Rick

Richard D. Jones
+1 215 833 1024
rjones@crunchedcredit.com

In Defense of Closings Human-ware Style:  Fixing Our Growing Lord of the Flies Problem

We used to do many negotiations and virtually all closings in person, not much choice really.  The process might start with an exchange of draft documents, closing checklist, etc., While initial negotiations and the exchange of diligence would typically be conducted by, at one point, snail mail, then FedEx and finally, online, ultimately we’d gather to hash out the tough stuff and close. 

We’d repair to a suite of rooms to get the deal closed.  All hands in attendance, lawyers and business side.  Coffee and bagels would be served and reams of paper would be assembled by teams of paralegals and junior associates.  Remember those weird, fold-out metal expandable doc organizers?  One of those would appear on a long conference room table somewhere in the closing suite (I wonder if one is in the Smithsonian now).  We’d have sustained conversations, as we’d all be there with nothing much else to do.  Conversations might seem somewhat desultory, but since everyone was in the same place, everyone stayed engaged.   While we’d periodically go to our separate corners to caucus, we indeed have the type of sustained dialogue that actually gets things done.  Momentum to get the deal done was palpable and compelling.  Lots of conference room food would get consumed.  

Between bouts of negotiation about the deal, we’d talk family, we’d talk baseball, we’d talk stuff.  We got to know each other.  We’ve lost track of how critically important this socialization was. 

Eventually, fueled by exhaustion and the risk of diabetic shock from the conference room cookies, we’d close.  Documents would get signed, money wired, copied distributed and recorded.  Hands would be shaken all around, a few moments of euphoric jubilation would follow and then we’d all go home to take a snooze and then spend days catching up with the paper on our desks.  Ah, the good old days. 

I’ve haven’t been to a real closing in a decade or more.  You?  Today, maybe we Zoom a bit, but actual human contact?  Egads, no!  That can’t possibly be efficient!

There are consequences of the embrace of this model.  What happens in today’s process?  Every time a call is done or a point is made or conceded, someone would circulate a complete set of documents; a new set of documents for every new “and” and “but.”  Unserious changes abounded because technology made that possible.  Since you really didn’t know the folks on the other side, there was no personal price in annoying them (and wasting everyone’s time with silly redrafts.  Lobbing documents over the transom (best, of course, on a late Friday afternoon) substituted for real progress. 

This remoteness, this disconnect between the parties encouraged folks (usually lawyers) to show their self-perceived intellectual prowess by rewriting and rewriting.  This gets done as a very solitary endeavor where it’s easy to psychologically confirm one’s views of the other side as hostile huddled in their trenches across a shell pocked battlefield.  The enemy!  How many times have you seen documents with hundreds of redline changes which amounted to virtually nothing but consumed time and energy?  Make all those “thats” into “whiches!”  (Regrettably, I remembered a deal where that actually happened.)  Time wasted, too many trees killed. 

It’s much easier to misunderstand, or to willfully ignore, counterparties’ comments in this paradigm.  You click off a call and beaver away in the dark turning drafts. 

This isn’t a good way to run a railroad. 

This is a self-inflicted wound.  We’ve decided to comport ourselves this way because of the siren song of technology and the misplaced faith that doing things at a distance back in our respective offices is efficient.  We have eschewed personal contact.  Regrettably, I can’t see us returning to the days of physical closings, although it’s clear to me we should. 

We’re de-civilizing our young lawyers, reducing their effectiveness and degrading their skillsets.  We’re deemphasizing the ability to work together.  There’s lots of chatter out there about collegiality, but less actual collaboration between folks.  For younger cohorts, this is infinitely worse.  It is so much easier to tell a face on a Zoom call to go to hell than to be obnoxious to someone with whom moments ago, you were talking trash about the Yankees.  Working at a remove, we’re degrading the ability of folks to make cogent arguments in real time, to be an active listener and discuss points with opposing parties and find a way to yes.  Sure, it can be done remotely, but that remoteness burdens the process.  Sitting around a conference room table, working through tough issues is the best and most efficient way to get to yes.  (While largely I’m talking lawyers here, this applies to business folks as well, albeit the problems are probably worse for young lawyers.)  If we’re stuck with this new paradigm (and I’m afraid we are), we ought to recognize and deal with the negative externalities of the current model of interaction between business and legal teams and do something about it.

In order to try to ameliorate the inevitable bad consequences of our abandonment of the physical closings (and in general, in-person meetings) here are some ideas:

• Send the youngsters to CREFC or the trade organization of your choice.  I know, I know it’s expensive and there’s always a suspicion that going to Miami is more perk than work, but the youngsters have to get to meet each other somehow; to bond, to build relationships.  They have to hear what folks are sayings; they have to network with their cohorts in business and law, as well as the more senior folks there.  It’s a worthwhile investment.  (Oh, by the way, for all you folks who control in-house attorneys’ budgets, please send your in-house attorneys!  They never get to go, as budgets are reallocated to more important stuff like golf outings, but it would clearly enhance the performance of our market participants if their lawyers got a chance to hang with the industry folks at these conferences.).
• Get your youngsters involved in trade organization initiatives.  At CREFC, get them into the forums, have them volunteer to work on comment letters and the like.  This is the best way to get connected in a way that will hold them in good stead as times goes on. 
• After each deal, harvest the working parties list as a resource, as a source of connections.  Get the youngsters to pick folks off those lists they don’t know and go have a coffee, go have lunch. 
• Focus on mentoring EQ.  Teach good behavior, teach how to cooperate and find common cause.  Certainly, the deal is not the client, and sometimes we need to disagree (and sometimes do so aggressively) but there is almost always a point where the parties need to get to yes.  Consider mock negotiations in the office as a training tool. 
• Provide leadership to the youngsters and demonstrate that winning a conference call is not winning.  That embarrassing or diminishing a counterparty in the course of a transaction is not winning.  Scoring points over unsubstantive issues is not winning.  Over-editing documents to show how smart you are in the darkened confines of your own office is not winning.  Deferring delivery of key information to the other side on the theory that somehow there is a tactical advantage in jamming the other side is not smart.  Conducting yourself so that you don’t generate career-long goodwill is not smart.  Building credibility as a counterparty and honest negotiator is smart.  Investing in relationships is smart.  Trying to find common ground is smart.  Annoying counterparties for no purpose is not smart.  A decapitated pig is not a good totem for transactional practice. 
• Don’t do internal Zoom meetings.  You’re in the same damn building, collect in a conference room.  Buy doughnuts.  While I’m talking Zoom, if you’re on zoom, keep the video on. 
• Hey, radical thought; if the principal players are all in the same city, try getting together.  How silly is a Zoom call team between teams sitting a block apart?  You might find you like it. 

We need to actively manage the problems created by our current sterile lack of connectivity in the modern transactional practice.  It may cost money, it may take time, but the dividends in terms of developing competent, capable, thoughtful and engaging of young lawyers and other professionals is worth the price.

No one has to embrace the frisson of a scary movie, just don’t go.  However, we are stuck with the real life equivalent in financial markets right now:   inflation versus recession (or stagflation).  

The Feds’ confusing and confused meetings and Fed head chatter about inflation and recession brings disaster scenarios to mind, doesn’t it?  The Fed clearly is enjoying a rock and hard place, Charybdis and Scylla, Godzilla and King Kong moment with really bad things threatening on both sides of the debate.  The wrong decision here could be the stuff of its own disaster movie.

Let’s put aside the yammering of our glorious political elites who reflexively yell for lower interest rates now.  They, of the reptilian brain, only see Fed decisions through the lens of what the voters, the folks, instinctively want and they surely want lower interest rates right now.  Our pols are pretty sure that pontificating about the fact that interest rates are too high is an electioneering winner.  The assumption, of course, is that, damn the merits, the bulk of the voters can be fooled at least through early November and any costs associated with artificially reducing interest rates (think Turkey for a minute) will  remain clouded by opacity; unappreciated.  Negative externalities anyone?  

But, are interest rates too high, too low, or just right from the perspective of the real business of government which is (supposedly) nurturing a healthy economy?  I want to talk about the debate, not the answer.  What is the Fed thinking about when they think about Fed funds?  

First, any debate on interest rate change has to take a view of the lag effect.  It doesn’t get talked about enough.  We don’t really know what the lag is between Fed funds moving and the impact on the real world.  We don’t know how much time we should expect to pass between accelerants and acceleration (and vice versa) but we know that the lag is real.  Then there is the question of whether the accommodative fiscal policy is more powerful than monetary contraction.  Both have lags, but which wins this race?  Gotta take a view.  

What’s the case for accommodation?  What’s the case for a more restrictive policy?  

The case for sitting still must begin with the observation that a five handle on Fed funds and a ten year that may soon uninvert does, unburdened by facts or much analytics, look restrictive...but really it is not.  From a blackboard point of view, if you think the real cost of short term money over the longtime is 2% and long term inflation is roughly 2% then a 4% Fed funds rate and a ten year slightly above that looks pretty much right.  Moreover, if the Fed tosses the long-held 2% base case for inflation on the midden heap of history and embraces a brand spanking new 3% base case for acceptable inflation, then there’s surely no reason to cut.  (The Fed, of course, is shying away from any admission that the base case might change, as it looks embarrassingly like the financial equivalent of 1938’s “peace for our time,” but that doesn’t mean they aren’t going there.) 

The economy is doing swell.  Gross domestic product is expanding, unemployment is historically low, the consumer remains relatively enthusiastic and the stock market continues to trend upward.  While some sentiment indices are flashing caution and consumer debt is growing concerningly, there’s not much evidence in the data right now suggesting a real slowdown, let alone a hard landing.  We’ve lived with a 5% Fed funds rate for the majority of the last 60 years, so why fix it if it ain’t broke?  

To lower interest rates in an economy that is expanding and robust seems a bit out of touch, doesn’t it?  According to my research assistant, Professor Google, it has happened rarely in the past 70-ish years.  Isn’t cutting interest rates in a growing economy like pouring gasoline on the fire?  

Moreover, as we’ve mused before in this column, Chairman Powell would prefer his legacy to be Volkerish and not Burnsian.  Right now, it’s very far from clear whether inflation will recommence trending downward or whether it might reaccelerate.  Based on recent data, it looks simply stubbornly intent on staying where it is for the foreseeable future.  Finishing this commentary up on Data Dump Friday, there is, in fact, more than a whiff of stagflation in the air; growth is meh and inflation simply won’t go away.  That’s a prescription for staying the course.  

If, based on the macro, the equities for either accommodation or restriction are roughly balanced.  There remains a case for fresh accommodation and a pretty strong one at that, in one perhaps obscure, to many, corners of the data.  There are two market segments in our economy that are extremely sensitive to Fed funds that are in trouble.  Both are large and struggling the broad based collapse and either is capable of doing real damage to the broader economy.  As we’ve argued in the past, once the match is lit, a new conflagration is possible.  

What we’re talking here is commercial real estate and the balance sheets of small to mid-market corporates.  

Best guess is that between 30-40% of the debt held by enterprises in these two market segments is floating.  Much of this debt was taken on board when SOFR or its predecessor, LIBOR, was close to the zero bound.  Now over 500 bps higher than its low water mark, there is enormous stress on these enterprises (and that’s, putting aside for the second, inflationary impact on costs which have skyrocketed during the past several years and the fact that easy revenue growth is largely behind us).  Note this is materially different from the GRC and actually worse.  Back then, the stress was the terminal point, at refinancing.  Today the stress is May with on-the-run expenses, the interest cost, materially higher than when this debt was contracted.  Note also that rate caps continue to burn off.  No one knows how or at what pace, but that will make this problem even harder to deal with.  Moreover, a significant amount of this debt is coming due very soon.  A significant amount of the assets supporting this debt are now wildly mispriced and cannot avoid the necessity of significant restructuring (that is a euphemism for lots and lots of new equity).   

I wrote a column a few weeks back suggesting that it’s possible that commercial real estate and its first cousin the corporate market could be the match that lights the conflagration (Could We Bring It All Down?).  Of course, I wrote two weeks later that I could be entirely wrong and Goldilocks may be in the house but call me a pessimist, I have a decided bias toward the doom-loop scenario.  

Assessing the tripwire characteristics of mispriced corporate and CRE debt in large measure depends on one’s view of the higher for longer narrative.  At least in the CRE market the current take is that while there is a lot of noise around inflation, inflation is still coming down.  If not coming down really soon, it’s coming down moderately soon.  Whether it’s phantasmagorical or not, the whole notion that if interest rates come down eventually, we can relax for the moment, seems to be an ascendancy, witness the modest bull market in issuance in SASB and conduit securitization.  

That’s just wrong.  

I’ve got no particular insight (make that actually no insight at all) into how those who occupy the heights of power view the relative risks of reigniting inflation by suppressing Fed funds versus the risk of causing a recession and the possible multiplier effect on recession risk of ongoing interest shocks in the CRE and corporate marketplace.  It’s a tough call.  Can we kick the can down the road?  Can we skirt the abyss?  Can we keep doing it if interest rates remain elevated for many quarters to come?   Maybe the residents of the heights think that we’ll find a way to fix this down in the trenches, in those market segments where the interest rate problem is most acute, that we’ll all muddle through like last time.  Deals will be cobbled together.  Lenders, shy of ownership of these assets and shy of the responsibility for taking businesses down will find a way to pretend all is well long enough for well to arrive.  I’m not buying that this extend and pretend strategy is going to work this time.  

I’m betting that the current interest rate environment is our reality for many, many quarters, possibly years.  I return to the observation that Mr. Volcker, who literally destroyed the economy, is an honored member of the pantheon of economic Gods and Mr. Burns has been consigned to one of Mr. Dante’s lower rings.  Political noise is almost a neutral factor here because no matter what the Fed does, they will be blamed by half the country.  There’s really no political safe harbor for the Fed.  Moreover, the data is unconvincing and if we remain data driven, a compelling case for up or down is simply not there.  

In that troubled landscape, legacy trumps all and because of that, I don’t see rate relief on the table any time soon.  Those who talk about a potential rate increase in the next year are not any longer only denizens of the loony fringe.  That means that while economic activity should continue at a moderately high level for the balance of this year, there is real trouble in the floating rate markets.  The Fed and our fiscal masters will pay their money and take their chances.  They’ll run the risk that a disaster in the commercial real estate and small corporate sectors will not cause broader contagion.  Good bet?  Bad bet?  

Get ready.  

I could be wrong (shocked...I’m shocked!).  What happens if we do indeed steer this brobdingnagian (think Mr. Swift) economy between the rock and the hard place (and miss the bridge)?  What happens if the Fed really has found magic dust so that inflation continues to abate, yet the economy continues to grow?  What happens if all of this fiscal excess actually does turn into the elixir for continued economic growth and productivity?  What happens if after embracing climate change and gobs of money is spent, jobs really are created, innovation soars, great businesses are founded, inflation abates and full employment follows?  What happens if this approaching train wreck of an election turns out to be a nothing burger and all the geopolitical noise out there stays just noise?  Could happen.  

If you’re of the view that we are about to enter a new halcyon-like period of strong growth and economic vitality, if we’re about to return to an interest rate curve anchored by a sub 3% Fed funds rate an uninverted long bond still hanging around the 4% range, what do we do?  

If you think that the end of the commercial real estate market’s interregnum birthed by Covid and fueled by fiscal and monetary misstep is near its end, it might be time to open the play book on a return to normalcy.  What might that entail?  

·  Raise capital.  I know everyone has been doing it for distressed debt, but maybe it’s time to refresh capital for regular-way lending.  Counterprogramming to the doomsters!  

·  Refresh or get a new warehouse.  Every non-bank lender needs at least two warehouses because it’s difficult to predict how any bank’s credit committee will react to particular loans.  You need options.  I know warehouses are ridiculously expensive to close and painful if there’s not product readily available to begin to amortize the cost, but it also takes months to get one of these closed.  Better start now.  And right now, many a bank is panting for warehouse exposure (low RBC, low attachment point, plenty of fees, not bad spreads, repo remedies, guaranties and cross-collateralization...what’s not to like).  

·  Aggressively reengage with the client base.  Hire some of the origination team back.  Get out there and build the bridges necessary to get a shot at production.  As we know, if you’re not one of the top 5 options for a borrower (or, God help us, its mortgage banker), you’re probably aren’t going to see much good stuff.  How about doing a client event (in this more prudent and unextravagant time, something short of the Nomura parties of old, perhaps)?  How about sending senior people out on a charm tour to meet with significant borrowers, even if there’s nothing currently on the table?  Might be money well spent.  

·  Work on building a reputation on not being a pirate.  When times are tough and distressed debt abounds, everyone goes to their corner.  While it makes compelling sense for lenders who need to protect shareholders or investors to get aggressive in enforcing loan documents and exercising remedies, the borrowers may have more of a more “barbarians at the gate” view of such behavior.  You can’t change the facts, a lender has to do what it must do, but you can change the narrative.  A bit more honey and a little less vinegar?  A smile while foreclosing?  Build (or rebuild) the case that your institution is a good counterparty.  

·  Build out the chassis of a CRE CLO to shorten the launch interval between accumulating collateral and issuing securities.  The traditional CRE CLO timeline is multiple months, usually considerably longer than closing on a warehouse.  A lot of work can be done long before the tape is finished and the pool is set to build out key documents, establish relationships with likely counterparties, etc.  Good investment.  

·  In times of diminished flow (and that will be true for a while even as the market reflates), consider (or reconsider) the possibility of a multi-seller CRE CLO.  Totally doable, just needs a bit of engineering.  

·  And for something a little off-piece but something worth thinking about, engineer a structure wherein the lender can benefit from the return to a lower index.  Why not share this public policy generated gift to the market?  How about a pricing matrix that would allow the lender to harvest more spread as the underlying index drops?  Could be paid for with a discount to the market’s current spread?  There are undoubtedly derivative trades that might accomplish the same thing on individual assets or portfolio basis.  Nothing’s free, but 200-300 bps of index retrenchment is certainly a juicy thing to monetize.  Worth a thought.  

·  Get comfortable with relatively short rate caps (or use a corresponding reserve).  If the index comes in, rate caps will rapidly become less expensive and will be generally available.  If the bet’s right, all will be good.   

·  Negotiate for a lengthier yield maintenance position than normal because it might be a while before you can successfully securitize the new cadre of assets. 

·  Get more comfortable in extending existing loans in expectation of a more rapid retrenchment of the index.  A kick the can down the road strategy has often been associated with a certain lack of courage, but actually could be brilliant strategy if the macro is right.  In connection with loan modifications, think about a ROFR on refinancing. 

You pay your money; you take your chances.  If the optimists are right and the level of normalcy which will allow refinancing of the huge wall of maturities confronting us is around the corner, then the first movers will have a huge advantage.  A couple of weeks ago, I published a commentary raising the question whether commercial real estate could be the match that lights the next major financial conflagration, I hedged my bets by saying I didn’t really believe that story.  Well, let me hedge my bets again, I’m not sure I really believe this story either. 

Once upon a time, in a time we now call the GFC, “no doc” residential loans lit the match that caused a financial conflagration.  We, in commercial real estate, were just tinder.  I remember at that time assuring folks that the horrific problems in the residential space had nothing to do with commercial mortgage finance.  We were careful stewards of investors’ capital and this mess had nothing to do with us.  Oops.  

So, why the history lesson?  The question today is could commercial real estate be the match this time?  There are real risks.  Conditions are ripe.  While all the talk is now about a soft landing, that unicorn of financial conditions, it is hardly assured.  Interest rates remains extraordinarily high (at least by comparison to the past decade or so).  We huddle like Schrödinger’s cat between reignited inflation and recession in the hope that interest rates will come down gently while the economy continues to flourish. 

Our market has been whipsawed by radically oscillating narratives over the past several months.  In September it was higher for longer.  By December, things looked considerably better.  Rates are coming down fast!  Yippee!  Soft landing city.  By March:  Not so fast!  Higher for longer was back on the table (and recent data is not terribly helpful).  

In some circles, there remains almost a doctrinal certainty that things will get better soon and all we need do is wait.  Indeed, things might.  We might be about to enter into the bright sunlit uplands of economic transcendence!  If rates retreat while the economy remains healthy, and it all happens very, very soon, the conflagration is not inexorable. 

The good news case for a soft landing and restoration of some level of normalcy in the commercial real estate finance space is not a fabulist confection.  Good GDP growth, good employment levels, inflation moderating (albeit slowly).  That’s all to the good.  The Fed-heads are still hanging onto some level of Fed funds reduction this year.  There’s surely plenty of capital on the sidelines looking for something to do.  The banks may have pulled in their horns, but they’ll still be lending.  Moreover, the broader economy, less sensitive to interest rates and cap rates, seems to be getting on with its reconciliation with the current rate environment.  While the new normal is not as much fun as the zero-bound, it is something the broader economy can deal with.  This is all noise, say the optimistic contrarians.  

That’s all well and good, but come on folks, we have trillions of  dollars of CRE assets that need to be refinanced this year and next, probably more than that that need to be repriced.  If this debt cannot be refinanced without massive asset repricing, we have a problem.  A widespread convulsive paroxysm of forced sales of commercial real estate is going to occur (it can only be put off so long by magical thinking) and only that will trigger the sort of re-equitization of properties that is essential.  The experience of that sort of explosion of compelled transactions will not be amiable. 

This is a debt bomb.  Hey, this isn’t our fault (okay, not largely our fault).  This was virtually assured by Federal policy miscues.  First, the Fed ran up Fed funds rate 500 bps in a single year, somehow assuming nothing could go wrong.  The run-up appears less a nuanced and calibrated effort to address the inflation problem and more an embarrassed reaction to prior policy mistakes.  The Fed then seemingly ignored the well-known lag effect, kept pushing up rates and then held rates at those high levels even as inflation, as measured by many of the indices that the Fed and the market watchers pay attention to, began to relax and retrace.  For the scouts among us, do you remember winter camp when you stuck your frozen booted feet too close the fire to get warm and inevitably left them there too long?  The hot foot shuffle ensued.  Those errors are predictable for a bunch of 13 year olds, but for the Fed?  It’s a tad embarrassing.  The market now appears to be reconciled to the fact that Fed policy won’t change quickly.  The forward curve which, for years has housed a remarkable number of optimists, only sees SOFR at little better that 4%…well nearly forever!  4% SOFR and a flat or uninverted yield curve is not going to save our bacon here.  

Exacerbating the damage from the government’s interest rate policy, the regulatory establishment has decided that this is a perfectly great time to crush banks (particularly non-bulge bracket banks) and non-banks and particularly CRE debt positions and insist on more capital, less fee income, less lending and significant regulatory pressure on the regulated institutions to dispose of commercial real estate exposures (including direct lending and warehouse lending).  Can anyone say “procyclical” here?  

A word has to be said (perhaps wasted) about the Basel Endgame Rules, an extraordinarily ill-suited initiative for this time and place.  The Basel Endgame Rules were delivered on the back of a liquidity crisis from last spring for which the Basel Endgame capital rules have absolutely no causal connection.  Just an excuse for regulators who have never seen too much capital.  The Basel Endgame Rules as proposed, were a product of slavishly importing rules from Europe without the Europeans’ well-known penchant for exceptions and crafty enforcement to fit the needs of the marketplace.  Okay, I get that the Basel Endgame Rules are probably a dead letter at this point, but it’s a piece of the regulatory mindset; another signal (if one were needed) that the regulatory establishment has its foot on the neck of the lending business is damned pleased with itself, convinced it’s doing God’s work.  We should expect more and more intrusive regulation as the answer to almost all questions; facts be damned.  

There was a brief, shining moment in the early winter when hope seemed to have transmogrified into expectations that the Fed would take Fed funds down quickly and take this cup of poison away.  If that were to have happened, we could have perhaps all taken a deep breath and kicked the can down the road like it’s the GFC all over again.  Now, in March, that expectation again looks like a tattered hope.  The looming crisis brought to us by the juxtaposition of decades of zero-bound interest rates crashing into a multiyear period of high interest rates, exacerbated by a regulatory mistake that savage lenders’ balance sheets and constrain capital formation is, as they say, a problem. Again, anyone ever heard of procyclicality?  

That’s all worrying enough within the confines of the commercial real estate finance market, but it might not be comfortably confined.  As goes the old aphorism, for want of a nail, the shoe was lost, for want of a shoe, the horse was lost, for want of a horse, the general was lost and for want of a general, the battle was lost.  It’s kind of evocative, isn’t it?  It happened in 2007, it could happen again now.  

Contagion!

Here’s how.  Value destruction in commercial real estate will impact the balance sheets of both the regulated and the non-regulated institutions.  Direct bank lending will retreat.  In the non-bank world, we might see warehouse lending, nav financing, subscription financing and the like becoming increasingly difficult and expensive.  That will threaten the business model of the entire non-bank sector which will follow the banks into conserving capital, restraining lending and investing.  In the classic, non-virtuous circle, liquidity constrains values and values impacts liquidity.  When the horns are pulled in, the horns are pulled in.  The consumer will do its part in this little tragedy by struggling with ongoing high interest rates which will suppress consumption (which remains 70% of our GDP).  Growth will be materially damaged by both the disfigured corporate and personal balance sheets.  

Would the government step in through aggressive fiscal policy to fix the problem?  Would the Fed aggressively drop rates to try to supply a safety net, even though both those steps might have, shall we say, negative collateral damage?  Who knows, but it’s hard to build a strategy on a governmental Hail Mary.  

Diminished liquidity, diminished lending and the reality that billions of dollars of CRE debt that cannot be refinanced is a problem that could cascade through the broader economy in ways we cannot envision.  Perhaps the boiled frog is a potentially useful metaphor here...but remember at the end of the day the frog did die.  

We could be the match this time, and take the blame.  

Of course, that all might not happen.  It surely need not, but the path through the very choppy waters between the Charybdis and Scylla of reignited inflation and actual recession is narrowing.  Reignited inflation (and there are those who think we’ll see it) would require further Fed action exacerbating the interest rate impact on fixed income assets which could lead to the hard landing.   An actual recession could result in a more rapid retracement of Fed funds but of course recession brings its own risks for the commercial real estate marketplace in terms of valuations and reduced income.  We cannot assume we’re done with boneheaded regulatory intrusion, all of which is likely to make the problem worse, not better.  (Further macroeconomic difficulties will simply encourage the regulatory state to regulate more aggressively and, as we know, the regulators generally view regulatory failures as simply proof that they failed to be sufficiently aggressive in the first instance).  More please!

We can prepare for further economic disruption or simply hope that the soft-landing narrative is indeed correct.  The latter is more amiable; the former is more prudent.  

And remember, in the silver-lining department, in the lee of the GFC the big bucks were made at the epicenter of the crisis, in the residential mortgage world, where the match was lit.  Something to think about.  

As we begin to reflate the CRE CLO business this year with shrinking spreads and hopefully shrinking SOFR, we need to think of this as CRE CLO 3.0. This business,  this technology, which is truly a brilliant way to deliver leverage to portfolios of commercial real estate loans has been, shall we say, somewhat moribund, almost having cooled to room temperature over the past two years. 

It’s coming back and it’s time for us to make it even better. 

First, a short advert for the CRE CLO. The CRE CLO is the absolutely best technology to provide leverage to commercial mortgage loan portfolios. Across the securitization business, it represents the best alignment of issuer and investor (with the investor holding a significant part of the first lost risk of the pool), with the capacity to provide match term stability across the life of the transaction without the margin mechanics of warehouse lending. 

It’s coming back in 2024 and will do nothing but grow thereafter. (In the spirit of full disclosure, I’m talking my book here, as I predicted a robust $25 billion issuance level for 2024...FanDuel has me at 15:1.)

We’ve been compiling a list of fixes, improvements, adjustments and clarifications for these past couple of years as we’ve developed operating experience with the technology in the crucible of once-in-a-lifetime interest rate stress. While the bolts haven’t blown off the door, our technology also has a certain built-while-flying-it vibe. Now, several years of operational experience has taught us about the things that need improving, that need clarifying, and that will make the vehicle more operationally efficient. We’ll return to the small-bore fixes at the end. 

A couple of other perhaps wider bore changes that the market might want to consider: Let’s talk about a trading bucket; let’s talk about repricing outstanding securities. 

The trading bucket is one bit of technology that hasn’t darkened our door since it was merrily marched out of the fort with saber broken and shoulder patches ripped off (obscure Chuck Connors 1960s tv show reference). I frankly never thought that a trading bucket was a terrible idea. In the day, usually subject to a relatively tight cap, collateral managers were allowed to sell or exchange performing assets where doing so was in the best interests of the certificate holders and helped shape, in a positive way, the collateral pool. Then, as we buried the late, lamented CRE CDO, the trading bucket was buried with it (like pharaoh’s concubines and hunting dogs).  A shame (particularly for them). 

Why not have a collateral manager have a right to exchange performing assets that might have some concerning attributes, yet where the asset has not risen to the level of a credit impaired asset?  Why not allow a collateral manager to trade, at a premium, an asset and reinvest proceeds consistent with a credit profile of the pool and grow the collateral cushion? 

If there was ever a time to think about that, now is that time. First, we know that it is certainly possible to see trouble on the horizon long before it would be determined that something was credit impaired. Get out while the getting’s good. It’s net positive for investors. Second, with interest rates coming in (my lips to God’s ear) spreads are likely to trend lower as SOFR follows Fed funds. When this happens loans, particularly those not yet out of make-wholes, may trade at a premium. If a loan could be sold at 101 or 102 or 103 of OPB, why not harvest the upside? If exchange properties are purchased with the proceeds, collateral cushions could improve. If no exchange assets could be acquired, the premium would flow through the waterfall. 

How about considering a repricing mechanism that could allow repricing of an existing capital stack without the full cost and expense of a windup of a deal and issuance of a new deal. Once again, as spreads come in, it could be an effective strategy. This so-called Refinancing Redemption (or at least that’s what we called it) could be triggered after the non-call period expires. Yes, it sounds odd in the CRE space, but this is not an entirely novel feature in the corporate CLO arena. Obviously, we haven’t seen this done in a rising interest rate environment, but now with a possibility that spreads might come in on the horizon, this deal feature could be extremely valuable for certain sponsors The trick, of course, is to do it without full redo of the book and disclosures. The issuer would undertake to redeem the notes and where investors agreed to redemption, exchange the old notes for replacement notes at lower coupons. If some investors choose not to participate, they would be paid out in cash. To avoid a new offering, this would probably have to be done inside the existing investor population, but that certainly is a possibility. Could be engineered. Note that in connection with any such refinancing, things such as caps on criteria modifications, caps on replenishment buckets and the like, could be achieved. The result would be an effectively a new issuance at a significant cost savings. Hmm. Worth a thought. 

