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Thursday, 23 November 2017

CMBS Roundtable 2005: Transcript

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IFR: We are going to start by looking at growth levels and the sustainability of the tremendous market growth that we have seen in the past year. Let us start with Rodney, who has more of an overview of what is going on in terms of net volumes than most of us.

Rodney Pelletier (Fitch Ratings): The volumes have been tremendous this year. They have confounded everybody's expectations. I think there was a CSFB conference at the beginning of the year that anticipated we would have about US$29bn equivalent this year. We blasted through that in June, and up to the end of July we were at US$36bn, or about €30bn.

We should quite easily surpass US$50bn, meaning about €42bn–€43bn for the year, which is an amazing statistic compared to last year, so we are actually a little bit more than double where we were last year.

In terms of the number of transactions we would probably be up about 75%, and there is no shortage in sight if the deal pipe continues to grow. It is amazing how many arrangers out there are doing not just two deals but three, four, five, or potentially even six deals in the next three to six months.

IFR: How does that compare with the more mature US market in terms of volume?

Pelletier: Well, we thought we would be catching up with the US market, but talking to US counterparts, it seems there are some months where they see US$10bn worth of product now. That just dumbfounds me.

IFR: Charles, do you think growth will continue over the next 12 months at the same rate?

Charles Roberts: (Cadwalader): I think what we are seeing is a market that has evolved in a different way from the US market. There the investor market was established and it basically helped originators to come up with more competitive pricing. Now the market has been established and the originators are competing with the balance sheet lenders, regardless of where rates go. What is going on in Europe is that there is really a large untapped market as far as CMBS origination is concerned. The US has already been through this, and I think they are coasting on what rates are right now, and they know it.

Caroline Philips (Eurohypo): Do you think European growth can be sustained? That would imply €18bn–€19bn of extra growth in 2006, and I cannot see that happening. It would be a great target to keep the levels as they are, but I cannot see growth increasing that much.

Roberts: Maybe not exactly sustained, but I think growth will still be there. Morgan Stanley was predicting some US$100bn by the decade end.

Shirish Godbole (Morgan Stanley): Yes, but that is doubling in four or five years, as opposed to doubling in a year, which would be pretty amazing.

Pelletier: There are two sides to this – supply and demand. Let's think about it from the perspective of the arrangers. How do you feel? Do you think there is capacity to get to US$100bn in the next four or five years?

Philips: Over that period of time, frankly who knows? It is perfectly feasible. Next year will be very interesting because our experience this year has been that there has been an awful lot of refinancings. You flip loans from the bank market to the bond market because there has been that big difference in pricing. Now the bank market and the bond markets are pretty aligned pricing wise, and a lot of the refinancings have already happened. Spreads are not going to tighten that much further, because they physically cannot. So we have lost that driver.

Roberts: We should not expect refinancings to continue that way.

Philips: No, exactly. I don't know if Ron has done the sums, but it would be interesting to know what proportion of the collateral underlying this year's issuance is refinancings.

Godbole: You talked about people having six deals in the market in the next three to six months, and I look forward to 2006. It is very hard for me to look beyond that, but it looks like the pace is going to continue. There is a tremendous amount of principal volume; there is still a lot of agency demand. The UK carried the market this year, but we need to see a similar volume in the European market, which, longer term, is the real question: will that carry us to US$100bn? If [Continental] Europe does not really come alive, then it is going to be a very difficult year.

Philips: That is a fair point, because the growth in Continental Europe should be significant, because it is off a pretty low base.

Peter Voisey (Clifford Chance): It has been patchy, hasn't it? It has been stop/start in some countries, although Germany has always been promising.

Philips: And should finally deliver.

Scott Goedken (LNR Partners): You are right. We have only tapped into a few jurisdictions on the Continent and hopefully, with principal transactions going on in Germany at the moment, we will see a lot of issuance out of Germany this coming year. We will also see more issuance out of Italy this year, and we have not really tapped many jurisdictions beyond that.

Ron Thomson (RBS): France is an open issue.

Philips: When did it drop off, because it used to be pretty big, didn't it?

Jonathan Pollack (Deutsche Bank): My experience is just that the bank market pricing in France is extremely competitive, whereas in Germany the banks just do not have the capacity to lend at the buying rate.

IFR: You talked about the competitiveness of bank financing, but what is the impact of Basel II going to be in everyone's opinion on how CMBS lending can compete?

Godbole: Zippo.

Pollack: I think it will help.

Pelletier: The impact will be felt on both sides, on the origination side, for balance sheet lenders, and also on the investment side for both investors in securitisations and investors in the high-yield B tranches.

Another noticeable thing about Basel II is that there is a tremendously different capital treatment for B tranches as opposed to B bonds. So that does put more increased pressure to create more B tranches.

