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October 18, 2019  

Sponsors Buy Back First Troubled CLO Loans

The first sizeable distressed bridge loans showed up in the collateral pools of commercial real estate CLOs in the third quarter, but most observers believe overall credit quality in the sector remains sound.

The troubled loans range in size from $35.6 million to $57 million. The sponsors of the affected issues — LoanCore Capital and Benefit Street Partners — bought the mortgages out of the collateral pools at par value, a step that gives them more flexibility to work them out while preserving the credit quality of the transactions.

CLO investors praised the buyouts as a sign of strength for the sector, saying they demonstrate that sponsors have a vested interest in defending their reputations and deals. But some cautioned that sponsors have no obligation to do so, and wouldn’t be able to sustain the practice amid a sharp downturn.

Defaults have been rare so far in the CLO market, where issuance didn’t start picking up until 2017. Kroll, a leading rating agency on CLOs, said seven bridge loans have defaulted in CLOs that it rates — all this year. In each case, the sponsor bought back the loans. In three other cases, sponsors bought back loans that were encountering credit risks, but hadn’t actually defaulted. Other agencies don’t disclose when loans are bought back.

Seven loans were bought back in the first half, and all were relatively small. The sponsors were Fortress Investment (an $11.9 million loan), Granite Point Mortgage (a $19.8 million loan), M360 Advisors (four loans totaling $19.2 million) and ReadyCap Commercial (a $16.1 million loan), according to Kroll.

But the three loans bought back in the third quarter were bigger. Two financed Manhattan apartment renovations that had their business plans upended by the state’s move to restrict the conversion of rent-stabilized units to market rates: a $55 million loan on four apartment buildings on West 107th Street, and a $35.6 million loan on one at 471-476 Central Park West. Both were in the collateral pool of a $1 billion LoanCore offering (LNCR 2018-CRE1). The third, a $57 million mortgage on the Williamsburg Hotel in Brooklyn, was securitized by Benefit Street in a $610 million deal (BSPRT 2018-FL3).

Investors applauded CLO sponsors for buying back the problem loans. “In many cases, issuers will tell you on the record that if a loan goes [bad], they will buy it out,” said one bond buyer. “If you are comfortable with that, in some ways there is no credit risk unless all the loans start going delinquent.”

Because sponsors retain the bottom 15-25% of transactions, they have incentive to buy out loans — up to a point. They will incur the initial loan losses in any event, and buyouts give them more flexibility to resolve loans out of the spotlight. Also, the default of even one good-size loan can breach overcollateralization requirements, preventing sponsors from receiving interest payments on the bonds they hold. Finally, a reluctance to buy out loans could hurt the reputation of a sponsor, undermining its ability to float new deals.

“The fact they are buying out the loans attests to the strength of the structure,” one investor said. “These are financing vehicles, so the issuers are not trying to gouge the investors. They have an interest in ensuring the market remains healthy and their access to the capital markets is available when they need it.”

Another bond buyer said that by keeping deals “pristine,” issuers also bolster secondary-market trading, further enhancing the sector’s strength.

Rating-agency officials noted that the practice of buying out loans could end during a recession. “In a meaningful economic downturn, investors should expect issuers to act in a rational economic manner within the four corners of deal documents,” said Eric Thompson, who leads Kroll’s structured-finance effort.

Deryk Meherik, who focuses on CLO ratings at Moody’s, agreed. “We can only rely on what the deal’s docs require to be done, and buying out credit risk or defaulted loans is not a requirement,” he said.

He added, however, that the CLO structure offers inherent protections to holders of bonds that are senior to the component retained by sponsors. “There is an alignment of interests in CRE CLOs as the collateral manager has an incentive and is motivated to buy out impaired or defaulted loans” because it has a substantial first-loss position, he said. “That alignment of interest is further incentivized by the consultation and enforcement rights the bondholders have with the collateral manager, which provide additional impetus to keep underwriting tight. No one has spilled the apple cart yet. Everyone in the market appears to be keeping things honest.”

One market professional, while agreeing that issuers are keeping a lid on leverage, noted that lenders are facing strong competition for business and that the sector hasn’t yet faced a recession. “Anyone who tells you they are just putting out good loans is talking their book,” he said. “They raise money, and they have to put it to work. They are out there trying to compete, and some of them are looking at assets with rose-colored glasses and hoping for the best.”

To date, the deals have performed extremely well. According to a Wells Fargo report on Sept. 9, the percentage of CLO loans in special servicing stood at a skimpy 0.28%, compared to 0.48% for single-borrower commercial MBS deals and 1.56% for conduit offerings. The $214.6 million of loans bought out of 2018 deals equals 1.7% of the $12.4 billion of CLO issuance rated by Kroll that year.

One investor contended that stiff competition among bridge lenders is causing some slippage in underwriting standards. “Clearly credit is deteriorating,” he said. “The question is why? My conclusion is the bridge lenders are stretching due to competition, but at this point it also seems to be idiosyncratic. When things are underwritten to perfection, the chances are greater that something goes wrong.”

One bridge lender agreed that there is some slippage, but insisted it’s at the margin. “On a very high level, lenders are holding the line,” he said. “On the fringes, you are getting some stuff that is getting chipped away.”