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Owen Sanderson

In the year of our lord 2023, who on earth wants department stores? That’s a pertinent question because of the collapse, earlier this year, of German chain GKK or Galeria for short. One of the Ks in GKK, however, stands for Karstadt.

For securitisation people of a certain vintage, this name will be dredging up war stories. KarstadtQuelle was the anchor tenant of the Fleet Street Finance Two, a 2006 CMBS sponsored by Goldman Sachs, which became an incredibly high profile restructuring following Karstadt’s 2009 insolvency. It was the first CMBS in Europe where bondholders manage to agree a bond extension, and required all manner of creditor-balancing, with four CMBS classes, three mezz classes and a separate senior loan.

Here’s Brookland Partners, Moelis, Paul Hastings, and Fitch’s Euan Gatfield calling it a “landmark event” in structured finance.

Anyway, Karstadt got back on its feet, and running the clock forwards somewhat, collapsed again in 2020 in its GKK format. By this point it was owned by the Signa Group, a conglomerate controlled by Austrian mogul René Benko.

There’s a whole other story to be written about Benko, but I’m just going to let a pricing graph of the bonds issued by his “Signa Development” unit do the talking. Expect more coverage from our distressed debt team in the coming days.

During 2020, Signa sold off a bunch of GKK real estate to raise liquidity, and who should come along to scoop it up but Apollo? Apollo bought 21 units of a 33 unit portfolio in 2020, in a deal reportedly valued at around €700m and was a front runner to acquire more of them in 2021. It now owns 24 stores, following one disposal.

This underlines the shift we’ve seen in commercial real estate since the global financial crisis. Goldman’s CRE fund was the sponsor of the Fleet Street Two deal; pre-crisis GS stuck its nose in absolutely every arena of capital allocation. 

These days, the alternative asset managers are the big beasts of the financial markets, the most feared counterparties, the masters of the universe, present up and down capital structures doing everything the pre-2008 banks would do and more. Is Apollo the Goldman of the 2020s? Sure, probably.

The standard financing structure has also flipped in the years between Karstadt collapses. When Fleet Street Two came to market, public securitisation markets were in their pomp. SIVs and CDOs of ABS all walked the earth, and investment houses could not wait to launch securitisation operations.

The post-crisis capital regime now makes it expensive for banks to provide direct CRE loans, which has, as in corporate debt, driven an explosion of non-bank interest in the sector. The likes of Blackstone, Brookfield, Starwood, Marathon and (of course) Apollo are no longer a capital provider of last resort; they functionally are the market for real estate debt.

The banks are still involved, but generally through providing ‘back leverage’, meaning leverage one layer removed from the asset. This could mean levering a real estate fund, providing “loan on loan” leverage (lending secured on a CRE loan) or repo against a CRE loan or note.

It’s the latter structure that funded Apollo’s purchase. A vehicle called “Ionic III Sarl” issued some €474m of private CMBS notes, paying a blended interest rate of 6.25% over Euribor (according to the accounts). Some €457m of these notes were listed on TISE in 2021, but they were never sold to investors. 

Instead, they were used to collateralise a repo with Barclays, which was the real financing for the acquisition. This repo was for €320m, and pays 380bps over Euribor, again, according to the accounts for the Ionic vehicle.

Now, this underlines the relative conservatism of the post-crisis investment banks. If the reported €700m valuation for the portfolio was remotely accurate, then we’re looking at a 68% LTV for the whole CMBS structure, 65% for the listed notes, and 45% for the repo. If you assume the repo was collateralised only by the listed notes, it comes out at a nice round 70% advance rate — prudent and wise given the illiquidity of the asset?

The key question for back leverage, however, is recourse, and this is a key term of variability beyond the basics of advance rate and cost of funds. Some structures are full recourse to a fund, some structures are 25% or less, and the approach to marking is variable. “Credit marks” are usual for illiquid repos like CRE loans; when you have reason to believe the credit has worsened, you can make a margin call.

The actual call in question might not be pleasant. Margin calls, even on liquid assets with observable prices, are not fun conversations. How much fun is it going to be to phone up Apollo or Blackstone and explain to them that you think the asset they own isn’t worth what they say and could they please find a few million to send over by EOD? CRE valuations are always more art than science; sure, maybe the cap rate is well through Bank Rate, but just wait for that 2027 rent review!

We could not determine the structure of the Barclays repo from the accounts, but what happened earlier this year was GKK collapsed again, and the deal is being restructured. 

On emergence from insolvency, GKK reinstated long-dated leases on less than half of the Apollo assets, while Apollo is now looking to sell some of the rest are now up for sale. The listed CMBS notes have been pushed out three years, giving a chance for assets to be sold to unwind the Barclays financing.