Philips: Our experience as a commercial lender is that we are starting now to apply Basel II to internal pricing models, and we have seen margins coming in there. So in effect now, for certain situations, you are pretty much at parity between these two options: do I keep it on balance sheet, or do I securitise it?

Voisey: Some of the research is showing that the capital charge for holding assets unsecuritised on the balance sheet actually goes up. So for some asset classes Basel II does not favour securitisation, though, on balance, I think that Basel II does favour securitisation.

With B pieces it is different, because they are going to be more challenging for banks to get away. We have already seen a very different investor base in the B market, and different buyers of the piece, which has kept the market going.

IFR: And what of the Prospectus Directive in terms of pan-European growth and the impact on disclosure?

Godbole: I thought Peter [Voisey] and Clifford Chance invented it.

Voisey: We have been through the process from July 1 of writing offering circulars, including the prospectuses, and making them PD compliant, and the bottom line is that there has not been a huge amount of change. I am sure you have found the same in the CMBS market, that the level of disclosure about borrowers, particularly where you have small pools of five or fewer loans, goes up, and you have to disclose two years' accounts. That can be sensitive when you have borrowers that are sensitive to that kind of thing.

But on the other side of the coin, a lot of these borrowers are SPVs, and do not have two years' accounts anyway. They are deliberately set up to be bankruptcy-remote SPVs; some of them are in jurisdictions where they do not have to prepare accounts. I think the disclosures on valuations have changed a little bit, but I think all in all we have not had a huge change.

Roberts: Perhaps there is room for quite a bit of change, in the deals overall. They still lag behind the US as far as disclosure goes, and I think a lot of that reflects the information people can get from their borrowers. It is amazing how difficult it is to get historical information.

IFR: How analogous are the requirements of the PD and US market standards?

Roberts: They are very comparable. They use different language to get to the same point, which is that all the material information that an investor

needs to make an investment decision needs to be in there. The PD is telling us to do this, but how is it going to really come into effect? Investors who feel that disclosure has not been sufficient will use that to their benefit if something goes wrong. The market is already there, originators are doing a great job in getting more information for the borrowers. Changing the market convention for what you can get out of your borrower has been the most challenging thing.

Philips: But that is happening.

It is the market driving it rather than the PD, because investors want it. There is all this talk about how we improve secondary market liquidity. By giving more information on our issues, the secondary market trades tighter and our primary issuance trades tighter and we make more money.

Pollack: But it is not just the information that is provided upfront. A lot of issuers are reluctant to provide ongoing information to the rest of the market. That is a challenge that needs to be overcome.

The US is a very transparent market, and if anything it has retrenched a little bit more because of servicer liability concerns rather than issuers trying to protect things. It has become a lot richer in terms of how information is delivered. But here in Europe, it is virtually impossible to get a deal report on something unless an investor sends it to you.

Voisey: The other thing that will have an impact is the Market Abuse Directive, which has already changed the landscape in ways that we are still working out. If there is anything in the service report which could be price sensitive, it is no longer sufficient to put it on a password-protected website and so disclose it on a very selective basis.

Roberts: The MAD has the potential to take ongoing disclosure in a European deal even further than what we see in the US.

Thomson: Even in initial offerings there is a lot of information that is disclosed separately in different documents. We would like to see a more comprehensive document.

Pollack: Yes, our internal counsel has always required us to include our term sheet for the life of the term in the back of our offering circulars, so that there is no disconnect between the ultimate offering circular and the information that went out to the investor.

Goedken: The amount of information and the quality of information has become better, even in the nine or 10 months that I have been here in the market. But I think, coming from the US perspective, we have some way to go over here, both on the new issue front and on the secondary front.

Hopefully, over time, as we standardise some of this documentation, we will begin to see better information coming out. But that is going to have to come from investors, and consequently pricing deals differently based upon issuers who provide better information.

IFR: That is interesting. Jon, do you see a potential opportunity for tiering based on disclosure in the primary market?

Pollack: I think the potential is there, though I do not think it will ever actually occur. I just think it is going to be less a case of voting with your feet and more voting with your voice to get it to happen, because more often than not this only comes up when somebody wants to sell a position. Investors do not necessarily take it into consideration when they are looking at the initial transaction. To the extent that investors have an interest in seeing liquidity develop substantially, you will see tiering.

One of the big drivers in the US market is the presence of money management firms who trade in and out of positions pretty regularly. A lot of the people who buy our European paper are just locking it away for term, so there is not a massive amount of potential volume out there pressuring this point.

Philips: It is a bit chicken-and-egg. There is not much trading because there is no information for investors to base their trades on.

Pollack: To a degree. I think maybe that keeps some asset managers out of the market, people who would otherwise be buying new issues to try to flip to the secondary, but you do get those kinds of traders.

