The Life and Death of a Real Estate CDO

Deutsche Bank is winding down a troubled $1.25 billion CDO that it set up with two partners in 2006 to invest in commercial real estate debt.

The transaction was unusual for real estate CDOs because it involved only three players — Deutsche, Norinchukin Bank of Tokyo and Otera Capital of Montreal. They divvied up the $144 million equity position and all $1.1 billion of bonds floated by the CDO, called Spring Asset Funding, 2006-1.

The investment vehicle primarily acquired B-notes and mezzanine loans, as well as some senior debt. Among its purchases: $75 million of mezzanine debt on the 1,332-unit Independence Plaza apartment complex in Manhattan and “rake” bonds backed by a $37.8 million B-note on the 2.3 million-square-foot Palisades Center mall in West Nyack, N.Y.

But the investments were made as the real estate market was peaking, and many of the assets subsequently declined in value. That left the collateral pool with large potential losses, even though the payments on the CDO bonds continued as scheduled.

Commercial real estate CDOs have generally performed better than their counterparts in the residential and asset-backed markets, incurring significantly lower default rates. But the Spring Asset deal reflects the fact that some real estate CDOs that are technically performing are saddled with underwater collateral loans that will eventually lead to bond defaults.

A change in accounting rules appears to have forced the hand of Deutsche, which underwrote the CDO and served as collateral manager. The rules would have required the bank to consolidate on its books either all of the CDO’s $1.25 billion of assets or, under one interpretation of the guidelines, the whole balance of loans for which it held only subordinate positions — a far greater amount.

Faced with the burden of having to hold capital against the consolidated assets, Deutsche mapped an exit strategy. It bought out the positions of Norinchukin and Otera late last year, giving it full control of the collateral, and then started liquidating assets.

At issuance, the CDO encompassed $869 million of triple-A bonds, $237 million of bonds ranging in grade from double-A to double-B-minus, and the $144 million equity position.

Deutsche and Otera each took down 40%, or $57.5 million, of the equity piece. Norinchukin bought the remaining 20% interest. Deutsche also acquired $569 million of triple-A notes. Norinchukin bought the remaining $300 million of triple-A bonds and $209 million of subordinate paper from almost every other class of the deal. And Otera held $28 million of paper from the two most-junior classes.

The losses incurred by the trio are unknown, but appear to be substantial. According to market players, Deutsche bought out Otera’s position at a steep discount in October and acquired Norinchukin’s interest for about 55 cents on the dollar about three months later.

On the plus side, the partners did receive interest payments on the bonds for about four years, plus a 14% annualized return on the equity investments.

What’s more, Deutsche mitigated losses by switching the vehicle’s investment strategy during the darkest days of the credit crunch. As loans in the collateral pool matured or were liquidated in 2008 and 2009, Deutsche reinvested the proceeds in high-grade commercial MBS, which were then trading at rock-bottom prices.

The strategy, developed by Deutsche director Mark Berry, the CDO’s portfolio manager at the time, led to the purchase of about $250 million of CMBS that subsequently rose in value substantially, boosting the returns on the deal’s equity piece, according to market pros. Berry, who left Deutsche last August, declined to comment. Deutsche also declined to comment for this story.

But the rebound in CMBS prices blocked Deutsche from continuing to employ the strategy. Meanwhile, losses on the much-larger batch of loans in the collateral pool were a ticking time bomb that would eventually eclipse the CMBS gains.

Word has it that most, if not all, of the CMBS were the first assets to go when Deutsche began selling collateral early this year. It’s unclear how much Deutsche has already liquidated. It hasn’t conducted any bulk offerings, as other CDO managers have done when unwinding transactions. That suggests that the bank is selling off individual assets opportunistically.

One indication of the activity came in a report filed by the CDO’s trustee, U.S. Bank, which said that almost $550 million, or 63%, of the triple-A notes were paid off in the first quarter. That presumably reflects sales by Deutsche, which now owns all of the CDO bonds.

Moody’s, which never downgraded the CDO, withdrew its then-moot ratings on May 24.

Before buying out its partners, Deutsche made an unsuccessful attempt to sever its relationship with the CDO about a year ago, when it sought to transfer management of the vehicle to 650 Capital, a unit of Ranieri Partners of Uniondale, N.Y.

When Otera and Norinchukin balked, Deutsche considered hiring 650 Capital as a sub-advisor instead. But that never happened either, most likely because it wouldn’t have provided the desired accounting relief.

Meanwhile, Otera wanted out of the CDO because it was moving away from investments in structured products in order to focus on originating and syndicating construction loans for commercial properties in Canada. Deutsche’s trading desk tried selling Otera’s stake in the secondary market before the bank ended up buying the interest itself.

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