Back in the summer of 2017, I wrote, together with my partner, Stewart McQueen, a commentary entitled Direct Issuance is Here – A New Paradigm For Single Asset Single Borrower (SASB) Securitizations. Well, it wasn’t really here in the sense that it surely didn’t take off as a transformational innovation, albeit we have done a series of deals based on the direct issuance structure since then. I was an enthusiast. I thought it would immediately become a significant tool in the toolbox, but it really has languished in the alternative structure, break the glass, open only in emergencies bottom drawer.
I am beginning to hear that in the here and now, there is a bit of a sizzle, a bit of frisson, around the notion of the direct issuance structures. Will it no longer be off piste? As there now seems to be some considerable interest around the structure, I thought I would revisit my 2017 missive. Not burying the lede, I remain convinced that it’s a terrific way to proceed for some, if not many, transactions.
Direct issuance refers to a transactional structure in which an SPE entity, which owns commercial real estate, directly issues its debt to investors. The debt is secured by a mortgage and the other traditional securitization collateral security documents we’ve come to know and love while a trustee and note administrator intermediates between the issuer and the actual noteholders. This debt is, from the investors’ perspective, essentially the same as conventionally issued securitization debt in which a mortgage loan, made to a borrower, is transferred into a securitization vehicle which itself issues notes to investors.
The structure has several advantages which make its use compelling for certain transactions. While there are some detriments (more on that later), the advantages dominate. The structure was initially inspired by an ability to avoid risk retention, but its advantages go well beyond the structural elimination of that silly and if its purpose was sponsor/investor alignment, largely ineffective Dodd-Frank Rule. While I argued then, and still argue now, that the Risk Retention Rule is clear on the point that direct issuance is not subject to risk retention, the decision of the DC Circuit Court of Appeals in the Loan Syndication & Trading Ass’n. vs Securities and Exchange Commission and the Board of Governors of the Federal Reserve in 2018, put paid to that issue.
The Court in that case concluded, quite rationally and, in fact mundanely, that under the Risk Retention Rules, if there’s no transfer of a financial asset to a vehicle which issues securities, there is no risk retention. (While that case was about an open market corporate CLO and not a commercial mortgage structure, the salient facts around risk retention are the same). Based upon the Loan Syndication precedent, a no risk retention conclusion is broadly but not uniformly opionable these days in Big Law.
The structure has a number of advantages. Because risk retention is not applicable, the capital stack can be constructed without regard to the drag from risk retention (I note that some bankers I know think that the structural drag is essentially illusory) and its attendant kabuki theatre structure and expensive disclosures (sorry about that, my accounting friends).
In this structure, the lender does not have credit risk. Additionally, the lender should not have anxiety about either reputational or enterprise risk about the success of the transaction (which might still exist in a structure transferring much of the credit risk to a borrower through the use of an agent structure or material price flex). In other words, the bankers really have a considerably smaller oar in the water in the structure of this type of credit. The bank will discharge its customary role as a securitization advisor, assist in the management of the ratings agency process, investor-relations, provide instructional guidance and, of course, distribution. Consequently, the borrower should have increased control over the structure. The bankers might advise as to marketability (and they are not going to tilt at windmills), but the sponsor, in large measure, will be able to construct a bespoke deal that works for it. Less yield maintenance? Fine. Longer term? Okay. Different covenant structure? Okay (probably). The borrower may pay for it in pricing and proceeds and the bank may have to work harder to place the bonds that are structurally divergent from the bonds they placed in the last 50 deals, but that comes down to a conversation about price, proceeds and fees between the banker and the customer. They can work that out.
The structure may also be a solution to the mortgage lending licensure laws in some states. These rules typically scope out banks and life companies (on the premise that they are regulated by some other governmental entity and the folks don’t need the state’s licensure regime to protect them). Nonetheless, this can be a significant problem for the non-bank set. Since there is no loan made by a “lender” to a borrower, the mortgage banking and mortgage brokerage rules should be inapplicable. (I’m not here to promise that some state agency, jealous of its authority and perquisites may not try to extend the licensure regime to a direct issuance structure, but that really does seem, at least intellectually, a bridge too far.)
There are, of course, some…issues with the structure. There may be some novelty drag as our market does not love things that are new and different. Nonetheless, if we see a significant volume of these transactions, that novelty drag should burn off.
From the bankers’ perspective, there may be some concern about the economics of doing these deals. Some banks, in some cases, might actually prefer to assume some credit risk in exchange for an origination fee and may not be keen to embrace a structure in which they’re simply earning arranging and distribution fees. That’s fine. The structural tent is large and direct issue is merely something on offer to the sophisticated borrower. It will not take the place of the existing structure of a lender making a loan to a borrower and transferring it to a securitization vehicle for a securitization.
From the borrower’s perspective, some may feel anxiety about direct exposure to the investor marketplace and prefer the comfort (illusory or not) received by the intermediation of a major bank. (On the other hand, in the SASB space, most loans that already agented and hard commitments without significant market flex are, shall we say, unicorn-ish.) Direct issuance is just another way of approaching these issues and the parties to the transaction can sort that out.
It should be mentioned that last I checked, one ratings agency continued to be concerned about the lack of a day-one set of reps from an institution acting as a lender. I didn’t understand the problem with this then, and I don’t now, particularly in the SASB market where the reps in large measure always flow directly from the sponsor/borrower and the lender’s reps are essentially limited to the fact that it owns the loan and conveys it to the securitization vehicle. Well, in this transaction, they don’t own the loan and they don’t convey it to a securitization vehicle, so I don’t really see the difficulty.
In any event, this is a good structure. It deserves more attention. It’s a tool in the toolbox. It clearly doesn’t replace the existing structures and it won’t work in all cases. To state the obvious, it’s probably only really relevant in the SASB market, but as that market represents such a huge portion of securitization today, its relevance is indisputable.
Come on, folks, get out of your comfort zone and have some fun in Innovation Land.