Goedken: The sector has been here for a while, but it has really grown exponentially in the last year or so. How much of the deficit of secondary trading is because we have investors who are entering the market and building up their initial portfolio? Once they reach a certain level, they may begin to trade those portfolios in secondary.

And how many times have you been asked to trade a position that you did not originate and did not have information on? If you had that information then you could take a different view than the originator of the deal. May that not help liquidity?

Pollack: Do not get me wrong, I definitely think that is a hindrance to liquidity. A number of the new investors coming into the market are still guys who are not necessarily planning to trade out of the position. That said, more investors means more likely traders.

I think this is an issue on two fronts. It is an issue on a transaction that is particularly credit intensive, or a bond that is particularly credit intensive, and it is an issue in the case of a very high premium bond that is a first-pay bond, where somebody in the market may have some information that a loan is likely to pay off, causing some repayment, which would cause me to take – for lack of a better expression – a hit. It is hard to pinpoint what the exact driver is, I think there are several.

Goedken: I would pose the same question to Rodney from a rating agency perspective. I remember when I was in the US we were frequent users of Fitch's monitoring reports, and we had a very strong presence in the monitoring of those transactions. Do you see the possibility to help the market and provide liquidity?

Pelletier: We would love to, but we are limited to how much information we do get. Frankly it has become much better, but it is certainly nowhere near what we get in the States. The things that we are trying to do to get to that level include publishing issuer report grades, like we are doing now. It is amazing. When we first published them about a year ago there were many with very low scores, and immediately they really jumped on the opportunity to increase their scores and have improved themselves tremendously.

Godbole: There has been tremendous progress made in 12 months on this issue, which I think the market recognises. And I think a year from today you will see a much more open market than you used to see.

Pelletier: At least I have seen those data CDs and nice pull-out charts. But frankly, we do not have one hundred loan pools anyway, so it is five loans that people have to get their heads around.

Thomson: But you still need to see the attendant cashflows, you still need to see all that information. That is very important.

We have seen a secular shift in the investor base. The Triple A investor base used to be mostly banks, and that has shifted. We are seeing more SIVs in the market, and we are seeing other money managers moving into the market, people who had not, up until this point, been present.

We still see a strong bid from banks, and if we circle back to Basel II, under Basel II it is a lot better from a capital perspective to be buying CMBS because your returns are going to be that much higher. So you can buy the same structured paper for the same risk weight and you get paid substantially more by buying CMBS.

IFR: How does an institution with both principal and agency models balance the two?

Godbole: Clearly the principal business makes more money than the agency business, so there is no question where the real butter is. Having said that, we are in the business of flow. Flow gives us a lot of knowledge about how the rating agencies look at deals; it gives us a lot of knowledge about what investors are thinking about, and it really allows us to use that information to do other things: trading and principal.

We are trying to match both principal and the agency business, and I think they work very well. We have had situations where there is a principal trade round the corner, but we have managed to work it out with the client, and be transparent about what is coming on our side. So we see it as a very do-able business. It makes decent money, not great money, but is a very good add-on to our principal business.

IFR: There have been a few instances in the past six months of conduit players having to shelve their conduit deals to service their client business, and that has maybe kept them out of the more public conduit race for business. How do you see it, Jon?

Pollack: If you sign up to do a deal for a client, you have to deliver for that client. It is clear that if you have a capacity issue, you always prioritise the client ahead of your deal in the pipeline. You do not pull conduit originators out of the field to work on an agency securitisation. The people who work on agency securitisations are structured finance specialists, so in terms of originating volume, it is not difficult to do both.

Where some people may run into a pipeline clog is just in terms of interacting with rating agencies, and staffing, and the structured finance professionals that they have, so that can be a challenge.

Philips: On the agency versus principal debate, I think we just view them as similar products to offer our clients. If they want it underwritten and want to have nothing to do with the securitisation, then that is great. But if they actually want to take full market risk, then we can do that as well. We would love to underwrite, but sometimes the borrower does not want it. It depends where we are in the cycle. If they think that spreads are going to widen, then – funnily enough – they want it underwritten.

IFR: Let's move on to the issue of competition in the conduit space. What will that competitive landscape look like in 12 or 18 months, given the amount of partnering up that we have seen in the latter stages?

Philips: The competition is at the origination end. We may be competing with Morgan Stanley and Deutsche Bank, but we are also competing with big balance sheet lenders who could not care less about securitisation.

Pollack: I agree with you, and that is actually a bigger challenge for some of the smaller conduit shops out there. Morgan Stanley, Eurohypo and Deutsche Bank have a lot of people working on this business. I think that with regard to the people who are just getting into this market and have less staffing, the biggest challenge for them to overcome is to be able to originate volume and win business away, not only from the likes of us, who are originating a lot for CMBS, but from the balance sheet lenders, and understanding that model and understanding how to compete with those guys. It is a challenge and it takes a lot of time to work out.

