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Point out (of the money)

On Tuesday, Brookfield released the terms on its planned restructuring of the debt secured on the CityPoint tower in London’s Moorgate.

CityPoint is a big prestige asset, let to brand-name institutions (Simpson Thacher, Wilkie Farr, Simmons & Simmons, SquarePoint Capital) and with a chequered securitisation history.

It previously backed the 2007 CMBS deal Ulysses (ELoC 27). I suppose it’s a sad indictment of the state of European CMBS that the 2018 deal, Salus (ELoC 33), was only six ELoCs later. ELoC, or European Loan Conduit, is Morgan Stanley’s European CMBS shelf, now up to #39 (Haus).

Ulysses underwent an epic restructuring battle. Cheyne Capital, holder of the CMBS class Es, sought to appoint itself operating advisor, arranger Morgan Stanley bought back the senior notes, while special sits fund Mount Kellet made a healthy turn on the B notes, flipping them to Brookfield, which used them to take control of the asset.

They’re still held in a Brookfield vehicle called Castle 46, while the mezzanine loan financing Brookfield’s acquisition of the building also ended up in securitised form, packaged into a Cheyne Capital-sponsored vehicle called Cleveland Row Finance.

That’s all ancient history now, though. Salus passed its expected loan maturity in 2022, a time when rising rates, environmental refits and the continued WFH trend put immense pressure on office valuations. The can was therefore kicked several times, with extensions and margin increases, until Brookfield launched a sale process for the asset last September.

Offices, it seems, haven’t recovered all that much (and very few buildings of this size and location have changed hands). The Financial Times reported that Brookfield was looking for £500m, which would have at least made the debt whole with some change. But bids were coming in below £400m, and some with a two-handle. The sale process was shelved earlier this year, prompting a further loan extension to give time to whip up this week’s restructuring proposal.

The official valuation (last done in March 2023) is still a ludicrous £670m, according to the latest investor report, giving a healthy 55% LTV, and avoiding tripping either cash trap or class X diversion triggers. Marking to market at below £400m gives a different story — equity gone, mezzanine mostly toast and senior debt (£367.5m) looking vulnerable.

There’s a decent rent roll (£34m), so it’s not like one of those “asset makes no money” or “asset makes < debt cost” things. But there is a fair bit of capex needed, and a few worrisome lease events — SquarePoint has a break in 2028, and Simmons & Simmons is leaving in 2030, each more than 20% of rent.

Noteholders in Salus are being asked to vote on a three-year extension in return for a 20bps margin increase, plus a legal final extension to 2032. That will take the senior class to 205bps, or 216bps with the credit adjustment spread — miles outside most other senior bonds, and it’s still triple-A with KBRA at least.

Senior bonds in the last Taurus print, a challenging syndication of a mixed CRE pool, came at 118bps, so you are at least getting paid for hanging around to see what happens.

Valuing the rest of the goodies on offer depends on whether you think something will turn up in the next few years to get Brookfield out at a better price — noteholders receive an additional 45bps of PIK interest to be paid on exit, and 10% contingent value rights to participate in upside, should upside become available, the bulk of which are allocated to the senior class.

Under the restructuring proposals, the mezzanine loan will become entirely PIK, so Brookfield’s out-of-the-money equity will become even more so over time. If prime office is going to bounce back, it needs to bounce back hard.

Brookfield is dribbling in some new money across four tranches, below the senior loan. There’s £21.5m in committed financing, earmarked for various purposes, including restructuring fees, topping up reserves and rehedging the loan, plus an uncommitted facility of size TBD which can be used for capex.

Brookland Partners is advising, and certainly know its way around a CMBS restructuring, advising on most of the rash of post-crisis workouts.

Bondholders minded to play hardball have a strong hand though — all maturity extension options have been exercised, and if they vote to reject the package on 16 April, final loan maturity is 20 April. At that point note-holders can let the deal drop into cash trap and sequential amortisation, or get together and enforce.