As I mentioned at the outset, there is a host of smaller bore fixes which should be considered. Just for a taste of these cleanups:

• To make sure we get better alignment between payment dates at the loan level and bond level. 
• Clean up dissonance around appraisal reduction events, special servicing transfer events and default loan definitions. 
• Rationalize for RAC on due on encumbrance and due on sale waivers.
• Clarify treatment on deferred interest in certain calculations,
• Clarify how the modified loan definitions work (or not). 
• Give credit for rate cap payments in debt service definitions.
• Make sure the investor Q&A form works in a way that allows broad distribution of information which could be MNPI;
• Add some clarity around the stabilized value concept for all the future fundings.
• Add some additional clarity around the tension between servicing and the best interests for the investors and servicing with a view to timely recovery of payments.

You get the idea, there are a lot of these and it’s a reverse of “death by a thousand paper cuts.” Addressing these operational issues will make the vehicle more responsive and efficient. 

The point here is to at least think outside of the box a bit as we get ready to reflate our business. Retest our assumptions, think about things afresh. I’ve already addressed in other commentaries about the possibility of two sponsors buddying up (yes, it can be done) and re-purposing these vehicles as a CRT modality. We have a chance to expand the use and functionality of the CRE CLO and we should do so. A definition of insanity is to do the same thing over and over and expect a different outcome. We’d like a different outcome this time. Doing the same thing over and over for lack of imagination is equally problematic. 

Yes, I get it that our industry, like all capital market silos has a natural conservatism about it. If it’s new, it’s suspect. But that doesn’t mean we shouldn’t try. That doesn’t mean we shouldn’t try to educate the investor cadres about building a better mousetrap that still functions in the best interest of the investors but also provides opportunities to grow the asset class, thereby providing additional liquidity in the space by making the CRE CLO a better machine for the portfolio lenders that’s good for investors too. 

I sure hope they will. While I’m a member in good standing of the higher-for-longer club, I would love to be convinced that rates are coming down...a lot. I want to believe all those eminent and eminent-adjacent talking heads making convincing arguments that interest rates are going to come down fast and hard. The derivatives market seems to be on board. Forward-market pricing implies 6-7 downward adjustments of the Fed funds rate this year taking Fed funds from the low 5s into the upper 3s. (Of course, when is the last time that market got it right?)

But the Fed heads are seemingly not fully on board. As some wag said not that long ago (I am unburdened by charges of plagiarism, having withdrawn my application for the presidency of Harvard) perhaps, we should stop reading between the lines and actually read the lines. The Fed’s been consistently messaging “not so fast” as Coach Corso might say. 

The question for the real estate capital markets is, of course, not will they come down, but will they come down far enough and fast enough to reliquefy our market? Certainly, even a couple of 25 bps reductions will help and perhaps create a sense of momentum which, while it might not be permanent, would be an enjoyable sugar high as everyone decides to get all their deals languishing on the shelf done at once. But in order to put paid to the latent and abeyant risk (certainty?) that the legacy book will surely experience a difficult period of repricing,  the curve would need to shift down an awful lot...and quickly. 

Many of my colleagues who actually make their living in debt capital markets, seem very much of two minds about the course of interest rates during the current year. The December survey results from the CREFC Board of Governors was pretty sunny but conversations among that same group of people at the CREFC in early January were considerably less so. Folks aren’t lacking in acumen...the data isn’t just terribly coherent. 

There are easy arguments for Fed funds to come down dramatically this year. While one could quibble about which dataset regarding inflation one looks at, on balance, inflation is definitely on a downward trend. (But note for those, like me, who are mathematically challenged, a 3% inflation rate is still 50% above the 2% target.) From a blackboard perspective, if inflation is 2%-ish, a 5% nominal Fed funds rate would be quite restrictive. 

While unemployment is certainly not a problem now, there’s a reasonable concern that employment levels may begin to shudder and that would be a strong argument for the Fed to get increasingly accommodative. If we’re worried, perhaps it’s best to at least be less restrictive right now? 

And there is the lingering worry that we are we missing some of the tells that the economy really is not that robust. The glow on the cheek is fever and not ruddy health? Is it possible that a recession remains around the corner? As most of the fiscal stimulus from the past several years is now burning off; we might find out what happens, as Mr. Buffet famously said, “When the tide goes out.” Similarly,  while the consumer appears to be undaunted by pretty much everything (the December buying season was pretty damn good) the consumer sector, at any moment, might all of a sudden become aware of its burgeoning credit card debt and turn on the proverbial dime. 

With all that said, it’s fair to say that a recession is not entirely off the table within the year to 18 months, and under those circumstances perhaps a soupcon of Fed funds relief would be a good thing...a little insurance? Yet the economy is doing pretty damn well. How annoying for the doves! GDP is holding up. Fourth quarter GDP was about 2.4% and 2023 is likely to come in closer to 3%. That is, by historical standards, vigorous. There also seems to be a consensus on the Street that something in that 2.3-2.4 range is likely for the full year of 2024. Unemployment is not right now a problem. Wages are holding up. The long-predicted recession continues to drift into the gauzy distance. 

So, what do we make of all that? Will we get material interest rate relief? Should we get material interest rate relief? Will Fed funds come in? Will SOFR retrace and carry with it the ten-year? Will QT stop? Reverse? 

Bottom line, market interest rates are almost certain to come in materially (note the “almost” part of that) this year. Not only does that make (some) sense, it also reflects the consensus. When committing to a plan, however, it behooves us to ask are there things out there that might still spoil the party? There are. 

First, of course, the economy is doing just fine. The Fed doesn’t typically cut rates in that environment. I think it happened once. If GDP holds up as expected in 2024, it would be, from a certain perspective, rather odd for Fed funds to come in materially. 

Let’s talk legacy. 

Mr. Powell clearly has a picture of Paul Volcker taped to his bathroom mirror at home, having surely consigned portraits of Arthur Burns and William Miller to a dark corner of his basement. He’s a smart man (he is a lawyer after all). He is undoubtedly aware that Messrs. Burns and Miller have largely faded from collective memory, except for residual sense that their leadership might be best forgotten. Mr. Volcker is still resplendently present with us with his reputation intact. He may have destroyed the economy for a bit, but he did defeat inflation. There’s a lesson here. Protect the economy in the short term and use interest rate policy to support growth and be tossed on the midden heap of history. Bring it all down and fix inflation and be a star. Hmm. Legacy suggests the current Fed is more inclined to Volcker-ize us than not. 

How about politics? Like most of us, I  am saddened that we’re already in the election year tumult and let’s be clear, Fed policy impacts political realities and political realities affects Fed policy. I know, I know. Independence is sacrosanct, but everyone understands the realities. If they cut near to the election, they’re beholden to the White House. If they don’t, they’ve been MAGNA-tized. Not very comforting. If they’re going to do something, they better move early and right now the data constitutes less than a compelling argument for any big moves. If the Fed moves late, they’ll struggle to avoid the Charybdis and Scylla of politics. 

Finally, there’s just good old housekeeping. Policymakers have to be extremely mindful as to what they might need to do if the economy truly suffers a significant recession (and at some point, it of course will). Since one of the Fed’s primary functions is to ride in on the white horse when things go casters up and provide liquidity, would the Fed rather enter the next economic crisis with Fed funds at 3 or even lower, or would they rather encounter those sorts of existential problems with Fed funds a couple of hundred points higher? The answer is obvious: dry powder is the ultimate balm for Fed policymakers. 

So, the economy doesn’t suck. Politics makes any dramatic change this year challenging at the least. Legacy anxiety suggests that there is asymmetrical risk between accommodating too early and fighting inflation. Policymakers have to be mindful of the efficacy of the tools in their toolbox in the years to come. 

Could someone on the Fed develop an “if it ain’t broke, don’t fix it” cast of mind? Might some members become bewitched by the notion that our current rate anxiety is largely attributable to having marinated in the zero bound for over a decade and is somewhat illusory? There was a day, not that long ago, when a healthy economy looked like 2-4-6. 2% inflation; 2% real Fed funds (4%); 2% for duration (6%) and a cap rate making all that accretive. If the economy is functioning well, one might make the observation that it might be less than prudent to pour accelerant onto an already moderately hot economy (ok, not hot, but warm)? 

Look, I’m not gainsaying the experts here. Even the Fed heads are saying that Fed funds are coming in this year. All I’m saying is that there are circumstances out there that may suppress the speed and scale of any Fed funds retrenchment. Even a whiff of inflation, a whiff of excess exuberance may turn the Fed eyes back to these other issues embolden it to resist the drumbeat of pressure to cut fast and deep. 

Remember, when I’m engaging in this “on the one hand vs the other hand” dialectic, I’m doing it through the lens of the CRE finance marketplace. Surely, none of us would be offended by the possibility of a bit of a sugar high over the next 2 or 3 quarters. Some deals would get done, but 100 or even 200 bps downdraft in the curve, while perhaps good for the economy writ large and certainly for the consumer, doesn’t look like it would be enough to fix the problem confronting us in the commercial real estate finance marketplace. The legacy book is still enormous. We’ve got a trillion dollars of debt or more to be refinanced within the next year and a half. Most of that was closed when Fed funds was near zero and the ten-year hadn’t been far in excess of 2%.

Where that leaves me is with annoying concern that our legacy problem will continue to be painful and that nothing the Fed can do in any reasonable range of policy bromides will fix it. We’re not going back to the zero bound (or at least most of us hope not). That means billions of dollars of assets will need to be repriced. That’s true of SOFRs at 5.4%, that’s true of SOFRs at 4.2%; that’s even true of SOFRs at 3% (which very few think it will see anytime soon). What may salve many wounds to the body economic might actually not do all that much for the CRE market. We will, of course, repair, but that repair is going to continue to involve a painful repricing. 

But then again, maybe I’m wrong. I’m okay being wrong here. 

In any event, I’m starting off with what might, in a different time and place, have been called the 2023 Golden Turkeys. 

Amongst all the really compelling invitations to become suicidally depressed, there’s much that’s happened this past year that, with the right attitude, or perhaps pharmacological intervention, can be seen as funny and qualifying for a Turkey. I’ve now combed the front pages of our once mighty newspapers (and Page 6, of course) and with bloodstained eyes, watched countless hours of what passes for news (and blessedly, I am mis-generationed to hoover up stuff from TikTok, X, YouTube and the deeper recesses of the conspiracy-addled web and for that I am grateful). One could cry, or laugh...and I’ve elected to continue to find humor in the inanity, absurdity and the mutterings, natterings and mendacious pontifications of the self-proclaimed residents of the heights. 

So here we go. 

The Self-Inflicted Wound Award goes jointly to our glorious Democrat and Republican parties. Okay, I get the fact that they have to fight with each other. It’s often silly. It’s almost always unproductive. Opportunities to actually get something done are squandered and sacrificed on the altar of self-gratification (you’re not alone, Mr. Tobin). But now it’s worse. We’ve gone all intermural, raising dysfunctional nastiness to a new level. We’re now wasting precious time that could be used to call members of the other party “poo-heads,” by expending considerable effort insulting members of one’s own tribe. The Republicans are at war over the budget deficit and cultural issues. These purists, who would make a 12thcentury Spanish cardinal blush, embrace legislative suicide missions day in and day out. No chance of success, nothing but the sheer joy of self-immolation. (By the way, if you obsess over deficits and don’t talk about the third rail of middle-class entitlement, I call bullshit.) Doesn’t any Republican remember the sainted Ronald Reagan and his adage that you can’t a loaf, a half loaf will do? Apparently not. And the Democrats?  Maybe they felt left out watching the Republicans’ circular firing squad and have now decided to join the fray to claw each other to shreds over the Mideast and the border. Fellows, come on. This is not how the game is played. A little internecine sniping is okay, but remember the enemy is in the other trenches. We’ve been working on that script since we kicked out the Brits. This is infinitely worse. 

It’s a Tough Time for Comics Award. How does one earn a living behind a mike in a country where half the folks think the other half are lying, stupid and venal all the time. (Vermin? Cue the tiny brush moustache?)  Every time you open your mouth, while half the country might chuckle, the other half is enraged and is off to the gun store to buy more ammo, or packing a Peace Molotov in his or her biodegradable rucksack to participate in a largely peaceful protest. Everything triggers; rage ensues. To the barricades! There’s just not enough funny jokes about the habits of Icelandic fisherman (where it has been determined that there are no active (I mean within a 1000 years) colonizer indictments overtones nor intersectional constituencies to offend) to make a 60-minute show. Particular kudos in the Comic Award category to those poor comics in Russia and China. While you might die in front of a tough audience here, there, you might just simply die (and in the Russian case, fall out a window).

The Common-Sense is Overvalued Award goes to the SEC; the perennial winner. The Bronx Bombers of inanity (okay, not the current Yanks, but you know what I mean). There’s plenty to pick on here, but let’s focus for the moment on the proposal, floated earlier this year, to protect small investors from buying securities that small investors can’t buy. While we planned to give this award away before we found out the SEC, in a moment of sensibility, reversed itself and scoped out ABS sold in the 144A market from this new rule (Rule 15c-2-11 for the wonkiest amongst us), it’s still too damn funny to leave out. While they’ve withdrawn the rule, the fact that they thought this was a good idea in the first instance  gives them cred for this award. In this proposed rule, the SEC had determined that the small investors, the Mom-and-Pop investors, needed to get the same sort of information they got when buying a share of IBM whilst buying bonds in a private 144A transaction. Well,  apparently the penny finally dropped that Mom and Pop couldn’t buy ABS in the 144A market cause Mom and Pop ain’t QIBs. I don’t care who you are, passing a rule that protects someone from doing something they can’t do, is pretty silly.  Seriously, don’t be so sure this won’t come back and the SEC will again be competitive for a Turkey. 

The Captain Renault Award goes to the bank regulatory community which was shocked, shocked, to learn recently that some banks had lots of deposits and held lots of Treasury securities. Who knew? Outrageous! Lots of deposits used to be a good thing and Treasuries were terrific investments; no risk! Well, in the same way that food is essential for life but sometimes one last fine, thin wafer can be fatal, as Mr. Cresote learned, too may deposits and too many Treasuries can result in unsustainable liquidity crisis. No one seemed to notice that deposits have feet and the value of Treasuries is inversely related to yield while interest rates screamed out 400 bps. The regulators were appalled and then, the politicians got involved, surely raising the intellectual level of the discourse. Our gloriously elected representatives then commenced to  rant, huff and puff about the fact that they were also shocked and appalled that bank’s liabilities were short-tenured and bank’s assets were often long-tenured. Never mind that borrowing short and lending long is the essence of banking and has always been. So, what’s the government to do? In response to the failure of several banks this year because of liquidity concerns, the regulators turned to more regulation larding on more capital to fix a problem that had nothing to do with capital. How about just exercising the existing enforcement powers? Aren’t the examiners supposed to know what’s going on in these banks? Might real oversight perhaps have noticed that zillions of Treasuries held in mark-to-market books and non-guaranteed deposits might be problematic? Who knew? 

The Straight Face Award goes to our entire political class (another perennial winner). All of these worthies continued in 2023 to say the most incredibly outrageous, uncommonsensical and often blatantly untrue things day in an day out without any apparent shame or concern. That may have worked fine in 1850 when you could have lied through your teeth in Bumstock Township and then said something entirely differently in Smallberg City and no one would catch wise (Billy, singing Razzle Dazzle from Chicago, a paen to lawyers everywhere). Haven’t you guys sussed out that it is no longer 1850 and everything you say is preserved in the cloud forever? Whatever absurdity you blathered about yesterday or ten years ago, or in Joe Biden’s case, a 100 years ago, is still around. Who’re you going to believe, me or your lying eyes? I know politicians are a thick-skinned bunch, but this willingness to be caught red-handed lying to the American public incessantly is, let’s agree, impressive. 

The Winnie the Pooh Award goes to Chairman Xi Jinping who met with Mr. Biden in November. It was clear that he was delighted that there would be no risk of embarrassment while perambulating around the meeting grounds where the palaver ensued. No risk that he would be photographed looking like Winnie-the-Pooh to Barack’s Tigger. (Check out YouTube and you’ll get why there might have been some anxiety.) His only concern with the current President was to make sure Mr. Biden didn’t wander off the stage during the joint news conference or say “giberotatort... that’s the deal, God save the Queen,” when asked about the importance of the Chinese relationship. 

The Shining City on the Hill Award goes to all of us who appear intent on running a presidential campaign between two of the least liked politicians in history. Virtually everyone in America knows that this upcoming reprise of the 2020 election is an embarrassment, but no one seems to know what to do about it. Couldn’t we have just asked both of them to move on, pretty please?  Maybe if we offer them buckets of money?  Hunter wouldn’t then have to try to sell the stuff he and some Democratic donors call “art” and The Donald can stop pretending he’s already a billionaire. Maybe we offer decent parole terms? How about we build each of them a simulacron of the White House, give them a gently used AirForce One to fly around on, endless supply of White House cuff links? An alarm clocks that play Hail to the Chief? We’ll all promise to never mention insurrection, plagiarism, foreign corrupt practices and dementia ever again. Promise. 

The Matrix Award goes to the exploding competence of AI technology. Yes, Madam Vice President, I, too, know what AI stands for...albeit I have no real idea of what it actually is. AI may be wonderful andwe may live to regret it. To all my legal friends out there, don’t use AI to write your next brief, and to the romantically inclined, don’t let it write your next love letter. Remember, AI these days has a sense of humor (a Turing victory?). I can’t even imagine what AI will bring to us in the next 10 years, but I have a more than a sneaking suspicion that I won’t be entirely pleased. 

The British Invasion Award goes to all those the new and nifty regulatory ideas sweeping across the ocean from London, Basel and Strassburg. Last time we had an invasion from across the pond, we got the Beatles, Rolling Stones, the Animals and Abba (well, maybe not Abba) and all sorts of terrific music that fundamentally changed America. Now we have a less amiable invasion as regulatory notions imbued with Mommy state sensibilities, and a certain hostility to and deep suspicion of striving and messy capitalism. It’s not just creeping on cat’s feet, but kicking down the door and stomping into the US business world. Can’t we be left to screw up our own economy ourselves without all this help from Europe? Come on, Europe. We saved your rump twice in the past 100+ years; leave us alone. 

The Talking Head Award goes to our network business colleagues. If politicians can be indicted for saying the most outrageous, uncommonsensical things and often saying blatantly untrue things day in and day out, what about the business commentariat? The chatter of these talking heads can be equally maddening! You should buy. No, you should sell. Markets are great. No, markets are terrible. I confidently predict 3% growth in Q1. I confidently predict the end of the world in Q1. To fully enjoy the whiplash, you don’t even have to change channels, just watch whatever network you’re on for more than 10 minutes as talking heads wander in, plop down and confidently predict something and then wander off to be replaced by the next master of the universe who says the absolute opposite thing. I get it that you don’t get booked for balance, but, really! (I could probably give this award to myself, but that’d be hubris.). Frankly, consistency is the hobgoblin of little minds (cred to RWE) and I sort of love this sort of thing. 

The H. L. Mencken Award goes to the Crypto Currency Industry. H. L. Mencken famously said no one ever went broke underestimating the intelligence of the American public.  Some in the crypto currency industry seems to be continuing to prove that right. While there are some cryptos out there that are actually backed dollar for dollar with US currency and US dollar-denominated assets, our friend Sam Bankman-Fried proved that, by itself, that’s not a complete answer. Moreover, while people have explained to me over and over again how a currency backed by an algorithm was rock-solid, I don’t know. Most agencies that issue currencies around the world have armies, police and maximum-security lockups. There’s a reason for that. Maybe if you say “blockchain” often and loudly enough a case is made. I’m staying on the sidelines. 

Funny as a Heart Attack Award goes to the Hamas Invasion of Israel and the ensuing war. Nothing even remotely funny here, but it just seemed wrong to publish a screed about disheartening things in 2023 without mention of that horror. (wouldn’t want to do a Nicky Haley here).

My apologies to end on a downer, so let me conclude by wishing everyone a happy, less interesting (in a Chinese proverb sort of way) and prosperous New Year. Stay tuned for more Crunched Everything!

Rick

Why are we so calm?  What has anesthetized us? 

I’ve had numerous conversations with market-makers in and around our business and many, not all, but many, seem very relaxed about the here and now.  I hear:  Spreads are coming in.  Business is going to get better.  The Fed will start to retrace the rise of interest rates before the middle of next year.  The curve will shift down at both the long and the short end sooner than you think.  Cap rates will retrace.  On the first whiff of grape in this political environment, the Fed will drive borrowing costs down and probably start QE all over again.  We’re going to have a soft landing, or maybe...we’ve already had our soft landing!  No one cares about M1 or M2.  No one cares about deficits nor monetary knock-on effects.  Geopolitics is just noise.  Domestic politics is just noise.  What?  Me worry?

Frankly, I don’t get it.  We’ve got two shooting wars going on and a serious threat in the Pacific Theatre.  These are real wars, folks.  They aren’t police action dust-ups.  We’ve got howitzers and cannons and missiles and tanks and jet aircraft.  We’ve got tens of thousands dead.  A big hunk of Europe is being ravaged in ways that make it look like it’s recapitulating the 1940s.  The Mideast is on fire (and may get worse before I actually get this thing posted).  Right now, a case can be made that there’s a real likelihood that we’ll be drawn into a shooting war (that assumes you don’t think we’re already at war in the Mideast or in the Ukraine.  The enemies of our friends seem to think we are.) 

Notwithstanding the recent performance of the price of oil, the Mideast war represents an immediate threat to the oil supply.  While US production is up, our strategic oil reserves are at an all-time low, and various governmental actors seem intent on trying to suppress US production in service of our current green agenda.  We’re still beholden to China for many strategic metals and an awful lot rides on Taiwan’s ability to continue to make and distribute chips to the rest of the world.  The budget deficit is shocking and there is no serious conversation going on about what to do about it.  Moreover, it seems both government and private market actors often act as if it doesn’t matter.  Let’s be clear – both political parties are complicit.  The current commitment to guns and butter is simply unsustainable.  No one, and I mean no one, will even mention the third rail of middle-class entitlement programs.  Talk about the elephant in the room!

Moreover, current projections of the deficit don’t really take into account what happens as the current weighted coupon of government debt rises from its current 2.9% to something closer to 5%.  While math is not my strong suit, a 5% coupon on $30+ trillion of debt is close to $2 trillion a year...do I have that right?  That change by itself will beggar our fiscal policy. 

China and others are intent upon defenestrating us as the world’s reserve currency.  If you haven’t thought much about that, don’t start now unless you like sleepless nights.  Our economy floats on a sea of positive externalities of our status as reserve currency.  Much of what we take for granted couldn’t occur if that status were really threatened. 

The yield curve is intractably stuck at very high levels.  It could steepen; it’s certainly not going to retrace any time soon.  No one seems to really understand what term premium is, but we all understand that term premium is something.  The short end is inextricably tied to Fed funds.  While we may be enjoying a pause, I’ve not heard any credible case for a rapid retrenchment absent the super difficult and deep recession (which brings with it its own set of different but bad consequences).  The curve is incredibly unlikely to shift downward at any time in the near future. 

Closer to home, it’s been estimated that $1.5 trillion of commercial real estate loans will mature in the next couple of years.  Most (a very big most) will struggle mightily to refinance.  For many of those loans, and perhaps most, a 20% or 30% decrease in value will be realized. 

How about our own politics?  I just saw today a survey that suggested that 40% of Americans think democracy is kaput and think violence against your political foes is okay.  I don’t think that’s ever happened before.  The Republican party is a mess...a circular firing squad on a good day.  The Democrats are now discovering significant fault lines over the Mideast war (yes, it is a war) and all the while, the Democrats and Republicans are drifting (or sprinting) left or right.  The middle looks increasingly lonely.  Then, we’re increasingly likely to see a rematch of Trump and Biden, and I don’t have to actually say what’s problematic about that, do I?  All the country thinks the other half is lying all the time. 

How about secular changes in the way commercial real estate is used?  We’re not back to work yet, but will we ever be?  And how about AI?  (Just like our Vice President, I know that stands for Artificial Intelligence.)  Disruptive technology?  Creative destruction?  Seems that way.  Where it goes, where it leads us is absolutely unclear.

So why are we so calm? 

Is it because there’s no obvious precipitating event looming on our immediate horizon?  We actually rarely see bad things coming, do we? 

As regular readers of this column might know, I am fascinated by the level of obliviousness around existential threats and events that change the course of history, the geopolitical equivalent of tectonic plates colliding. 

Let me start where I often do with the obliviousness evidenced across Europe and North America in the months and weeks leading up to the commencement of World War I.  The English were focused on Ireland; the Americans were focused on ignoring the fact that there was actually a broader world out there.  The French were fascinated by the murder trial of Madame Henriette Caillaux (who was not convicted, even though she shot the poor man six times in the abdomen – Francophile passion was apparently a compelling defense.).  It was summer and the high command of all the major actors were on holiday.  (I have this mental image of fat, old, mustachioed German generals bobbing around in the hot springs of Baden-Baden wearing their pickelhaube and thinking about little else than mistresses, wine and gluttony...certainly not machine guns.)  The Archduke Franz Ferdinand was assassinated in Bosnia on June 28 and no one seemed to smell the fuses’ sulfur sputtering.  In Paris, the annual Grand Prix de Paris horse race went on.  Someone apparently suggested that it was a tad tacky to do so in light of the death of one of the heirs to the throne of a major European power, but hey, the Austrians hadn’t really mattered all that much in the past 100 years, and the horse race, part of the patrimony of France, must go on!  Peace, exit stage left. 

Black Thursday happened on October 24, 1929, but the summer of 1929 was terrific and pacific.  The Babe hit his 500^th dinger.  The Dow hit all-time highs, and everyone was all in.  Joe Kennedy famously said that when you’re getting stock tips from the shoeshine boy, it was time to get out.  He did.  Most everyone else did not.  Margin was king.  The Roaring Twenties were still roaring.  Prohibition, which was party catnip, turbocharged significant changes in social norms, the type of thing that only happens when anxiety over real problems abate.  What could possibly go wrong? 

How about 1941 in the lee of Pearl Harbor?  Certainly, some of our military leaders in officialdom were concerned.  The American public?  Clueless.  Poling suggested that while we thought war was possible, no one seem terribly troubled by the prospect.  I remember asking my mom, who was aged 19 at the time and working in show business in New York, what she remembered.  “Not much,” she said.  More pressing matters of the next performance, her love life and fun occluded more serious thought it seems. 

Lastly (and this is admittedly an unscientific survey), what about the GFC?  Here, memories are sharper but for most of us who can remember, and aren’t pretending, we didn’t see it coming.  I remember assuring my partners that the horrid mess in the subprime resi space (who knew no docs loans were risky!) was nothing that should concern us in the commercial real estate space or the broader economy.  Investors would have losses, but they were paid for that risk and would move on.  How bad could that be?  We didn’t appreciate contagion.  We didn’t appreciate how deep and jagged the hole in asset values would be.  We didn’t appreciate how badly it would impact liquidity and how horrific the knock-on effects would be of the enormous damage to our major financial institutions.  (I watched Too Big To Fail over the weekend – nausea inducing!) 

The absence of some compelling precipitating event or compelling data sets screaming that the balloon is about to go up, is not all that comforting; not a good argument that nothing bad will happen.  Maybe we glide by here.  Maybe things are more benign, than I, at least, think they are.  Maybe the economy avoids a recession.  Maybe we adjust to high interest rates and business again thrives.  Maybe the cost of money begins to rapidly go down.  Maybe a much wider war is avoided.  Maybe our politics recover from this fevered malaise. 

I rather think not.  But then again, given what I do, I am a professional pessimist.  What am I going to do about all of this?  Probably nothing.  Get back to work, think about revenue projections for Q1, look forward to the holidays and hope all is well enough. 

What?  Me worry?

For those who are still wondering, you can stop.  We are on the cusp of a material wave of distressed debt.  It’s baked into the cake and cannot be avoided by any combination of monetary and fiscal policy, insouciant disregard or magic dust.  I won’t repeat the case I’ve been making on this point recently, but higher for longer is our reality.  If you think you see a bridge returning to the zero bound, it’s a pier; it’s an illusion.  It’s time to embrace the fact that we are confronting a substantial volume of mortgage debt across the CRE space that neither works nor will work for a very considerable period of time.  It’s time to adjust strategies and think hard about finding the pony in that manure-filled stall.   That is our reality. 

This is hard and muscle memory about how to navigate a distress cycle has atrophied.  These periods of distress seem to happen only at decades-long intervals, so, few of us have been long enough in the business (I absolutely refuse to use the word “old,” for obvious reasons) to remember.  Even for those who did this before, it’s the stuff of suppressed memories, perhaps for good reason.  For the rest of our colleagues who only read about distressed debt whilst getting their MBAs, let’s be clear, reading about it is far from actually living it.  So now we all have to learn or relearn the contours of this space afresh, and redevelop strategies and instincts to deal with the reality of large quantities of distressed debt. 

Part of any strategy to navigate in this land of broken toys will be finding leverage against sub‑performing and non-performing CRE assets to get to yields commensurate with the risk. 

That’s what we’re talking about here today.  NPL securitizations must be a part of that plan.  NPL securitizations were a quotidian part of our post-GFC life and the tools to deal with them can indeed be found at the dusty bottom of everyone’s toolbox. 

NPL securitizations developed as a means of obtaining match term back leverage on non-performing loans (NPLs) and sub-performing loans (SPLs) and indeed on REO.  They involve a technology that could mix and match different asset categories, performance status and, indeed to a certain extent, could tolerate a small amount of non-CRE assets in the collateral pool.  The ultimate leverage wasn’t terribly high and it wasn’t cheap, but it did facilitate the purchase, accumulation and finance of assets that needed to be traded and needed to be repriced.  It helped clear out the zombies. 

While NPL securitizations came in more than one flavor, the most common structure was called a liquidating trust.  This title is a bit of a misnomer, as typically the structure involved a sponsor-owned SPV issuer which issued notes under an indenture for the benefit of noteholders.  In many respects, it looked a lot like a modern CRE CLO with considerably dodgier assets. 

The notion underlying this structure was that the financial assets held by the issuer would, between current period interest, repayments, prepayments, liquidation and resolution proceeds, net of expenses and operating costs, provide sufficient funds to service the debt.  Typically, the technology was capable of producing a modest amount of low investment grade paper at attachment points in the mid-50s against fair value.  In most cases, this structure paid off handsomely for the sponsors.  Perhaps this was more attributable to timing and luck than structure and the quality of assets, but as cash was recognized earlier and at higher levels than was projected when the transaction was assembled and rated, the results were outstanding. 