IFR: On the lawyer side, is competition narrowing down?

Voisey: I would say there are probably three or four firms that specialise in the market. Obviously Charles' firm [Cadwalader] is strong, Clifford Chance is very strong, and two other firms also, I would say, have a strong presence in the market. I think there are barriers to entry. I do not see too many other firms coming on board the European CMBS bus.

Pelletier: There are other players on the originating side knocking on the door. But maybe they have come too late.

Roberts: I see a lot of that. Just about every bank is considering a CMBS platform. If they do not already officially have one, then they unofficially have one. What has happened is that all the banks that started these programmes, at first they kind of laughed at them and now they are saying: we are losing clients. At the end of the day, who are going to be real significant players is another story.

Godbole: Whoever can hire the most people from Rodney!

Pelletier: That has happened quite a bit. We know, we are not naive. It happens.

Voisey: You would think that the balance sheet lenders ought to have the strongest conduits out there, because they have been doing this kind of lending in the UK and other parts of Europe for decades, and sometimes – for the older banks – for centuries. But I think they have their own problems being in this sort of market.

We have some investment banks round the table, but not too many of the larger balance sheet retail banks. They have great loan books on the balance sheet, but can they securitise them without giving rise to all sorts of difficulties?

Philips: Do they want to securitise them? If you work in a bank, your main business driver is making loans, and therefore it has to make sense to securitise, either to the bank from a P&L standpoint, or the borrower, because you can give them cheaper pricing.

Voisey: Yes, and the guy in the office in Manchester is not interested in securitising that loan. Why should he be?

Roberts: You are seeing a little tension between the CMBS originators and the balance sheet originators. People who have been doing balance sheet originations for years do not want to learn how to do CMBS originations. They are perfectly happy as things are.

Thomson: If you look at a bank deal versus an investment bank deal there is always a price differential for it, and people would theoretically assume that the bank deal was better underwritten. So I think that those tensions probably will continue to exist.

Roberts: Another thing that is definitely different is that balance sheet lenders are a bigger force in most of these banks than the conduit lenders, which in the States is not the case, as the conduit lenders are the significant force in any bank.

Pelletier: Do we see anything changing that balance?

Roberts: Obviously retail banks do not laugh anymore, they take this seriously, so that has definitely happened. Now that all the big banks are considering, or are actually implementing, conduit programmes, that says everything.

Godbole: In 1998 and 1999, when Morgan Stanley was out there trying to originate, "laugh" is an exaggeration maybe, but not that much. It was really a case of: why would I do that with you when I have Barclays? Now I do not think it is even questioned that that is a legitimate option, and that is a huge change in six or seven years in terms of how the business has grown, so if you continue that trend and go another six years, things could be quite different.

Goedken: I have a question for Rodney. Given all the new players coming into the market and the incredible competition for loan product, it is obviously going to take some time for some of these players to build a sizeable book, at least large enough to securitise on their own as a standard loan securitisation. Do you think we are going to see more pairing up?

Pelletier: I think so. Why not? It is happening; it happened in the States. As long as you can push egos aside and come up with an agreement as to how you are going to split profits, it is a win-win for these originators, and I tell that to the investor: there are two different books supporting this deal.

Goedken: That is my view. From my training in the US it seems that pairing up helped get me two different trading desks making a market in the security, plus larger transactions, so obviously the bigger the deal, the more liquidity, and the more investors in the market, the more the lower-rated trades change hands.

IFR: Scott, does that have an impact on the kind of diligence you might do on a dual-originated pool of loans, as a lower grade investor?

Goedken: We are still going to do the same level of due diligence. It may help us see more product, as maybe some of this product comes to market more quickly. There are a number of players out there who have loans on their balance sheets right now, who are trying to figure out what their exit strategy is. Do they continue to accumulate for the next six months and hopefully come out with their own branded deal, or do they pair up with someone and bring something to market sooner?

Pollack: I think the only place you would see the level of diligence decline because of teaming up is if somebody teamed up to get to a pool of 80, 100 or 120 loans. But as long as the loan count stays under 50, at least the largest loans are going to take a lot of scrutiny, even from the Triple A investors. Scott and people who buy down the curve are going to do loan-by-loan diligence probably no matter what the loan count, unless it gets up to 1,000, or something.

But if you look at the US model, the guy who invests at the bottom of the deal gets every loan file and does diligence on every single loan, and that will, I am sure, continue to be the case here. Whereas I think a Triple A investor buying Northern Rock's deal is going to do a lot less diligence on the underlying collateral – look at the stats and everything – than they would on, say, one of my large loan deals.

IFR: How would you asses the cost benefit analysis of doing a joint-originated transaction?

