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CMA
April 03, 2020  

CLO Managers Brace for Wave of Defaults

After several years of meteoric growth, the commercial real estate CLO sector is poised for a shakeout amid expectations that many deals are vulnerable to a high rate of loan defaults.

Well-capitalized managers that can afford to buy defaulted loans out of their collateral pools at par, thereby insulating bondholders from potential losses, could emerge from the crisis in reasonably good shape. But issuers that are already struggling with liquidity, and those with heavy exposure to the hotel and retail sectors, could be doomed.

“They have no money,” one investor said, referring to some of the most highly leveraged managers. “It’s game over unless there is some way this turns around. I don’t see how that is going to happen.”

The field of CRE CLO managers has expanded rapidly in the past few years as the asset class has gained currency with investors. Annual issuance volume surged to $19.2 billion last year, up 38% from 2018, as the number of active issuers exceeded two dozen. As a result of the coronavirus pandemic, however, issuance has been dormant since the last deal priced on March 2.

How quickly the market revives — and which firms are still standing — will depend largely on how managers navigate an anticipated wave of loan defaults. When a few large CLO loans defaulted last year, issuers including Benefit Street Partners and LoanCore Capital set a precedent by buying back the loans at par. The move was widely applauded by investors, who saw it as a sign that the market was maturing.

The question is whether managers will be able to continue that practice in the face of mounting defaults and margin calls on warehoused loans.

“There will be loans that default,” said an executive at a CLO shop. “Historically, issuers have bought those kind of loans out of the CLO. Do people have the money to do that on this scale? I’m not sure that is going to happen.”

Some shops appear to be better positioned than others. Market participants point to Bancorp Bank, Blackstone Mortgage, Bridge Investment and Starwood Property among the issuers with enough capital to absorb loan defaults and margin calls. Others, including Arbor Realty and MF1 REIT, are on a stronger footing than many of their peers because they focus on multi-family properties, which are seen as relatively safe compared to the hospitality and retail sectors.

Meanwhile, one of the more active CLO issuers, TPG Real Estate Finance, is struggling. The New York firm said last week it was facing a cash squeeze after several banks demanded it put up more collateral to finance a portfolio of commercial-mortgage securities. The mortgage REIT said it would delay dividend payments and was in danger of running out of money. Since then, its shares have collapsed, trading last week at a low of $3.25, down from more than $20 at the start of March.

“Clearly the mortgage REITs are in trouble,” the CLO investor said. “They will fail unless there is some kind of savior. Their loans are going to default. They have no cash. There is no liquidity in the market. Will the banks just forbear on all this? I don’t think that will be the case, at least not for long.”

Whether CLO managers can protect bondholders from losses remains to be seen. Pricing in the secondary market indicates holders of the most-subordinate notes could take a hit. While triple-A-rated securities rose slightly from a low of 85 cents on the dollar the previous week, the most-subordinate tranches were still trading this week at less than 50 cents on the dollar.

Still, market pros are confident that it’s a matter of “when,” not “if,” the new-issue market bounces back. In the past few years, CRE CLOs have emerged as a critical funding mechanism for bridge loans on transitional properties, and investors generally have given issuers high marks for the way they’ve structured and managed the transactions. The fact that managers typically retain 15% interests in their deals has been a key selling point.

And CLOs as a whole have been gradually reducing risk. Consider that the percentage of hotel properties in CLO portfolios fell from an average of 12.5% in 2018 to 10.4% in the first quarter of this year, according to Commercial Mortgage Alert’s CRE CLO database. The portion of multi-family collateral, meanwhile, increased to 52.6% from 39.5%.

“You can’t put all transitional assets in the same bucket,” another issuer said. “There are light transitional assets — a multi-family building that was 93% leased and [the owner] planned renovations to push up rents.”

Some market pros suggested the new-deal pipeline could resume flowing sooner rather than later if managers take additional steps to shore up investor confidence. Steering clear of hotel and retail loans would help. So would a commitment to retain an even larger portion of the risk.

“It’s very hard to have perspective when you are in the middle of the storm,” still another issuer said. “When you think back to past financial crises, we have always come back stronger. It’s hard to imagine now, but I do believe that when the country comes out of this, it will be roaring like maybe we’ve never seen before.”