So, welcome back folks.  Moody’s, KBRA and DBRS have criteria for this structure currently available in the market.  Fitch is refreshing its criteria and will publish soon. 

Here’s what you need to know to build your very own NPL securitization:

• The fundamental legal structure will be pretty straightforward and familiar in the CRE-CLO securitization space.  There is a seller, and perhaps an originator which conveys assets into an issuer.  There will be an asset manager which is probably an affiliate of the sponsor, a servicer, a special servicer, a custodian, a note administrator and a trustee (and, of course, let’s not forget the placement agents, lawyers, accountants and attendant hangers-on).  
• There will be the regular panoply of cash management arrangements (more on liquidity below). 
• There will be an MLPA, but not a lot of reps.  There may be a guarantor of that limited set of reps.  The assumption is that property level data will not be great.  Assets may come off multiple platforms and, in many cases, the loans will have never been intended for securitization.  However, there’s a core set of data fields which will be required and the agencies have all made clear that in some cases the data may be so bad that no rating is possible.  If you can actually get close to completing the CREFC IRP, you will be golden.  The core data will include such things as loan term, UPB, payment status, lien status, property type and basic property information, a rent roll (which might be far from complete or current), an appraisal or BOV (again, which may not be current) and sponsor’s cost basis.  Environmental, property condition and seismic information will obviously be very desirable. 
• Typically, there will be a simple cap stack with rated senior bonds (probably BBB-) and either equity or a subordinate note held by the sponsor.  There’s no reason that the structure couldn’t be more complex, more nuanced in its segregation in risk and yield, but, at least in the early days, there will surely be a return to simplicity here.
• The structures are available for NPLs, SPLs and REOs.  The structure will even accommodate a little bit of non-real estate collateral tucked in around the edges.  All asset classes are grist for this particular mill, including... (gasp!) land.  Deals might include performing loans to sweeten levels.  They also might include performing loans which are in some way non-conforming, including re-performing loans.  Late in the post-GFC world, loans with future funding also made it into these deals without full reserve funding in place and we should probably expect that to happen again. 
• Except with respect to very large pools of small assets, the fundamental analysis will be highly granular, built up from the asset level.  This will be done using any data that’s available.  Each asset will have an attributed cash flow model which will take into account any principal and interest to be paid on the run prior to maturity and resolution proceeds, all net of operating expenses.  Operating expenses are clearly things like enforcement costs, payment of property protection amounts, and particularly for REO, even things like capex.  The model takes into account the timeline of the resolution and includes an NPV analysis; early resolution is obviously better than a later resolution.  From that information, an aggregate cash flow model with a pool is constructed and hair-cutted by the agency based on its internal modeling paradigm.  KBRA, for instance, calls this a Resolution Path for each asset. 
• The quality of the sponsor and the asset manager will be critical.  This analysis is not widely dissimilar from the inquiry into the competencies of a collateral manager, special and primary servicer in a regular-way deal, and includes a review of people, experience, capabilities, policies and procedures. But there’s perhaps a sharper point on the stick here, given the dodgy nature of the assets and the need to manage aggressively.   
• One of the key structural issues in these transactions is how cash is managed and how liquidity is obtained.  Is there cash leakage, and is there any sort of liquidity facility in the structure?  Leakage is (shockingly) not favored by the agencies nor investors, albeit loved by sponsors.  Note however that leakage became a regular component of these deals as the market matured.  Where leakage occurred, there was typically one or more fast pay triggers which would cut off leakage in the event of the pool’s deterioration. 
• Liquidity typically took the form of interest and working capital reserves replenished on an ongoing basis during the lifetime of the transaction.  In some cases, funded liquidity facilities may also be viewed as a form of credit enhancement if not subject to leakage, and improve the levels for the transaction as a whole.  A third-party P&I advancing is unlikely to be part of the structure (but certainly could be). 
• Expect servicing fees to be higher in the NPL deals than regular-way transactions given the nature of the assets. 
• From that, we move to the math and the agencies’ haircutting sorcery, which I won’t pretend to understand, and will leave to those more numeric than I.  Voila! Levels and attachment points are found.

Each of the agencies has a somewhat different approach to rating these types of transactions.  Not to do my Captain Obvious routine here, but it behooves any potential user of this technology to interact with each of the agencies, delivering preliminary tape information and structure to discern whether the variables in one’s proposed tape or structure will be important to the agency and how.  By way of example, some of the agencies’ criteria appear to take recourse into account in a much more significant way than others.  There are different approaches to diversity (some might argue that diversity is irrelevant in a distressed debt pool).  There are differences to the extent the type of legal foreclosure jurisdiction in which the assets are located matters. 

So, there’s a path forward.  Based on my conversations with the agencies, there is a fair amount of interest illustrated by the number of folks who have asked about criteria.  Now, that does not a market make, but in a macroeconomic environment characterized by cyclically high interest rates, a growing conviction that interest rates will remain higher for longer, increased pressure on bank and non-bank balance sheets and the probability of ongoing liquidity constraints, this product might become the best game in town.  Leverage is needed (as it always will be).  As the saying goes, you may not get what you want, but if you try, you may get what you need. 

The CliffsNotes version of my June commentary is that while the data looked like a splatter diagram, it was likely that interest rates would stay elevated in the short- to medium- term and that the future path of interest rates (most notably one-month SOFR and the five- and ten- year Treasuries, the key interest rates for the CRE lending business), were materially uncorrelated to the headline inflation rate and the presence or absence of the most widely forecasted and still elusive recession in recent memory.

The opinion of the commentariat is as muddled as the data.  Some, an increasingly large some, have gotten the ball rolling on a victory dance for the Fed’s engineering of a soft landing.  Low inflation and no recession certainly would be grounds for a party!  Some, an increasingly smaller some, still worry that inflation is not dead and indeed considerably more durable than the optimists think and that the choice remains accepting a higher notion of baseline inflation or triggering the long-predicted and continuously elusive recession.  This is a not a debate between serious and credentialed, card-carrying members of the intellectual literati on the one side and the tinfoil-hatted, grassy knoll conspiracy fabulists on the other.  There’s some of both in each camp.

There is plenty of conflicting data to be picked over by the participants in this mighty battle of the pontifical.  Just for color:

• The chattering Fed heads are becoming more heterodox. There are soft landers and recession worrywarts there.
• The most recent CPI and PPI data is modestly encouraging, albeit hardly compelling. (People who are vastly more numeric than I have suggested that when one looks into the CPI and PPI indices and peels the onion, it would suggest that the headline numbers are overstating inflation and that material reductions are on offer rather soon.)
• Labor markets are cooling (maybe they’re not).
• Home buying continues to be suppressed. High interest rates or limited supply, or both?
• Paychecks grew last month. Consumer sentiment indicators continue to flash yellow.
• The Conference Board announced the 15^th month of decrease in its economic index last month and said, “Elevated prices, tighter monetary policy, harder to get credit and reduced government spending are poised to dampen economic growth further.” They still see a recession in late Q3 through Q1 of 2024.
• Barr is fixing to significantly enhance capital across all banks with at least in excess of $100 billion in assets with full “global Basel III endgame changes”, which together with a continued application of CECL and pressure on NIM from the need to satisfy depositors with increasingly happy feet, are expected to depress bank lending.  Net/net, banks are almost certain to be more conservative and lend less as the year goes on.
• GDP exceeded all expectations in Q3 and that much-feared recession seems no where in sight.
• Moody’s just announced downgrades of the bonds of ten significant banks, citing increasing stress to their balance sheets and increasing regulatory pressure.
• The Treasury yield curve inversion continues after more than a year.
• The Fed boosted the Fed fund rate last month for the 11th time by 25 bps and guidance suggests that while the Fed remains data-dependent and the end may be nigh, but nigh enough? Equities don’t seem to care.

It’s great fun to pontificate on all this.  One of the joys of being a self-proclaimed talking head is that if you’re wrong, no one remembers and if you’re right, you get to endlessly remind everyone how brilliant, intuitive and insightful you are.  Consequently, I’m happy to weigh in, and if I’m wrong, I’ll just shut up like all the other losers.  But I will take this moment to remind myself and all my fellow nattering nabobs of certitude to remember that the lag between policy changes and actual economic performance remains of indeterminate length and indeterminate strength.  The day of reckoning when all this comes home to roost is still in front of us.

Diving into the big muddy, my take remains that for CRE markets, much of the foregoing simply doesn’t matter.  It’s largely noise (except, for sure, the regulatory jihad against the banks which will depress liquidity and depress asset values).  Soft landing?  Modest recession?  I don’t see a set of circumstances which would lead me to conclude that the yield curve is likely to materially retrace the past year anytime in the near or even intermediate term.  Saving CRE markets from the butcher’s bill and not enjoying our very own little crisis is simply not in the cards.

If you think inflation is stickier than not (I actually do), then the Fed’s going to continue to push up Fed funds or at least slow walk any sort of retreat.  (If you think that interest rates have nothing to do with inflation, you indeed do qualify for your own tinfoil hat.)

If, on the other hand, a soft landing is indeed engineered and economic activity begins to accelerate, that will also substantially slow the pace at which Fed funds will begin its retreat.  The only circumstance under which Fed funds can step down as rapidly as it had accelerated is if we experience an extraordinarily hard landing...a GFC 2.0.  That’s blessedly unlikely and while it fixes our interest rate problem in an iceberg-trumps-deck chair sort of way, in that lies a completely different and equally unamiable set of issues for commercial real estate.

While contemplating higher for longer, we should remain somewhat comforted by the notion that for decades our economy worked just fine and the commercial real estate industry functioned just fine with a 5% Fed funds rate and a positively sloping yield curve.  Look, if you look at Fed funds over the past 25 years or so, while there have been periods of stress where the Fed funds rate dropped precipitously, more often than not, Fed funds was closer to 5% (and sometimes more) than it was to the zero bound.  We knew how to run the economy and grow CRE markets in those credit environments and we’ll do it again.  Might Fed funds drop into the 3-4% range sometime over the next couple of years (note I said “a couple of years” here)?  Sure.  But it won’t approach the zero bound unless GFC 2.0 shows up.  That means that the legacy book (anything originated prior to the 2020 run-up) will still be under considerable stress.  Moreover, new transactional activity will still be dependent upon reconciliation between buyers and sellers as to the permanency of this interest rate environment...a thing will happen, but it’s a slow burn.

So, in some ways, both the pessimists and optimists are correct about our market.  Market conditions will inevitably cause us to experience a period of significant strain as assets acquired in a low interest rate and low cap rate environment will simply not pencil.  Note this is not just the office sector, which is the popular epicenter of current anxiety, but all sectors across the board.  (Multifamily?  Who knew?)  Concomitantly, with constrained liquidity and pressure on asset values, many portfolio lenders, both banks and non-banks, will feel a compulsion to reduce their loan book and particularly their CRE loan book.

And the optimists are also right.  The economy seems considerably more robust than could have been expected even many months ago, and the prospects of a soft landing are improving.  A soft landing will facilitate more rapid reconciliation between buyers and sellers to the new normal but won’t fix our broken toys problem.  A substantial sea of loans on life support will be at risk of default.

From an anecdotal point of view, this assessment of conditions is confirmed by our Global Finance practice which is getting considerably busier.  The warehouse lending and fund formation businesses are alive and well.  There’s life and love in the SASB space and in a miracle akin to finding Jesus’ profile on a piece of toast, the CRE CLO business is showing some life.

This is our new normal.  In this new normal, assets are mispriced, liquidity is limited.   But take heart, over the next several quarters, several galvanic forces will emerge or accelerate to create a reasonable level of transactional activity and get us all back to some semblance of business.

As Fed funds stabilize, and maybe even begin to drift lower, folks will again transact as uncertainty diminishes, even if its removal leaves a fairly dreary landscape.  The gap between buy side and sell side will continue to shrink, as it always has done when fundamental interest conditions have stopped moving furiously, as the first mover risk of looking foolish ameliorates and folks begin to reconcile to the new normal.  There is a ton of capital on the sidelines which simply needs to get deployed.  This is particularly true of closed-end funds where investment periods are waning while managers continue to stare into the abyss of interest rate pain.  Win one for the optimists.

Progressing along a very different path, but also producing enhanced transactional activity is the virtually inevitable wave of distressed debt and the need of distressed balance sheets to transact.  In some respects, we’ve been in a phony war, reminiscent of 2008 (or 1939), where a strategy of hope that a restoration of tolerable interest rate conditions will occur magically, allowing us to avoid the butcher’s bill.  Time’s running out on that forlorn hope.  The lender community (including the capital markets and servicing community) appears disinclined to kick the can this time without considerable fresh equity.  In many cases, the equity will not be available as it’s simply non-economic to provide it.  Assets will change hands and assets will reprice.  Remembering that there are no bad assets just bad pricing, the bad pricing we have right now needs to be washed out of the system.  A distressed debt cycle will do that and it is certainly not entirely unappealing for those of us who sup at the well of transactional velocity.

So, while far short of a restoration of robust health, the CRE market and the CRE finance market, will, over the next six months, show enhanced activity when compared with the past year.  Come on now, folks.  It can be fun.

Here’s what you need to do.

• Jawbone those sellers; convince them that sub 4% cap rates ain’t coming back and the numbers are the numbers. So, if they want to transact, it’s time to get real.  There are no bridges to the other side, merely piers to the middle of the deep and darkening lake.
• If you’re a balance sheet ladened with NPLs and performing but criticized assets, take the first loss, which is often the best loss, and get out.
• If you’re a balance sheet, consider a securitization using CRE CLO strategy as an exit as opposed to exposing pools of loans to the tender mercies of the bank open-bid marketplace. A sale of a pool of loans into a securitization vehicle with an acceptable B-buyer will allow derecognition, reduction of risk-based capital and provide the institution with the ability to buy the senior security from the transaction, thereby putting a great deal of the purchase price back to work with lower risk-based capital charges.
• If you’re a bank and no one has explained Reg Q, make someone do it. Credit risk transfers are alive and well and likely to grow exponentially over the next 6 months.  With a little bit of regulatory help, credit linked notes will become a fantastic means of repairing balance sheets.  Credit risk transfer will begin to be a quotidian feature of the financial landscape.
• Embrace your inner workout competencies. Workouts do not always lead to bad outcomes.  If you’re a lender, in many cases it’s probably your asset already.
• Whether you’re a buyer or seller, think about NPL securitizations. The technology is with us.  The ratings agencies are reconfirming criteria and there are a lot of folks who are thinking about using this to poke at the midden heap of distressed debt.  It’s going to be a thing.
• If you’re a portfolio lender, and your borrowers can’t step up with a significant infusion of additional equity, get to your remedies and move on. This time, time won’t fix it.

In any event, transaction velocity is set to increase.  Embrace your valiant warrior self.  The confluence of brains, capital and conviction will out.  That’s something to look forward to.

This technology, the tool as it were, has surely been languishing in the toolbox for the past year because of the mismatch between bond yields and coupons on legacy assets.  Anything originated prior to the enormous Fed run-up last year simply cannot attain positive leverage (we need to come up with a catchy name for that unpleasant experience, like GFC . . . maybe the LAFF . . . Last Awful Fed Fantasy). 

And so, the CRE floating rate market has been sitting on its hands pursuing the always alluring strategy of hope that something, without a price tag or a butcher’s bill, will happen that makes markets work again. 

The unavailability of CRE CLO leverage has been tolerable, that is, tolerable the same way the absence of a pen knife in a gunfight is tolerable, for a number of reasons.  On the one hand, banks providing leverage through the repo market have simply been accommodative and so leverage has been, if not abundant, at least available.  Marks have been limited and consequently, margin calls have caused only modest pain.  Facilities are getting extended where they might not have otherwise been, and new facilities are being made available in the marketplace by existing and new entries into the warehouse space. 

Then, of course, no one is borrowing.  Why then refresh capital?  Coupon sticker shock, gaping disagreement between buyers and sellers as to value and a general unwillingness to plunge and look stupid in an opaquely unfathomable market has suppressed transactional velocity.  Legacy loan borrowers have been sitting on their hands and not transacting if they can possibly avoid it, given the fact that many leverage assets are under water (or close to it) and the precipitous collapse of asset values means little still pencils. 

While we have had a couple of deals price recently, the disconnect continues to chill market activity. 

But I do have a private data set that suggests something positive might be afoot.  I get readership information on CrunchedCredit on a regular basis and, within the past few weeks, an awfully large percentage of the hits have been on CRE CLO articles.  We’ve seen a lot of activity on:    

• The CRE CLO Repurposed: Part II
• Fix the CRE CLO, Mr. Market:  Tear Down This Wall!
• Why Don’t (Enough) Investors Like CRE CLO?
• The CRE CLO Unleashed
• Prognosticators’ Regret
• A Modest Proposal: Why Can’t CRE CLOs Be More Like Corporate CLOs?

Hmmm.  While I must admit a certain fondness for my own deathless prose, I figure that all those hits from a disparate selection of readers suggests that something’s stirring.  Is the day of the resurgence of the CRE CLO tool’s utility maybe closer than we think? 

Does it suggest that buyers and sellers will begin to transact at current cap rates and coupons such that leverage in the current environment works again?  Does it suggest worrying about potential tightening in the warehouse market?  Does it suggest that folks have decided that there is indeed a reason to refresh capital? 

If I am right about the current economic conditions, the interregnum between the prior amiable economic conditions and return to something even remotely similar is longer than any “kick the can” bridge we can construct.  In that environment, embracing the pain, taking the hit (pick your preferred metaphor) and recommencing transactional activity actually makes sense.   

Well, for my own personal interest (and as I regularly say, it’s really all about me), I certainly hope so.  In a healthy market, the CRE CLO technology has proved itself to be incredibly valuable.  Production in the last truly economically healthy year before the LAFF (pronounced LAUGH . . . trying to build some momentum here), exceeded $40 billion.  In a healthy market, that type of volume or more should be expected.  The product is just too damn good to be left in the toolbox.  When it pencils, it will flourish.  

We’re also excited to see it come back soon because we’ve gotten a lot smarter since before the time of the LAFF in early 2021.  Because of the trials and tribulations the structure has endured over the past year, and the attendant opportunity to test the machinery of the CRE CLO construct, we’ve been developing a list of fixes and innovations that we consider baking into deals on a go-forward basis.  CRE CLO 3.0 will be better!  New and improved! 

Look, we all knew we were building the CRE CLO airplane while we flew it and, shockingly, when we flew it into the eye of the storm, bits and pieces shook off.  We found, on an operational basis, that things that appeared to make good sense when deals were structured (or more likely not thought about at all), didn’t always work as well as expected in the crucible of real stress and the need to engage in active asset management.  As old von Moltke (the elder and smarter one) said, “No plan survives first contact with the enemy,” and here the enemy is reality; super tight monetary conditions.  We see changes that could improve the functionality for the sponsors, and indeed improve the experience for the investor community as well.   All of my Dechert CRE CLO partners and senior colleagues . . . Laura Swihart, Stewart McQueen, Matt Fischer, Devin Swaney, Matt Armstrong, Gennady Gorel, Ken Hackman, Ella Smith, Bill Lee and Greg Renick have been beavering away, solving problems and compiling lists of things in need of attention as we return to the market and build out CRE CLO 3.0.  We are anxious to bake these into the cake, or at least discuss them, with bankers and issuers.  Just for a taste, some of these worth considering include:

• Using the new Annex A, as just recently issued by CREFC.  While this remains a work in progress, it is still a significant improvement over what we had before.  We recently saw it in the ReadyCap deal and clearly this will be best practice going forward.  This was an easy one.
• The relationship between rate caps and things like debt service, U/W stabilized NCF DSCR and Par Value Test has simply not been clear.  In a world where rate caps were just things bought for pennies with little regard for actual value, they didn’t get the attention they deserve.  Now they will. 
• Improved clarity around the identification and disposition of credit-impaired assets. 
• Make sure, for Advisors Act purposes, the independent member of the advisory committee can consent to a full range of conflicted transactions that may arise during the course of the vehicle’s operation. 
• Add a reissue/repricing mechanic following the non-call period.  We did this in a few instances back before the LAFF (still trying here).  This was essentially irrelevant in a stable to rising interest environment.  Now that we’re perhaps at the top of the cycle, this could be a valuable functionality for the issuer and would occur at the same time when otherwise the issuer’s only other option might be to unwind the structure.  This could be more efficient. 

And that’s just a teaser on the things which we might consider fixing on a go-forward basis. 

Look, we’ve suffered the interregnum on credit availability.  Let’s at least get the benefit of a reset here.  We can make the CRE CLO simpler, more robust and more functional. 

So, taking comfort from my CrunchedCredit dataset that we’re getting closer to the point where some sort of re-launch of the technology at scale is contemplated, we’re starting to gear up here.  When you’re ready to take a test ride, please give us a call.  Cycles are cycles.  This isn’t a secular change.  The CRE CLO is coming back.  HAPPY 4^th OF JULY!

Sticking to business, it’s hard to get conviction around anything right now.  Nonetheless, we must.  Everyone needs a view as to where our business world is going, a base case, something on which you would be prepared to invest time, energy and treasure.  It’s simply untenable to merely observe that things are pretty screwy out there and shrug.  The lack of a view on where the economy is going and how to conduct business in this current environment is, in effect, a commitment to let unreflective inertia be your guidepost and that’s not a good idea.  (I’d use pococurante, but that’s a silly fifty cent word, so I won’t.)

As this difficult year has progressed, questions remain:  Which strategies are viable and which are not? 

In figuring it out, the problem is trying to square the circle of disparate and conflicting data.  Are there discrete events, phenomena that will shape commercial real estate markets going forward?  Are we looking for a single tell?  We just concluded (for the moment) another debt ceiling crisis and while it dominated the media news cycle, it was seen, correctly, by the markets as slightly unserious.  Markets didn’t move, even though it sounded scary.  If the threat of a sovereign default by the United States didn’t change market dynamics, what will?  (Maybe the sale over these next 3 months of $1 trillion of fresh government debt will?) 

Discrete phenomena, apparently even really bad ones, rarely result in secular changes to our economy.  It’s changes in the underlying substructure of our market, the plumbing if you will, that affects change and that’s where we need to look to try to understand where the commercial real estate markets are going.  Great Man Theory doesn’t cut it. 

Right now, we have an unstable stasis.  It looks like it wants to go somewhere, but it isn’t sure where.  Nothing’s transacting, nothing’s getting resolved.  There’s little price discovery in the capital markets.  Transactional volume is low and while we see periodic bursts of transactional activity, suggesting directional change, like the flashing of a lonely lightning bug on a dark night, it’s just that... lonely.  There’s little evidence that things are changing, that things are resolving themselves and that there’s a new normal on the horizon. 

Where to look for answers?  Does the broader corporate market provide guidance?  The stock market is trading in a tight range with apparently little conviction that things are getting better, or, indeed, worse.  Another earnings season suggests that many companies are continuing to do just fine, notwithstanding all this talk of recession.  Job creation is surprisingly good.  Talk about a high employment recession abounds.  That does sound fundamentally silly, doesn’t it?  It would be fair to say that the performance of corporate America does not a compelling narrative make. 

Do other economic data provide a real tell?  Do we find it in the path of our GDP?  Q1 GDP was above long-term trends and the early indications is that Q2 might be as well.  Many economists, including those of the Fed, are expecting GDP to grow, albeit slightly, in Q3.  Take any 10 PhD economists and 6 will predict recession right now and 7 will predict a return to robust growth after a brief interregnum.  Amongst those who see recession, they’re broadly split between deep and shallow (with a bit of a bias towards shallow).  At the margins, a return to modest growth versus a continued desultory retreat into a recession will impact the commercial real estate business, but not that much. 

How about inflation?  Headline numbers are coming down.  While there are innumerable ways to measure inflation, including the egg price index, all suggest that inflation is coming down a bit, but it’s still too high.  As I write this, the Fed just announced a pause on Fed funds while they await new data before the July meeting.  Do they see new data arriving in the interim which will provide answers or is this just the equivalent of can-kicking? 

My premise here is that none of that actually matters a lot.  It’s largely, almost exclusively, interest rates that are set and controlled by the Fed and Treasury that actually matters for where our CRE economy is going.  Everything else is largely noise. 

The forward curve, where people make bets with real money, suggest that some considerable money thought, just weeks ago, that the Fed funds rate would begin to move down soon and be materially lower sometime in early 2024.  That looks a bad bet now.  That also seems to have been the weight of the views of the PhD crowd, although I don’t see anyone predicting that interest rates will anytime soon get back to a level in which legacy deals will once again perform.  (Please, Dear Lord, protect us from the zero bound.  That should not be anyone’s idea of a new normal!)

Here’s a cross sample of views interest rates:

• The Philadelphia Fed sees the core CPI dropping to 3.6% in Q3.
• The MBA continues to forecast a 3% flat ten-year in the fourth quarter and a 4.375 fed funds rate.
• Wells Fargo is looking for a fed funds rate slightly below 5% by Q4. 
• Chatham Financial, which probably has more visibility into these markets than virtually anybody, sees one-month term SOFR below 5% by Q4.
• Several Federal Reserve committee members have mused about a pause at the June meeting, while others have continued to support significant increases until evidence of falling inflation is more palpable.  JPMorgan Asset Management sees a fed pivot as early as September and rates dropping throughout the fall. 
• Goldman Sachs expects core PCE inflation to fall to 3% by December. 

And, of course, the Fed just paused. 

There is an endless babble of opinion around the future course of interest rates; it is fascinatingly non-homogeneous.  There’s no consensus about almost anything out there. Those who pay attention to these things are all looking at the same data and coming to widely disparate answers.  How comforting is that? 

But you gotta pay your money and take your chances.  You, too, can be an opinion purveyor!  All you need is an indurate tolerance for embarrassment and a pen (guilty). 

The structure of US interest rates is a construct, the price of money is directly or indirectly manufactured by the Fed and the Treasury.  Adam Smith need not apply.  Market forces are suppressed by government policy choices.  And so, the movement of “market” interest rates are largely decoupled from the presence or absence of GDP growth or subsistence, the presence or absence of a recession, and perhaps surprisingly, largely decoupled at least for a time, from the actual inflation data. 

Interest rates, neither floating and fixed, will materially retreat within the next 18 months to two years.  (By the way, for this purpose, my definition of material is a large enough change to make legacy commercial real estate assets, acquired, underwritten and financed before the Fed funds runup actually anywhere close to penciling.) 

One reason, and perhaps the most important reason for this sticky high interest rate environment is that Fed fund’s policy is as much politics and personality as it is driven by technical analysis. 

The Fed has made it absolutely clear that fighting inflation is its top priority.  As someone said the other day, we need to stop reading between the lines and actually read the lines.  It’s clear that the Chairman, with an excellent grasp of history, understands it’s better to be Paul Volcker than William Miller.  Mr. Volcker made it okay to crush the economy in service of taming inflation.  He’s famous and honored.  His predecessor made, what I’m sure was an honest and thoughtful decision, to step off the brake when the economy began to shudder and his reputation is, shall we say, somewhat tattered.  Mr. Powell is going to be Mr. Volcker, not Mr. Miller.  It is absolutely certain that we will overshoot, stomping on the inflation carcass long after it’s dead.  We’ll probably find out sometime in the next few years that the rapid increase of the Fed funds rate over the past year was a huge policy mistake, the lag having come home to roost.  But that’s a different story.  In any event, interest will not move down far enough to matter within the next 18 to 24 months, even in the face of considerable evidence that inflation is diminishing.  (Note that in the Fed’s June meeting commentary, they essentially said that the Fed’s expectation is that short-term interest rates would stay in the 5+ region well into next year.  Yikes!)

Elevated interest rates are a triple whammy for our biz.  First, coupons are troublingly high.  Little acquired or financed before the runup in Fed funds will pencil.  Little will pencil without significantly repricing assets.  Second, elevated interest rates crater the value of legacy financial assets.  That impairs bank capital, reinforcing the political and regulatory narrative that bank regulation must be made more assertive.  For our purposes, “assertive” is a euphemism for don’t-lend-much, significantly increased credit standards, and, oh by the way, don’t lend much money.  Between the impact of CECL, all the new enhanced capital rules (FRTB, etc.), and the very real examination pressure of the regulatory authorities, capital available for lending will be suppressed. 

Finally, banks, and to a certain extent even non-banks, are and will be compelled to preserve and demonstrate liquidity, manage risk-based capital and prove up asset values, causing lenders to shed assets, an exigency that in turn puts additional downward pressures on asset values in a very unvirtuous circle sort of way.  Distress begets distress. 

So, that’s my base case; the immediate future looks a lot like today.  A whiff, for a period of time of stagflation, at least in the CRE marketplace.  Very sticky high interest rates and high cap rates.  Restrained liquidity.  That means very difficult conditions in the commercial real estate for the foreseeable future.  A CRE recession, if you will, largely untethered to the path of the broader economy.  Our CRE recession will not end until assets are repriced and liquidity rebounds, a notion captured in the phrase “stay alive till ‘25”. 

But, blessedly (at least for me), we will see some increase in transaction velocity this year and early next.  Fed funds are now beginning to peak in the mid 5% range, and maybe that provides a certain amount of predictability, even if the landscape continues to look dire.  As market perceptions begin to change, as market participants become reconciled to the new normal, people will begin to transact (not much of a choice really).  Gone will be the fantasy that the zero bound (or something like it) is coming back.  Gone will be a notion that sub four cap rates across all market sectors will again be a new normal.  Gone will be the notion that liquidity is cheap and easy.  Assets will be repricing; strategies of hope collapse.  Compelled transactions will abound.  Many legacy loans will default as sponsors are either unable or unwilling to infuse additional capital.  We will see what we used to call “jingle mail” (keys in envelopes sent back to lender).  Buyers and sellers who have remained far apart on their notions of value will begin to confront reality and some deals will get done.  Owners of property and lenders will shed assets where there is no visible path back to viability.  Distressed debt securitizations will again be a thing. 

This is all about repricing assets and right-pricing assets must occur for our market to be restored to health.  Remember, generally there are no bad assets, just bad pricing. 

This is the path on which our markets will be restored to health.  As interest rates first stabilize and then slowly come down, confidence in the future begins to have a positive impact on cap rates and liquidity.  The Fed will eventually (certainly far too late) take its foot off the brake.  It’s going to take a while.  There will likely be plenty of false dawns, a notion captured by something one of my old friends (thank you, Joe Franzetti) said years ago during the GFC, while we may be out of the woods, we may discover the woods end at a cliff.  Restoration of a market that looks something like 2015 through 2020 will probably require more patience than most of us possess or can afford.  In the meantime, embrace reality and look for opportunities.  (There’s really nothing else to do.) 