Philips: It is just risk management, isn't it? Getting out quicker. We have not done a joint deal, but we have looked at it. The increased costs of doing a joint deal and the increased complexity often outweigh the increased pricing benefits and liquidity. So it clearly comes down to getting enough collateral to get out and reduce your risk.

Roberts: The larger deals reduce fixed costs?

Pollack: Yes, definitely with regard to some costs.

Godbole: I think there are jurisdictional issues that make it complicated. We are going to have a French deal that is not very big. If there were someone else who had a French pool that we knew, that would have been helpful. With multi-jurisdictional loans, what we found was that it was very expensive to get those deals done, and there are a lot of structuring issues that make it expensive from a legal standpoint.

Roberts: The other complication is that a significant part of the profit of the deal comes out of the Interest Only strip [IO], and structuring an IO around the waterfalls here, when you have a partner deal, is very challenging, because it is hard to keep track of who caused the sequential waterfall and who should be penalised.

Pollack: Yes, you cannot just split profits upfront and say: that is it, we are done.

Philips: I would be interested to know the additional time costs and legal costs of working out all of those things.

Roberts: I have done three of them now and every single one of them was handled differently.

Philips: So until we get some real standardisation, I think we are going to continue on our own.

Roberts: I do not think there will ever be standardisation.

Pollack: It is easy to do a partner deal on a US conduit deal, where you have 10 years of lock-out on every single loan. But here, when everything is pretty much freely prepayable from day one, prepayments drastically change the value of an IO, and if one guy's loan pays off and he gets prepayment penalties, the other guy is set with an IO that is worth a lot less now, and that is an issue.

IFR: Rodney, of the conduit trades that you mentioned submitted for rating, how many are from standalone conduits and how many are partnerships?

Pelletier: The vast majority of them are standalone. I would say north of 80, probably 90%.

IFR: So there is still a lot of space for partnerships?

Godbole: That is a tough issue. It is hard to structure and you have to combine that with the jurisdictional point. I guess the ego is still there for some to have their own deal, although it is quickly eroding, as you can see, which is the right thing, because there is no point in having an ego about this. You should just team up and do the right thing for risk management.

IFR: Let's take a look at the lending side that we were alluding to a second ago. With the increased competition and increased offerings, has there been any significant change to lending standards?

Goedken: One of the most obvious things that we have seen in the past year is that borrowers are more capable of getting higher leverage on their deals. Where previously we would rarely see a deal with 90% leverage, we are routinely seeing that now, and that presents a number of issues given the environment in which we are operating right now, with low yields. It poses a refinancing challenge for us. It is impacting our analysis of these underlying assets significantly.

To compensate for that, you really have to pay attention to the covenants, which we monitor very, very closely. That has probably been the biggest change for us, plus the underlying quality of the loans.

IFR: Charles, has there been a step-change in the competence of covenants?

Roberts: I think if anything they have been getting tougher. Sometimes you see things weakening in some way. Even with the financial covenants, over a period of time it seems that they were starting going to go towards a US standard, and then S&P came out and said: don't do that. The situation has stabilised. Overall, though, covenants are probably getting better.

Voisey: They are getting more sophisticated, I would agree. Particularly with the larger single-borrower structures, you have the concept of tiered covenants coming in now.

IFR: Like with Land Securities.

Voisey: Yes, so I think a lot of flexibility goes into the level of sophistication of covenants at different tierings.

Godbole: I agree. It is the higher LTV at pretty tight spreads that we are seeing as the big change. Compared with 12–18 months ago, the same LTV is being done today at a much tighter spread, and people are stretching on the margin at the LTV to try and get the loans.

Voisey: You are obviously talking about the B buyers.

Godbole: Yes, It's a combination of things. A lot of banks are prepared to own the B pieces themselves, and there are other B buyers emerging in the market, so that is allowing people to be more aggressive.

Pelletier: There is no question that there has been a little bit of creep-up on the LTV side, and I think yield compression on the cap rate side in valuing properties is one issue. But one thing that helps is that many banks come to us now and tell us: we have a B note coming in, so some of that higher leverage is being taken out of the deal. There are certain covenants in B notes that can be favourable from a senior note perspective, and that has helped mitigate it a little bit.

Pollack: The expansion of the CMBS lender into continental Europe has actually caused some of this LTV growth, because given where interest rates are in the UK it is very hard to lend 90% LTV. You wind up having this convergence of property yield and actual base interest rates, whereas in the case of a lot of stuff we are seeing from our borrowers in Germany, they are buying properties with 7% yields, and bond borrowing rates are in the fours, so there is a lot of excess cash from the property that can be used to amortise the loan over time.

I am not necessarily saying that is a good thing, but it does help in terms of sizing the 90% LTV loan there, versus the UK where you can maybe afford 50bp of amortisation a year.

Pelletier: So it is not unusual to see maybe an 80% loan to value loan with a 1.7 coverage ratio, because of that spread?

Pollack: Exactly.