Per the accounts of Ionic II, a related SPV:

Hence the question with which we began — who on earth wants department stores? The business model is clearly winding down, even if it has some life left in it, but part of the answer has to be mixed use of some sort. Some retail on the ground floor, offices, flats, hotels and more. Department stores often occupy flagship prestige city centre locations; buying them cheap after yet another insolvency might be an efficient way to get location, even if the retail earnings aren’t up to much.

The tide is drifting out on labelled debt instruments of various kinds. Nobody seems overtly excited about the chance to be the first green/social/ESG whatever; the shelves out there which do have some kind of label generally achieve this without having to alter their existing business very much. Render your RMBS green by lending money to energy-efficient properties, or social by banking the underbanked.

But securitisation is a particularly powerful technology for actually changing the world through lending money (or that, at least is the theory).

A UK Green RMBS would basically just be a package of loans secured by new builds (which would get a beating going through the rating agencies), but far more impactful for the UK’s aging housing stock would be a package of loans to fund improvements like cavity wall insulation and double-glazing. Solar ABS, an asset class generating much excitement in these pages, is just a special case of this; rather than mess about with rooftop liens and feed-in tariffs, the best way to fund solar is a long-term personal loan with UoP to a solar installation.

In the European Union, moves are already afoot in this direction — The European Investment Bank said this week it had spent €450m buying ABS notes from BNP Paribas Personal Finance, in an arrangement which will fund BNPPPF to supply “fresh lending of around €627 million to private individuals over a three-year period. Financing will exclusively support energy-efficient housing equipment, notably high-energy performance boilers, insulation windows, and installation of solar panels”.

The forward commitment is the meaningful and impactful bit. The transaction in question is Noria 2023, which priced in July, and the present portfolio is a bit more ambiguous, mixing energy improvement loans with debt consolidation and point of sale lending.

Noria 2023 is actually a dual-purpose deal — it was announced in July with all notes retained other than Class F and G, which were preplaced, allowing the deal to serve as a cash SRT transaction. But the EIB bought most of the other tranches.

There’s a subtle tension between the objectives of capital relief and concessional funding with a green use of proceeds. For one thing, the actual resource supporting new lending, at BNP Paribas Personal Finance or anywhere else, is capital, so you could argue that it’s the external investor, likely a securitisation-focused hedge fund, who’s doing the ethical heavy lifting.

Achieving SRT through a cash transaction has also historically required placing the senior notes at a market price, since this determines the excess spread available in the deal, and ensures that a bank isn’t subsidising its capital relief. This is arguably harder if you’re privately placing everything to a development bank! 

The senior tranche was structured with a 58bps coupon; Credit Agricole placed a French personal loan deal at 79bps at the end of September and Santander did a German consumer loan deal at 72bps in July, which seem like the most obvious primary comps, but I could be wrong.

Anyway, the EIB also wants to own deals at market-ish levels for general prudence and liquidity, so structures its concessional elements into deals through a bilateral contract with the originator, passing back some of the spread. BNPPPF is supposed to lend money at least 25bps cheaper than it otherwise would for these new energy efficiency loans; the EIB gets a loan tape of the new origination so it can check.

There’s actually a pretty big chequebook for this kind of activity — as agreed last year, there’s a €7bn European facilityfor “participation in senior and /or mezzanine tranches of securitisation structures”, already accessed by BBVA, among others.

Were Irish reperforming loan RMBS deals a ZIRP phenomenon, along with Dogecoin, Chamath, and companies with no vowels in? 

I mean no, obviously not, Morgan Stanley priced Merrion Square Residential 2023-1 just last week, landing more or less in line with guidance. The loans in this deal have been round the houses, being previously securitised in Shamrock 2021-1 and Strandhill RMBS, and the portfolio mixes residential OO, BTL and SME loans (8.5% agricultural loans). These deals are always going to be something of a niche asset class and are never likely to be 8x done. 

But certainly the RPL deals do better against a ZIRP backdrop. Even the deals done in the 2019-2021 period were already struggling with how high rates were. This was because credit spreads for off-the-run securitisation asset classes were high, and asset yields on restructured mortgage loans were low. This constraint drove certain structuring choices; low steps ups, WAC caps, complex call optionality, discounted bonds. The art of the deal was maximising the advance rate on a transaction which had very little yield running through it.

Now credit spreads on off-the-run securitisation assets are still high (though not that high? Merrion Square at 165bps over 1ME is basically on top of new issue CLO senior, plus shorter, convexity etc) and Euribor base rates have added nearly 400bps. That strains the skinny yields on RPL portfolios even more, and has pretty much eroded excess spread.