The last time I talked about multiseller transactions, I talked about breaking down silos between CRE debt and corporate debt and its potential use as a tool for disintermediating warehouse lenders from excess exposure. 

I forgot something important:  The use of CRE CLO technology as an alternative to the sale of CRE assets by lenders either needing capital relief or relief from excess concentration in CRE exposures. 

Why not securitize as opposed to sell?  Securitization can provide the same benefits of capital relief and general de-risking as an outright sale.  Assuming it pencils, it can also avoid the potential further deterioration of the market value of the chosen pool (as well as the retained book) by avoiding exposure in an open market sales transaction.  It also gives the lender an opportunity to put to work a considerable portion of the disposition/financing proceeds by investing in senior, generally investment grade, bonds. 

Here’s how the transaction works.  The lender would identify and craft a pool of assets for the transaction.  This need not be exclusively the type of assets one would try to assemble to do a broadly syndicated CRE CLO (although that would be great).  You certainly could include assets which are money-good but are criticized under the lender’s own risk rating system. 

To make this transaction work, the lender is going to need an investor to buy the sub debt (Money Point:  For my high-yield friends with a taste for it, this is going to be a major opportunity!).  Depending upon the tax structure of the transaction, the investor will either need to be a partner or member in the issuer vehicle, or could simply be the sub debt buyer from the securitization.  In this structure, the lender could retain the investment grade securities generated by the transaction and thereby put the sales proceeds or a portion of the sales proceeds back to work.

The customary structure for this type of thing is a CRE CLO with a Qualified REIT Subsidiary or QRS issuer.  The QRS structure allows maximum flexibility in terms of managing assets and would allow the addition of additional collateral.

If a REIT is used, the REIT must hold the non-investment grade securities created by the QRS issuer as a matter of tax law.  This would also achieve our goals of derecognition of the commercial real estate assets and a material reduction in risk-based capital. 

In this structure, the investor could own the REIT outright or, alternatively, the investor could be a member of an upstream vehicle which owns the REIT with significant control over the business of the REIT and with a special allocation of the gains and loss of the retained non-investment grade securities.  (The upstream vehicle could also retain some or all of the investment grade securities which would be for the account of the lender.)  The investor could also be the risk retention party.    

As an alternative to a REIT, the vehicle could be organized as a REMIC and this has certainly been done before.  If organized as a REMIC, all of the related securities can be transferred to third parties in outright sale transactions, but there are, of course, certain operating limitations associated with REMIC status.

The third approach is to use a simplified capital structure with just a single senior and a single subordinate class.  The notes would be senior/subordinate and not sequential, meaning cash would be distributed pro rata unless a default or another triggering event occurs, in which case the senior class would be turboed.  Neither a REIT nor a REMIC election would be required yet the structure would not constitute a taxable mortgage pool.  Note, however, that this nonsequential capital structure might have something of a negative impact on ratings levels and pricing efficiency. 

In all three of these structures, the investor must have control because in order to derecognize the commercial mortgage loans and get the required risk-based capital pickup, the party with the predominance of control over the business of the entity will be the party which would consolidate the assets and liabilities of the vehicle for GAAP purposes.  GAAP treatment here will drive RBC treatment. 

Okay, I know that in the first instance, the paramount question, and in some ways the only question is, does this pencil?  If the economics of pursuing this type of an exit strategy are wildly less attractive than an outright sale of the pool of loans, the structure might not work, or at least it would make the value proposition of this structure more uncertain. 

But, in addition to a straightforward dollar and cents analysis (and remember that this calculus needs to be done on a net dollar basis as all of these alternatives will have a significant cost drag), there may be other factors at play here.  There may be positive externalities that might materially weigh in favor of a structured solution. 

What could the structure do for us? 

• The structure would allow derecognition of the loans from a GAAP perspective. 
• RBC would be reduced from 100% to a 20% charge only against the retained bonds.  In connection with a full sellout of all the investment grade bonds, there would be obviously no risk-based capital charges in respect to the underlying pool. 
• The transaction could be structured so the lender retains point of sale contact with its borrowers to facilitate its ability to manage borrower relationships.  This could be done if the lender retains a role in servicing, perhaps as primary servicer.
• The transaction could also provide a separate income stream to the lender for servicing the transaction.
• This structure could facilitate the ease with dealing with future funding obligations which could be very important for a pool that contains a number of high-touch, heavy transitional (construction?) assets.
• There will be reduced celebrity (and I don’t mean that in a good way). There’s something rather unseemly about selling a pool of loans in an open market transaction.  The optics aren’t great.  They’re better here. 
• The lender could deploy capital into the investment grade securities and put money back to work on a low risk-based capital basis.
• It creates a new path of liquidity for the lender.
• This could habituate the market to the lender’s name as an issuer which could be important for other purposes. 

This is a ‘horses for courses’ sort of thing.  It’s highly fact and circumstance dependent.  Obviously, it’s very sensitive as to whether the transaction will pencil.  Note also, there are other alternatives, some substantially more complex than this, including the sale of credit-linked notes (the credit linked note structure is a subject for another day), but this structure has considerable certainty.  At a time when liquidity may be dear and multiple modalities to access liquidity are important, this type of thing should receive some considerable attention.  And, as I said in my last post, thinking about a novel transaction (or even better doing one) is considerably better than simply waiting for our market to come back.

Transactional volume in the CRE non-stabilized or bridge space has crashed as deals don’t pencil and as many property owners remain attached to the magical thinking that the macroeconomic conditions of the past decade will return any moment.  Sub four cap rates, sub 1% SOFR...yippee!  Here’s a newsflash.  Absent the arrival of some truly ugly black swan, as I was discussing in last week’s commentary, the current high interest rate and high cap rate environment in CRE financing is likely to persist well into 2024.  Even then, if you’re expecting a return to the halcyon days of 2020, I think you’re fooling yourself.  

It’s not that nothing is happening out there.  Some transitional mortgage loans are getting done and perhaps if one takes off one’s glasses and squints hard enough, some green shoots might be perceptible; green shoots suggesting a return to some level of financial health in our marketplace.  Nonetheless, right now, assets are not getting repriced fast enough and transactions are not getting done rapidly enough to reliquefy a functioning, let alone robust, CRE CLO marketplace and it’s hard to see when that will happen.

Things change, of course.  They always do.  (Except, I would have said it was virtually certain that Tucker and Don would continue to dominate the chatospheres over their respective alternate universes forever...whoops!) 

Some things could reinvigorate the CRE CLO market more rapidly than otherwise might be expected.  The return of the Fed Put might give us rapidly falling interest rates.  That would make a difference.  The problem, of course, is that rapidly reducing Fed fund rates probably indicates something awful has happened, so I’m not sure that’s a great trade.  The inventory of commercial real estate assets could reprice faster than I currently expect.  It took an incredibly long time for the detritus of the GFC to be cleared out of the system.  Could it happen faster this time?  If the lending community, writ large, decides that enforcing their loan documents and selling collateral rapidly is cheaper than can-kicking, that could help reset the stage for renewed transactional volume faster than I expect.  If the warehouse lenders start to tighten the screws (something which appeared to have begun last summer and then rapidly went away...not a happy thought, but a thing), that could also change the calculus, causing a considerable number of non-accretive securitizations to get done to refresh capital. 

So, with my Captain Obvious hat firmly on, I will observe that the market will either slowly, or more quickly, revert to ruddy health sometime during the next couple of years and, when it does, we’ll pull the CRE CLO we have grown to love back out of the toolbox and deploy it with vigor and a certain jubilation. 

But are we fated to simply wait around for current trend lines to be disrupted?  Must we tolerate this inability to function without capital market leverage, to refresh capital and deal with mispriced assets for years?  Are we stuck with only the tools we’ve got in the toolbox?  Maybe not. 

Tools can be repurposed.  Here are a couple of ideas. 

The CRE CLO technology could become a solution for a high-yield investors looking for exposure to commercial real estate seeking to marry up with a warehouse lender which might be looking to lighten the load.  Look, the warehouse lending business has, for years, been based on a trade in which the warehouse accumulates collateral and the repo borrower/seller ultimately conveys that collateral into a CRE CLO in which the warehouse lender becomes the banker.  That trade has collapsed as the conventional CRE CLO market has slowed to a crawl and presumably there are an awful lot of warehouse lenders who would be delighted to reduce risk in their warehouses. 

It is more than conceivable that this circle could be squared by using CRE CLO technology to create a senior/subordinate structure in an ongoing repo warehouse.  Oh sure, there are other ways to do this, including things like simple participation, but the CRE CLO has some unique advantages which might make it attractive.  Structurally, this gets done by moving the buy side of a repo into a vehicle which issues a senior and a subordinate note.  Both notes could be variable funding notes (VFN) to facilitate a repo which must continue to refresh capital for its underlying customer.  If the repo is in a runoff phase, of course, the notes could be static. The advantage of the structure is twofold:  First, there is an overall reduction of risk.  If the warehouse lender’s attachment point pre this runup in Fed Funds rate had been 50%, it might now be 70% or more and the sale of subordinate interest, while pricey, could right-size loan to value.  Second, the transaction should provide a material risk-based capital pickup as what the bank will be holding after this transaction is certainly a securitization position.  The senior note might even (gasp) be ratable, but that might be a bridge too far. 

The transaction could be serviced by the bank who would continue to face the customer even providing special servicing as a separate workstream on the transaction. Presumably, the holder of the subordinate note would hold major decision/directing certificate type rights and indeed could provide special servicing with the bank in what amounts to a master servicer/primary servicer role. Of course, not all warehouses would permit this type of transaction, without the underlying borrowers’ consent, but my guess is that the underlying user of capital could be incented to facilitate the transaction given current economic conditions. 

How about a multiseller structure?  We’ve been down the path on this a couple of times with clients and while no one has pulled the trigger, the structure appears viable.  Issuers could buddy up (God knows we do it as a matter of course in the conduit securitization marketplace).  Yes, I know that the knock on this strategy has always been that in a CRE CLO, one needs to eat more of one’s own cooking, and in a multiseller structure, someone else’s cooking, too.  That’s an issue that can be fixed in the structure. 

Essentially, this could get done between a sponsor with multiple advised funds, or between entirely unrelated lenders.  The predicate is, of course, highly motivated sellers who get over their natural conviction that their collateral is way better than everyone else’s and an intellectual and emotional ability to come to some agreement on relative value.  That won’t be easy, but necessity is the mother of invention, right?  If there’s simply an inadequate velocity out there in the lending market to build one’s own pool, this might be an answer.  Each lender would convey collateral into the vehicle through a baby REIT which would in turn transfer the collateral into a QRS issuer.  Each seller would get its proportional share of REIT stock, its proportional share of the cash proceeds of the securitization and, of course, its proportional share of the beneficial ownership interests in the non-investment grade securities through its ownership of the REIT stock.  Each of the contributing parties would be responsible under its own MLPA for breaches of rep and warrant.  On the other hand, it would be fair and reasonable to share the positive economics of the vehicle through the REIT stock as that stock was allocated based on the agreed fair value of the contributed collateral and, of course, on the assumption that all loans are money good.  An upstream partnership would be used to specially allocate any losses that may occur to the seller who contributed that loan. 

The multiseller structure obviously can create interesting advisory questions and would entail some complex and perhaps difficult negotiations.  But given an understanding between the parties of fair value, it certainly is doable.  In a market where we have insufficient deal flow to go one’s own way, this could be an answer. 

Note that, except for the fact that there are multiple sellers in the structure, the deal would otherwise look, in all other respects, conventional, from the investors’ perspective. 

How about breaking down the artificial wall that exists between the CRE CLO and the corporate CLO?  Why not add a sleeve of middle market or broadly syndicated CLO assets to a vehicle which also has a sleeve for CRE?  Adding non-homogeneous collateral into a CRE CLO might, surficially carry with it a whiff of the fatal alchemy of the pre-GFC CRE CDOs whose witches’ brew failed spectacularly, but that’s a false equivalence.  If we don’t have enough repriced and resized CRE to put into a pure play CRE CLO, we could add corporate paper which perhaps is (or perhaps is not) tied in some way to the CRE sector.  Corporate CLO issuance is robust and pricing is, at least by the lights of the CRE market, damn good.  Could a regular way commercial real estate issuer purchase this paper in open market transactions to fill out its offering and could that provide all-in better leverage, better pricing and attract more investor interest?  This would give the sponsor some leverage on its existing CRE CLO loan portfolio and keep the sponsor’s name in circulation in the investor marketplace as a regular issuer (which could be important when transactional activity repairs).  This is rather reminiscent of early RTC securitizations when the FDIC added cash and cash-equivalent collateral to the deals to draw in investors to this new technology. 

In the meantime, if we import some corporate CLO-type collateral into our vehicles, might we incorporate a little corporate CLO technology?  Let’s face it, the corporate market has always been more amiably structured from the sponsor’s perspective than the CRE market, less focused on a granular loan-by-loan analysis, more willing to embrace the value of good active management and hence more willing to tolerate ramps and reinvestment.  A reinvestment feature that would preserve the relative proportions of the corporate and mortgage assets or indeed permit the collateral manager to migrate more commercial real estate assets into the structure as the market opens up and product becomes available might be very attractive.    

Corporate paper tends to be shadow rated and both ratings agencies and investors appear to have a certain fondness for it, at least when compared to CRE assets.  The structure could end up with better diversity, tighter ratings attachment points and better pricing. 

I know that as I’m saying this, that some investors, not always the most forward-thinking bunch, might simply refuse to engage.  Run away, run away!  But perhaps if a few private deals could get done and done successfully, it could wet their whistle.  Similarly, the ratings agencies would have a cow dealing with the conflicting ratings methodologies of the CRE CLO and the corporate CLO marketplace.  The two approaches of assessing credit risk and everything else are wildly different.  But hey, in this torpid market, they have time on their hands, too.  Figure it out. 

Might there be other strategies out there that bring back leverage, bring back match term non-marked-to-market leverage to our marketplace?  Markets aren’t immutable and neither are tools.  When we need a new tool, we build one.  It’s time we look at our toolbox and think about modifying old tools or building new ones.  Is all this hard?  Sure.  But as Sherlock famously said, “When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

It really beats the hell out of waiting around for the markets to come back, doesn’t it? 

These folks cherry-pick from what is admittedly a plethora of generally troubling things and events, ignore the positive and weave a narrative of doom.  It’s not hard to do, it’s certainly fun and it’s apparently lucrative (ratings-wise at least). 

Serious people don’t buy any of this (I’ve applied to join the Serious Persons Club, but there have been strong objections).  Serious people think that crises tend to resolve themselves, that all doomsters are overwrought and that systems revert to the mean.  Serious people embrace what that 19^th century wag Georg Jellinek called the “normative power of the factual.”  His point was that it’s human nature to see the world as static, as fixed and immutable, almost a weighty thing, resistant to change.  Serious people believe that the social and economic momentum of our highly interconnected system, our geopolitical and macroeconomic reality, always resists discontinuous change.  Data suggest they are usually right (except where they’re not).  Crises, or perceived crises, come and go, talking heads blather portentously about bad things about to happen, but we’re all still here.  

But what if the looneratti are right this time?  Maybe aliens are, in fact, among us (eschewing Harvard Square for their depraved experiments on the abducted for small towns in Arkansas, probably because they’re just not comfortable with the woke Cambridge vibe).  Maybe Elvis still is in the house.  Maybe the medicinal powers of bleach have indeed been overlooked. 

Just because one is paranoid doesn’t mean one is not being followed.  In the same spirit, could we be somnambulating towards disaster, already locked into a path inevitability leading to calamity? 

If it’s true, no one is paying much attention.  Notwithstanding the shrill clamor of the nutters and the portentous blather of the commentariat warning us this and that, most of us are just getting on with life, dealing with the day to day.  Tire rotation, doctor appointments, kids’ online lives, the stuff of everyday life, leaves little bandwidth for contemplating the Four Horsemen of the Apocalypse.  But what if we’re fiddling while the match has been lit and Rome will burn? 

To be fair, there are a lot of anxiety-producing events in the geopolitical and macroeconomic sphere.  Torn from the headlines, here’s a partial list that is passingly troublesome:

• Revanchist powers around the world, eager to restore past glories are causing trouble.
• Two large, long-ossified alliance systems are facing each other, bickering internally and constantly roiled by micro-confrontations and bellicose tubthumping from the other side.
• An ascendant power is growing increasingly aggressive in the pursuit of its global ambitions.
• Autocrats with enormous power stand at the helm of revanchist regimes and aspirational hegemons around the world. 
• Kinetic war in Southeast Europe. 
• A US polity that is increasingly populist and isolationist and deeply divided.
• A weapons race underway with new technologies threatening to upset the existing balance of power. 
• There are policy voices amongst the heights of governments around the world who seem to think conflict is inevitable and sort of okay.  
• Episodic efforts to restore detente continue to erode and fail, and longstanding treaties are allowed to expire.
• Active economic competition among the hegemons and aspiring hegemons has begun to slop over the edges of its purely economic lanes, and is evidenced by more directly hostile conduct (hostages anyone?).
• Hegemons fighting for clients and influence across large portions of the Third World.
• Trouble in the Bosporus.
• Politicians remain, as always, ill-informed, largely dazed and confused driven, in a reptilian sort of way, by self-interest which makes the passing fascinations and entitlement mentality of the “folk” (voters) more important than larger issues of geopolitical and macroeconomic menace.
• A major global financial crisis is in the near memory of policymakers (and those MBAs who at least read about it while getting their degrees).
• Sex scandals among the political elite rivet and distract the world from considerably more important matters (arguably).   

Quite a litany.  You know that’s all true.  You read about it every day.  One can see how the tin-foil hat set can conflate that data series with some sort of inevitable march toward calamity, can’t you? 

Well, the only problem with this data set is that it’s not only today’s dataset.  In fact, all that happened in the years leading up to World War I.  Oops.  A world-girding war that killed over 20 million people, redrew the political boundaries of Europe, Asia and the Mideast, and incidentally sowed the seeds of World War II, would qualify, I suspect, as a bad thing. 

Now, as a card-carrying aspirant to the Serious Person’s Club, I’m not suggesting we get all Santayana here and conclude we’re seeing a remake of the same old movie.  I’m not suggesting the inevitability of some world-girding conflict but, on the other hand, it seems more than a tad intellectually unserious, languorous indeed to dismiss or ignore the possibility that these parallels are meaningful.  (Anyone want to volunteer to play the Archduke Franz Ferdinand this time around?  Hey, he was the star of the show.  It was a brief appearance and it didn’t end well for him, but you could end up more famous than your career heretofore would justify.)

Arguably, we should give more thought to the sort of discontinuous misadventure which we haven’t seen for a very long time.  Is the risk of something seriously disruptive 1 in a 1000?  Is it 1 in 100?  What if it’s 1 in 10?  And to be clear, a kinetic war is far from the only thing that could go wrong and be meaningfully disruptive.  Obviously, if the big one goes up, not much matters and the advice from the 1960s will remain compelling...put your head between your legs and...well, you know the rest.  If we end up in some sort of significant level of global economic conflict, some significant level of disruption of global norms, the US domestic landscape may radically change. 

What would happen?  Who knows?  I certainly won’t even assay much of a prediction.  I’m just trying to raise awareness that this is a real question. 

Okay, I said I wouldn’t make a prediction, but my best guess, based on a past-is-prologue sort of analysis, is that when a major crisis occurs, central banks (including ours) would rapidly begin to print money and fiscal stimulus will go into high gear (thank God our national debt is a mere $35 trillion, so we have plenty of room to react to geopolitical stress...kidding!).  Labor will get tight.  Supply disruptions will ensue.  Inflation will probably reaccelerate.  Industrial policy will follow.  Governmental intrusion into all aspects of the economy will occur.  The free flow of information will diminish as censorship grows (it was called the Spanish Flu because Spain was neutral and the only country in Europe that didn’t have massive censorship preventing discussion of the disease, so they’ve got naming rights, not perhaps what they had in mind).  This will make it hard to conduct business and business decisions and assess the value of assets.  Market forces will be diminished by governmental activity.  Business will be torqued by the government’s crisis response and it might be difficult to make money except at the intersection of profit and industrial policy. 

But, as we are sitting here today, continuing to wait for our Godot-like recession that’s been predicted (promised?) for the better part of a year to finally arrive, we should think about this.  While we’re waiting for Fed tightening to actually become nonaccommodative, or at least show some stability embracing a neutral stance, while we’re waiting for inflation to begin to slow and value discovery of commercial real estate assets (among other things) to again be achievable, we should take into account the risk of something truly disruptive happening over the next several years.  What that argues for me is that the current environment of high interest rates, high cap rates, a diminution in the availability of liquidity from the banking system could end sooner than we would otherwise expect.  (Absent such an event, I rather expect current conditions to continue well into 2025.)

This thought exercise through the darkling woods is meant to remind that while the straight-line projection of disparate events and false narratives are the mother’s milk of the conspiracy theorists, the straight-line projections and assumptions of continuity of the Serious People might also be wrong. 

You’ve got to play the cards you’ve got.  The opportunity we see now to take advantage of distressed debt, distressed lenders and the rapid repricing of assets resulting from the Fed’s efforts to squash inflation must be taken up.  Raise capital.  Find more leverage (or develop your own).  Relearn the rules of the liquidating trust and the means and methodologies of levering nonperforming assets.  Take advantage of risk-based capital issues in our banking system and embrace both cash and synthetic means of transferring risk.   We need to get ready.  The current status, the phony war resulting from markets’ inability to internalize the fact that current conditions aren’t transitory will end soon. 

The opportunities of this current market mosaic might not last all that long.  Find revenue where revenue can be had, but be prepared to pivot to a place where there is a rapid restoration of accommodative interest rates, all sorts of fiscal fun that would make the response to the Covid contretemps look modest and be ready to engage with an activist government that for good or ill will clearly intrude into the economy in ways that we can barely imagine today. 

Net/net.  If you have capital, conviction and analytic horsepower, get into the game now before the game has a chance to change again. 

No one is talking about the risk of SIFIs (Systemically Important Financial Institution) or Global SIFIs failing in this environment.  The fortress balance sheets of these institutions are large and considerably larger than they were during the Great Recession.  This is not the Great Financial Collapse of ‘08, but does this not have more than a whiff of the 1980s’ Savings and Loan mess about it?  Sure does. Remember the late 1980’s interest rates? I remember, and not fondly, my 13% home mortgage loan. Any parallels here? Hmmmm?

For what it’s worth, here’s my recipe for bank failure or bank bailout, because we’re going to see it again.  Start with a material negative difference between the book or par value of a bank assets and the fair value of those assets.  This delta has just about been baked into the cake in the Fed’s actions by rapidly increasing the Fed funds rate.  If you originated or acquired assets prior to the end of the first quarter of 2022, you own this pain.  In the SVB case, the problem was long-dated treasuries, but it could have easily been loans.  This valuation gap, which is tracked as the Economic Value of Equity (EVE) under the Basel rules, has heretofore not elicited much attention, but clearly it should have.  In 2021, SVB reported that a 200-bps increase in interest rates would result in a 27% decline in the value of its assets or a 35% reduction in Tier 1 Capital!  No one apparently noticed.  Of course, interest rates have escalated about twice as much as SVB modeled in 2021.  The result was inevitable.

For many small banks, their capital is heavily invested in loans.  Fixed rate loans have the same problem as treasuries.  Even if performing, value crashes as market yields go up.  Floating rate loans are sheltered from this basic price/yield effect but as coupons skyrocket, credit issues ensue.  In both cases, the value of these loans rapidly goes down. 

The other fact to consider in understanding risk here, is how these assets are held by a bank.  If held in a held-to-maturity (HTM) book, these assets are held at book value and are not subject to a fair value mark.  Other assets of the bank may be held in an available for sale (AFS) book and these are subject to quarterly marks.  When loans are sold from either book, losses will be recognized.  When HTM loans must be sold (and most banks will run through their AFS book pretty quick), losses will be recognized, and further, it’s likely that the bank auditors will recharacterize the preponderance of its HTM assets as ASF assets.  Consequently, the entire book will be subject to mark to market, further depleting the institution’s capital (Note that the new CECL rules in effect this year will exacerbate this for floaters, but CECL only addresses credit losses, not fair value).  Rinse and repeat.  Cue the FDIC and we have a bank failure or a bailout candidate. 

Any bank which is heavily invested in mortgage loans, whether resi or commercial, will carry on its balance sheet that risk, and know with an absolute certainty, these assets are worth far less than par in a rate increasing environment.  To manage these risks, banks are of course supposed to hedge, but my guess is not enough risk will be hedged away. 

So, the critical predicates to the danse macabre will be present in many institutions.  Only question is who will light the match. Virtually all banks have material non-insured balances. Plenty of matches out there.

Look, I don’t want to cry wolf here and maybe all this settles down.  The Fed and Treasury stepped in and utilized (dubious) systemic risk powers to guarantee all of SVB’s and Signature’s deposits and everyone took a deep breath and climbed down off the ledge.  Moreover, Treasury officials muttered something about everyone’s deposits are safe.  That caught the eyes of many observers.  One wonders if that means the government is saying that all deposits are fully insured now?  I don’t see the authority for that to happen, and clearly such a move would be a big step toward recasting our entire banking system as a utility.  That would be fixing one problem in exchange for a cascading set of other more consequential problems.  Seems that what those soft assurances presaged was this nifty new Fed credit facility.  The Fed has now announced a new credit facility for banks.  The facility, called the Bank Term Funding Program (BTFP) will provide liquidity by providing 100% financing for a year at extraordinarily low interest rates against treasuries, mortgage-backed securities and certain other traded assets (mortgage loans will not qualify).  For these purposes, those assets will be valued at par.  How wonderful!  Thank you, taxpayers!  This bailout (did I say bailout?  Oops!) is backstopped by a $25 billion line from the Treasury. 

My operating assumption at the beginning of the week was that bank failures would cascade.  Now, in the short run, we may not see bank failures (what happens a year from now is an interesting question).  But surely we will continue to see bank distress.  Many have already bellied up to the existing Fed window and the new BTFP window, and borrowed something close to $160 billion as of last week.

So don’t put your broken bank playbook away.  For now and into the intermediate short term, all banking institutions, both large and small, are likely to be put under significantly enhanced regulatory pressure to shore up balance sheets and to manage assets and liabilities to reduce the chance of failure.  New fun and frustrating regulations are likely to be enacted (stand by for this... see our advice below).  Bank boards will turtle and loan growth will dramatically slow.  I have already heard lenders saying, at least for the moment, that the window is shut.  Will this change banks posture on loan defaults, waiver requests, replacement of rate caps and other accommodations requested by stress borrowers?  It very well might.  All that will result in is a material reduction of liquidity to CRE markets for the foreseeable future and possibly a less flexible approach to workouts and restructurings than we had been anticipating.

Well, we’ll all get to watch this slow-motion train wreck and the question is what to do about it.

In no particular order, here’s what we think right now: 

• Non-banks, start your engines!  The competitive pressure from the regulated banks is about to abate.  Pricing power will return to you.  Go ahead and get a new warehouse.  Consider refreshing capital, now there is something to do with it, through securitization or loan sales of the legacy book, even if not accretive. Take the hit, make good, new loans and move on. You will need it. 
  
• Also, for the non-bank set, turbocharge efforts to assemble money and leverage to acquire both distressed debt and other debt from distressed institutions.  It seems to us that there will clearly be a drive inside the regulatory establishment and in fact with the Boards of many institutions, both large and small, to be increasingly “disciplined” about the content and construction of the balance sheet.  Maybe management will recall the hard-earned wisdom of the GFC that the first loss is the best loss.  Some with overwrought balance sheets will embrace that now.  Nothing that was originated before the interest rate runup last year is going to trade at par, and indeed nothing should.  Coupons are up 400-500 bps for floaters and cap rates have widened by a couple hundred bps.  Refinancing will be inaccessible without a great deal of new equity.  Many institutions will be ill-prepared to deal with burgeoning distressed debt.  Private credit should take advantage of this.  There will be motivated sellers in the marketplace.  Months ago, CrunchedCredit projected that we would see distressed debt and distressed sellers at some point in the future.  Taking a lesson from economists, we only said it would happen, not when.  Maybe, when is now. 
  
• Adopt a DACA.  If you’re a bank and things are good, look at this as a huge competitive advantage.  Hang that big “open for business” sign where everyone can see it.  Institutions with fortress balance sheets could offer to the marketplace willingness to accept the transfer of DACAs and other reserve accounts without the laborious multi-week-long process it now takes to negotiate fresh documents.  Agree to execute the form of the pre-negotiated DACA that the other institution had, with the understanding that the DACA will either be renegotiated or terminated within some finite period of time; perhaps 60 or 90 days.  Let’s face it, while it’s been increasingly difficult to get a DACA negotiated because of the high level of negotiation around these damned things, they are all fundamentally alike.  It would not be unreasonable to take a view that if another institution negotiated a DACA, it’s probably okay.  Oh, we will need to run KYC, but that can be fast-tracked.  A bank could do this and hoover up a significant amount of money and banking relationships in this crisis.  Win, win.  Please feel free to embrace this notion.
  
• If you are a depositor, carefully review all your banking relationships (DUH!).  Even if all your accounts are below the $250,000 level or if you happen to be a fabulist with a sunny disposition and think all deposits are in fact now secured (I don’t), think carefully about the frictional cost of having money tied up in an institution that’s in significant financial difficulty.  Bake in early triggers to respond to evidence that a bank might commence the danse macabre at some time in the near future.  We need a rapid mechanic to allow the transfer of deposits or DACA funds to another institution, ideally before the institution becomes page one news. 
  
• If you’re lender, clean up your loan documents.  Make it clear that a lender is not liable if a DACA or cash management bank fails.  Confirm and clean up ownership of accounts.  Figure out what your servicers are doing.  Make sure that if accounts may be commingled, there’s now mechanics in place to avoid major uninsured deposit positions.   (Please see Part I and Part II of the Dechert OnPoints by Laura Ciabarra and Kate Mylod). Are we good here?
  
• Consider other lending opportunities.  Can a credit vehicle lend against the FDIC receivership certificates with respect to the uninsured portions of deposits?  Sort of like any other distressed debt lending, isn’t it?  The calculation is when will money be forthcoming and how much?  That could be modeled.  Consider doing a liquidating trust full of those sorts of financings.  Could be a thing. 
  