IFR: We are going to move on to A/B notes. What is everyone's opinion of the impact of S&P's published criteria on structures?

Goedken: It is good for us all to bring out a lot of these issues, not that we have not done it enough already in the various conferences we have all attended, but I do think that we need to discuss this openly and get everything out there so that everyone can make their own judgment on the various structures. Obviously we have a particular view that may not be the view that everyone else takes. We will advocate our opinion to the best of our ability, but I would encourage everyone to go out and make their own judgement.

IFR: How successful do you think you have been in advocating that view?

Goedken: That is a very good question. I would say we have either done a better job of advocating our view, or we have done a better job in selecting the deals in which we have been participating. We have found that it is getting a bit easier for us to get some of the structures that we are looking for, and I think some of the things we are advocating do provide a benefit to some of the senior bond holders, much as you were talking about, Rodney, with the B notes.

We are a large B note buyer, and some of these things about the cure rights, keeping the senior bonds current – because we are a first-loss holder of a security, we are highly incentivised to make sure that the loan maintains its performance status. So, you know, maybe we are doing a better job in convincing senior bond holders that what we are asking for is not necessarily a bad thing.

Pelletier: Frankly, I would have expected less standardisation. We have seen relatively similar structures right now.

Voisey: It is not quite clear who the good guys and bad guys are, because I know everyone is on the same side. The same banks that are trying to sell the senior notes are also holding the B pieces, and the raters are perhaps a little suspicious of the B pieces. But on the other hand, as you say, they are subordinated credit and an enhancement for the deal.

With LNR and Fortress and other US investors coming in and applying their analysis, I have seen quite a lot of convergence. Just over the summer, a lot of things that once you could not imagine happening are already happening on European deals.

Roberts: The arranger has the most difficult position, because they have to do a perfect balancing act – they have to guess how execution is going to go for the securitisation, and what their key B note investor wants. Sometimes, they are creating these things before they really know who they are selling to, so they want to make it as broadly acceptable as possible.

IFR: On that point, how important is the B note buyer to a deal like Thyssenkrupp and other higher value principal trades?

Godbole: Very, very important. The B loan market is extremely hot right now and on any deal we are doing we are basically not issuing non-investment grade bonds, unfortunately.

So we have to deal with this issue of what rates are much more. It just seems that the European bank market has traditionally had a different approach to this methodology of what the rates should be versus what the US rates are, and the problem we have right now is to match the two. We have found that European banks continue to be pretty aggressive buyers of B pieces, and if you are going to get a large percentage of buyers from the European bank market, how do you get the US investors in there, and unfortunately that is causing a bit of concern.

So if it is a smaller yield, you just sell it to the BB guy from the US. It is almost easier than trying to get the Europeans and the Americans into the same B note. We have started doing that, but not as much as we would like. However, this issue is very important. As you people are saying, there is more and more convergence. It will sort itself, I think, one way or the other, over the next 12 months.

Philips: But does it need convergence? I mean these are just different ways of doing something, and different ways of paying bonds. I think you are stuck with creativity.

Roberts: That is the one thing that the S&P piece really highlighted. Basically, in the US, we are used to two ways of doing things: you either had no agreement with the B piece or a specific agreement with the B piece, and now there is this room to change, which I think is what S&P punished. They basically said: you can do this range, and this is generally how we are looking at it, so you can figure out where you are going to fit on the map. So it really helped to create that discussion.

One of the great things about Europe is that the agencies are not inflexible, they listen. In the US they just told us the way that market had to be structured, and we pushed them. In the beginning it was really bad and we pushed them, but it is pretty static at this point. Every deal looks exactly the same in the US. I do not think you will ever see that here.

Philips: One of the key benefits of the B note – obviously pricing at where we are today – is that you can get over the risk a lot quicker. The securitisation of a big, complex transaction takes a long time, whereas you can actually structure out a B note pretty quickly, and syndicate it. When we are undertaking big underwriting positions, that is a huge benefit.

Godbole: On Thyssenkrupp, we already sold the B note in May for a transaction we are still struggling to get out, which was originated in February. The securitisation requires the mergers to happen, analysis at the asset level, the mortgage to be in place (et cetera), to make the structure complete.

IFR: There are several trades of similar volume and similar complexity that have been financed to the mortgaging stage this year at least, so the significance of these investors in the next 12 months is growing.

Pollack: And there are primary benefits for investors, too. If Scott [Goedken] buys a rated bond off a deal with five or six loans in it, and a couple of those pay off, there may be issues in the deal paying full coupon out to Scott.

Also, he may not like two or three of those loans, so by buying a B note he guarantees himself coupon payments as long as the borrowers keep the loan current, and also gets to select the asset. Out of the pool of assets that we are going to be securitising, he gets to select the asset or assets that he likes best. So it is kind of a mutually beneficial evolution in the market.

