Let me begin with an apology for not being in print for a while. All that Ho-ho-ho-ing and a lot of mulling over this particular commentary is to blame. Today, with writer’s block behind me, this commentary is about acknowledging and considering addressing dysfunction in our industry.
The CRE securitization business never quite seems to reach robust, comfortable maturity. We grew slowly in the waning years of the last century, grew rapidly during the run up to the Great Recession then crashed into almost insignificance. We’ve grown back, but it just doesn’t feel as institutionally muscular in terms of market share and investor engagement as it ought. The CRE market is enormous. While it’s smaller than some, it’s still somewhere north of $6 trillion, and that ain’t nothing. In a market where banks, life companies, the GSEs and non-bank lenders represent the bulk of the supply of liquidity, it just seems that CMBS, conduit SASB and CRE CLO has been kept at the children’s table.
We have two existential problems that we’ve known about for years, decades in fact. Indeed, we’ve launched countless initiatives to address these problems. In short, borrowers don’t love us (understatement alert) and there’s simply not enough investors regularly buying our bonds.
Oh, we’ve engaged in any number of initiatives to address one or the other of these problems and right now under the auspices of CREFC, CMBS 4.0 is under construction. 4.0 will be useful. The ideas embraced, or under discussion by the team that’s been beavering away at 4.0 are good and will improve investor engagement. However, in no respect, will any of it be transformational. It often seems we’re more worried about doing anything with even the slightest potentially disruptive impact on our sclerotic business while rejecting, out of hand, fresh and more ambitious solutions which could have a positive transformational impact. I get it. Right now the business is quite profitable. All market participants are doing…well, okay? We embrace, perhaps subliminally, a widely shared operational principle that if it ain’t obviously and horribly broke, don’t even think about fixing it, and maybe not even then. But that conservative impulse actually puts our business at considerable risk. Are we the fin de siècle buggy makers of this new century? This is all reminiscent of Hemingway’s quip, “I went bankrupt two ways…first slowly, then fast.” We’re still enjoying the slow bit, but that surely won’t last forever.
Those annoyingly practical borrowers are our central problem. They understand that capital markets loans are rarely the best bid. As a good friend and a major market participant recently observed, competition for his capital market dollars only happens after a borrower has exhausted all other sources, banks, lifecos and other portfolio lenders. It’s a real problem if we don’t get consideration until after all other borrower options have been tried and dismissed. We have been, and remain, the lenders of last resort, after our borrowers strap on the financial beer goggles late in the hunt for money.
Why the borrower hesitancy? After all, we often provide competitive pricing, more proceeds and better terms. Well, No Duh. They hate the servicing experience with its complexity, its high and often unpredictable fees, its problems with timeliness and responsiveness and the structural impediments to flexibility and creativity. In short, it’s hard to manage a dynamic commercial real estate while encumbered by the structural rigidity of a capital markets financed mortgage loan. And let’s be clear, and not pretend, all commercial real estate is dynamic.
Investor issues? We haven’t seen the development of a big enough investor base to comfortably ensure there’s always demand for our bonds. Largely, the same investment grade players we’ve had since the end of the Great Recession are the only ones buying bonds today and the 80/20 Rule applies with a smaller percentage of those accounts doing most of the buying day in and day out. While bids have been strong in the tail end of 2024, might that be the result of fever as opposed to ruddy health? Our industry is at risk that any black swan events (and they are out there) could cause material investor disengagement.
Investor hesitancy is a complex issue. There’s a liquidity issue, because individual issuances are rather small. There is a granularity problem because the underlying assets are relatively large and if a small number goes sideways losses can begin to threaten the IG bonds. There’s simply a scale issue. The business doesn’t have sufficient scale to attract a bigger investor community and even existing investors are loathe to staff up to support a growing footprint to a business that seems to have scale issues. Finally, there are perceived issues associated with conflicts among transactional parties which can leave investment grade buyers uncomfortably unable to predict the performance of the structure in a stressed environment (in other words they could get screwed).
On the other hand, spreads are better. That’s the reason investors are here.
It has been received wisdom since the inception of our business that the competing demands of the borrower community and the investors are at existential loggerheads. The borrowers want ease and flexibility, the investors want certainty and clarity. That’s the calculus we’ve never been able to solve and that’s why it’s time to use the hammer that says
BREAK THE GLASS IN CASE OF EMERGENCIES.