• Look into Credit Risk Transfer deals.  Many banks will be badly in need of risk-based capital relief.  Have a mechanic to transform CRE exposure into securitization exposure with much lower risk-based capital charges.  This could also be a thing.
  
• Buy a bank (why not?).
  
• Contribute to your PAC...or at least get involved.  Onto the battlements!  If you don’t think these events will trigger a significant effort to regulate banks more comprehensively (both large and small), you’re in for a very bad surprise.  Some of that enhanced regulation may be understandable and, indeed, a rational response to a new set of perceived risks, but the negative externalities of new comprehensive regulation will be myriad and far-reaching.  The government will overshoot.  We need to be ready.

There’s probably more to do, and as we think about it, we will share it with our readers.  But make no mistake, the collapse of SVB is consequential.  It is likely to usher in a period of enhanced insecurity with respect to the health of the banking system and create complexity and uncertainty across the finance landscape. 

As is always the case in periods of rapid change and stress, there will be opportunities to harvest significant profits for those with capital, strong analytics and conviction.

But Santa is coming down the chimney delivering lumps of coal so often these days, his knickers are smoldering (I hope they do).  The pace of regulatory initiatives from the White House, the Department of Labor, the FTC, the CFPB, from the Fed banking regulators and the SEC has been blistering and shows no signs of abating.  Comments are due March 27, 2023.

This newest initiative (though God knows, something else may pop up before I’ve finished writing this) is the SEC’s reproposed “Prohibition Against Conflicts of Interest in Certain Securitizations” or “Rule 192” (the banality of numerosity).  This Rule, casting an extraordinarily wide net, purports to stipulate that all “sponsors” and other “securitization participants,” and their subsidiaries and affiliates, cannot engage in a transaction constituting a material conflict of interest with an investor in any securitization in which such sponsor or securitization participant was involved.  The prohibition begins when the sponsor or the securitization participant first takes “substantial steps” to become a securitization participant (not clear when “fixin’ to securitize,” as they say down South, is deemed to begin) and ends one year after the first closing of the sale of the security. 

A material conflict of interest in this missive includes any of the following: 

• a short sale,
• the purchase of a credit default swap or other credit derivative tied to the relevant ABS, or
• the purchase or sale of any financial instrument or entry into any transaction through which the securitization participant would benefit from the actual anticipated or potential occurrence of specified events, such as adverse performance of the asset pool or loss of principal, monetary default or decline of the market value of the ABS;

provided, only if there is a “substantial likelihood” that a “reasonable investor” would consider the transaction important to their investment decisions (or the SEC thinks they would). 

Not to bury the lede; but this is a bad idea.  It will impair capital formation.  It will impair the efficient operation of debt securities markets, impair the ability of market participants to manage risk, and deliver very little real benefit.  Another example of virtue signaling as opposed to a serious pursuit of serious policy. 

This is a re-proposal.  The SEC tried this one on for size a dozen years ago, as it was directed to do under the Dodd-Frank Act, but abandoned it after it was excoriated throughout the comment period.  It’s back.

Dodd-Frank mandated regulatory implementation of the legislative bar on an underwriter, placement agent, initial purchaser, or sponsor engaging in a transaction causing or resulting in a material conflict of interest with respect to any investor in a related securitization.  The law directed rulemaking within 270 days after its enactment on July 21, 2010.  Oops, sort of missed that deadline, didn’t we? 

Why do we have to deal with this more than a decade after its unlamented internment?  Certainly a surprise, this Frankenstein monster reanimation.  The answer might be that the SEC has concluded that it had to regulate because the law required it.  Maybe.  Hmm, it feels more like an excuse to deepen the engagement of the administrative state in our markets; the leitmotif of the SEC these days.  We all know the Dodd-Frank Act was a bit of a dumpster fire, another example of a “we have to pass the law to know it” sort of thing.  Dodd-Frank mandated the SEC to issue a number of regulations that have never seen the light of day, notably a requirement that the SEC revamp the entire NRSRO ratings process.  These elisions occurred, obviously, because, upon reflection, the proposed regulatory initiative was impractical, ill-suited to purpose or just plain damn silly.  Apparently, those are not good reasons to stop this initiative now. 

Other sleeping dogs have been let to lie, and clearly, this one should have been, too.  A solution in search of a problem.  (Please see the Dechert OnPoint published recently, and linked here, for what’s probably a more balanced and less exercised commentary on the Rule). 

We are 12 years out of the Great Recession, and, to my knowledge, the sort of conflict being singled out here has never been a subject around which the investor community has had very much energy.  Moreover, Dodd-Frank profoundly changed the contours of our market.  It’s not 2007 anymore!  If the SEC had proposed a rule which was rightsized to the scale of the actual problem, it would be tolerable, perhaps even constructive, but, of course, that’s not what we have.  Just to be clear, the problem which was apparently on our legislators’ minds (or at least that tiny handful of our gloriously elected clerisy that actually wrote the Dodd-Frank Act) was the need to stop a truly nefarious actor from engineering a securitization designed to fail while simultaneously betting against it to make an outsized profit.  That’s pretty bad behavior.  It should not be tolerated, but instead of a rifle shot on a very discrete problem, the SEC just carpet bombed the industry. 

The flaws of this Rule are legion.  We’ll begin with who is subject to this Rule.  The guardrails as to who is in and who is out are not clear.  It surely includes the “sponsor” as we’ve come to understand that term in the securities law writ large, but it is clearly more than that in this case.  Is it every co-manager in a bank syndicate, whether they have actual input into the structure of the securitization or merely what amounts to a stuffie?  It certainly is a mortgage loan seller who had some input into the tape.  How about special servicers?  How about B-buyers and control class representatives who are entitled to take action for their own account without regard to the interest of other investors?  (With a delightful bit of sensible clarity, the lawyers who work on the deal are out!) 

For a world-girding bank or other large enterprise, one needs to worry not only about the desk or business unit that securitized the loan, but business units all over the institution around the world who might engage in hedging or market-making activities completely distant and separate from the securitization and virtually certainly without any knowledge of it.  The Rule applies to all affiliates of sponsors and securitization participants, and hence includes enterprises that are merely under common control with the business unit that engineered a securitization.  This will apply the Rule to business units that have little or nothing to do with the securitization business.  

The first two prongs of the prohibition, short sales and credit derivatives are at least largely understandable.  The third prong is a puzzle.  It’s written so broadly that one wonders which type of transaction the staff had in mind (and which they did not).  Would it apply to a follow-on securitization that competes with a prior securitization?  If the co-manager (earning very modest compensation) becomes lead left on a subsequent securitization and earns significantly more, do we have a conflict if the follow-on securitization allegedly suppressed demand for the prior one?  Have we then fallen into the scope of the Rule?  I don’t know. 

Oh, there are exceptions, the statute requires them.  There are three.  Providing liquidity, pursuant to a commitment; engaging in customary market-making activity; and engaging in customary risk mitigating hedging. 

Liquidity should be, but is not, straightforward.  According to the commentary, the liquidity exception captures commitments to promote timely principal/interest payments, and commitments to provide financing to accommodate differences between bond-level and asset-level payment dates.  Huh?  Is that it?  Is it a repo with a high default interest rate or an exit fee just acceptable liquidity, or could it be seen as a bet against the deal?  Not addressed in the commentary. 

Market-making?  We already have market-making restrictions in Dodd-Frank.  That all seems to work.  Why do we need additional guardrails around the core business of market-making?  Bona fide market-making will be in the eye of the beholder and as the beholder will be the SEC collecting points; that’s a little scary. 

How about hedging?  Can a securitization participant hedge with CMBX?  What happens if a prior securitization is included in the next index?  Is that now prohibited?  The hedging exemption also requires the hedging party not to make a profit (gasp).  How can a hedging position that subsequently (subsequently!) becomes profitable be a problem?  It strikes me that avoiding the possibility that a hedge position morphs into a profitable hedge could be a daunting task. 

One thing that is particularly worthy of note is the obligation to establish, implement and maintain an internal compliance program that is reasonably designed to ensure securitization participants’ compliance.  The staff comments suggests that EVERY securitization participant should have to have policies and procedures regardless of whether they are currently relying on the exemption.  Essentially then, this would become a rule for every enterprise which would itself, or through an affiliate or a subsidiary, might become a securitization participant, now or in the future. 

This is noteworthy because this obligation to maintain policies and procedures is an independent obligation from the fundamental obligation not to engage in conflicted transactions.  Caesar’s wife on conflicts but, in the staff’s determination, inadequate policies and procedures makes one a rulebreaker.  Another trap for the unwary.

The two obvious bright lines which should have been incorporated into this Rule are intent and knowledge firewalls.  Neither has and moreover, the SEC’s commentary suggests neither should. 

Incorporating an element of intent seems breathtakingly reasonable and obvious here.  If a party intends to create a bad deal in order to benefit from that construct, that’s obviously inappropriate and should be subject to censure.  But gotchas for trades not structured to conflict?  The SEC remains hostile to an intent analysis because they think the restrictions would provide cover for the nefarious.  Ok, so, while we’re at it, shall we get rid of the presumption of innocence, which we agree would make the criminal justice system way more efficient? 

The second thing which would have made the Rule more sensible is some notion of information firewalls.  If a desk thousands of miles away from New York (physically) and thousands of miles substantively away from any securitization (metaphorically), buys or sells a hedge, buys or sells a CDS or makes a market in a security, how could that be possibly be part of a scheme to stick a rod in the wheels of the initial securitization?  It’s just unreasonable to extend the ambit of the Rule that far. 

The Rule effectively makes everyone who directly or through an affiliate securitizes anything, a party who could very intentionally violate this Rule and the Rule’s inclusion of an independent obligation to build and maintain policies and procedures makes the Rule relevant and expensive to everyone, all the time. 

What about enforcement?  As with the risk retention rule, there’s essentially nothing about enforcement in the actual text of the Rule.  Would we expect SEC audits to determine whether policies and procedures are in place and robust enough in the staff’s judgment?  What about a private right of action?  It’s extremely unclear whether one exists, but it’s hard to dismiss the possibility.  That by itself raises the stakes of simply being a securitization participant and exposes all participants to the threat of litigation.  As my senior trial partner, Andy Levander, regularly says, “You may not do the time, but you certainly may take the ride.”

The obvious response to this republication is to make the case strongly that this is an undue burden on capital formation for little benefit.  We know who the bad guys are.  A rule could be crafted which would be very focused on bad guy behavior.  That’s not what’s been done here, and this proposed solution is disproportionate to the problem.  The SEC should be mindful of the impact this will have on capital formation and the efficient operation of markets, but is willfully dismissive. 

The economic analysis section of the Rule’s commentary suggests the staff is entirely uninterested in economic arguments here.  In the economic analysis, the staff blithely asserts that complying with the rule would cause very little change from current compliance regimes and therefore would not cause significant increase in compliance costs (a mere $27 million per year, according to them). That is surely not true.  The commentary then goes on to admit that the Rule will constrain the current activities of underwriters and other securitization participants and it could, or probably will, have an adverse impact upon securitization participants and, “taken together...will reduce the availability of investment opportunities and could ‘impact market efficiency, competition among asset-backed securitization market participants and capital formation by the ABS markets.’”  Such a terrific idea!  How does one make an economic impact argument when the SEC has already put the rabbit in the hat?  The staff seems to have already concluded that the pain is worth the candle.  It’s not. 

On to the barricades, folks.  This Rule will materially reduce competition, materially reduce access to capital, and vastly increase the cost of compliance for an industry already burdened by enormous regulatory burdens for very little benefit.  What could possibly go wrong? 

Anecdotally, early signs are...not bad.  We’ve got a handful of prints across SASB, CRE CLO and conduit that are directionally upbeat.  Maybe total crap compared to Q1 2022, but given the last eight months...fantastic!  I’ve seen a pretty good uptick in warehouse and debt fund term sheets over the past several weeks.  That means that some players in our market, on both the buy and sell side, seem to think there may be a reason to put fresh capital to work.  Refreshing capital is not an inexpensive exercise so, is engagement an augury of reconciliation and capitulation by the borrower community and a presentiment of conviction by the lenders?  One can hope. 

To reflate our business, we need a number of things to happen.  Critically amongst them, we need investors to buy our bonds and provide equity for our debt platforms.  That is, we need more investors than we’ve got right now. 

Let’s make the positive case for investors.  Relative value in our securities is supportive when compared to investments in other asset classes.  Information, which is important to investors, is pretty good in our space, notwithstanding some cavils about gaps and limitations (we’re working on those and kudos to CREFC, its Executive Director Lisa Pendergast and the rest of the staff, and our members for the work on our debt fund index which is getting close to completion.  That will help.).  Investor reporting should be a net positive for CRE.  SASBs are relatively easy to underwrite and remain attractive across both capital markets and the portfolio market.  The CRE CLO structure has fabulous alignment between investors and sponsors and should be attractive.   The conduit business, for all its flaws, has a long history of resilience.  Generally, there’s decent fundamental performance across all commercial real estate categories (perhaps shockingly so).  Legacy office might be a hot mess, but not the office that’s getting financed on a go-forward basis.  There are good office assets out there.  The same is certainly true for multi-family, industrial and retail (and SFR).  Come on, man, as our President (perhaps sometimes unwisely) often says, buy our bonds!

I remain worried that even if the borrower community embraces the new reality of higher coupons and higher cap rates and returns to the capital markets’ borrowing window, and even if fundamentals continue to hold up, our sector will underperform because of the lack of investors and a lack of a passion to invest. 

Not enough investors are educated about our market, not enough investors understand our relative value proposition, and not enough investors are excited about the opportunities presented in the CRE securitization space.  Our industry, writ large, could and should do a better job of making the case. 

CREFC does a great job of bringing all elements of our industry together and having frank, productive and open conversations which, indeed, continuously makes our industry better.  CREFC has an Investor Forum which is a place where investors can be educated and convey concerns, discuss issues and embrace changes that improve our industry.  All the major banks have research departments which publish stuff for the investor marketplace on a regular basis.  Apparently, that’s not enough. 

What we don’t do is advertise.  What we don’t do is make a full-throated case to get into the game and buy CRE-securitized product. 

Ford Motor advertises, Procter & Gamble advertises, plumbers advertise, drug companies advertise and even the big four accounting firms spend a fortune on advertising.  Advertising is simply advocacy writ large, unburdened by the need to make a balanced case.  It’s not a Solomonic exercise.  It’s not a forum to debate the pros and cons of a product or service, it’s a full-throated peroration of the case. 

Advertising, by its very nature, is unbound from an obsessive fascination with facts.  Don’t laugh, it’s true.  By definition, it’s not balanced.  Do you think Ricardo Montalban’s crooning about fine Corinthian leather (a made-up handle, like Chilean Sea Bass) for Chrysler cars was mediated by a need for factual precision (is that too obscure an historical cultural reference?)  How about the GOAT and his late lamented passion for Crypto?  Do you really think all those ads for High “T” are really about science?  Does “Made in America” really make car floormats better?  Advertisement has more than a whiff of puffery.  I don’t remember Ford including in their advertisement the possibility that my Ford Pinto might explode.  I’m pretty sure it didn’t.  Advertising is not about flaws.  It’s about making the case that a product is good, valuable and attractive. 

Why do folks advertise and pay a huge amount of money to do it?  Because it works...even if it’s often annoying.  (Super Bowl advertisements aside.)  Some of this crystalized for me the other night while watching PBS and being exasperated by yet another interruption by the local station’s fundraising campaign, full of chirpy, cheerful people telling me how wonderful the station is and how important and fun it would be to contribute.  They do it all the time.  It’s mind-numbing but they do it because it works.  If advertising works across every other sector of the American economy, it probably would work for us.  Oh, perhaps we think investors are way too sophisticated to be influenced by shameless advertisement, but I’m pretty sure that’s not true. 

We understand that there are issues and complexities and concerns around investing in any CRE debt product.  We often highlight these issues when the industry meets because we are all working together to make the business better.  That’s what a good trade organization will do.  Is investor hesitancy attributable to other asset classes making better competing relative value claims better than we do?  Is it that investors don’t like the concentration of risk in CRE loan pools?  Is there not enough diversity?  Is CRE debt too dependent upon manager competence?  Is it really a problem with insufficient liquidity in our market?  Is it that the model industry portfolios by which investment managers allocate investments is suppressing CRE bond purchases, particularly as the denominator effect bites?  Is it that investors think they need particular expertise in our space in order to invest and don’t want the headcount?  The problem can’t be the macroeconomic risks of recession, shape of the yield curve and fun with the Fed, which apply to all asset categories. 

I don’t know.  These may all be real concerns, but all products have...issues, have flaws.  Advertising is ballyhooing the positive about a product and suppressing attention to its flaws.  Our products are not fundamentally different than anything else for sale in the sense that all products and services have good bits and bad. 

Advertising would do two things for us.  First, it helps create an environment in which decisionmakers are more positively disposed to the asset class before an opportunity is even encountered.  The evidence is overwhelming that the creation of such a positive narrative turbocharges expanded purchasing behavior. 

Second, advertising would also help us reach two audiences that we just don’t touch within the confines of our trade organizations and banking relationships that are important to investment decisions.  First, there are investors who invest in fixed income, but simply don’t participate in the CRE space.  We need to at least talk to them.  Moreover, we need to communicate with senior management who don’t come to CRE events, yet who have significant control of the allocation of dollars at a meta level above those who invest in our products.  We need to encourage the leadership of major investors to be supportive...or at least not be hostile.  

This may just be a thought exercise; it is surely far from a proposal.  But the type of B to B advertising we see on TV every time we watch a tennis match or a golf tournament, creates an environment in which the actual decisions to buy a product or a service are simply easier and more likely to be successful.  It softens up the beach for the landing.  It’s not wrong, it’s not unseemly. 

Certainly, there are significant legal and practical issues associated with embracing such advocacy and building out a platform, but that doesn’t mean it’s not a legitimate undertaking. 

We need more demand for our product.  At some fundamental level, bonds aren’t any different than bananas.

[1] Apologies to the late, great Ella Fitzgerald for appropriating, or perhaps misappropriating, her lyrics.

Part of the problem is that we live in a period of rapid, continuous and unknowable change.  Maybe everyone says that all the time, but it seems demonstrably truer today.  All is mutable.  All is opaque and contagion is our reality.  Things that we always thought we knew are confounded.  There is more discontinuous change than in the time before. 

What’s a talking head supposed to do?  Everything that is good might be bad.  Everything that is demonstrably bad can be good.  Or both.  Schrödinger’s cat.  Inflation is going down.  That’s bad because that means there’s a recession coming.  Inflation is stubbornly high.  That’s bad, of course, because that means the Fed will continue to tighten.  That means a recession is coming, too.  Employment stays high; employment is not high enough.  Both bad, see above.  The Fed is pursuing a policy of restrictive credit formation through elevated Fed funds rates while our elected leaders continue to pass more stimulation.  The Federal Reserve balance sheet matters!  No, it doesn’t.  There’re no negative externalities from the Fed printing as much money as they need to meet all their obligations and desires.  Yes, there are.

There are apparently troubling and unknown risks in the hedging posture of many financial institutions, particularly in the FOREX market, or not.  Isn’t hedging an unalloyed good?  The US trade deficit is bad, we’re getting outproduced!  But hold on, we give foreigners little bits of paper that everyone pretends are valuable (no, not Bitcoin) which the Treasury prints without end and we get actual stuff in return, that’s good! 

Geopolitical risk remains elevated (that’s such a delightfully circumspect turn of phrase used by the self-proclaimed adults in the room where “Holy Shit, we’re in trouble” might suffice).  Something really bad is bound to happen, or it’s not.  Maybe, we’ll just carry on with this gentle boil that we’ve learned to live with for years and years.  Crime is up!  No, it’s not!  Pick your data set and everyone else should shut up.  Democracy is under attack; we’re doomed to wear red hats!  No, our democracy is resilient.  No worries!  American exceptionalism is fading as a totem of American political life, and that’s bad, or is it good?  Inequality is on the rise, or it’s not, depending on what data set you look at.  The country is riven by institutional racism which threatens the underlying pillars of civil society, or it’s not. 

The yield curve is inverted.  We’re doomed.  The inverted yield curve has predicted 11 of the last 7 recessions.  So, the yield curve doesn’t matter, and all that fancy monetary stuff doesn’t actually touch the economy.  Cue Modern Monetary Theory. 

It’s exhausting and one could go on in a Manichean dialectic sort of way, tit-for-tat with folks with lots of degrees and pretentious inches of print in academic publications picking sides and leaning in.  (All that’s not to mention our entertainment glitterati who think, for reasons I can’t fathom, that their opinions should matter.)

So, I have concluded that bloviating with a straight face about what’s going to happen in 2023 in this chaos of fundamental disagreements over critical first principles is a waste of energy (or not serious and, God knows, we’re always serious here). 

So, I thought I would take this space to describe the macroeconomic and geopolitical world I’d like to see in 2023.  To hell with the facts, this is the entitlement age and I’m entitled to be a fabulist.  So, here we go with a prospective alternate history, if you would.

I want inflation to begin to abate, but neither too slowly nor too fast.  We’re going to have a recession and I’d like the Fed to get on with it, if it’s the nice little recession we all expect.  The yin and yang of restrictive monetary policy and expansionary fiscal policy will ultimately be won on the monetary battlefield.  Inflation is and always will be a monetary phenomenon.   With inflation staying above the Fed’s rather phantasmagorical obsession with a 2% baseline, coupons and cap rates will remain elevated.  That means a vast proportion of all hard assets and financial assets will be, in the circumstances extant next year, overvalued.  Remember, there are no bad assets, just bad price points. 

I’d like to see a nice little distressed debt bulge, neither wave nor ripple but bulge against an economic environment with more than a whiff of stagflation.  Winners and losers will abound.  The days where it was pretty easy to make money are over for the foreseeable future.  Everything will be harder.  I’d like to see more distressed loans and more distressed platforms.  (Sorry for those of you who might own the former or are the latter.)  I want to see a period of consolidation, of M&A and the structural changes attendant upon those types of transactions.  I want to see legal fees go up.  (Well, that’s probably something I shouldn’t say, but hey, this is my wish list not yours, isn’t it?)

I remember workouts can be fun, but I don’t expect a lot of lavish closing dinners. 

I trust the government will continue to dither.  Our two malignantly and reflexively hostile political tribes will continue to wrestle to little point or effect in Washington and around the country over the levers of policy.  Gridlock might not always be a good thing for business, but it’s going to be our thing this year. 

Notwithstanding, the government will continue to expand into the economic sphere and more and more decisions will be driven by the dictates of the regulatory state.  There will be circumstances where, for reasons good and bad, risk is socialized and private return is preserved.  I hope to see significant dollars flowing into those trades (think all things ESG and infrastructure). 

In all other respects, the bureaucratic instinct will continue to impose what amounts to a growing transactional friction-type tax on business, making transactions more expensive.  No matter how much of a fabulist I want to be, I can’t seem to gin up any energy to hope for anything much better here.  I hope that while liquidity will be dear, it will be available. 

Financial engineering will be king.  One won’t be able to do next month what one did last month, rinse and repeat, and make money.  So, those for a penchant for out-of-the-box thinking will win. 

New technologies will develop and old ones, such as liquidating trusts, will be back in currency.  We’ll investigate credit risk transfers and will be fascinated with risk-based capital transactions as many financial institutions’ risk-based capital ratios will face stress and bank examiners will continue to exert pressure on commercial loan concentrations (particularly CRE). 

On the home front, I want to see stability in the quality of our social interactions here at home.  Maybe it will continue to coarsen, but I’d like to think the social contracts will not break.  Ditto, I want democracy to be safe and the broad patterns of American life not to be wildly disrupted.  While surely political strife will continue, seemingly getting louder and louder, it will be contested less and less as the government is fundamentally unable to engage in meaningful, directed change. 

As we begin to traverse to the formal beginning of the next election cycle (that’s pretending that there are actual cycles and we don’t just do this day in and day out in essentially a permanent election campaign), I want to see government action increasingly constrained as the tribes, er parties, begin to circle the wagons to think, almost exclusively, in a reptilian sort of way, about how to preserve their careers through the 2024 election.  Gridlock will only get worse.  Thank you for staying out of our way. 

On the geopolitical front, let’s just keep everything on the same low boil we’ve come to tolerate these past several years.  No wildly intolerable denouement in the Russian invasion of the Ukraine. Nothing kinetic pointed our way from the North Koreans or Iranians; a continuing moderately independent acting (but surely not independent) Taiwan wouldn’t be a bad thing.  And while we’re at it, a more engaged and less confrontational China would be delightful.  I’m not so silly as to wish geopolitical risk and violence away, but I really don’t want to have to think about digging a hole and jumping in with my go-bag. 

You may have noticed that while I’m in the wish business and not the predictive business here, I’m not wishing for halcyon days of wine and roses, where life is beautiful all the time (credit to Jerry Samuels).  That would be silly.  I’m a fabulist, but not a silly fabulist today.  What I’m hoping for is a reasonable geopolitical and macroeconomic environment not wildly inconsistent with our desire to continue to conduct business.  I want to see transactional velocity return.  I want to see people making bets about the future.  I want to see people who think they know what’s actually going to happen putting money to work based on those theories.  It will surely be harder to make money in 2023, but we can get stuff done.  I want innovation and engineering to be crucial (fun for me).  In chaos lies a considerable quantum of opportunity. 

Look, the combined consequences of black swans, opacity and contagion surely means that more could go wrong than could right and therefore a certain amount of caution is required in executing your 2023 business plan.  But, folks, there’s a pony in there somewhere and it’s our job to go find it. 

It’s Golden Turkey Awards Time, Folks!

Our Turkeys are a little late this year but hey, we’ve been busy worrying about the collapse of the world’s economy.  This is the 10^th edition of our Turkeys and much thanks to our disorderly, often dysfunctional, regularly inscrutable and absurd government, polity and marketplace for continuing to provide us with materials for this annual compilation of that we find most silly, absurd and worthy of a Turkey.

Last year at this time, the market was on fire.  I was shocked that we actually found time to put out a Turkey.  This year, the market looks more like a smoldering ruin rather than a roaring bonfire, but hey, maybe that means we have an upside to look forward to.  So, with irrational exuberance and hope that sometime in 2023 it’s better than now, here are our 2022 Turkeys.

The New Normal Award.  Goes to the Federal Reserve Board of Governors.  How shocking to the panjandrums of the economic heights to have to abandon the transitory to embrace “oh God, my hair’s on fire” as inflation roared toward 10%.  Proof yet again that you can get ten opinions on virtually any point from five economists.  After hovering at the zero bound for over a decade, it’s shocking, appalling and deeply annoying that the curve is so rapidly shifting upwards.  How high is high?  Interesting question.  TBD.  Will the Fed overshoot?  Of course, it will.  If past is prologue, it’s about 100% certain.  It reminds me of my Boy Scout days when on a winter campout, we’d put our feet close to the roaring fire to salve the pain of our freezing toes, but then never pull them away fast enough to avoid the soles getting hotter and hotter until we ended up pulling off our boots and sticking our feet back into the snow.  Here, the only question is when we have to stick our feet back into the snow this time.

Birds Gotta Fly and Regulators Gotta Regulate Award.  So many finalists in this category, we’ve chosen two.

Let’s start with the European Commission and its insistence that its new Article 7 Transparency rules apply to issuers, sponsors and originators of US securitizations.  Why?  This is a classic example of a solution in search of a problem.  The US IRP for CMBS is actually the best reporting package on the planet for investors, and is lauded by the SEC on a regular basis as an exemplar of how to convey information to an investor community.  Now, we’re going to be forced to map the IRP to this annoying new EU regulatory transparency template, which contains a bunch of entirely inscrutable (it speaks in deep EU) and often irrelevant data fields.  Moreover, Article 7 asks for some data that should be kept confidential for the benefit of investors.  Do I really know the shoe size of the guarantor?  Do I really have to tell the world what our strategy will be to enforce a loan watchlist?  At a minimum, it’s going to be a lot of work.  It will actually turn out to produce more confusion than light.  Will it reduce investment opportunities for non-US investors?  Probably.

Not to be outdone, and to give equal time to the US apparatchiki, what in the world is the SEC thinking about with its new 15c2-11 rule?  In order to continue to provide critical price quotations in 2023, the broker-dealers will have to ensure that a significant amount of 144A market information is publicly available.  There is no undertaking to hold information as confidential and to use it only in connection with purchase or sale of a security.  So...we’re going to make available to the general public a bunch of information that will take us a fair amount of work to cull and assemble even though the general public can’t buy bonds in the 144A market because they’re not QIBs.  Now, QIBs, the actual buyers and sellers of the securities, have fabulous access to necessary information and while there are some cavils about how it’s organized and consistency across issues, they are generally content with the amount and quality of the information.  So, at considerable expense, we’ll make sure that folks who actually can’t use this information have it.  This reminds me of the old Catch 22 line that you could only make an appointment with Major Major when the Major was not in.  Ma and Pa Kettle can now get all of this terrific information, but can’t do anything with it.

Helping the Little Guy Award.  This award also goes to the SEC for its incredible courage and sympathy in issuing a new private funds rule to protect the poor, meek and feeble private fund, CLO investors and limited partners from the big bad fund managers. Do these “helpless investors,” who clearly have resources to absorb the risk of these investments and the intellectual professional resources to understand and assess what’s on offer, really need help from our government?  Well, we won’t have to worry about these poor dears any longer because the government has arrived and is intent upon helping.  These new regulations will require a material amount of additional and reconfigured information to be provided to investors and will significantly impair the ability of managers to actually do their job.  The rule is some 500 pages long, so God knows what’s really in it (ask Mrs. Pelosi).  The private investor did not ask to be saved.  The private investor did not want to be saved.  So, congrats to the SEC!

The Amazing, Shrinking CRE CLO Investor Base.  While the corporate CLO market goes gangbusters, the CRE CLO investor base is considerably smaller than it ought to be and stubbornly resists growing.  Come on, investors.  Don’t be shy.  Let’s do the virtuous circle thing.  The more you buy, the bigger the market; the bigger the market, the better the liquidity; the better the liquidity, the more you buy.  Isn’t that how it works?  The data provided in the CRE CLO is the best information available in all structured finance.  Large loan summaries, hundreds of data fields in Annex A, cross-collateralization, significant diversity and, at the end of the day, instead of owning debt on zombie, wildly overextended small operating companies with largely ephemeral collateral, at least you own some real estate.  Come on in, folks.  The water’s fine.