IFR: How many institutional investors are there in B notes in Europe?

Philips: It is all the mezz debt. I mean it is not full of B notes, it is just the mezzanine debt and how long has mezz debt been around in Europe? Forever. So it is just the usual mezz debt players.

Thomson: It is definitely a sexy part of the curve, and we get requests from investors in the States and from Asia looking at this market all the time and saying: well this is where I would like to be involved, how can I get into the market in Europe? So it will be interesting to see how it evolves, whether it becomes more and more global. But we do see some of the barriers that you mentioned, and looking at this from a US perspective is sometimes a little bit different than looking at it from a European perspective.

IFR: Let's talk about CMBS structures and borrower flexibility. We mentioned Land Securities earlier on. Is that trade actually the beacon for the market that was suggested?

Voisey: I think it is for the large property companies with large portfolios that they want to change over time, but obviously that is very different from your single borrower with a small pool. I think that it is always give and take between LTV and flexibility, and I think there are different models in the market. The Real Estate Capital programme is bringing a deal at the moment which is more or less 50% leverage, all Triple A rated, with very high levels of borrower flexibility.

This is a dynamic thing. This is not an over-banked market, but there are a lot of players in the market, as we said earlier, and there is a lot of competition with banks. Borrowers are getting increasingly sophisticated not only about getting lower spreads, but also about the maximum amount of flexibility in the structures.

Godbole: Europe is more flexible than the US. The US market is a lot more standardised, but it is large.

Pollack: The States started that way because, as Charles [Roberts] said earlier, the investment banks were the only source of capital for real estate investors. Over here, the investment banks had to be extremely flexible to try to convince some of these real estate investors who were used to balance sheet-style loans where they could change things and further negotiate their deal two years after they had originally signed it.

Now that the CMBS borrower has become more accepting of the product, they are willing to accept a little bit more rigidity in the loan structures, and, conversely, in the States I think now you are seeing a ton more flexibility in loan documents and a lot more leverage as well, just as the number of available lenders has just mushroomed.

Voisey: There is cross-fertilisation going between the investment bank model and the relationship model, and borrowers are quite skilled at taking the best of both.

Pelletier: There is room for a happy medium. There is room for flexibility in deals. We have demonstrated that in the past few years. You have to think out of the box, and you could challenge some of that dogma which is there, because it was easier to have no flexibility.

Roberts: The perfect example is the Austrian deal [Forest Finance]. It was a whole deal that had no mortgages. Can you imagine that in the States?

Philips: But this is just the result of having to compete with the normal lending market, because that is normal in Austria, where people do not have mortgages, and in France maybe as well. That is what Shirish [Godbole] was saying about the creativity of the market over here: it has to be like that because it has to compete, and in theory if it works for the lending market, it has to make sense. Obviously we have to maybe tweak it a bit to make it Triple A compliant, but . . .

Pelletier: Yes, there is a slope there that you are going up and down when you are talking about springing [activating] mortgages. First and foremost, you need some form of granularity. If you can get that, at least on a tenant basis, and you can start springing these mortgages when things start to move downward, you get a little bit more comfort. But then, you know, those are the exception, hopefully, and not the rule.

IFR: That is interesting. Thinking about what has happened in the past 12 months, can you pick the three most flexible trail-blazing CMBS structures that you have looked at.

Pelletier: Obviously the Land Securities deal was by far the most flexible, but that really was not CMBS, it was a corporate finance package with a CMBS type of package in it if things started going a little bit more pear-shaped. That was by far the best in that respect, but there was no Triple A in it.

At the end of the day, what we as rating agencies are weighing is how far that flexibility is quantifiable. In other words, there are limits to certain property types that can get in, limits to certain tenants that you can have.

Godbole: Don't worry, Rodney, we are not saying that you are being too lenient.

Pelletier: Our biggest challenge, obviously, is modelling that flexibility. I think the other great equaliser in that debate is the question of how low the LTV is going? If your LTV is at, say, 40% going in and our typical Triple A bogeys are somewhere around 50%–55%, well there is a lot of room for flexibility there, and you are going to have a much easier time getting to what you need to.

Philips: One of the most interesting developments is the increase of low leverage, because if you look historically, securitisation has been used in high leverage, and now suddenly it is as if people are saying: hang on, low leverage gets flexibility as well as low pricing, and I think there is a lot of room there for growth.

Thomson: The volume pool structure is one that we have not seen, though I am surprised we have not seen more of them from some of the smaller banks. If you want flexibility, you can substitute collateral, you have a financing structure that is known, so from a bank's perspective it creates a nice vehicle.

Whether it is the most flexible from the borrower's perspective remains to be seen, but you still get a lot of that, because investors were finding diversification within the pool, and getting comfortable with that.

IFR: Let's move on to discuss the pro-rata question.