That might be harder than it looks though. Within the CMBS structure, class D would be the controlling class, and most likely feeling nervous. If the best bid last year was below £400m (how far we don’t know) when Brookfield was shopping it, does the firesale value land inside the £367.5m senior debt and impair the D notes? Incentives could point to can-kicking from inside the CMBS structure as well.

What’s the implied cost of the intense brain damage involved in a protracted CMBS fight?

The bare knuckle brawling of the post-crisis period is somewhat behind us, but perhaps the special sits funds have just been biding their time wait for the interminable rounds of extensions to work through the market, and it’s all going to kick off in 2025.

Or perhaps the institutional structure of the CRE market has changed.

Fewer, larger more stable sponsors, private credit-style debt funds largely buying and back-levering whole loans mean a more consensual, extend-and-pretend market than in the past. A hedge-fund dominated investor base more like that of the US B note market might be more tempted to put on loan-to-own trades. And it would be more able to do so if more deals were in freely transferable CMBS format, rather than structured as agented loan with restricted transferability. Perhaps private credit just wants to sit and collect carry?

Subscription lines

Apart from the rapidly collapsed Stenn, one of the biggest examples so far of asset-based finance getting over its skis has been consumer tech rental platform Grover, which we touched on before Christmas, and which 9fin’s Bianca Boorer has been watching closely.

The next key date is 16 April, when the company is due in Berlin court for a “StaRUG” hearing — a German insolvency process that can be used to cram down lenders and, in this case, is also going to be used to write down shareholders.

The company’s business model involved renting out consumer technology on a subscription basis — iPhones, games consoles, TVs and the like — a business with a few obvious risks.

The depreciation curve for these gadgets is rapid, and the consumer who’d rather rent their games console than buy is not necessarily the best credit risk. Carrying large amounts of inventory proved expensive (thanks to the depreciation), especially in lesser-used product lines, and finally servicing wasn’t easy. Consumer tech is portable, customers were subprime, and effectively these were unsecured loans; repossessing a three-year old mobile phone is absolutely not worth the cost of sending round the bailiffs.

Add to this a business plan based on tech startup valuations and hockey stick growth, and it all proved too good to be true. A capital raising effort last year failed, and the focus switched to putting the business on a more sustainable footing — slashing unprofitable product lines, and reworking the asset-based debt facilities to better fit the new plan.

A major hazard is servicing arrangements. In a regular consumer lending or mortgage business, even if a backup servicer isn’t “hot” (ready to step in at a moment’s notice), the products are reasonably standardised and plenty of third party servicers able to step in. Market standard is for at least a “warm” back-up (step in within 30 days). But Grover’s proposition is not standardised!

Fasanara Capital and M&G are the two lenders, and offered generous terms with high advance rates, part of 2021’s high-water-mark of bullishness.

The StarRUG plan doesn’t contemplate a principal haircut to these positions, but it does involve flipping some of the exposures from the senior secured loan against the Grover assets to a deeply subordinated debt instrument at the Grover op co, with lenders also receiving a slug of equity (Fasanara already had some).

With the business hopefully stabilised, new equity can be raised and the plan includes €35m-€40m of capital coming from new and existing shareholders. Existing shares are mostly written down, but will receive some upside participation instruments (”hope notes”) to sugar the pill.

Every unhappy company is unhappy in its own way, but Grover throws up a set of issues which are common across asset-based finance.

Much business is done with youngish fintechs that may not be profitable. These businesses can only finance themselves directly with expensive venture debt or startup equity; asset-based funding fills the gap, but lenders must ask whether these loans are really delinked from a servicer insolvency. If a lender can take the keys that helps, but founders understandably don’t want to give that if they can avoid it, and enforcement is never as easy in practice as in theory.

As with Grover, many innovative fintech business models are more familiar than they look. Scratch an “XYZ-as-a-service” approach and you find short-term subprime leasing or loans. Sometimes the “innovation” is just an incredibly aggressive residual value assumption, and the under-served customer segments are just high risk, not unfairly maligned by the mainstream.