The ESG Abuser Award.  Goes to the cadre of excessively enthusiastic investors, legislators, regulators and professionals helping ESG, a phenomenon, grow at lightning speed.  Federal, state and even local governments are creating laws and the regulators are doing what regulators do.  We’re creating incentives and disincentives.  Yet another effort at guiding the market remains which so rarely works.  Negative externalities anyone?  We all know that greenwashing is bad, but even well intended efforts to do the right thing in accordance with new rules, laws, regulations and the predilections of market participants all, presumably in the pursuit of a greenium, is going to lead to bad outcomes.  Caveat emptor my friends.

The Creative Destruction Award.  Goes to (tentatively) Elon Musk for whatever the heck he’s doing at Twitter.  The guy who invented the electric car, who’s getting us into space more efficiently and cheaply than our vaunted NASA, the man who wants to die on Mars, is certainly doing something important at Twitter.  Maybe this works or maybe it doesn’t.  But it is a classic example of Mr. Schumpeter’s notion of creative destruction in action.  It’s either really good or really bad, depending on where you sit when the wheels come off.  If Twitter comes out of all of this as a viable business, then hands down Mr. Musk gets the award.  If not, others should apply (maybe Al Gore should dust off his resume and throw his hat in the ring as the inventor of the internet?).

The Margaret Thatcher Told You So Award.  Goes to virtually every government in the western world for forgetting that the problem with governmental largesse is that eventually you run out of other people’s money.  Oh, no, wait!  That’s not a problem, we just make-up money.  Cue the printing press.  Keynes might not have been entirely wrong, but neither was Milton Friedman, and after trillions of dollars had been added to global liquidity, largely a product of simple governmental borrowing, we’re shocked, shocked that inflation ensues.  So, interest rates are skyrocketing, liquidity is fleeing and austerity programs are beginning to proliferate.  (Look at poor, old England.)  Be very careful.  If we push it too far, it might begin to feel a little 1930-ish.

The Matrix Award.  Goes to the crypto currency industry and our erstwhile friends at FTX, Doge Coin, Pay Coin, Ethereum’s DAO and the other failed crypto platforms, NFT art and whatever the heck the “Metaverse” is.  I remember first hearing about someone spending tens of millions of dollars on NFTs and thinking that yes, indeed, we have finally entirely lost our minds.  We may have long ago left the gold standard and embraced fiat currencies, but at least those that issue fiat currencies have armies.  If fiat currency is an illusory repository of value, crypto is a first derivative, an illusory repository of an illusory repository.  Maybe someday that’ll be great, but this is not then.  I’m sticking with the greenback until I discover that I’m a figment of the imagination of an AI program pretending to be an 8-year-old gamer.

Once More Onto the Breach Award.  Goes the ARRC, the Bank of England and all those other seriously minded wonky bureaucrats who are high-fiving themselves on the almost immediate extirpation of LIBOR.  I know we’ve talked about this before, but it deserves one last mention in our list of Turkeys as we roll into the dying days of LIBOR.  The transition has been an enormous waste of time and energy.  I’m still looking for a market participant to tell me how wildly distressed they were with LIBOR and how compellingly better the world is because of SOFR and SONIA.  Couldn’t we just have thrown a few miscreants in the slammer and moved on?  Hey, on the other hand, it did give a bunch of lawyers and consultants something fun to do for the past three years, and that’s not nothing.

The Cronkite Award.  Goes to virtually everyone in the media.  This is a return from a prior award season, but worth revisiting as it doesn’t seem to get any better, does it?  The old adage that everyone is entitled to their own opinions but not their own facts seems to be so 20^th century.  Flipping from MSNBC and FoxNews is like flipping between alternate universes.  The Man in the High Castle stuff (for afficionados).  CNN shocked the world this past fall by saying it was going to return to hard news.  Such a shocking concept!  Maybe it’s time we just get over ourselves and acknowledge that we’re returning to the good old days of the 19^th century where no news outlet ever claimed that it was anything other than the political bullhorn of its ownership.  Time to embrace nostalgia?  On the other hand, it would be nice to know that when we next land on the moon, I don’t have to worry that it happened on the backlot of Paramount.

The Remembrance of Things Past Award.  Goes to the closing dinner.  It’s been a delightful several years for the institution of the closing dinner.  Bon ami, chotchkes, sea food towers, pounds of post-mortem cow and gallons of red wine, often paid by the lawyers because hey, they’re lawyers.  As memory serves, in periods of financial stress, closing dinners are the first to go and I think we may have seen our last closing dinner for quite a while.  So, if one is lucky enough to get invited to one last legacy dinner, take some pictures and record some oral history so that when good times return, we might even remember how it’s done (it could be quite a while).

The Civility Award.  Goes to the US Political Class.  We have just finished another seemingly endless, mentally enervating and entirely predictably annoying midterm election.  As our political class knows, the articulation of policy prescriptions or saying good things barely moves the needle, but accusing your opponents of sundry and nefarious behavior is a winning strategy.  Every year we appear to plumb new depths, but let’s give the wannabes a small shout out, no one actually accused anyone else of being a cannibal.  Apparently, that was a thing in the Brazilian election and we can take heart that no one accused anyone of actually eating people here in the States in 2022.  Eating their souls for sure, but that comes with the territory.

Here Be Dragons Award.  Goes to all the bloviating talking head class who, yet again, utilize predictive powers about expectations.  How’s that working out for you this year?  Not particularly well for me.  The New York Jets and Giants are really good.  The Philadelphia Phillies made it to the World Series.  The Red Wave was barely a red ripple.  Serious war in Europe was inconceivable because of the interconnectivity of economies.  The English have had three prime ministers in the course of four months.  UFOs (or now UAPs) could be real (but I’m still waiting for these reproductively-fascinated aliens to show up in Harvard Yard).  Is that really disabling?  Such a disappointment.  The weather, or climate depending upon your politics, was either worse or better than predicted somewhere in the world this year.  Shockingly, the Russians have used oil as a weapon.  Who knew?  Harold Stassen may run for president in 2024 (okay, he’s dead, but given the type of folks we’ve nominated recently, is that really disabling?).  So, take a shot and get into the prediction game.  Explain to us what’s going to happen to the economy, but if you are silly enough to try, you probably need to explain how the job market can be hot, while inflation is unmanageably high, sentiment is horribly negative and the interest curve is both inverted and shifted up several hundred basis points.  How about the economy?  This is a movie we haven’t seen before.  Take a shot at that for 2023 and make the awards next year.  Anyway, the bloviating class can always take some comfort from the fact that if it turns out they were right, they’ll get to trumpet their brilliant omniscience for years.  If it turns out they’re wrong, no one remembers anyway.

The Follow the Science Award.  Goes to the CDC and our gloriously elected leaders who use that delightfully adult sounding phrase to harangue us a wide range of policy prescriptions during the COVID-19 emergency.  “Follow the science” was used to support a series of continuously changing, constantly morphing and often contorted, inconsistent and often inscrutable policy initiatives.  Anyone still silly enough to pontificate under a “follow the science” banner should remember that it could have gotten you burnt at the stake 500 years ago, bled to death by your doctor a little more than a century ago and almost resulting in the closing of our Patent Office around the turn of the last century.  Follow the Science!  A current equivalent of “Inconceivable!” from the Princess Bride.  It obviously doesn’t mean what it sounds like it means.  Michael Crichton famously said that “if it’s consensus, it isn’t science; if it’s science, it isn’t consensus.”  He was wise.  Our gloriously elected representatives and their apparatchiki are not.

The market’s a mess, but hey, enjoy the season!

Q: Good Morning Laura and Stewart, thanks for joining us today. To get things started – based on the current economy, what was the consensus amongst everyone at the conference?

A: (Laura) This was the first conference where everyone finally admitted there has been a downturn in the industry and it may last for a bit. Obviously, if you’re in the business you don’t want to admit that it’s not great right now. And so, it takes a while for people to face it, but that is the first step to a recovery.

Q: What was your impression of the general mood?

A: (Stewart) The mood was a little bit more positive than I expected. However, we do not see an upward trend anytime soon.  There will be deals, but I don’t think we’re going to be saying, “Okay, we’re back to business on January 1^st.” Most of the people I talked to said the volatility is probably going to bleed into next year.

A: (Laura) I agree. We’ll be fine and we always have been. And we’ve been through this rodeo before. So, it’s not doom and gloom. It’s just that we were on an uptick for 12 years. That’s unheard of. So, there’s a reset going on. And it’s due. It’s going to last a few months, and we’ll figure it out again.

Q: What do you think is contributing to the downturn?

A: (Stewart) What’s driving this is where spreads are moving and the volatility it’s creating. Once we know where the new normal is, then people can figure out how to buy and sell at the right prices and decide what to do.

Q: So, are we in familiar territory?

A: (Laura) I mean I don’t know if you disagree Stewart, but I’ve seen it. I’ve lived through this several times now, and people need space. You know, that’s the beauty of real estate, it doesn’t go away.

A: (Stewart) I agree. This is my second cycle reset in my career. As Laura said, we knew this was going to happen. And even back in 2016, we kept asking, “What inning are we in?” Now the game’s not over, but we’re going back to inning one. I’m not worried about it. I came out of the conference feeling a lot better.

A: (Laura) Yeah, I did too, because people faced that we’re in a downcycle right now, but it’s not horrible. It’s not unfixable. We’re going to figure it out. There will be a few slow months. Then we’re all going to roll up our sleeves and move on.

Q: How has Dechert approached this recent downcycle?

A: (Stewart) This is a great time for attorneys, especially young attorneys, to improve and learn. We always come out stronger on the back end­­—better products, better engineering, better everything. I’m very optimistic.

A: (Laura) It’s a great time to learn. I’ve learned the most in the downturns in my career. It’s scary. I have always said that when it’s slow, we [at Dechert] are nimble. We don’t do the cookie cutter stuff. We produce new products with our clients, and it’s so interesting. If you’re forced into being nimbler, you’ll come up with interesting ways of financing things. You’re keeping your clients going, and it’s like your brain peaks. We are not the firm that only does public securitizations like a machine. We do the weird side stuff. So, we get to be partners with our clients during this time and try to come up with the new normal. And I find it to be fun.

A: (Stewart) We have to be nimble and creative. I couldn’t walk five feet without bumping into someone who wanted my thoughts on possible alternative structures and solutions.  I’m sure, Laura, you had the same experience. It was constant. I must have talked to three hundred different people.

A: (Laura) I was getting bombarded.

Q: How are companies staying competitive?

A: (Stewart) This industry evolves, we always evolve. We’re always looking for the next solution.

A: (Laura) In the last downturn, people’s houses were foreclosed on and so there were all these empty houses all over the country. In response, companies decided to buy, fix, and rent them to people. They were buying already-existing abandoned houses and fixing them up so people could live in them. That’s what an SFR is, a single-family rental. And it made neighborhoods better; it made cities better. A lot of people start out in multi-family rentals, in apartments. Then they start a family, and they understandably want a backyard and a place for their kids to ride bikes and play outside. If they can’t afford to buy a home yet, single-family rentals give them the opportunity.

A: (Stewart) Single family rentals produced positive economic growth in neighborhoods too, first with retail—the shops that opened, the jobs that were created. There was a benefit to it. But there’s still not enough.

Q: What about “Build-To-Rent” properties? How do they fit into the equation?

A: (Laura) Now companies are connecting with contractors and buying, for example, a field in Ohio, and then they are building homes there. It can be all ranges, too. Some of them are smaller houses, others are five-bedroom houses with swimming pools. The companies build these properties and then tenants can rent them. The company takes care of everything—they mow the lawn, fix the dishwasher, all the things that a property owner would do—but the properties are homes, not condominiums. It’s nice because if a tenant has a large family with children, they can live in a home, and then if they run into financial troubles, it’s just a rental, so they’re only on the hook for one year.

Q: Interesting. Any final thoughts or impressions you’d like to share?

A: (Laura) Housing has always been interesting to me. It was a great conference, and it was great to reflect on how Dechert is leading the initiative with real estate capital markets.

A: (Stewart) I agree, and I thought Laura’s panel was great.

Q: Thank you for your time, Laura and Stewart.

Griffin:  How was ABS East?

Sarah:  ABS East was great!  People seemed to be in generally good spirits and not as gloomy as I’ve heard about some of the other conferences.  People are still issuing, people are still doing deals, people are finding new ways to do deals and, generally speaking, finding ways to adjust to the volatility of the market and the difficult interest rate environment.

Griffin:  Sentiment among attendees and presenters was good?  Hungry for innovation?

Sarah:  Yeah, I think that everybody is obviously concerned about what the near future brings and what appears is certainly going to be a downturn.  It is already proving to be a challenging interest rate environment, but asset backed securitization, as we know from the previous crisis, is less cyclical than other areas.  Originators are looking toward the future and ways they can finance.  There has been some expansion in private investment and non-traditional securitization structures.  A good portion of ABS securitization has moved into the 144A market; all these factors, I think, contribute to more optimism than some other sectors.

Griffin:  Despite volatility in the markets, ABS issuance overall, not necessarily auto ABS, is maintaining pace with 2021 issuance, a post-crisis record year.  Why do you think ABS is out-pacing other bonds?  Is auto ABS holding up as well as other asset classes?

Sarah:  Generally speaking, what we consider ABS: auto, consumer, credit card, just hasn’t taken as much of a hit.  We are starting to see higher delinquencies in auto, moving towards pre-pandemic levels, but it is only beginning to translate into losses.  As is in the case of our broad asset classes, we really benefited a lot from a strong first quarter, so that’s really a continuation on from 2021.  I think a big concern is what the fourth quarter will bring.  Traditionally Q4 has been such a strong quarter.  This year it’s looking like it may not be that way, as deal flow has slowed.  That being said, there’s a lot of issuers who need to issue; they have assets and they need to put them somewhere.  They need to continue to securitize to fund their business, and auto in particular.  It has been a very strong auto market in a lot of ways.  So, I really think the headline is that 2022 has kept on pace, but there is a lot of concern about the fourth quarter, and I think everyone is generally in agreement that it is likely things will fall off at some point.  So, in some ways, people are just trying to move along transactions now before that happens.

Griffin:  Do you think another reason ABS is holding up better than other securitization is that the consumer is relatively strong?

Sarah:  Consumers are still purchasing.  We are going to get to a point where people are not purchasing. We are just starting to see delinquencies, but with the strong job market, etc. we haven’t gotten to the point where it’s showing up in losses.  As consumer health and employment changes, it will happen.

Griffin:  With the relatively short maturity of auto loans, is auto ABS a good hedge against elevated interest rates?

Sarah:  A lot of people do think there is a lot of opportunity in the riskier side of transactions, like non-investment grade, due to the high returns.  Those who think the rhetoric around interest rates is over-hyped see a lot of opportunity in sub-investment grade.  Initial Purchasers are requiring increased overcollateralization and reserves in new issuances.

Griffin:  How is the financial climate affecting spreads and pricing?

Sarah:  It is wild.  The difference between last year and this year is nuts.  The same issuer, the same type of asset pool, and it’s like night and day.  Deals are still getting done because people have assets to sell.  I think you are going to start to see people move away from straight securitization and 144A deals because there is going to be more attractive sources of capital—through whole loan sales, forward flow sales, particularly by private debt purchasers.  I think private debt will be on the forefront once things shake out.  There will be investors that continue to find these assets attractive.  Private capital and alternative transaction structures has been the story for a while, and I think this trend will accelerate during the downturn.

Griffin:  COVID-19 resulted in global supply chain strains and an influx of consumer cash, which drove up demand for new cars and especially for used cars.  More recently, supply chain pressures are starting to subside, the used cars market is cooling, interest rates are high, and consumers are tighter on cash.  How is that affecting demand, new issuance, collateral performance, and deal structure?

Sarah:  Delinquencies dropped dramatically during COVID.  Money was flowing into the economy, interest rates were low, people were not buying and selling their cars because they couldn’t.  We are seeing that normalize and get back to pre-pandemic levels.  Prime is holding up pretty well.  Subprime a little less so, but that is just what you would expect.  This has not been a normal time as far as losses go.

It is concerning that delinquencies have gotten back to pre-pandemic levels so quickly.  I guess the big question is when do delinquencies rise above pre-pandemic levels and how will that affect things.  The question remains: what happens when some of these consumer issues start hitting?  Particularly with subprime.  Depending what happens with employment and the supply chain—a lot of different factors.  Subprime will always carry heavier losses than prime.

We also have to consider what happens as used car prices drop, supply of new cars increases, and interest rates continue to rise.

Griffin:  Switching gears, electric vehicles are becoming a bigger part of the conversation each day.  Do you see increased ESG prominence in the sector stemming from the push toward electrification?

Sarah:  I do see increased interest in ESG.  There is not much of a difference showing in spreads or pricing for ESG bonds, yet, and I think this is partially driven by the fact that there is little consensus about what exactly qualifies for ESG.  As opposed to Europe, the U.S. lacks strong guidelines about what qualifies as a green bond and there are still questions about greenwashing.  We haven’t gotten to a point where we have a good, strong set of principles to guide ESG investing.  We are going to see that develop over time.  I think we are getting close to a tipping point, as the conversation is there, and people are coming together to form a consensus on what can qualify.  Investment managers are raising funds that have ESG directives and are going to need ESG investments—one of the ways to do that is through auto.  There is still a lot to evaluate even with green vehicles when it comes to whether something should or does qualify under ESG principles.  Also, the SEC is increasingly focused on ESG-related disclosure. Initially, that focus has been on investment funds, but the expectation is that it will trickle down to ESG bonds as well.

Griffin:  How is ABS competing against whole loan sales as a form of funding for issuers?

Sarah:  We have seen issuers become more interested in whole loan sales.  Some issuers have decreased the size of their ABS offerings in order to sell whole loans.  I think this can partially be attributed to private funding and investors that are able to purchase.  There’s more investors and structures outside of plain vanilla 144A term securitizations than there have been in the past.  It’s just that people have found other, more creative, ways to do things.  144A deals will always be there, but people will continue to innovate.

Griffin:  What are some trends you expect to see continue, or new ones you think might pop up, in 2023?  Changes in deal structure in the volatile market?

Sarah:  We’ve seen variable reserve accounts to compensate for variations in pricing and flexibility in other areas and structures to address volatility, and, again, increasing overcollateralization requirements to absorb expected losses.  There’s been a lot of stop and go in a lot of transactions just because of how volatile the market has been.

Griffin:  Thank you for your time, Sarah.  I’m glad to hear your panel at ABS East was a success and the industry is excited to continue evolving.

Sarah:  Thank you, Griffin.

Fixing the conduit is hardly a new idea.  We’ve surely tried.  Over the past decade, we have made some modest improvements to the servicing experience for the borrower, particularly in connection with the control of unanticipated and what, in the borrower’s view, would be unwarranted fees, but we’ve gotten little to show for it.

At the outset, let me acknowledge that I obviously don’t know if the conduit is dying or whether it’s just dormant, hibernating like a bear waiting for spring.  Is this a lacuna or an extinction event?  If you are convinced of the former, please skip the balance of this note and wait for spring and my next commentary.  For those who are worried, perhaps read on.

The problem seems to be simple enough.  It’s like we’re trying to sell a car with a governor on the engine that caps the speed at 40 mph.  It works.  It gets you from point A to B.  Solid, safe.  But if no one wants to buy it, we either have to make a new kind of car or get out of the car biz entirely.  That may be where we are today.  We keep telling the borrower to like our damn product, but seemingly they don’t.

The calculus of the average commercial real estate borrower hasn’t really changed in the years since the heyday of the conduit.  How much money do I get; and, how expensive is that money?

The somewhat dismissive joke was oft told while the business was thriving that all the stuff that borrowers disliked about conduits was worth 4 bps.

Demonstrably, that turns out not to be true.  It seems the transactional friction, inefficiencies and the simple functional failures of the conduit product are worth a great deal more than 4 bps.

Let’s begin by acknowledging that the problems of the conduit are not all self-inflicted.  First, since its day in the sun, many other sources of liquidity have entered the market.  There are lots of alternatives for borrowers.  Banks have lent more, lifecos have lent more, debt funds breed like tribbles , the GSEs are bigger, bolder and brassier, etc.  Some of these, perhaps many, are offering products which, if not precisely competitive with the conduit, are quite close.  During the years of the Great Moderation 2.0, we had super-benign interest rates and tons of liquidity.  In that environment, the value proposition of the ten-year fixed rate loan was seriously diminished.

But does that explain it all?  At some level, a ten-year fixed rate, non-recourse loan should be an extraordinarily attractive product for the commercial real estate space.  It particularly ought to be super attractive right now with short term rates on fire, but the data suggest that the conduit business is not reflating.

The problem may be that there are numerous structural flaws in our conduit product which have never been effectively addressed.

It can be boiled down to just two problems.  First, while the borrowers like ten-year money, they are not fond of the straightjacket of yield maintenance.  For many years, yield maintenance was simply economically unfeasible.  (In an every-cloud-has-a-silver-lining sort of thing, the current run up in treasuries has actually made defeasance less painful, but that’s a moment in time, one suspects.)

Second, borrowers hate the fact that their asset management judgments are second-guessed by a seeming army of bureaucratic naysayers.  They hate that it takes too long to get a decision.  They hate that it costs too much money to process cases and make formalistic arguments for things which appear blindingly obvious to the property owner.  They hate the fees they have to pay to get the servicer and directing certificateholder approvals.  Frankly, they hate the fact that they have to ask at all.  They see the servicing construct of the conduit loan as inconsistent with solid asset management.

No one has seriously suggested that a change to the lockout on ten-year money is a good idea.  It’s lucrative and baked into the cake of the calculus of servicers and investors.  The yield maintenance mechanic is, like the weather (but, according to the best among us, not this climate), to be tolerated not fixed.

On the other hand, our industry has tried to address the servicing limb of these problems for years without success.  We’ve always been aware that the current model is not terrific, but for many years the consensus was that as long as the borrowers just grumble but vote with their dollars by continuing to come to the window, there’s not a compelling reason to change, recognizing that all change would probably negatively impact the lender and investor value proposition.

Perhaps now fixing it is compelling.

Maybe, if all the constituencies in the conduit process stick to their discrete and unique pecuniary interests, stay in their lanes, stick to their conviction that the way the structure works is essentially God-given the borrowers will come back...but what if they don’t come back?

This is the age-old Tragedy of the Commons.  This observation about human nature originated with the British economist, William Forster Lloyd, in the early 19^th century.  The estimable Mr. Lloyd used as an exemplar of the problem, the structure of a medieval village, surrounded by common fields on which the folks were entitled to graze their cattle and sheep.  Everyone knew that overgrazing would endanger the viability of the village and, let’s face it, in that time and place, cause them all to die of starvation.  But individually, it was certainly advantageous to graze all your cattle and let some other poor bastard’s cattle starve.  Perfect solution, except it doesn’t work, if everyone had the same idea and pursued the instincts of their common reptilian brain, starvation and death would ensue.

Something like that may be going on here (okay, no one will actually starve).  Everyone knows there’s a problem, but like the boiling frog, no one is inclined to change position, to get out front, to take one for the team.

Let’s do a whip around the principal constituencies.

The investment banking community wants to sell bonds and hopes that everyone else would just get this right.  From the banker’s point of view, the easier a product is to sell, the better it is.  Doing anything that makes selling the bonds more difficult is not in their pecuniary best interests.  Not much help there.

The servicing community is in a pickle.  We don’t pay them very well, and we get what we pay for.  Putting aside for the moment the servicer’s driving need for additional fee income from the borrowers, which annoys the borrowers no end, the servicers are deeply concerned with liability, particularly when measured against the modest returns the servicing business delivers.  But that is problematic for borrowers looking for increasingly efficient asset management.  (Sidebar memo:  One of the false conceits about our conduit business is that while the CRE CLO leverages unstable assets that require active management and hence has enhanced focus on servicing flexibility, the conduit business finances stabilized commercial real estate where active management is less critical.  That’s sort of silly, isn’t it?  If you think about it, there’s no such thing as a commercial real estate asset that’s stable over a ten-year time horizon.)

Everyone in the servicing community is, with reason, afraid they’ll be sued by the borrowers; or they’ll be sued by the IG investors (even though they really can’t be) and the B-buyer.  They’ll be sued by somebody.  Remember, the standard of liability throughout the servicing structure is simple negligence.  In a country where everyone has a God-given right to sue everyone over every possible bad outcome (the servicing equivalent of pouring a hot McDonald’s coffee on your lap and blaming the franchise), those concerns about liability are real.

In our current servicing paradigm, it’s easier to get to “No” than to get to “Yes.”  It’s easier to demand more and more information before making a decision.  Numerous constituencies need to be consulted.  Numerous constituencies might need different data, data which is expensive and time consuming to develop.  The consequence is that we are stuck with a creaky system that absorbs a monstrous amount of time and energy as servicing decisions bounce from the borrower through the servicing structure, from master to special, from special to B-piece buyer and back again.

Moreover, the servicing standard is itself problematic.  As we all know, that standard is to protect the investors as a collective whole with a view to the timely recovery of all payments of principal and interest.  That standard elevates certainty of return over actions that might improve, on a long-term basis, the prospect of the mortgaged property.  Getting cash back is elevated over long-term value creation.  That means that a lot of decisions a competent asset manager of the underlying commercial real estate makes would be inconsistent with the servicing standard.  This tension has never been resolved.

In the CRE CLO space, which is purpose-built to leverage transitional assets, the tension between the servicing standard and good asset management became obvious and the consequence was that certain decisions have been removed from the servicing standard.  The so-called Administrative Modifications and Criteria-Based Modifications are made by the collateral manager without consent of the special servicer (and, of course, there is no B-buyer).  This is deemed to better align the securitization experience with the compelling needs of an asset manager who simply wants to create value.

This hasn’t migrated to the conduit business for a number of reasons. Conduit loans are allegedly stable, the tax regime is REMIC which limits flexibility and the B-buyers are independent players exposed to the risk of first loss exposure.  The B-buyer is paid to absorb first loss exposure on a pool of loans and so for very obvious reasons, is highly focused on whether the servicer is protecting the interest of the certificateholders as a collective whole of which they are part – and the first party to get obliterated when losses ensue.  Early dollars in are clearly better than dollars deferred.  This creates a bias in terms of the rapid realization at par of a pool of loans and does not encourage flexibility in performing asset management (where the annoyed borrower’s option might be prepayment).  This essentially substitutes the judgment of the B-buyer for the asset manager.  Entirely understandable, but also problematic.

IG investors?  Happy with the current structure and, as most are multi-strat investors, there’s not much incentive for them to get behind any actions to grow or indeed preserve this business... they will just take their custom elsewhere.

How about the role of the ratings agencies?  Let’s save a little bit of love for them.  For better or worse, the ratings agencies’ model rewards unwavering fealty to the existing model and its policies and procedures.  Variations are credit negative in almost all cases.  Not much incentive there to address changing the conduit paradigm.

So, largely we just wish this would all just go away and the borrowers would come back.  Servicers want to hold on to the meager compensation they receive without getting sued.  B-buyers want to run the deals and get to par ASAP.  Ratings agencies with their hardwired, fully baked-in models, have little incentive to change.  IG investors don’t really care for the business contracts.  Banks just wish it was easier to sell bonds.

Everyone’s individual pecuniary interest is tied, with considerable fidelity, to the existing conduit paradigm.  If everyone sticks to their principles and individualistic pecuniary interests, this product may indeed be ready for a nice glass case at the museum.

Okay, so there you go.  What could be done if the key constituencies could come together and think hard about building a structure ab initio — a conduit 2.0?

This may not be possible, or even advisable.  It’s indeed possible that the current structure of the conduit will come back into favor.  It’s indeed possible that in a period of significant escalating floating rate coupons, the borrower community will once again fall in love with the existing conduit model.  Maybe the past several years is just an aberration.  Maybe it’s simply a long, cycle where change in demand will be reversed and once again bring us a $100 billion plus conduit market.  Maybe.

But, it’s arguably worth a moment to at least wonder whether that’s true.

Here are some ideas.

We could change the standard of care in the servicing model.  We could specify that the amount of information provided under the applicable loan documentation is, except in extraordinary circumstances, sufficient for prudent decision making.  We could specify that the periods of time available under most loan documentation for making decisions about things like leasing, property releases, etc., are adequate for servicing decisions to be made and servicing decisions should be judged (and liability assessed) within the structure of the available information and timeframe.

Maybe the standard of care is gross negligence, not negligence.  (Who’s going to make a lot of money suing servicers anyway?)

Maybe we can import into the conduit things such as the Criteria-Based Modification and Administration Modifications found in current CRE CLOs.  Some of this is inconsistent with REMIC, although not all.  If these tenets are inconsistent with REMIC, maybe we should consider a non-REMIC shelf!  Maybe virtually all leasing decisions are within a very wide box would not subject to servicer or B-buyer consent.

Maybe it’s possible to bake into the servicing standard a notion that the duration of the receipt of interest from an underlying loan and not just the rapidity of recovery of principal is a valuable goal to be weighed in the servicing decision process.  One might argue that it is not always good to economically compel a borrower to seek an exit from the loan in order to do what it, as a competent asset manager, thinks it should do about the property.  Do investors always want their money back early?

Maybe we should think about paying servicers more and demanding a higher level of service and touch.  This could eliminate the need for servicers to chase borrowers for additional payments for off the run servicing decisions, reducing an area of tension with the product.

Let’s have a third rail moment.  Maybe we need to do something about yield maintenance.  Maybe we need to cap yield maintenance and hence defeasance costs at some sort of dollar amount with a stable relationship to the value of the underlying property.  Or, how about five years of full metal jacket yield maintenance and then a sliding scale for the final five years of a ten-year term?

Velocity is critical for the conduit market to thrive.  I know the markets are thinking about five-year product, but production volumes and hedging concerns have kept that idea on the sidelines.  Can we look into alternatives for the current dearth of effective hedging strategies?  Maybe an exchange, like the Merc, could be created where folks could bid on providing hedging for not only interest rate spread but economic spread in an active marketplace.  This could be built on a co-op model.

The rating agencies need to consider seriously new criteria for new models.  Everything discussed above is probably credit negative to the existing model, but to what extent?  This needs to be quantified before an alternate model could even be considered.

All changes to the existing model will make debt more expensive.  More flexibility to the borrowers, less certainty in the servicing function, more risk on the B-buyer, will all require risk to be repriced.  Maybe borrowers confronted with a more expensive ten-year fixed rate product will once again develop a yearning desire for conduit 1.0.  Maybe these 1.0 and 2.0 versions of the conduit are viable alternatives that can exist in parallel, like homo sapiens and Neanderthals for 100,000 years or so (didn’t work out for the latter, but oh well).