Pelletier: That certainly has grown. A lot more investors are opening their eyes to it and asking what it is all about, but from our standpoint I think there are some pros and some cons to it.

One of the biggest problems in some deals, where you have a sequential pay structure, is that you do have an issue at the bottom when you start getting some prepayments. This creates weighted average spread issues so that your loans can now no longer support the weighted average spread on your bonds. We had a downgrade that occurred about three years ago in a particular transaction that had that very problem.

The part that makes others a little bit more worried is that there is no Triple A outstanding for a longer period of time, and I think Triple A investors get a little bit more concerned about that. We model that pretty extensively, and try to make sure that in the worst or near-worst case negative selection scenarios we have adequate subordination to go forward. But that adds quite a bit of complexity to our analysis. After all the models are run, you still have this other fairly sophisticated model you need to create to take care of that.

Thomson: A sequential model is just not going to work. With spreads where they are, they are just not going to work, so they had to come up with additional solutions. That makes a lot of sense and we are going to have to have those kinds of structures. As you say, investors are getting more and more comfortable when they realise that it is actually in their benefit longer term.

Roberts: The complexity of the investment decision increased when coupled with the available funds cap issue; this is what investors in CMBS sub-bonds are really worried about. People are incorporating at least WAC (weighted average coupon) on spread. Eventually, you are going to see multiple classes with an available funds cap.

Pollack: Unfortunately, the dealers cannot really afford to be selling too many WAC bonds, because you do not have enough prepayment protection to support the IO value to overcome the original discount.

Throughout this discussion we have been talking about the States, but in the States you have these 10-year fixed rate deals, where you can pretty much model your IO, and shape it how you want, and you are always going to extract enough value to be able to sell a whole slew of discount bonds at the bottom of the deal.

As a dealer in Europe, you cannot afford to do that. You are selling floating-rate loans, which can pay off at any time. There are also part loans so you have to sell part bonds. There is some give and take there. Again, the B note market developed for that very reason.

The Triple B bond is pretty easily supportable. We did a conduit deal in July and we sold some of the bottom bonds at around 98 cents on the dollar, but they were pretty much part par bonds throughout the entire life of the deal aside from the last few payment periods. There were among the 25 loans or so that were assigned coupons in the whole pool, that could not, as the last loan standing, support the Triple B bonds. That is where the non-investment grade risk outside of the trust really comes into play.

Voisey: The great thing about pro-rata is that in a market where there is a lot of standardisation, that is the one thing that is never standard, because it is to do with the way the deal's waterfall works and the pro-rata amortisation, and every single deal has its own bespoken language. It is very interesting.

IFR: Another recent new entrant in European CMBS structures is the super-senior tranche. Does this mean that our European investors have become more conservative than our European rating agencies?

Pelletier: Because super senior is just very narrow, you mean?

Philips: It is pricing, is it not, just so you can find pockets of demand.

Godbole: It doesn't have any reflection on whether the junior Triple As are not as safe as the senior Triple As. I think it is more of a pricing arbitrage in the market, where people have found that there is some pick-up by doing this sort of super-senior tranche.

Pollack: There is an investor base out there that, particularly for majority of your deals, are Triple A buyers. These accounts do not want to – well, I won't say that they do not want to run any of that risk, but they don't want to run it if they can avoid it. Let's say that they are very safe Triple A buyers who will typically play in a more granular asset pool and who, by adding some additional support to a Triple A class, are eliminating a certain element of risk, and are willing to pay up for that.

At the same time, there is a cluster of investors that would rather take the extra spread and have a Triple A bond in their book. So from my perspective, it increases the hit rate of selling a deal to the investor base. If you just do one Triple A and one of your more conservative Triple A buyers does not trust it, they are gone, whereas if you can offer them a slightly less leveraged structure, then they might be interested in that.

Pelletier: This is binary type of issue where I think some individuals might not agree that a Triple A rating is the same if one of them is deferrable relative to the other. However, I think there are also economic arguments that you can make in certain instances, when a super-senior piece is so small that the chances of that actually happening are basically irrelevant.

IFR: Does the emergence of super senior so recently signal a movement of new investors into the market, or are these investors who have been sitting on the sidelines waiting for some additional insulation, and this is a timely response?

Voisey: Do US investors buy this stuff, or is it European, or is it a bit of both?

Pollack: If you can if you can structure any ABS deal to be three years or less, you are going to hit a huge pocket of money, basically the money market investor. The super-senior structure is more of a credit-driven thing and it is more about consistency of hit rate with investors. I do not think we had an investor in the book who had not at least looked at one of our deals in the past, but I increase my likelihood of selling to some of those guys by providing them with a little bit less leverage in one of the triple A tranches. However, I would not say that some gigantic RMBS investor who had not played in CMBS before came into the market. That was not the case.

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