From Bank of America’s research desk: “RPL deals estimated excess spread started to decline in 2022, dropping c.0.4ppt for 2021 vintage. Excess spread continued to erode in 1-3Q23. Of the eight RPL deals, three had zero excess spread (and underfunded reserve funds) in 4Q22. By 3Q23, only one deal (Primrose Residential 2021-1) had excess spread left (c.1%). Reserve funds are underfunded, especially in Shamrock deals (c.50% of the target) and Kinbane (c.20% of the target), but the deficit is still small as a percentage of the collateral balance (c.0.5% or lower).”

Excess spread isn’t necessarily the main point of these transactions. They’re about efficiently levering a portfolio of assets which you expect to increase in price. Nonetheless, excess spread is the grease that makes securitisation run smoothly.

Collateral performance also looks ropey, though by their very nature, these are challenging portfolios. Bank of America again: “Severe arrears (90 days or more) in legacy pools grew by 6ppt in 2022 and another 3ppt in 1-3Q23. This is by far the worst deterioration among EU/UK RMBS sectors, despite relatively contained increase in average mortgage rate of c.2.8ppt since 2021.”

The team continued: “Among RPL RMBS, the variation by deal is very big. The lowest arrears of c.17% in 3Q23 were reported by Roundstone Securities 1 and Primrose transactions, which have much lower severe arrears, followed by Shamrock RMBS (c.27%. The highest were posted by Kinbane (45%, the highest severe arrears) and Summerhill Residential/Jamestown Residential (36%) which had much higher early arrears (c.12% vs c.6% in the rest).”

The basic trade for Irish legacy mortgage portfolios has been to buy non-performing books and render them reperforming with payment plans or other arrangements, such as capitalising arrears and pushing out maturities. Per the Merrion Square rating from Fitch, “Most restructures were capitalisations (22.5%), term extensions(29.0%), reduced rate(12.5%), part capital and interest payments(5.5%) or split mortgages(10.4%), and have led to a material sustained reduction in arrears over the last four years.”

These tools work far better when there’s a lot of space and headroom created by interest rates on the floor. Almost the entire Merrion Square portfolio is floating and linked to current rates (only 5.5% is fixed). Given that these borrowers have not been in a position to refinance their mortgages in the past 16 years, they presumably don’t have a lot of spare cash around or interest cover headroom to match Euribor at nearly 4%.

So what happens when an NPL has become an RPL but is about to become an NPL again? That’s a No Longer Reperforming Loan, right? Someone should securitise them.

There is a beauty in financial structuring, and Credit Suisse’s culture appeared to foster and appreciate this. So it was that Credit Suisse could structure bonds to hedge the risk of its own mistakes (Operational Re, so successful they did it three times), pay its bankers in ‘toxic’ assets (for a massive windfall), pay its bankers in counterparty risk, package an entire business line for private equity interest and so on.

SRT securitisation provides a superb forum to demonstrate this skill, and Credit Suisse was an unusually active and inventive bank. So much so that I feel compelled to highlight a competitors’ event, and note that Credit Suisse won an innovation in SRT award in the year when it collapsed. This isn’t strictly true; the awards year for SCI is calendar 2022 I believe, and the trade in question is from November 2022. Still, we were well into Credit Suisse deposit flight by then, and by the time of the actual awards the other day, UBS was already taking the sign off the building (is it for sale?).

It is actually a cool deal though, in a very characteristic Credit Suisse way. I’d encourage you to read the SCI writeup, but TLDR, it’s an SRT hedge on a portfolio of mid-market loans.

The actual hedge comes from a bespoke credit default swap, but this is backed out through a “transformer SPV” to a captive insurer, which can be reinsured by the ultimate capital providers, unfunded insurers/reinsurers. There’s tricky currency stuff as well; three currencies in the equity, provided by a funded investor, but tied together into a single euro mezz tranche for the unfunded insurers. There’s a cash trap mechanic, such that if the equity size falls below a certain level it can be rebuilt, and a long ramp up period which can 10x the size of the deal.

I have no strong views on how useful these various innovations might be, or whether others will replicate them. If pushed, I’d guess that the bread and butter of the SRT market is going to remain large cap corporate lending hedged with simple-ish financial guarantee / CLN structures, and that few issuance teams are going to go through the brain damage likely incurred at Credit Suisse for the sake of an initial €100m deal.

But that doesn’t mean it wasn’t a beautiful thing while it lasted. Pour one out. We suggest the Atlas cocktail….

Excess Spread — Apollo and the department stores, requiem for Credit Suisse, how to do good

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