I’m not smart enough to capture all the things that might be considered to improve the current dismal straights of our conduit product nor courageous enough for everyone to get at it, but it does seem to me to be something worth thinking about.  And, as we think about it, remember the comments of the estimable Holmes who once said, “Once you eliminate the impossible, whatever remains, no matter how improbable, must be the truth.”  (And once again, for those of you who think this is a really bad idea, please pretend I didn’t write this.)

But from the trenches, where those abide whose opinions are backed by actual money at risk as opposed to bloviated hot air, there is a sense that the butcher’s bill is coming due.

We are in the riptide of a risk-off storm.  The Fed is fully engaged in its war with “transitory” inflation, with a “make my day” cavalier disdain for the country’s economic pain.  At inimically cross purposes, our executive branch continues to push easy money and liquidity.  Student loan forgiveness, the absurdly named Inflation Reduction Act, money for CHIPS, the last blast of Mr. Biden’s Build Back Better Plan and the leftovers from the Covid goody bag are adding liquidity into a market that has been bloated by liquidity for a decade.  Talk about a cage match between monetary and fiscal authorities (think Biden and Powell in those cute little WWE leotards...there’s a visual for you).

Fiscal excesses make monetary constraint more compelling and will keep the Fed on the barricades, increasing the already near certainty that the Fed will overshoot, deepening the looming recession.

Thinking about that all led me to noodle on (I knew the answer before I started) whether any elements of our government, executive or legislative, were doing anything remotely useful to ameliorate the coming financial distress.  Nope.  Regrettably, they’re acting to the contrary.  Our Congress and regulatory apparatchiki are intent on pushing a number of policy initiatives that are having the effect of suppressing capital formation, diminishing the ability of lenders to lend, and diminishing animal spirits, things required for a thriving marketplace.

I know, I know, after four years of our adventure in Trump-land and recognizing that elections matter, the fact that the current masters of the heights are intent upon righting perceived wrongs and rebalancing perceived imbalances, is entirely understandable.  Notwithstanding, when circumstances change (to channel our inner Winston Churchill), policy should adjust, shouldn’t it?   One might have hoped, that when a macroeconomic storm is upon us, the pace of regulatory change, best suited for a robust and growing economy, might have abated a bit.  Pursuing with fervor and purity, a commitment to Mr. Biden’s suite of campaign promises and Bernie and Elizabeth’s most ardently-held fever dreams in this time and place seems, at best, risky.

What mischief is afoot?  How much time do you have?  To keep this commentary to one slim volume, let’s just look at a sample of the mischief roaming around the regulatory landscape.  The banking regulators have now gifted us with CECL (Current Expected Credit Losses).  With CECL in place, all lenders will soon be required to add to loan loss reserves on a quarterly basis based upon complex, barely understood by most lenders, and controversial models.  (Beware of geeks bearing models?)  Will these models set loan losses right?  Almost assuredly not.

When CECL is imposed, at a time when the economy is contracting and liquidity is shaky, you know what’s going to happen, right?  It will be strongly procyclical.  Lenders are going to book more losses, adding to capital buffers and consequently reducing their ability and willingness to lend just when we actually need them to step up and provide liquidity.  Remember, this is on top of a multi-year wave of bank regulatorily imposed capital increases (FRTB, CCAR stress tests, other fun with Basel III, etc.).  All this was sold as being “countercyclical,” an ant versus grasshopper sort of thing.  While that might have been true when markets were on fire, given current market conditions, this larding of capital on capital will turn out to be badly procyclical.

There is more (of course...there’s more.)  Don’t forget the revised CRA requirements and the CFPB’s expanded Home Mortgage Disclosure Act (HMDA) reporting.  Each focused on fairness and equality (and there’s nothing wrong with that) but expensive.  The word is also out there that the eye of Sauron the Bank Examiner, being regularly flogged by our political elites, continues to focus substantial energy on a virtue campaign across the banking sector, chasing foot faults, reporting errors, policy and procedure failures and other alleged bad behavior far from the distant past and or far removed from the core business of lending.  A campaign is pursued with considerable fervor as evidenced by a week in and week out litany of fines and the imposition of ongoing new compliance obligations.  It can sometimes seem a bit asymmetrical, a bit retributive.

I hope that everyone gets it that increasing the price of a product means the cost of it will be concomitantly higher and the affordable supply goes down precipitously.

Our banking regulatory friends are not alone.  Add to this the SEC’s regulatory word salad of proposed rules imposing new duties, obligations and responsibilities on private funds and fund managers regarding disclosure of vehicle ownership, additional financial disclosure and a new and thoroughly unvetted cohort of disclosure around ESG.  As a considerable share of capital formation is occurring in the non-bank market, this matters a lot.

So, to recap, at a time when capital formation is already being suppressed by macroeconomic conditions, the regulatory estate is making it more expensive and riskier for lenders, both bank and non-bank, to do their basic job of lending.  More capital, more limitations on trading, more headcount devoted to reporting and compliance as opposed to lending.  More anxiety over complying with often inconsistent, contradictory and opaque rules.  More anxiety about striving, innovation, straying from the herd?  The psychological and emotional penumbra on the financial sector participants of all this is meaningful.  That will only exacerbate institutional instincts to be cautious, perhaps even a bit timid.  This penumbral impact itself will impair capital formation as a first derivative of the actual regulatory actions.

Cliffs Notes summary; this regulatory environment is inconsistent with our expectation that the financial sector can be relied upon as a critical engine of growth.

It’s all rather distressing, isn’t it?  But, playing the cards dealt is the only option.  Remember, a lack of revenue can be as highly correlated with severely diminished bonus pools (and indeed unemployment) as realized losses.  Distressed conditions will ease eventually and markets will repair, just not soon enough to allow us to hunker down and wait.

We need to find stuff to do.  So, here’s what I’m thinking about.

First, find borrowers willing to borrow at spreads consistent with the new price of risk and new cap rates.  Eventually, reconciliation will be attained and the entire market will reprice in terms of both the value of fixed assets and the price of debt and fresh capital, but, in most cases, not for a while.  If, however, this works well for you now, please feel free to ignore the rest of this note.  You’re good.

Be a buyer when scale and risk aversion bite.  The increased regulatory pressure on the banking and lending world is likely to cause disintermediation of commercial loans (mortgage loans and others) and indeed parts of loan platforms.  Loans will trade.  Pools of loans will trade.  While reconciliation will only slowly penetrate the borrower community, the financial marketplace will have gotten the joke.  To the extent business realities and regulatory burdens impact many shops, there will be willing sellers in the marketplace.

The coming distressed debt wave will turbocharge this trend.  Trepp, this past week, identified $52 billion in CRE loans maturing in the next 24 months with DSCR below 1.25.  This stuff won’t refinance without significant equity or sub debt.  The same will be true for all other asset categories.

For the non-bank market (where the regulatory future might  be considerably worse than the regulatory present), the increased cost of compliance with the panoply of new regulations will put a premium on scale.  Small platforms will simply be stressed.  They will be stressed by the enhanced regulatory disclosure burden that is in place and growing, they will be stressed by the withdrawal of liquidity from the warehouse marketplace, and they will be stressed by the diminished velocity of transactional activity writ large.

Buyers with free cash will occupy the catbird seat.  Creative destruction, baby!

Consider providing liquidity in the warehouse space as the regulated bulge bracket banking market retreats a bit.  Liquidity will be increasingly dear and warehouse lending at a significant premium to what the market has experienced recently might be the only game in town.  Some users of capital might literally tolerate negative arb on legacy portfolios in order to refresh capital.  Loan on loan is again becoming a thing.  Provide the leverage.  Wider spreads, higher fees, co-investment opportunities, kickers, etc. All will be on the table.

Be a buyer of high yield, first loss tranches of existing loans.  This is really straightforward.  Regrettably, however, using participation structures, which is  the only way to do this easily, has a limited appeal as, from a GAAP point of view, selling subordinate participations doesn’t really accomplish much for a GAAP-sensitive seller.  This is also a hard process to scale.  Restructuring loans with the borrower and slicing off a mezz or a B note will certainly work and might scratch what itches, but is mechanically rather burdensome.  There’s not a borrower on the planet that will not use that as an opportunity to extract a pound of flesh.

Consider the power of credit risk transfers.  Under federal banking law, credit risk transfer trades can be done if properly structured, can transmogrify commercial real estate exposure into securitization exposure with an 80-90% reduction of risk-based capital.  Go read Reg. Q.  It may also get a bank out of 100/300/600% hell.  For the regulated bank marketplace, this could be a powerful tool to help banks improve their regulatory posture through risk-based capital management.

Buy a platform.  There’s an awful lot of public companies in our space that will be trading below book and arguably trading well below reasonable asset valuations, and we’re also likely to see some small platforms be willing to sell as an alternative to closing the doors.  (Okay, the people walk out the door each night, but brand, counterparty relationships and existing liquidity might all make this interesting).  Going private, tenders and other organic M&A transactions at this time might be an enormously powerful tool for acquiring value.

Consider joint ventures.  As Ronald Reagan famously said, “Half a loaf is better than none.”  Spread the risk, improve the quality of management, use the balance sheet where others are struggling.  Joint ventures might be a powerful device for acquiring AUM.

Finally (finally?  I doubt that), where the government is socializing risk or subsidizing returns, go there.  ESG looks to be such a place.  Certain types of multi-family, workplace housing, tax credit plays and infrastructure all sort of leap to mind.

As we always say, there’s a pony in there somewhere.  If regular way, down the middle of the fairway, lending for fee income, lending for spread and lending for securitization profit is no longer working, other things will.  So put the thinking cap on, embrace the new reality, embrace the chaos and find the next deal.

It is now virtually certain that we will have a wave of distressed debt between now and the return of robust growth.  I know, I know.  I’ve written about the risk of leaning into a distressed debt wave before.  One raises money, beefs up workout and restructuring resources and then...waits.  And your delicious distressed debt wave fails to arrive and Godots you.  To slightly repurpose what some wag said (Lord Keynes perhaps?) markets can stay confounding longer than investors can stay patient.  But this time (Hah!) is different.  No, I’m serious.

The base case for the distressed opportunity I’m building here is coincident with the base macro case deemed most likely by the majority of the commentariat right now (even they can be right once in a while).  We’ll have slow or no growth for some period of time and probably a modest or shallow recession sometime soonish, if we’re not already in it.  Throughout, we will see stubborn inflation, which will not abate in any meaningful way.  The price of risk will stay elevated and debt coupons high.  I know there are voices in the market that the Fed is bluffing and the put is still in.  While I am on the record (in this commentary) that I suspect the Fed’s current inflation fighting ardor may abate temporarily with the election coming and a whiff of recession news in the air, post-election with persistent inflation being anything but transitory, the inflation fighters will re-emerge, and if we have not already begun to enjoy it, we’ll have ourselves a nice little recession.  Look, to be clear, a wave of distressed debt is not now dependent on future events.  This wave of distressed debt is now fully baked into the cake.  No probable or even wildly possible path forward for the economy over the next year or two, not a bit of growth, not a dodged recession, not a more rapid than expected decrease in inflation, will prevent it from occurring.

In these market conditions, there are and will continue to be increased premia for all species of risk.  Cap rates will go out, valuations on everything, and certainly commercial real estate, will come down.  Coupons remain elevated and more likely than not, continue to grind up for at least a while.  After a decade or more of stable cap rates and stable coupons at very low levels, it is an absolute certainty that many, many assets will be over levered and fundamentally not re-financeable.  This is true for commercial real estate and no less true for the leveraged loan marketplace (the land without covenants...boy, will that butcher’s bill come due now!).

In the real estate market, the MBA expects something north of $250 billion of commercial mortgage loans to require repayment or refinancing before the end of 2023, with another $250 billion in 2024, both because of hard maturities and extension criteria that can’t be met because of deteriorating financial conditions.  Moreover, the MBA data does not capture bank balance sheet lending which will certainly follow the same pattern.  Much of this will be a challenge to refinance.  Eventually, that will drive this market, but finding cooperative borrowers and getting these deals done will be a grind.  As this new market reality is likely to last for multiple quarters (not months) something’s gotta give, but reconciliation to this new normal will creep in on cat’s feet over many months.

LIBOR and now SOFR, which persistently stayed in the single digits for years, have now popped up to almost 250 bps and will certainly continue on this upward trend as Fed funds continue to go out.  The market is discounting a virtual certainty that will see at least 50 and perhaps 75 bps in September and the Open Market Committee minutes of the last meeting suggested (as opposed to the pacific tone of prior meetings) a tub-thumping Rambo-like commitment to do what it takes, for as long as it takes, to get interest rates back down somewhere close to the 2% Fed target, or at least to a level which is no longer obviously accommodative.

It’s not just the floating rate market.  Hardly shocking that.  The ten-year has stuck to a fairly narrow range but has once again crept back above 330 bps.  That’s not an exit ramp for commercial real estate confronting increasingly high coupons in the floating rate market.  The price of risk will be up across the board.

The consequence is that we’re going to see a lot of assets that will require significant new equity or material sub debt to refinance.

Will the equity be there?  While there’s plenty of equity sloshing around the system looking for a place to play, I don’t see that money pouring into commercial real estate without demanding a significant premia for risk that will make it non-accretive to the “old” equity and with a demand for a level of control unamiable to the current ownership.  Sagging valuations, an imminent recession, dodgy prospects at best for the next couple of years, and elevated coupons on all species of debt means that while investors might be there, they are going to extract a significant pound of flesh.

Sub debt will be the way forward for most deals.  Expensive for sure and risky for legacy equity, but what can one do?  Rescue equity will be even more expensive.  As more and more loans reach maturity or fail extension conditions, the demand for this money will be enormous.  The demand for anything that will fill the daunting gap in the capital stack that is accretive to the equity (or accretive to the equity in the wild imagining of a largely fabulist property ownership class) will mean a preference for sub debt over dilution by new equity.

There are two ways to play this environment for those with dry powder and...let’s call it, conviction.  One could simply go to the ownership class and offer to step into the breach and fund the cap stack gap.  But, how to get to these point-of-sale opportunities is the question.  One must find and identify distressed borrowers, but also find borrowers who are ready to confront the new realities and be agreeable to deal honestly with the world of lower valuations, smaller first mortgage loans and more expensive sub debt.  Right now, we’re not there as many levered property owners are pursuing a strategy (that’s a strategy?) of kicking the can down the road.  Look, one can make fun of can-kicking, but it has worked where credit interregnum is brief.  That’s not this time.  The road will end soon, albeit not today.  Capitulation is going to happen, but could be a slow burn.  Those who remember the Great Recession remember the interregnum after the recession’s bottom before transactional activity really picked up.  Even the proverbial chicken with its head cut off struts around the barnyard for a bit.  So, for anyone looking to put money to work soon, trawling the country club bars looking for a willing property-owning counterparty might be frustrating.

The other way to play this market is to view the lending community as the customer base.  Buy loans from portfolio lenders who want to shed risk or are not equipped to play in the cage-fighting matches of workout, foreclosure and bankruptcy.  Lenders, not typically infected with the fabulist mindset of the borrower community, already clearly see lower valuations, higher prices for risk and recognize these are not ephemeral conditions.  The lending community already can foresee the wave of maturities and frustrated extensions and bridges that are beginning to look more like piers than bridges.

Two very important things are happening now which may potentially transmogrify portfolio lenders into willing sellers.  First, the non-bank portfolio lender’s business model is based upon reasonably priced liquidity and easy access to that liquidity.  Liquidity has been relatively easy to acquire and relatively cheap for the past decade.  We are now seeing a broad withdrawal of liquidity from the marketplace.  While the liquidity is still there, it’s offered at considerably higher interest rates.  Warehouse lenders have turned cautious (there’s some word on the Street that the regulators have put something of a spike in the warehouse lending wheel).  Certainly, some new warehouses will be offered and some existing warehouses will be extended and renewed (but at much higher spreads).  Days of easy and cheap leverage for the portfolio market are over will not return for quite a while (and it may get considerably worse as QT expands, as some commentators have suggested that overenthusiastic QT will supercharge the arrival of the liquidity desert). And not to beat the obvious to death here, the CRE CLO market is still largely closed and unlikely to return to robust growth in the next few months.

As portfolio lenders are confronting their Scylla and Charybdis of the need to lend, with a balance sheet depending on leverage and a compelling need to refresh their capital, more and more will become motivated sellers.

The other thing, thank you, Gnomes of Basel, is the broad adoption of the Current Expected Credit Loss (CECL) accounting protocols that all banks and largely all other GAAP-reporting lenders must fully adopt by 2023 (many of the larger banks have already adopted).  CECL was designed by said Gnomes to prevent banks (and other lenders) from “hiding” losses when confronting early signs of enhanced credit risks or deteriorating market conditions.

Under the older loss recognition model, losses were only booked when the losses “were incurred.”  Basel, FASB and the regulators, concluded that the old model could transform balance sheets into Potemkin Villages as clearly foreseeable losses were not reflected in the balance sheet until losses actually occurred, at which point it is arguably too late and often happen at the very worst point in the business cycle.  In an ebullient market where borrowing costs are going down and valuations are going up and everyone is having a great deal of fun, CECL was just a Debbie Downer.  What?  I’ve got to book a loss when I make a loan?  That’s insane.  However, in the market we’re confronting now with falling valuations, CECL is likely do what the regulators expected it to do; cause the banks to take significant reserves against their positions far earlier than was true at the outset of the Great Recession.

For those who remember, during the Great Recession, many institutions understood that selling assets was simply a bad idea because it would then cause the institution to mark the rest of the portfolio as actual realized losses (that couldn’t be ignored) taking losses in a discontinuous way and causing enormous volatility in balance sheets.  Now with CECL in place, many of these losses may have already been booked month to month and quarter to quarter.  This should cause the banking and portfolio lending part of the marketplace to be more willing to lighten the load, particularly given ongoing regulatory heat on excess concentrations in certain asset classes, notably commercial real estate.

Going back to where we started, though, building up material piles of dry powder in expectation of a distressed debt cycle is hard and takes an inordinately long amount of time.  Raising a distressed debt fund now might not see a first closing until far into next year, resulting in managers watching the opportunity come and go before they are ready to deploy significant capital.

Consequently, what the distressed market needs to be nimble and get in when the getting is good, is leverage.  To stretch what dollars are available and join the battle early.  Obviously, traditional warehouses won’t be a likely source of this; most of the traditional warehouse lenders don’t like performing loans all that much, let alone non-performing loans.

What one needs to do is to build out a distressed debt securitization platform (or otherwise find leverage).  Securitization structures became briefly popular in the years following the Great Recession before the markets returned to ruddy health, but worked reasonably well.  In these transactions, underlying loans and REO assets were individually analyzed in order to assess how much cash could be harvested from aggressively managing these assets and how much time would be consumed until such assets were reduced to cash.  A proceeds pipeline and consequently a waterfall was built on that basis.  Some senior investment grade classes were possible, with the rest of the structure PIK-ing and with the manager, of course, holding first loss position.  We have this technology and it needs to be dusted off and conversations begun with both investors and ratings agencies.

Distressed debt securitizations can be broadly syndicated or done privately.  Perhaps structuring these transactions privately is the easiest path forward.  On a private basis, investment grade securities can be bespoken for IG investors with the stomach for the distressed debt game and sponsors can hold the entrepreneurial risk of last dollar and the real benefits of collecting more and faster.  If memory serves during the last period when these deals were modestly common, transactions outperformed and sponsors did extraordinarily well.

So, there we are, on the cusp of a significant...“opportunity” (for some, disaster for others)  It’s time to get ready.  It’s time to find some investors willing to step up.  It’s time to find leverage, dust off old technology, start to building relationships in the market.

This is not going to be a great deal of fun and, if I remember correctly, there are no closing dinners in a distressed debt cycle.  But valuations are going down.  The price of risk is going up.  The liquidity desert is real.  Distressed debt will proliferate and need good, new homes.

It’s only charitable to provide them, isn’t it?  Let’s have at it.

A few weeks back, I was talking about the superfluity of bad economic news, and I was suggesting that the debt capital markets were now waiting for capitulation from the borrower community in a market that is no longer as fun as it was before.

Big Picture, where are we?  Some (many?) say that we are on the cusp of a deep, almost GFC-type of recession from which it will take years to grow out of.  Others are backing the short and sweet version.  Others say we are looking at a market that has now absorbed and discounted all the bad news and is poised to continue to grow, perhaps more slowly, but grow.  All (most all) used as a predicate for these views, the notion that the current inflationary spike will be tamed by the Fed in the short to medium run causing some level of diminished economic vibrancy.  What matters, of course, is what you mean by “some.”

I don’t want to bury the lede here.  Generally, while it surely is a time to test presuppositions, revisit verities and watch for the proverbial canary, the watchword for the moment is:  Stay Calm and Carry On.

The problem with getting any conviction around where the economy is going is that the data doesn’t reveal an obvious pattern.  Crosscurrents abound.  Who’s ever heard, or even modeled, a full employment recession?

We really need the Albert Einstein of economics to deliver the unified field theory of economics and give us THE ANSWER (for Sci-Fi wonks, where is Hari Seldon?).  Absent such a Hail Mary, collecting the views of smart people about what they think is likely to happen seems like a pretty good idea.  I’ve spoken to people with balance sheets, people who lend, people who borrow, advisors, and yes, I’ve even spoken to economists.  Notwithstanding the well-earned derision heaped upon economists because of the congruity of their profession with both astrologists and alchemists, they’re some pretty smart people.  (While gently disparaging the profession, let me take a moment here for a callout to Jamie Woodwell of the MBA, because conversations with him are always useful.  I recommend his Trepp Talk “3 Pillars of Commercial Real Estate in Transition” for a balanced view of what the commercial real estate market is up to at the moment.)

To rationally embrace a view that my hair is not on fire, I surely must take a hard look at the bad news which abounds, take it on board, discount it and move on.  So, let me try.

The bad news:

• Inflation is not transitory. While officialdom continues to maintain that it will come down rapidly during the course of the year, does anyone really have conviction here?  Short term interest rates are up materially.  After the Fed’s action this week, the yield curve is seriously inverted (a circumstance which has predicted 11 out of the last 7 recessions).
• While consumer balance sheets are stronger than they were at the time of the Great Recession, they are weakening and credit debt is skyrocketing. As the consumer is 70% of the economy, that’s meaningful.
• Transactional activity is, duh, slowing. That’s what happens when market participants are confronted by discontinuous, rapid increases in cap rates, increasing coupons, a withdrawal of (cheap) liquidity and little conviction around underwriting and credit.  There remains a pouty nostalgia for the old days (e.g., a couple months ago when coupons were low, valuations were high and liquidity was plentiful), which adds a psychological impediment to getting on with things.  The ubiquity of a general risk-off psychology seriously and negatively impacts markets.
• There’s still a wounded supply chain out there. A considerable amount of that supply chain originates in economies that are themselves wounded or broken and/or controlled by regimes more than a tad hostile to US interests.
• Equity markets remain volatile. Right now, we’re seeing markets move higher.  Is this a little bull in a bear market, or the start of real, new bull market?  In the latter case, why, for heaven’s sake?
• With the GDP Q2 print, we now have two quarters of reduced economic activity. Notwithstanding what some have said about the technical definition of recession, large segments of the market will (reasonably) take a view that we are in one now.
• The Rest of the World is a Mess, Part I. China is fessing up to a 0.4% growth rate in Q2, but does anyone take that at face value?  Wanna bridge?  It’s surely worse.  The US is exporting inflation around the world, creating chaos in dollar denominated assets, particularly amongst the emerging markets.  Not good for the supply chain issue.  Not good for our economic growth.
• The World is a Mess, Part II. The European Central Bank has now finally begun to raise rates because they feel they have to, but are clearly deeply conflicted about recession risks.  Notwithstanding all the happy talk about the new Transmission Protection Instrument (what a beautiful euphemism for a bailout...almost as good as the “Inflation Reduction Act of 2022”) the northern Europeans are not going to go all that terribly far in mutualizing debt.  The Italians are going to have an election and there is a real risk a new government will be extremely hostile to Brussels.  The English don’t know who’s in charge.  The French know that Macron says he’s in charge, but it’s not entirely clear.  Schultz in Germany seems clueless, and the war continues.  You can tell the Euro project is in trouble because of the volume of assurances that is not.
• The World is a Mess, Part III. Don’t forget all those muscular dictators, chubby dictators, dictators who absolutely don’t look like Winnie the Pooh (with greatest sincerity here), and dictators who think they have a hot line to God, all with some sort of an inferiority complex, a chip on their shoulder and all with, or about to get, nuclear weapons.
• The World is a Mess, Part IV. Taiwan and Ukraine.  Geopolitically, the world looks pretty fragile.  As much as some folks might regret it, the world economy is highly interdependent and a sickly and fraught world is bad for a healthy US economy.
• Notwithstanding the fragile US economy, business is continuing to confront a, shall we say, muscular regulatory posture which seems less focused on fixing the economic problems of the here and now and more about by a set of “Big Ideas.” Are Big Ideas a luxury when economic performance degrades?
• The folks are very negative about the economy. I saw someone’s stats the other day that said 90% of Americans think we’re on the wrong track.  I don’t think I’ve ever seen that level of pessimism.  Up on the heights, there’s a sort of similar psychology; no one seems to think things are going to get better fast, even those who are very committed to pretending it will.  Psychology is important.  We can and have talked ourselves into recessions in the past.
• US politics remains fraught, and that’s being charitable. The country is pretty much split in two and has become increasingly tribal — tribes that can’t agree on anything and heartily loathe each other.  Gridlock might be periodically tolerable, but this status is not.  If the Republicans take the House (their grasp of the Senate seems increasingly enervated), don’t expect a boost for business issues, it probably won’t happen.  I suspect the Republicans will be more focused on retribution than good policy.  Good God, we’re actually discussing “the survival of our democracy.”  The two sides mean that in wildly different ways.
• The Fed’s toolbox on fighting recession is pretty damn empty. With a $9 trillion balance sheet and interest rates still low by historical standards, what’s in the tank to facilitate growing out of a recession if it happens?  Not much.  On the other side of the coin, the Fed certainly has tools to fight inflation, but they tend to be blunt instruments.  Do we really need a lot of demand suppression right now?  A betting man would say that whatever the Fed does, it will overshoot in whichever direction it goes.

If the news were unremittingly bad, while that might be awful, it would make planning easy.  Grab the go-bag and jump into a hole.  But it’s not all bad.  There are many important countervailing data points to be considered.

Employment has stayed strong and continues to grow (albeit there are some troubling data sets inside the marquee numbers).  As I’m writing this, we just got a good month-over-month inflation print, and while a month does not make a trend, an optimist might say that inflation has peaked.  July was the best month for the Big Board and the other indices since some time in 2020 and it would seem that after a thoroughly unamiable first half of the year, markets are considerably more constructive.  Also, the current earning season is not that awful.  Some on the Street say we are making a bottom...bring out the bulls!  Commodity prices are easing, the bond market is predicting Fed funds cut by the middle of next year.  Balance Sheets of both the consumer and business remain relatively strong and vastly stronger than they were at the beginning of the GFC and that gives everyone some extra gas in the tank to weather economic distress.  Consumers are spending to beat the band.  Apparently, we don’t feel as bad as we think we do.  Senator Manchin and Senator Schumer have engineered another whopping infusion of governmental spending into the economy.  The ludicrously named Inflation Reduction Act, and the lollapalooza of the so-called CHIPS Act, are likely to be positive for GDP growth at least in the short run (an impressive act of inflative sneakiness which really pantsed the Republicans).

In our little CRE corner of the world, revenue is holding up pretty well in the major food groups.  Retail continues to confound its obit notices, industrial remains strong.  The multi and SFR sectors are on fire (but I hear that rent growth in the multifamily space is beginning to slow), even though there is a lot of supply coming online (maybe bad news in the resi mortgage market is good news for the multi and SFR space...who knows?).  Office, what to do about office?  Current period revenue continues to hold up as the office sector is characterized by longer term leases, but it does have more than a passing resemblance to the famous chicken with its head cut off strutting around the barnyard before it flops over dead.  But, hey, for the moment, as long as you keep your eyes on the road right in front of the car, it doesn’t look so bad.

So, there are cross currents in the data.  I really struggle to connect the dots, to make sense of this, to find a pattern (cue our dismal science Einstein).  But again, one has got to have a view.

The majoritarian opinion is that while things have slowed and perhaps will continue to slow, this is not a cliff edge moment, more of a pause.  Market participants will reconcile themselves and become inured to the increased price of risk, reduced valuations and reduced and more expensive leverage.  Capitulations on both the buy and sell side of money will usher in a new moderation.  From a remove, this all might just seem to be a flickering moment in a volatile movie, but in this moment, the illusion of stability will give rise to renewed market vitality.

That all seems right to me.  It seems to me in this case the wisdom of the crowds is spot on.

So, for the moment, KEEP CALM AND CARRY ON.

All good then?  Not so fast!  Look down the road, beyond the next couple of quarters, and there’s something at the edge of our vision that continues to look a bit alarming.  Here’s the alarming case:  After a little bit of good inflation news, but with continued signs of trouble in the broader economy (the most recent job print, might begin to look like a false dawn) and with an election looming, the Fed will lose its political will to fight inflation aggressively.  (Chairman Powell’s recent comments suggested a certain dovish predilection, didn’t they?)  Before the year is out, we may have a meeting or two without any increases in the Fed fund rate and we’ll feel like we dodged the recessionary bullet.  But it’s unlikely that the economy will grow strongly, just too many headwinds.  Economic conditions simply won’t be good enough.  “More please,” will be shouted by the multitudes.

Our political class, including the Fed, may have precious few commonalities, but all possess a reptilian brain focused on political survival.  This will translate into keeping the candy bowl on the table far too long, satiating the multitudes’ demands for more growth, more jobs, higher salaries, more free stuff.  The pressure on the Fed and the rest of the political class to do something, to turbo charge growth, will be compelling.

Inflation will not have gone away.  It might moderate a point or two as the economy continues to slow in the next quarter or two, but it will remain far removed from the Fed’s long-term 2% target and the Fed will lose its passion for controlling inflation as the candy bowl gang continues to lean in, inflation simply won’t come under control and the government elites, writ large, taking their eye off the ball will focus more on rapid growth than stable prices.

But, in that scenario inflation will eventually become a crisis, a potentially fatal disease of the body politic and not just an ongoing annoying condition to be managed and the butcher’s bill will come due.  In a 1982 redux sort of way, some adults in some room (the room where it happens?) will finally do what is necessary.  The recession we then get (and deserve) will be far worse than the one we are obsessing over right now.

