarding HVCRE ADC loans] in good faith as they obtain additional information but will not be required to amend previously filed regulatory reports as these estimates are adjusted.” In addition, the agencies gave banks the option to continue to report and risk-weight HVCRE exposures in a manner consistent with the current instructions, until the agencies take further action. The agencies also indicated that they plan to promulgate regulatory revisions in the future. In response, Representative Pittenger and others sent a letter to the agencies on August 1st, thanking them for their assurances that the agencies will work to conform the existing regulations to EGRRCPA.

We too are jazzed up about the promised regulations. We’d like to see (at a minimum) the following addressed (or maybe we don’t…are we better off with ambiguity so then we can ask for forgiveness later?):

  1. What does “primarily finances” mean?
  2. When does a loan “ha[ve] the purpose” of providing financing for ADC?
  3. When is development “substantially” complete?
  4. What is the “cash flow” test?
  5. It’s clear that HVCRE ADC supersedes the old rule for loans made after May 24, 2018 (and provides grandfathering for loans made prior to January 1, 2015), but it’s unclear what it does to loans made from January 1, 2015 – May 24, 2018. Are these loans now subject to HVCRE ADC for re-classification? We would like for clarity (although maybe we already have it) that the new HVCRE ADC applies to those loans as well.
  6. Can mezzanine debt and preferred equity count for the 15% Borrower equity contribution test?

Check back in the coming weeks as we discuss the above and consider whether the FAQs apply to HVCRE ADC and the fate of HVADC. The forthcoming regulations, coupled with how banks adapt to HVCRE ADC will determine whether we finally got the major HVCRE reform we’ve been looking for or if EGRRCPA failed to move the needle. In the meantime, we will be sitting here musing over the new HVCRE ADC legislation, thinking of creative solutions to a problem someone has got to have. Give us a ring. Let’s see what we can make stick!

The Boundaries of Risk Retention Now That the D.C. Circuit Has Spoken

In February, the D.C. Court of Appeals ruled in The Loan Syndications and Trading Association v. Securities and Exchange Commission and Board of Governors of the Federal Reserve System, No. 17-5004 (D.C. Cir. Feb. 9, 2018) (the “LSTA decision”) that a manager of an open market CLO is not required to retain risk under the Dodd-Frank Act and Regulation RR, because only a securitizer which transfers financial assets into a securitization vehicle must retain risk.  No transfer, no risk retention.

In its decision (joined by Judge Brett Kavanaugh), the Court was very clear in its analysis.  Essentially, the decision said “thank you very much, we can read simple English sentences, and the law is crystal clear on this point (if not on much else).”  The regulators may not elide the transfer requirement of the Dodd-Frank Act by calling managers of open market CLOs securitization sponsors, when they don’t transfer assets to a securitization vehicle.  The Court went on to point out that if this was a loophole, it needed to be fixed by Congress, not the regulators.  Blessedly, a satisfying, albeit rare, victory for a plain reading of our mother tongue.  The regulations actually mean what they say!

The broadly syndicated CLO business has taken this ruling to heart and has been beavering away on transaction structures that no longer provide for the retention of credit risk. One big issue in that space now is whether you can square the circle about avoiding risk retention in the US, while somehow meeting the EU risk retention criteria.  But that’s a bit of legerdemain for discussion another day.  What I want to talk about is the utility of the LSTA decision in spaces other than the broadly syndicated CLO space—particularly for commercial real estate single-asset, single-borrower (SASB) securitizations, a product representing almost half of all CRE securitization offerings this year. Continue Reading

Securitizing Marijuana Dispensary Properties in the Sessions Era

In 2013, the Obama administration issued the Cole Memorandum, which called a truce between federal prosecutors and marijuana businesses operating legitimately under state law.  After regime change in Washington, however, it may come as no surprise that Jeff Sessions—the Attorney General who once opined that “good people don’t smoke marijuana”—rescinded the Obama-era guidance.  The only real surprise is that it took him a whole year to do it.

Since at least 2013, marijuana-related businesses have generally been operating on predictable, albeit legally shaky, ground.  Dispensaries have expanded dramatically.  Though details vary wildly, nine states currently allow recreational use and medicinal use is currently permitted under the laws of all but four states.

As a result, commercial real estate lenders have to grapple with the increasingly common problem of the dispensary tenant, and a number of lenders are dipping their toes into lending in expectation of securitizing loans secured in part by dispensaries.  But given the January 2018 announcement that the Cole memo is no longer in effect, the question everyone’s asking is: are things really that different?  The answer, we think, is no—but with an asterisk. Continue Reading