Reading regulatory runes

Much is hoped for from the European Commission’s review of the Securitisation Regulation, due to drop this quarter. That will probably mean 29 June, though it would be nice to have some proposals to chew over at the Barcelona conference.

While we wait for the white smoke, there’s the Joint Committee Report on the implementation and functioning of the Securitisation Regulation to enjoy.

This is a collaboration between the three big regulators in EU financial markets, the European Banking Authority, the European Securities and Markets Authority and the European Insurance and Occupational Pensions Authority, all bodies whose thinking is likely to be influential in the Commission’s drafting (and subsequent wrangling between Parliament and Council to get a new SecReg done). It’s also relevant in its own right, as these regulators set the details and interpretation of overall EU (Level 1) regulations.

The report is big news for the CLO market. My colleague Michelle D'souza has done a great piece looking at the risk retention aspects. The skinny is that the report tightens up rules on third party originator vehicles, with a test that they will need to receive more than 50% of revenue from something other than holding CLO risk retention equity.

Risk retention vehicles need to have another business besides holding risk retentions (for example, mezz investment or direct loan holdings) but the levels are much lower. With this interpretation applicable right away, it’s a direct disruption to deals in the market, as investors clamour for assurances that the risk retention structure is compatible with the new guidance.

There’s a decent argument risk retention wasn’t ever really designed with CLOs in mind. The original rationale, way back in the wreckage of the post-crisis period, was to align originator incentives with securitisation investors and prevent banks packaging up their worst loans to ship to hapless bond buyers. This was arguably more a problem in the public imagination than reality, but nonetheless, the feeling originators ought to keep “skin in the game” was popular post-crisis.

CLOs don’t originate their own loans, and CLO managers already have appreciable alignment of interest via the subordinated management fee and equity IRR hurdles. The business of CLO management doesn’t really wash its face if deals don’t perform, and a CLO manager can be pretty capital-lite. If it’s three men and a Bloomberg going off to start their own shop, raising €15m to hold 5% of even one deal is a big ask; they’re essentially fund managers, not deeply capitalised credit institutions, and the US market successfully challenged risk retention rules, such that US CLOs do not have to comply with US risk retention.

Still, if you’re going to do it, it’s a bit intellectually unsatisfying to half-ass it — if a risk retention vehicle needs to be an entity of substance, then the “substance” shouldn’t be a mere tick-box.

Also of interest in the report is a clear statement that the regulators consider CLOs to be public deals. Their broad syndication, public announcements, and widely tradeable and liquid market notwithstanding, CLOs are considered private, and don’t file data with a Securitisation Repository, such as European Datawarehouse or SecRep.

“The new definition broadens the scope of public securitisations, as segments of the securitisation market which are currently considered private for the purposes of the [Securitisation Regulation] would fall in the scope of the public,” says the report. “These include CLOs and, in some circumstances, synthetic securitisations with Credit-Linked Notes (CLNs).”

The report also gives some tantalising hints about the possibility of unfunded STS for synthetics.

Insurers have been building up their presence in the SRT market, writing protection from the liability side of their balance sheet (often at tighter spreads than credit hedge funds can manage).

But it’s a less capital-efficient structure than a funded (cash-collateralised) SRT. Not only does it substitute the insurer’s credit risk for the protected tranche (rather than 0% risk-weighted cash), it has also stopped banks claiming Simple Transparent and Standardised (STS) capital treatment on the retained senior.

There are workarounds for turning unfunded into funded protection (Celeste Tamers' excellent piece on the subject is here), but every time you add, for example, funding from a bank, or an extra SPV repacking layer, that adds cost and complexity to doing a deal.

The industry’s perspective is generally that one form of investor should be treated much like another, or at least any difference should be reflected already in the insurer’s risk weight versus cash risk weight discussion, without flowing through to the senior tranche.

