United States: It's Time To Bring Back The Square State Conduit: If We Build It, They Will Come.

Last Updated: August 1 2017
Article by Richard D. Jones

What in the world have we done to ourselves? Our CRE Securitization business, or at least the conduit part of our business, continues to shrink: $800 billion in outstanding principal balance in 2007 and now, $400 billion? Maybe, right now, we're at a run rate of $50 billion per year. Is that enough? Does that deliver critical mass? Are we a going concern?


As the business shrinks, the CMBS share of the Lehman Index (Bloomberg Index) continues to dwindle. That imperils liquidity and the diminishment of liquidity itself becomes yet another reason to abandon the sector. As that happens, some investors drop out, some "right size" their CMBS teams and as fewer analysts follow the space, the business again dwindles. Net/net, investors lose interest as there are fewer and fewer reasons to buy CMBS bonds. As the business gets smaller, less attention is paid by the mortgage banking community, fewer opportunities find their way to the CMBS window and other service providers are stressed. Wash, rinse and repeat until someone shuts off the lights and locks the door on the way out.

Okay, I'm overstating it a bit, but you get the idea. We've got a problem.

There are lots of reasons why this has happened, or at least lots of reasons articulated by industry professionals. There are not enough investment grade buyers to sustain a bigger industry. The investment grade buyers have gotten snooty and require only really good (e.g.: sub 60% LTV) loan pools. After a brief shining moment (at least from the issuer's perspective) when the B buyer's bid letters contained no kick-outs stips, the B buyers are kicking sand in the bankers' face and want to get paid pretty well for even pools of high quality loans. Maybe it's risk retention. Maybe LCR and other Basel fun. Maybe regulatory overreach is killing us off. Or not. It's the Russians. Or it's all Donald Trump's fault. Whatever.

We've gotten to a place where CMBS originators only want to make really, really good loans. Increasingly then, our competition is lifecos and other portfolio lenders. Is there any doubt whatsoever that a borrower looking for a really, really good loan, i.e., low LTV, terrific tenants, great location, prime market, etc., is going to go to the CMBS window last? I don't think so.

So what's all this mean? It means the business is shrinking because we're trying to do something that we're not good at, something the business is ill-equipped to do.

What have we been doing about it? We think about making the "servicing experience" less awful. ( See my prior blog on why borrowers hate us). Here's the above-the-fold headline, "We can't make the servicing experience in CMBS as good as the servicing experience that a borrower will have with a portfolio lender." Period. Full Stop. Why? Two big reasons. First, the power of and the fatal flaw of the CMBS paradigm is that we have deconstructed the traditional portfolio lender into its functional constituent parts. This makes a great deal of sense for a whole bunch of reasons, but servicing efficiency suffers as we act through a series of bilateral contractual relationships. Even with the best of intentions, acting in that type of structure takes time. Time is the enemy of happy borrowers. For our customers, our servicing structure gets in the way of the efficient conduct of their business. If you have a really good lease for which you need lender consent and you end up on Social Security with a walker by the time the master servicer, special servicer and controlling class representative get back to you with an okay, then you probably lost the lease and you're not going to be happy. That's the guy who sits at the end of the bar at the country club and swears a blue streak that he'll never borrow from the CMBS industry again.

The industry is trying to make this process work better and that is a salutary undertaking. Under the auspices of CREFC, a group of issuers, servicers and other service providers are working diligently to make the servicing process work better and more efficiently for the borrowers. This is good and good can and certainly will come from this.

But it will never be enough. What's the one thing missing in CMBS servicing that cannot be replicated? Here's the conversation between Joe Borrower and Mr. Portfolio Lender:

Hey buddy, I need to get a lease approved and I really need to get it done in the next couple of days. I have a term sheet. Tell me you're okay and we'll get this thing done. It's a great lease, trust me. And, by the way, I'd like to talk to you about a new loan....

You can't talk to a CMBS servicer about a new loan; it's like talking to a fish about gravy. A portfolio lender can look at a borrower relationship in its totality. It can take into account the borrower's interest in doing further business with the lender, as well as the borrower's request for accommodation with respect to an existing loan. That is simply going to make the servicing experience better for the borrower.

So what do we do? A pillar of good management, which you can read about in any business book randomly selected from any airport bookstore, is that one of the most common mistakes institutions make when naval gazing about strategy is that they focus on what they do poorly as opposed as to what they do well.

Institutions make real strides by focusing on what they do well and doing it better.

If you're not good at something, there may be a really good structural reason why you're not and the inability to take into account the totality of the borrower relationship and the multi-polar structure of our servicing, are incurable disabilities. There you go. Servicing improvement is not the answer.

We need to face up to this reality and ask what do we do well? We provide ten year fixed price non-recourse money to people who are hungry for proceeds or who cannot otherwise get their needs met by the more conservative portfolio lending marketplace. In short, proceeds starved owners of B and C properties often located in secondary and tertiary markets. That's what this business was born to do, that's what it did well in its heyday, and that's what it seems it has forgotten how to do.

So here's my modest proposal: Someone out there build a Square State Conduit. Build a conduit that can serve the needs of B and C borrowers and secondary and tertiary markets. Build a conduit that makes full loans, a conduit that assumes that there will be losses in pools and that the buyers at the bottom of the capital stack will need to earn a return which takes into account those sorts of losses. Build a program where the coupon pays for all this to meet the needs of those folks who cannot achieve their business goals with the 2017 conduit prime sausage-making machine. Build a conduit with higher subordination levels and wider spreads. Essentially reset the business to where it used to be.

If we did that, our business would double in size. The increased volume would improve efficiency of execution, would improve deal flow and production and find appetite in the investor community. Right now we're in a death spiral. We need to reverse that and create a virtuous cycle to reflate our business.

If we think we can keep this business alive while ignoring our strengths and trying to fix our weaknesses, we will fail.

That's what I took from CREFC this year.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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