Near the epicenter of the late unpleasantness was that wonder of complex engineering, the CRE CDO. It has been blamed for near everything that went wrong or was wrong in the commercial real estate space. It probably is responsible for the winters of 2010 and 2011.
The CRE CDO, as it was initially designed, was an on-balance sheet term financing facility which was designed to be free of the vicissitudes of traditional bank warehousing restrictions and, of course, the dread mark to market of the repo market. The transactions were often dynamic and had substantial term, often up to 7 years. Whole loans (as well as other stuff) which met the elaborate and complex (more on this later) eligibility criteria could be financed on a rolling basis with the proceeds from the disposition of assets reinvested for a substantial portion of the term. CRE CDO paper was customarily rated. The average cost of funds was substantially lower than what could be obtained on a straight bank facility.
But then Frankenstein’s monster smashed the bars of its cage and began to kill villagers. Turbo-charged by an environment where pushing the envelope was the mother’s milk of financial engineering, the CRE CDO became unhinged from its intellectual moorings and turned into the instrument of mass financial destruction.
Two decisions turned this perfectly good financial vehicle into the stuff of bad memories. First, we decided this would be a terrific vehicle to hold B notes, participations, mezz loans and other high-yield debt. Second, structural criteria were developed which enabled this business to flourish. Where high-yield debt was concerned, the criteria baked ill conceived structural arbs into the plumbing, which permitted sponsors to stuff these vehicles with dodgy but high yielding assets which were often treated the same in the eligibility and over-collateralization mechanics as less risky, lower yielding assets. Guess which type of asset filled those vehicles?
Enough painful memories. While the NRA’s famous slogan that guns don’t kill people, criminals do, causes eyes to roll amongst the chattering classes, there is some truth to the aphorism. The misuse of this technology should not blind us to the value of the device as part of a well-managed securitization or portfolio business. To be clear, I’m talking here about financing performing newly originated whole loans.
The whole loan CRE CDO is fundamentally a fairly simple structure. The rating agency driven criteria for whole loans, informed by years of experience in rating and surveilling CMBS, actually works pretty well. Whole loan deals with good diversity and CMBS consistent criteria will perform as well as the underlying asset category and frankly, that’s really all we can ask. Whole loan CRE CDO will work. With good managers, there is nothing intolerably scary about active management of a dynamic CDO with straightforward and transparent eligibility criteria and plumbing. These deals should not be conflated with the opaque, mind-numbingly complex, almost unmanageable (perhaps, in fact, unmanageable) multi-category CDOs that characterized 2006 and 2007 (everyone remember the synthetic bucket and future funding insanity?) and gave these devices the odor for which they are justly famous.
We know the criteria for whole loans, we know how it works. A dynamic reinvestment mechanic that allows for reinvestment, prudently constrained, in the hands of a high quality manager with an established track record and substantial skin in the game, is a perfectly reasonable device to help lever an origination business and we ought to find a way to bring it back.
But, we need a new name. The optics of CRE CDO are horrific. Perhaps we should have a contest to name the new vehicle. How about Dynamic Interim Mortgage Entity, or DIME? Brother, can you spare a dime?