The report flags a few different drafting errors (though it deals with them delicately) in the Securitisation Regulation. These have been longtime frustrations for practitioners, but are somewhat tedious to discuss here.

There’s an intriguing discussion, though, about deals which aren’t quite securitisations.

Per the report: “There are current transactions which fall outside the scope of the current definition of securitisation in [the Securitisation Regulation] that include, for example, the so-called 'single tranche securitisations' and credit funds, which are secured debt schemes issued by funds as an ABS investment alternative.

Furthermore, there seems to be a new growing market segment in the form of 'Credit funds (CRFs) collateralised debt', where the funds are closed-end loan funds that directly lend to SMEs as direct lending funds, but also invest in book loans through syndication by credit institutions. These funds are also not captured by the existing definition of securitisation.”

This sounds very much like a lot of the asset-based finance deals that come up around here. I’m not sure about adopting the 'CRFs' acronym, I feel like the securitisation market has quite enough of those, but it’s clearly very much on the regulatory radar.

The report, though, says it doesn’t see merit in changing the definition of securitisation, since it flows through bank regs in CRR, and international standards as well. But it does contemplate a “look at the various subsegments of the securitisation market and develop a more targeted approach to the application of the [Securitisation Regulation]”.

Modest proposal

As hoped-for reform of the European Securitisation Regulation looms, what would good regulation actually look like?

The point of regulation shouldn’t be to stop investors losing money, taking risks, or even doing what appears to be dumb stuff. The point is to protect the bits of the financial system that struggle to protect themselves — ensuring pensioners don’t lose their pension pots, insurers are solvent enough to pay claims, and deposit-taking banks don’t fall over.

If we’re looking at what banks actually buy, that mainly means senior positions, and the key difference between triple-A risk in securitisation and triple-A risk in covered bonds or corporate bonds is extension risk, not credit risk.

A covered bond triple-A is usually a bullet or soft bullet maturity, while an RMBS triple-A on a low CPR pool can flip from being a two-year bond to a 15-year bond if it isn’t called. Ratings are geared to full payment of principal and interest by legal final maturity, an attribute of purely academic interest. Structures are designed to delink securitisations from their sponsors, but sponsor insolvency, or inability/unwillingness to call, is the major factor that can cause prices to gap in securitisation senior bonds.

And yet… it is one of the only unregulated aspects of putting together a securitisation.

Lending? Regulated. Hedging? Regulated. Underwriting? Regulated. Disclosure? Regulated. Asset selection? Regulated. Ratings? Regulated.

Step up, callability, call structuring, call incentive? Whatever the market will accept.

If anything, the existing (regulated) ratings practice encourages issuer optionality with lower step-ups, since this gives a more efficient capital structure.

The 'non-neutrality' factor in securitisation regulation (the notorious P factor) is supposed to adjust securitisation capital treatment such that it exceeds the capital density of the unsecuritised pool, an adjustment justified by 'agency and model' risks. But these are far less important than the simple fact of call optionality in the largest asset class, RMBS.

So here’s my modest proposal: scrap most of the disclosure obligations, risk retention and securitisation-specific regulation. Securitisation capital treatment based on standard CRR/Basel risk-weighting approaches rather than flowing through a separate securitisation regime.

Banks wanting preferential regulatory treatment on senior tranches for capital and liquidity purposes (HQLA eligibility) can obtain it on tranches with at least 2x step-up and a full turbo after the call date. CLOs would need some adjustment (turbo after end of reinvestment period?).

This would make securitisation triple-As subject to the preferential regime more like other asset classes with predictable maturities and reduced price gap risk, and justify a more comparable capital treatment to bullet asset classes. Under this regime, banks would struggle to buy senior notes in, say, low WACC low CPR legacy RPL portfolios, but that doesn’t seem like such a bad outcome? Strip away a lot of the bureaucracy from deal structuring and investing, revive the animal spirits of the market, and put securitisation on an even footing.

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