But hey, that’s late 2023 or 2024.  It’s probably after the next presidential election.  In the meantime, things might not be terrible.  We can, for a bit, largely keep the party going.

So, in the moment, it’s not time to hunker down.  It’s not time to shed staff or resources.  It’s not time to turn off the capital spigots and withdraw capital from the market.  Not time to choke off liquidity.  We have some runway ahead of us still.  The world might be ending, but not today.  There will be plenty of time to panic later.

It’s capitulation.

About time, wasn’t it?  We met against the backdrop of pretty startlingly negative macro conditions.  A knife-falling equity market, rocketing interest rates, nosebleed inflation, 75 bps as the Fed’s new black, the war, CEO and consumer confidence tumbling, slower growth, marquee production indexes sneaking down on 50, recession talk abounding, ugly politics, tightening credit conditions, $9 trillion Fed balance sheet to unwind and a government apparently not willing to believe its own lying eyes on the depth and scale of the financial distress confronting us right now.

Oh yeah, there were reasons to be a tad despondent, but coming into the meeting there had been hope, hadn’t there?  One of the key reasons we all showed up was our compelling need to retest any possibility of optimism.  Was there a basis, in the face of objective reality, to still think things might get better in the short run?

Our industry hardly needs an excuse to get together.  We are very social and any opportunity to gather, talk, drink, backslap and belly rub is always welcome and these meetings delivered good fun.   But this time there was a special frisson; a need to find some reason to say it’s not as bad as we think it is.

It had been possible during the mid-spring to think that spreads that had blown out could come back in, right?  (Sidebar:  Jim VandeHei told me recently that no one reads anything beyond 200 words.  You’re there – fair warning.)  It was possible to believe that liquidity that was becoming dear would rebound and all return to those happy days of risk on.  Frankly, early days this spring, I’d rather expected that.  So, we had some inflation, a war, supply chain disruption, but it was a bang up first quarter and hey, the Modern Monetary Theory gang was telling us, “No worries, mate.  None of this really matters.”  Maybe they were right?  (Spoiler alert – they were not.  One of the dumbest theories not published by the Mysterious Q.)

But it hasn’t gotten better, has it?  And so, we met in New York.  The meeting was a coda, in a way, an exclamation point on the increasingly obvious and unavoidable denouement: we’re not going back to the amiable credit conditions of 2020, 2021 and early 2022 any time soon.

Spreads are now substantially wider than they were during all that period.  The forward curve has left the building.  Floating indexes are following Fed funds and all going up with startling speed.  The last I looked term SOFR was roughly 150 bps and the ten year was enjoying a short break from volatility at around 3.2%.  All inconceivable (or at least not conceived) as 2021 came to a halt.

No one can now think we are returning to the Great Moderation any time soon.  Sure, all changes to credit conditions are cyclical, but as we’ve often observed here, while you’re enjoying the ride, there’s not much difference between a long cycle and a secular change.  Nothing’s forever, but we’re clearly looking at tighter credit conditions, lower asset values, a likely reduction in liquidity and higher spreads for a considerable period of time.

It seems to me that that the debt capital markets have probably had the scales removed from their eyes before other parts of the CRE space.  I followed CREFC up with a meeting of the Real Estate Roundtable where there was considerably less despondency.  On the equity side of the house and from the bank and lifeco seats, the roiling discontinuous change in the debt capital markets is not so immediate.  There, the focus is on real estate fundamentals and indeed, there is a sense that revenue across much of the CRE space can remain strong in the short to medium term, preserving valuations, assuming of course cap rates remain stable and lending conditions remain constructive.  That is a hole in the bottom of that theoretical construct to be sure.

As we know, water finds its own level and these disparate views of fundamental macroeconomic conditions will have to reconcile.  My bet is that all parts of the CRE market will approach their capitulation moment sometime over the next several months.  The capital markets reality is the underlying reality and in some version of Gresham’s Law, capital markets’ valuations, capital markets cap rates and capital markets views about credit, risk and liquidity will ultimately drive out different or disparate views.

So, what does capitulation mean?

• Spreads will continue to rise on fixed and floating rate loans and proceeds will go down. Notwithstanding the relative readiness of lenders far removed from the capital markets to react to changing credit conditions, and the general grumpiness of borrowers who have happily fed on low coupons for many, many years, loan pricing will materially increase.
• Transaction velocity will materially contract because those who don’t need to transact in the short run, won’t.
• Warehouse money will become increasingly constrained and increasingly expensive.
• Cap rates in the commercial real estate market will go out and the views of cap rates from the equity and debt sides of the world will reconcile toward the more negative views of the debt capital markets resulting in significant pressure on valuations.
• Consequently, property values will also drop as cap rates go out and leverage gets dear.
• In general, the price of risk will go up and credit conditions will tighten. As the risk-free cost of money increases, the premiums for real risk will move up apace.
• Underwriting will undoubtedly tighten. Why?  I don’t know, it’s just something we do when credit gets dear.
• More folks will embrace the reality of the upcoming hard landing and recession. Conviction will become a reality and that psychology will turbo all the trends identified above.  A sort of a doom cycle.  Professional economists and astrologists who are taught to tell us what or when, but never what and when, perhaps is for the best.  To simply linger in stagflation for years, watching the economic activity slowly recede before finally hitting bottom, might cause the pain and damage from all this might to be worse.  So, perhaps a nice, quick sharp recession allowing the Fed thereupon to begin to reflate and stimulate the economy and take us back to the broad, sunlit uplands of financial success (thank you, Mr. Churchill) might be the best thing.
• Pirates will be out looking for bargains and cash and liquidity will be king.
• Mezzanine debt and preferred equity opportunities will abound.
• Velocity in the trading of troubled assets and any assets from troubled platforms will increase.

In the meantime, transactional activity is not going to zero.  As we reconcile ourselves to the enhanced cost of money and the price of risk, transactions will get done.  In some cases, the underlying opportunities will more than compensate participants for the increased cost of the leverage.  While it might be sad to fondly remember 9 bps LIBOR and 50 bps to 75 bps, 10-year Treasury money, if a trade works, it works.

Some will simply have to transact.  We’ve become extremely dependent upon leverage over the past decade and we’re not going cold turkey.  Leverage might not be as amiable as it was, but broad sectors of our marketplace, and particularly the non-bank sector, continue to need leverage.  As warehouse money may not prove to be a stable solution, we will see a reboot of the CRE CLO market.  No one (lawyers aside) may be happy about this, but capital needs to be recycled.

Fewer properties will trade as parties who have no compelling need to transact will not, but that hardly means that transactional activity will approach zero.  There are a lot of compelling reasons to transact even in an expensive leverage environment and those transactions will still get done.

Innovation will grow in popularity.  In good times, innovation is a hard sell.  Just rinse and repeat.  Good ideas may be interesting, but meh, not really necessary.  That changes when credit tightens and regular way is no way.  Thinking outside the box (ok, I’m talking my book here) will be more valuable and valued.  Stand by for new financial products, processes and strategies.

Somewhere in the middle of all this, we will have a distressed debt cycle.  Moderate coupon creep is not something that typically leads to a distressed debt cycle (boiling frog) but rapid, discontinuous increases?  Sure.  Refinance will get difficult and expensive, and if the health of the consumer is actually impacted by a serious recession, the health of the multi-family market, office, hospitality at least will be materially impaired.  Oh sure, balance sheets are healthier than at the time of the GFC, more institutional money is in commercial real estate and LTVs and DSCRs and debt yield going into this period of stress are relatively healthy, but they’ll still be stress and distressed.

So, the faster we embrace the new reality, the faster we can get back to business.  In the meantime, this does present opportunities to look for upsides.  There are ponies in there somewhere and innovation and dry powder can get you to yes.

As Dr. Venkman said in that foundational bit of American culture, Ghostbusters, “I love this plan!”

I learned that these pegged currencies are used in the crypto-verse as an easy way to trade in and out of Bitcoin and other cryptocurrencies which are repositories of value without having to actually acquire and deliver pesky actual governmental currencies.

Cryptocurrencies (with an exception of those backed dollar for dollar by liquid, conventional financial assets) are fiat currencies that have been subject to extraordinary volatility in terms of value over the past decade.  Now, of course, government currencies since the elimination of the gold standard early in the 20^th century have indeed also been fiat currencies as well, albeit fiat currencies backed by folks with armies, police and taxation powers.  That makes a difference.

If you are a crypto aficionado my apologies for perhaps a simplistic and unsophisticated summary of the value proposition, but my purpose here is not to validate or demonize cryptocurrencies but just to make an observation about contagion.  When I started reading stories about Terra these past weeks, I had a recovered memory event from 2008 (blessedly buried in the intervening years).  And it wasn’t good.  I clearly remember in the early stages of the Great Recession reading about the meltdown in the residential subprime lending market and its knock-on effects on resi conduit securitizations, CDOs and SIVs.  I distinctly remember assuring my colleagues that while this mess in the subprime market was indeed horrible and causing enormous losses, it had nothing to do with our safe and sound commercial real estate finance market.  Thank God that we missed that train wreck.  Ha!

Of course, we didn’t miss the train wreck.  Like an old Laurel and Hardy movie, the proverbial piano had been shoved out the window, but had not yet hit us on the heads.  When the emperor’s new clothes were stripped away and billions of dollars of securities were clearly no longer (and probably never had been) par assets and liquidity was entirely washed out of the system, one market segment after another experienced cascading failure.  In an environment whose common currency was leverage, we all learned that leverage can be a harsh mistress when the herd needs to exit the building.

Contagion is reality.

The detritus of the Great Recession consigned many great names to the dustbin of history and significantly impaired the financial health of banks, great and small, and other financial institutions for over a decade.  The consequence of the riptide which began in the subprime lending world scarred our financial markets for years.

I really don’t want to do that again.

I’m not here to say that what just happened in the crypto space is Lehman redux but there is an echo of past pain here, isn’t there?  Crypto-related losses have already exceeded $1 trillion.  Worldwide regulators are reportedly worried that they don’t know where these losses lie and they worry about the amount of leverage provided on these positions through the banking system.  Even if all is just fine, it’s a reasonable thing for regulators to worry about.  The losses to date are certainly not nothing.

As I started thinking about contagion, crypto is where my thought processes began, but it’s not where it ends.  Give a thought to the entire derivatives market.  It never fails to startle me when I think of it, and I don’t often, but in our complex financial markets today where financial engineering is commonplace, billions of dollars of risk can be bought and sold on tiny cash positions serving as reference securities which perhaps neither party to the trade actually owns (and probably doesn’t).  In this synthetic market, the ability to take a position on an asset neither you nor your counterparty owns, is a massive force multiplier.

It’s been common for years to muse about the large and opaque synthetics market and the ebbs and flows of risk through credit default swaps, total return swaps and other arcane and generally bespoke synthetic arrangements between and amongst financial institutions and other users of capital.  Don’t you sometimes wonder whether there’s an institution out there that through a long and elaborate chain of bilateral arrangements has ended up with trillions of dollars of unhedged risks on its balance sheet?  More seriously, we know, or suspect, that there are plenty of enterprises, funds, operating businesses and perhaps even governments that hold derivatives positions which, under certain circumstances, generally deemed to be remote, could result in devastating losses.  What confluence of disparate (remote?) circumstances could cause that to happen?  It’s an unknown, but remote has happened before.  And we know that losses cascade across counterparties and can grow as they cascade.  What happens if that’s the case and what happens when the butcher’s bill comes due?

So, as I said I’m neither here to bury or praise cryptocurrencies (nor swaps) but simply use them as a place to start a conversation around contagion.  Virtually all massive financial disruptions are accelerated or turbo-charged by contagion.  Generally, the match that lit the conflagration, something that no one or very few expected to incandesce before it happened.  As the late and unlamented Donald Rumsfeld said “It’s the unknown unknowns, baby!” (or something like that).  Remote is not never.

Also, the thing which lights the spark does not have to be momentous.  Chaos theory gave us the butterfly effect.  Flapping wings in Hong Kong caused the nor’easters in New York.  A small-scale event can trigger another and another and another, until a cascade of events actually becomes material.  A well-known mathematician once said (I actually don’t know any mathematicians which might say something about my lack of numeracy) according to Mr. Google, small changes in one state in a deterministic non-linear system can result in large differences in a later state.  How’s that for burying the lede?

The modern world and its financial structure are the very model of a major non-linear system whose interconnectivities are both obvious and hopelessly beyond the ability of people to understand and unwind.  This gives reality to the notion that remote happens more often than we like.

Now as I’ve said, I’m not here to suggest that crypto’s meltdown is such an event although a trillion-dollar loss in the past six weeks is not nothing.  A big friggin’ butterfly, right?  It could be.

My broad point here is that it’s a great time for a serious heads up on the possibility of unanticipated risk and contagion.  We are now entering an environment where not everything works and not everyone’s a genius and not every risk is worth running.  It’s hard to really think about and take concrete steps to adjust to a very much enhanced and altered risk profile in our marketplace after 10+ years of quietude.  But if nothing else, the meltdown in the stock market, the uncertainty in the bond market and raging inflation are tells that not all is right.  Could this uncertainty be nudged into fear and flight by a meltdown in crypto or in some obscure corner of the financial market as the knock-on effects begin to spread through the economy like concentric circles progressing from the stone dropped into a pond?  Yeah.

Look, it doesn’t strike me as a time to grab the go bag, canned food, guns and find a hole, but it strikes me that we’re closer to a point where the systemic risk rambling around our financial markets could actually light the fire.  Things have been lovely for the last decade.  It’s time to get a little George Santayana and embrace his prescription that those who cannot remember the past are condemned to repeat it.  2008 was not that long ago.

Oh well, sorry for the gloomy take on the state of the world.  Maybe it’s something I ate, but being reminded that there really are unknown unknowns out there that can destabilize the complex financial systems on which our business life depends is not comforting.

Enjoy the rest of the week.  The center will probably hold until Monday.

We hit $45 billion in CRE CLO production in 2021 and the market for secondary trading in CRE CLO securities is maturing.  2022 has been a challenge.  Absent inflation that was supposed to be transitory, an uncertain and conflicted Fed and that pesky little war in Europe, we surely would have been on pace to exceed that level in 2022.  Now we have to reset expectations for 2022, as we’ve lost the better part of 2 months of issuance.  Everyone “took a break.”  The path ahead had become uncertain and no one wanted to look stupid, right?  But, as I pen this, it seems like we’re starting to turn a corner (hopefully we’re not on a circular track) and we should see the market begin to reliquefy.  It may not be great year, but it should put in a bottom for 2023.

Why do I think we’re about to turn the corner?  In the first instance, and perhaps most importantly, we have become inured to the multiplicity of early spring crises that bedeviled our market.  As always happens, yesterday’s crisis metamorphizes into today’s new normal.  The US real economy seems to have broadly shrugged it off (a certain nauseating volatility in the equity markets aside).  As I write this, last week’s Jobs Report showed strong growth in employment and wages.  GDP growth was slightly negative in Q1, but the Fed sees positive growth for the rest of the year and that seems right.  The data keeps coming in to the positive side.  Unless something new goes wrong, a not completely implausible thing, we should be back to playing the cards we got dealt.  It doesn’t matter how startling a crisis, the passage of time always brings ennui.  I’m good with ennui right now.

Also driving the market back into a semblance of health, non-bank lenders simply need access to the capital markets.  Perhaps in the days before the modern CRE CLO when cell phones were still made of wood, non-bank lenders managed their balance sheet in other ways.  However, once the CRE CLO drug was broadly available, non-banks simply can’t do without it.  Earlier this spring every non-bank lender in the space toddled off to its warehouse lenders with an ingratiating mien to tell them what terrific business partners they were and couldn’t I have a bit more, please?  While that strategy has worked to a certain extent, it’s soon to have run its course.  Warehouse lenders are full and getting fuller.  They do not represent an endlessly deep well of liquidity.  Further, no lender can afford a pause in lending while awaiting its capital and cash flow to be refreshed.  Lenders cannot come and go from the primary lending space while bloated repo exposures are worked off.  To do so is to risk losing one’s place on the mortgage bankers’ speed dials and no longer getting first looks from key relationships.

You’ve got to lend; you’ve got to warehouse and you’ve got to refresh the warehouses on a regular basis.  That’s the reality of the way this market is constructed today.  Non-banks today cannot be effectively managed and grown on the back of equity and traditional bank repo warehouses.

Then there is the continued hunt for yield by investors.  There remains a vast amount of uninvested capital yearning for exposure to commercial real estate.  In addition to the robust US domestic bid, just look at the investment dollars pouring into the United States from around the world, largely and somewhat shockingly, notwithstanding our inflation.  Funny how investors and shareholders get annoyed by undeployed capital.  No fund manager can tolerate that for long.

So, where are our investors?  We need more investors to retain and build upon the vibrancy of the CRE CLO market.  Is the problem that the CRE CLO market is still new and shallow?  Is this the financial equivalent of vaccine hesitancy?  Is the float too small to make investors really happy with liquidity?  Ok, the market is still not large, but it’s only getting bigger and will continue to do so.  It is certainly reasonable to see, across cycles, an annual run rate in the $40-60 billion range.

It can’t be performance.  Over the past several years, this technology has performed extraordinarily well.  The data makes the case that the CRE CLO is a well-performing, safe technology.  DBRS just last week took a deep dive and was positive on the space.  Defaults are low, assets in forbearance (or with some form of relief in place) are a small fraction of the total.  Delinquencies in the CRE CLO space are considerably lower than other structured finance spaces and a fraction of delinquencies in the conduit CMBS space.  Low delinquencies in this marketplace are a meaningful tell.  A combination of good underwriting by folks who really have to eat their own cooking and structural features in the technology that permit assets to be removed to fix a problem or for refurbishment is very positive for investors.

Perhaps the CRE CLO still retains an unjustified odeur from the midden heap of the late and unlamented CRE CDO?  It’s been almost 15 years since the last Frankenstein’s monster of a CRE CDO slouched into Bethlehem.  Those mistakes have precious little to do with the state of the CRE CLO market today, but folks have long memories, don’t they, when bad things imperil careers.   Is there concern that there’s something poisonous and secret buried in the current version of the CRE CLO technology?  (Spoiler alert – I would know, and there is not.)

Is it just unfamiliarity?  Gadzooks!  Could it be that simple?  I think that might be it!  (Bear with me here.)  Let me try and fix that.

First and foremost, this is the structured finance space where there is the best alignment between investors and deal sponsors.  Even after Dodd-Frank’s truly annoying and largely ineffective risk retention regime went into effect, a 5% first loss piece can simply be priced to the deal.  In other asset categories there is considerable use of the vertical risk retention structure, which really is sort of like kissing your grandmother through a screen door in terms of alignment of interests.  Not so in the CRE CLO; it’s horizontal all the time.

In the CRE CLO space, most of the transactions are structured as Qualified REIT Subsidiaries (QRS) requiring the sponsor to retain all of the non-investment grade securities issued by the related securitization.  And it cannot be sold.  Depending upon underlying asset quality, this is a retention of 15-25% of the capital stack.  Now that’s alignment!

Let’s just take a look at the key credit positive structural features of a CRE CLO.  (Yes, I said credit positive.)

First let’s start with the fact these transactions are actively managed.  What?  I thought active management was bad!  No, not true my good personal friends.  Active management by a sponsor with around 20% of the bottom of the capital stack is actually credit positive.  Look at a straw man comparison to conduit CMBS.  Many have observed that securitization of long-tenured commercial real estate assets with stable cash flows are safer.  That’s high-minded amphigory.  Does anyone actually think that commercial real estate properties are stable over a 10-year time horizon?  I don’t know about you, but my level of certainty begins to tail off after lunch.  So, I would argue that as all commercial real estate is dynamic and fundamentally unstable, it’s better to have active management protecting my bonds than not.

The CRE CLO is going to have one sponsor, one seller.  How much better risk alignment is there between one sponsor and one set of underwriting criteria and one set of origination protocols than in a pool that has multiple sellers?  Collective responsibility, as we know, often means no responsibility.  As Henry Kissinger famously said, “Who do I call if I want to talk to Europe?”  Oh sure, multiple sellers can work just fine, but net/net, I would rather figure out if one counterparty knows its stuff and stays around to eat its own cooking.

The CRE CLO is characterized by significant overcollateralization.  Note protection tests which are typically set very tight to day-one performance, can result in significant cash being turboed to the senior bonds in the event of distress.  The sub-bonds in the CRE CLO PIK create the equivalent of a fortress balance sheet at the top of the capital stack.  Kind of cool, right?

The deals are shorter in duration.  Transition assets usually max out around 5 years and generally speaking, loans prepay far before that.  There is no existential prepayment penalty baked into transitional loans in recognition of the dynamism of most CRE assets.  Peering into the crystal ball for 5 years instead of 10, is hardly the stuff of a sure thing, but it’s a bit easier, isn’t it?  In fact, CRE CLOs generally have a real effective life of around 2 to 4 years (the longer tenure for the actively managed structures) and that’s something investors should appreciate.  Between optional redemption at around 2 years and cleanup calls at 10%, you can reasonably expect these deals to pay off during a time horizon when the level of certainty is considerably better than other long-tenured securitization structures.

In dynamic deals, loans aren’t added willy-nilly. In onboarding loans, the sponsor must comply with detailed and prescriptive eligibility criteria, both as to the performance of the pool and the loans that are added to the pool. In many cases, what’s added to the pool are the non-pooled portions of loans that have already been participated into the pool and therefore do not represent a change of the credit composition of the transaction.  If entirely new loans are added by a manager with real skin in the game, one might reasonably conclude that’s a good thing.

Consider one of the newest features in the marketplace that has attracted some attention, is the so-called criteria modification or “SIG MOD.”  These rights allowing the collateral manager to modify loans provide a significant enhanced flexibility to the sponsor.  Some have viewed this harshly from a credit perspective and that’s not a fair assessment.  As Coach Corso would say, “Not So Fast!”  The exercise of these rights is highly consistent with what a portfolio lender would do with its own portfolio.  That’s the point.  Investors ought to like that.  If a portfolio lender thinks a criteria modification should happen and owns 20+% of the bottom of the capital stack, it’s probably a pretty good decision on behalf of all the investors as a collective whole.

It’s really important, Mr. Investor, to take on board that a CRE CLO is essentially a leveraged device for a portfolio lender.  You’re backing a manager of its own assets.  If you don’t have faith in the manager, don’t invest in the structure.  The sensibilities of the sponsor reflect that.  The decision of a sponsor when making decisions about the pool of loans, reflect that.

The servicing standards are consistent with other CRE securitization structures and the information flow to the investors is robust.  (Okay, not perfect but robust or on its way to robustness.)  CREFC is continuing to work with investors, servicers and sponsors to improve the quality of the data as we have repurposed conduit IRPs for this new asset class and we haven’t quite caught up yet (not for lack of trying).  We have added borrower business plans to the disclosure material to give investors better visibility into the future performance of transitional assets.  That’s good.  The industry is working hard to increase the comparability of Annex As to facilitate comparison across sponsors as well.  These are good things.  The fact that they’re being worked on is not an indication of prior failure but an industry committed to increasing safety and soundness.

For heaven’s sake, even the NAIC said the CRE CLOs are “attractive” And in a market where there’s a potential for ongoing material inflation, there’s something awfully attractive about well-structured, relatively low LTV floating rate loans.

Our current cohort of loyal investors are benefiting from the fact that other investors haven’t yet figured this out and this lack of demand is supporting outsized returns.  So, for you folks who are already active in the space, apologies for this, but for the rest of you, it’s time to get into the pool.  The water is fine and they’re serving Mai Tais at the bar.

There’s some comfort in knowing the occupants of the heights recently gave up the usage “transitory” to describe inflation, because that was a very tattered excuse for inaction.  Now, at least, the Fed is talking the talk.  Lael Brainard said last week that the Fed would begin to shrink its balance sheet and move the Federal Funds rate in a muscular way.  Well, all that palaver is suggestive of a renewed seriousness of purpose, but the jury’s out on whether we are actually going to do what needs to be done and do it on the sustained basis necessary for success.  Even if Fed policy begins well, and they’re really serious about reducing the $9 trillion balance sheet and moving the Fed Funds rate by more than a meager 25 bps per meeting, it may be too little and too late and they are not very likely to keep at it when the political winds begin to howl in their direction.  A bad ending here has already been baked into the cake.

I need a plan!  I wish I had conviction about what’s ahead.  I’m sure, if I was an academic economist, a profession that bears a striking resemblance to astrology, a fact denied by many economists and almost all astrologists, I’d then be cloaked in the certainty characteristic of geeks with formulas (thank you, Mr. Buffett).  Then I could be dismissive of anxiety, of uncertainty, of the natterings of all the apostates wringing their hands while the economic mainstream consensus seems to stick with the notion that things aren’t really all that bad... it’s all going to be okay.  However, unlike economists and astrologists, I actually have to put real money at risk and not just write another Op-Ed.  And I’m not buying it.

The fact that sussing out what’s really likely to happen in the next months and years is very hard is troublesome, but the fact it’s hard is not an excuse not to plan and act.  The sort of rampant inflation that we are now seeing will change the calculus.  While inflation is always a cyclical phenomenon, it’s a long cycle and long cycles are virtually indistinguishable from secular change whilst you’re enjoying the ride.  It’s very cold comfort to know that inflation is cyclical and will end some day.  Some day?  As Lord Keynes said, “In the long run, we’re all dead.”

So, what to expect?  My baseline assumption is for sustained inflation, stagflation really, and then a serious contraction and a hard landing.  Inflation will stay too hot too long, surely above consensus estimates.  This Administration, in thrall to the notion of being every man’s friend in a progressive sort of way and mindful of the upcoming midterm elections, and the perfectly understandable general distaste amongst the folk to ever pay the piper, will not be the adult in the room.  History tells us that on the first whiff of powder, in the form of reduced economic performance, the clarion call will be ...Runaway, Runaway!  The Fed will retreat under enormous political pressure from the Administration, our gloriously elected representatives and broad swaths of the chattering class and will return to an accommodative stance (just for a little while, of course).

This is a prescription for anything but a soft landing.  You know what’s going to happen from here, don’t you?  You’ve seen the movie.  After an unjustifiably long period of accommodation, we will first see a bit of economic rigor and then, presented with some evidence of a slowdown, accommodation will return to the scene.  When the scale of an upcoming disaster can no longer be ignored and with the fiscal side of the government simply not capable of being serious and disciplined, the Fed will ultimately slam on the brakes.  Monetary policy is a blunt instrument and the Fed has rarely engineered a soft landing before and, given the conditions of our economy right now, they won’t do it this time.

Consequently, a recession of some significant scale will follow sometime in the 12 to 18 months.  How will the CRE finance world perform against this backdrop?  First, given the complexity of economic incentives surrounding the finance world, it’s pretty clear that some not insubstantial segment of our business will still be driving the production race car at 200 mph until we all actually hit the bridge abutment.  As one of our most prominent bankers said more than a decade ago when discussing the Great Recession in testimony to Congress... “As long as the music’s playing, I’ve got to keep dancing.”

For a while, interest rate change will trail inflation.   Competition to put money to work will remain stiff.  No one is really paid for caution.  Hard evidence of economic deterioration will remain a set of trailing indicators and so, as long as one doesn’t peer too far into the future (say any time after lunch today), confronting the reality of a hard landing can be deferred, if not ignored.  Okay, consumers may already be getting crushed by broad price inflation, but they’re still spending.  Perhaps they’re spending the helicopter largesse of our government over the past several years, living off the enhanced savings and reduced credit card balances accrued during the pandemic.

The canary in the mine should be the multi-family and SFR space, but the supply constraints in those sectors may obfuscate the deteriorating ability of the folk to pay their bills.  In the office space, the denouement will be delayed because of the long-term nature of most office leases.  Industrial and space usage will stay strong, until it’s not.  As long as you keep your eyes firmly on the road immediately in front of you, you won’t notice that the bridge is out.  It’s the boiling frog thing, right?  Recognition of and response to serious inflation and monetary disruption can be ignored...until it can’t.

At some point, the Fed will overshoot, money will become dear, credit will deteriorate, liquidity will evaporate and asset prices will fall.  Combine that with an almost complete absence of amortization across virtually all aspects of the commercial real estate finance marketplace and we have a prescription for ...an unpleasant event.  Refis won’t work, borrowers will default, cap rate shocks will begin to spread through the economy, bonds will dramatically lose value, coupons will soar, warehouses will retrench, liquidity problems will abound and ultimately bank failures and failures throughout the non-bank sector will follow (you do remember the pandemic, say around May 2020, don’t you?).

Recognizing that the music is still playing and that dancing will go on, the smart money should at least start to think about the virtual certainty of a material, near-term discontinuous recessionary event.  It’s out there 12 to 18 months from now.  I know, unless you were in the business 14 years ago, you have only read about real and deep recessions.  It’s way uglier than what the textbooks make it out to be.

What interim actions are actually doable right now?  Regrettably, in a real-world sort of way, not much.  One can socialize the base case with investors and customers.  It’s time to pass on deals where the pricing is too thin.  Maybe it’s time to look at inflation-adjusted pricing.  (We just closed a bond offering with the CRE bonds tied to an inflation index.  Maybe that should be a thing.)  For lenders, it’s certainly not a time to give up on covenants and structure, because they are going to be needed when the workout occurs.  Give a little on coupons, take a little on structure.  For borrowers, the converse:  trade some enhanced coupon for more flexibility.  A little more time, a little more certainty on extensions, maybe even a built-in workout?  It’s time to start managing warehouse exposures (on both sides).  It’s time to shorten accumulation periods where the exit is securitization.  It’s certainly a time to move aggressively to term SOFR as opposed to the now lagging compounded-in-arears SOFR pricing.  The disconnect between term and spot is going to continue as long as an expectation of inflation continues and compound SOFR will underprice market risk.  I know it’s brutal to build a business plan for playing with distressed debt before the distressed debt cycle begins (a lot of money has been wasted trying to time distressed debt cycles in the past), but there you are.  It needs to be done.

It’s time to keep some powder dry.

If you can embrace a somewhat cautionary posture (without deeply offending shareholders, investors and risking continued employment), it’s time to do so.

And remember, there will be money to be made out there when the cycle turns.  So, get ready.  It’s time to fix the roof before the rain starts.  Have some dry powder and have a clear-eyed approach to navigating through difficult economic times.  Be ready to leave something on the table and put something away for those times.

It’s going to be quite a ride.