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June 26, 2020  

Forbearance by CLO Managers Questioned

Investors in commercial real estate CLOs are increasingly concerned about the way managers are granting forbearance to borrowers struggling with pandemic-related cashflow shortages.

Most CLO issuers are taking the view that allowing troubled borrowers to skip a few loan payments under the circumstances doesn’t technically constitute a loan modification, several managers and investors said. The distinction is important because modifications typically require the manager to mark down the value of the loan — which in turn can cause the deal to breach its overcollateralization covenants.

Some investors believe managers are treating forbearance as a special situation, instead of a modification, specifically to avoid failing an overcollateralization test. When that happens, cashflows automatically are diverted from the deal’s equity holder — usually the manager — to senior bondholders.

“It would not surprise me if someone challenged this in court, but so far the investors are asleep at the switch and managers will do what is in their interests,” one bondholder said. “We saw this again and again in the 1.0 version of these deals during the credit crisis.”

While CLO deal documents specify the procedures for loan modifications, they’re generally silent on the issue of forbearance, market pros said. The assumption in the past was that if a loan defaults, the manager would remove it from the collateral pool rather than allow the borrower to miss payments.

But managers have had to rethink their strategies in light of the widespread economic damage caused by the pandemic. “They are all using forbearance and not considering it a modification,” a big CLO investor said.

Part of the problem, market pros said, is that many CRE CLOs have thin credit cushions, with overcollateralization levels of just 1-7% in many cases. Thus, modifying even a single loan could cause a deal to fail an overcollateralization test.

By treating pandemic-related forbearance as something other than a modification, managers are allowing money to “leak” from deals, potentially putting senior bondholders at a disadvantage, the big investor said.

“Once [investors] figure this out, they are going to flip out,” he said. “The senior guys are going to say, ‘This is ridiculous. The OC test is what we bought.’ Dealers were really pounding the table when they sold these bonds that investors didn’t need to worry, that the triggers on the OC tests were tight.”

But Deryk Meherik, a CRE CLO ratings analyst at Moody’s, said that since issuance revived in 2014, deal documents typically have included language designed to make it more difficult for managers to “game” overcollateralization tests. During the 2007-2008 credit crisis, he noted, some managers avoided failing the tests by repurchasing subordinate notes from their deals on the secondary market at deeply discounted prices, then submitting them to the trustee for cancellation, or “abandonment,” without compensation. That effectively increased the ratio of collateral to outstanding notes. Since then, deal documents generally have restricted such actions.

Two managers acknowledged their willingness to grant up to three months of forbearance to certain borrowers without classifying the relief as a modification. They argue that forbearance has come to be widely viewed across the industry as an acceptable response to a unique crisis.

“I don’t view that as playing games, and I don’t see anyone doing things that I would view as gaming the test,” one manager said. Post-2008, “it’s a lot harder to do that, and I think forbearance is the established game plan of the industry. I do agree that we might see stresses pick up after the 90 days run out in July.”

Some investors said they have no problem with the way CLO managers have been handling forbearance requests.

“All I care about as an investor is scooping up these bonds at 60-70 cents on the dollar and now seeing them back at 90 cents,” he said. “If there is leakage here or there, a point of interest to the manager that keeps them engaged, I’m all for that.”

But another investor said that issuers risk losing the confidence of bond buyers if the way they handle forbearance eventually leads to investor losses.

“They have to walk a fine line, because investors will accuse them of being shady,” he said. “But they also need to survive. If it’s a choice of issuing again or getting the money and surviving, they will take the money every time.”