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June 14, 2019  

Wrinkle Gives CLO Issuers More Flexibility

Three CLO issuers have taken a step aimed at fending off rivals seeking to refinance loans in their securitizations.

Arbor Realty, Benefit Street Partners and LoanCore Capital last month each introduced provisions in managed commercial real estate CLOs authorizing them to modify performing loans in collateral pools. While the specific changes varied from deal to deal, they included reducing the interest rate, extending the term and increasing the loan balance — provided that the modifications fell within prescribed parameters. Other issuers are expected to adopt similar provisions.

The move was prompted by fierce lender competition, which is enabling borrowers to quickly refinance bridge loans at more favorable terms. That’s especially true when properties are improved, driving up values. If the existing loan is in a CLO, the issuer loses a solid mortgage and has to incur the expense of finding and originating a new one.

“Issuers are looking for additional flexibility within the structure to modify the terms of the loans, so when a competitor offers one of their borrowers a better rate, they can make the same offer and keep it in the CLO,” said one securitization lawyer.

Steven Kolyer, a Sidley Austin lawyer involved in drafting the provisions, noted that lenders that are CLO sponsors have a special need for flexibility. “Unlike most other securitized financial assets, CRE bridge loans frequently involve desires to modify and amend where there is no credit stress or deterioration or default,” he said.

The provision is an extension of authority that already exists in managed CLOs. A sponsor has the right to recycle repaid principal into new loans and add them to collateral pools for a specific period during the life of deals, so long as their terms are compatible with the existing pool. Issuers contend that modifying the terms of existing loans isn’t much different.

“In a managed deal, the issuer has the ability to redeploy capital,” said one banker. “You can argue [a modification is like] a new loan. I don’t think this is controversial if it’s done during the reinvestment period.”

One investor agreed that as long as the provision is being reported to investors and the parameters are met by the manager, no one is getting hurt.

“The issuer is saying, ‘This retail mortgage is paying off and going to a rival. Rather than go through the expense of originating a brand new loan, let me reset,’ ” the investor said. “In many ways it’s no different from the machinations performed in any managed deal. It’s allowing the manager to manage in a different way. If an investor didn’t want that, they shouldn’t buy a managed deal.”

Still, some bond buyers expressed wariness, viewing the provision as the latest in a string of issuer-friendly changes that have been made as the market matures and more investors have piled in. Said one: “This feature is in there for the issuers, not the investors.”

One CLO lawyer agreed there are some worrying aspects for investors. “Lowering the interest rate doesn’t seem like a positive,” he said, adding that there’s potential for an impact on credit quality if the provision is abused. “If these are all really good loans and they use it sparingly, then it’s fine,” he said. “If it becomes every loan getting routinely modified regardless of the credit, then maybe it’s an abuse. It’s so new we really don’t know yet.”

The provisions appeared in a $1.1 billion offering by LoanCore (LNCR 2019-CRE2), an $810 million deal by Benefit Street (BSPRT 2019-FL5) and a $650 million offering by Arbor Realty (ARCLO 2019-FL1).

The provisions — variously referred to in deal documents as a “significant modification,” a “specified performing loan modification” and a “criteria-based modification” — include bondholder protections. For example, a loan in the Benefit Street offering can’t be modified if it is in default or if the issue has been downgraded. Also, the modified loan can’t exceed 10% of the collateral-pool balance, and the interest rate can’t be reduced by more than 75 bp or to less than 3.25%.

The LoanCore and Arbor deals permit a reduction of interest rates and extensions of maturities, but don’t allow an increase in loan balances. The Benefit Street deal permits the balance of a modified loan to increase, but the added amount must remain outside of the CLO.

In the Benefit Street transaction, for each modified loan, the sponsor must get rating-agency confirmation that a downgrade won’t result. That isn’t a requirement in the LoanCore and Arbor deals. The LoanCore deal, which is backed by 33 loans, limits the number of modifications to 12 and requires updated appraisals.

The LoanCore deal shares some loans with the collateral pool of a companion $415.9 million static issue that the same sponsor also priced last month (LNCR 2019-CRE3). Any modifications of shared loans in the managed deal would also be applied to the participation interests in the static CLO. The static deal contains a provision allowing for such changes, provided that prescribed conditions are met.