To really address our problems at a fundamental level, we need a Grand Bargain. We need to take steps to fix both our servicing problem for the borrowers and increase investor attachment to our industry. Grand. Bargains imply real, substantive change. Grand Bargains mean oxen will be gored, certainties will be challenged and people will need to rethink some of the fundaments of our business. Grand Bargains are hard.
Two prongs to this journey. First, we need to make capital market servicing work much more like the servicing of our competitors in the portfolio sector where asset management is often quick, nimble, unburdened by excess (and unpredictable) fees and creative (Freddie is pretty good, but we need to think bigger). Second, we need to sweeten the investor calculus to offset these things and, in fact, offset some of the issues investors have been complaining about for years.
We initially built our servicing structure on two fundamental suppositions. Servicing functions should be segregated by subfunctions and bits of the whole allocated to multiple institutions deemed particularly well-suited for those functions. Then, have all the parties deal with each other pursuant to detailed and prescriptive contracts. Easy-peasy, right? Call in the lawyers.
Second, we created a servicing standard which was, in short, the bests interests of the bondholders as a collective whole and created a cascading control structure in an effort to balance the interests of all parts of the capital stack by giving first loss holders the right to terminate the special servicers, without cause, with a servicing standard override to protect the rest of the capital stack.
All of this worked, sort of, on paper but it clearly didn’t work terribly well in the real world. Too many deal participants with disparate interests and some element of control, and all dealing with each other pursuant to picky, lengthy and complex contracts, what could possibly go wrong? It all has a whiff of Rube Goldberg about it. Gaming come to mind?
Our documentation can only make a lawyer smile. Largely driven by liability and reputational concerns (shoot the damn lawyers) we embraced a highly prescriptive, rule-based system encouraging rule following as opposed to judgment. So often, transaction parties excuse much by saying they are following the punctilio of their contract, even if all might conclude (in private) that the result was…suboptimal. You apparently don’t get fired or criticized even if the ballon goes up if you could say you did everything the contract said you must do.
We endeavor to task our documents to answer every question, address every exigency. We should have known, perhaps did know and ignored, that the effort was doomed to fail. One can’t manage mortgage exposures to commercial real estate or indeed commercial real estate itself in an entirely mechanistic, automaton 19th century clockwork type of way. More words, more subclauses, more Russian Doll definitions won’t fix it. In that doomed search for certainty, we have burdened the servicing exercise with enormous amount of time-consuming process-based work. In short, the negative externalities of our construct are overwhelming the intended benefits.
I made this point a couple of weeks ago talking about the regulatory instinct toward mechanistic precision, our almost steampunk prescriptive rule-based system that infects all governmental regulations. The rejection of a more principle-based regulatory regime because of anxiety that a principle-based regimes leave too much room for discretion and judgment is a mistake.
That led us to be consumed by what might go wrong and overlook what would surely go wrong.
Everyone knows the problem. Even in a perfect world (let’s all agree that borrowers can be their worst enemy in many respects) it’s often still a months-long, and perhaps multiple months-long process, to get answers to even easy asks (and almost all the important ones) as each of the primary, master and special do their jobs and, on anything important, the DHC or controlling class representative has an oar in the water as well. Everyone obsesses about their case, about criticism-proofing their decisions and justifying their actions. At the end of the day, regular way servicing decisions take way too long. This disconnect between the dynamic nature of commercial real estate and a rule-based prescriptive servicing structure is at the core of why we are the lenders of last resort.
And to be clear, I’m not blaming the servicers here. The problem is the structure. How to fix it? BREAK THE GLASS. Everything should be on the table. Let’s at least try the Big Idea thing and, at a minimum, enjoy the frisson of pretending to be adventurous.
Just to get the ball rolling, I’ve got some ideas to toss out. The purpose of this commentary is to encourage everyone to think about immodest, Grand Bargain type ideas and, before you hang me and send the peasants to my front door with torches and pitchforks, please actually read Mr. Swift’s short essay. How about creating an escape hatch from the process? When a servicer concludes acting quickly is in the best interest of the bondholders, they should be able to act without having to look over their shoulder, while shortcutting some of our vaunted and daunting process. When servicers become process drones, we are failing.
To make this work, we need to better protect servicers from liability, and indeed from criticism, when they exercise judgment. We need to clarify our servicing standard that good judgment is the core of good servicing. Sometimes decisions need to be made in extraordinarily tight timeframes and with limited information. We can’t be in a situation where the only way to meet the servicing standard is to punctiliously meet every jot in the servicing contract while Rome burns. So often have I heard, and entirely respect, the assertion from a servicer that it had no choice under the contract. We can’t substitute contractual formalism for good judgment. If a full case can’t be constructed, if not all the constituents have weighed in, if there’s missing information, servicers should still be able to act without liability or the assertion from other deal parties that it violated the servicing standard. Would a lifeco respond in the timeframe and the information provided? Yes, it would. If they can, we can.
How about replacing the negligence standard with a gross negligence standard to move out the anxiety guardrails of principle based decision? (Yikes!)
When we built our highly prescriptive, steampunk contractual edifice, we seem to have underappreciated, almost to dismiss, that a contractual straightjacket is not the only way to constrain bad behavior. We underappreciate that there are material economic factors that will constrain such bad behavior and indeed compel high quality performance from our servicing construct. Bad servicers will be blackballed by issuers. Investors will reject issuances with “bad” servicers. Rating agencies will criticize and withdraw ratings. We should move much of the policeman function of our contractual edifice to the markets.
Fixing our borrower problems at the risk of driving investors out of the marketplace is obviously not an option, and that’s why we need a Grand Bargain. In this Grand Bargain, we need to address the most important of the investor complains and indeed improve the trade to encourage more investors to get into the business and for existing investors to expand their footprint.
The investors currently have in front of the industry a whole series of asks which should be taken seriously. Concerns about transparency, reporting, definitional consistency, advancing, etcetera, can be addressed in a way which largely satisfies the relatively small-bore requests of our investor community in this 4.0 process.
We could build off of the investor ideas about a super operating advisor (with enhanced staff and economics in tow); it’s something we need to think about (and yes, if we had one, the OA would have to get paid out of the deal, considerably more than they are currently getting paid). With enhanced economics, they might be part of the answer.
How about baking in a toggle that if a pool deteriorates to a certain level, upon investor request (we need to work out how a functional registry would work), the servicer’s duty under the servicing standard would have a strong bias towards foreclosure or sale as opposed to work out and restructure?
Maybe in all structures and not just SASB, junior tranches are stripped of special servicer control in conduit. Maybe at some point, junior tranches are treated as equity.
How about a trigger allowing the investment grade or perhaps just the AAA class, to require the liquidation of a pool when material deterioration has occurred? (Again, we’ll need a functional investor registry to make any of this work.)
Thicker first loss pieces would be beneficial as they provide more alignment between issuer and investors. For tax reasons, that’s how the CRE CLOs have grown up and indeed, investors like the added alignment resulting from the thick first loss class.
We could build out a thick first loss tranche, indeed build in some of these IG friendly provisions into a sleeve in our business to encourage more investor engagement. Think of it as a teaser offer, an entry drug to get more investors to consider a more robust CRE desk. Dimes to dollars, if investors came in this door, they would tiptoe into other parts of our business, looking to put more money to work.
Let’s engineer a multi-seller CRE CLO. This is entirely doable with special allocations of gain and loss and rep responsibility in a partnership sitting above the baby REIT issuer. Freddie’s doing it; why not the rest of the industry? Naysayers say it can’t work, of course, but remember when the 5-year conduit was a completely nutty idea?
Maybe a robust institutional credit transfer marketplace would help, somewhere where bondholders could easily and efficiently purchase credit protection and trade credit protection.
How about an industry funded insurance fund to disintermediate a tranche of risk? This could be paid for in a way similar to the funding tied to the IRP currently. Industry issues would be to get a good housekeeping seal of approval from the managers of this vehicle to have access to the insurance.
It’s time to take on the REMIC straightjacket problem. We have a new sheriff in town and friends on the Hill. What could be done with a REMIC regime which embraced active management and asset substitution? Finally, we might want to rethink the disruptive role of the GSEs (gasp!).
A Grand Bargain is, by definition, grand. It involves material change for all participants. But if there’s even a potential way to make capital markets execution more compelling for the borrower community and grows our investor base, it’s something we should take seriously.
I know. I can hear loud and clear the objections, the demurrals; the investors will throw up. Ratings agencies will punish our deals. This will end the B-buyer marketplace. It will ruin the economics for everyone. The profit will be gone from securitization. It will all become more expensive. Coupons will have to rise, making us uncompetitive. The list of things to make some or all of these changes impossible goes on and on. But just for this second, let’s stop the negativity and embrace a little bit of bold.
Look, all of the foregoing is more about starting a conversation than suggesting concrete answers. It’s troubling that we seem so fixed in our views of what’s possible (and impossible) that we can’t even envision material change, and we ought to.
Happy New Year to all and I look forward to seeing many of you in South Beach soon.