Host Amar Reganti is joined by head of financial reserves management Alyssa Irving to discuss the state of commercial real estate lending, focusing on CMBS, private credit, and evolving market dynamics.
Host Amar Reganti is joined by head of financial reserves management Alyssa Irving to discuss the state of commercial real estate lending, focusing on CMBS, private credit, and evolving market dynamics.
2:00 What is financial reserves management?
3:05 Early days of the commercial real estate lending
5:30 Similarities and differences with the current CMBS market
7:45 Effect of private credit
9:50 Valuations and risks of CMBS
13:00 How can investors gain exposure?
14:30 Esoteric securitizations
ALYSSA IRVING: Insurance globally are one of the biggest investors in fixed income markets. And their asset allocation decisions can drive the technicals of many of the global fixed income sectors.
AMAR REGANTI: In the early 1990s, commercial real estate lending on Wall Street was in the doldrums. Banks were not lending as they once were. Billions of dollars of debt issued in the 1980s was coming due, and few professionals saw that that area of the market could be a place to grow and innovate. But Ethan Penner, then a young fixed income professional with stints at Drexel and Morgan Stanley, saw a chance to initiate what would become a massive change for the industry. From Penner’s work at Nomura, the commercial mortgage-backed securities market was born, the work of lending billions in what were at the time considered mega-deals, then pooling those loans and selling off slices or tranches. That unique innovation has become a linchpin in modern real estate finance, and fixed income markets as well. For that reason alone, Penner is regarded as one of the giants whose work led to the creation of an entirely new field. Much like Michael Milken at Drexel, Lewis Ranieri at Salomon Brothers, Penner’s time at Nomura changed modern public fixed income investing. My guest today worked with Penner as a young analyst, and she was present at the creation of the CMBS market, which today has such a dominant role in the securitized credit markets. Alyssa Irving is now Head of Financial Reserves Management here at Wellington, and we have a unique opportunity to talk to her about the evolution of commercial real estate lending, and what she thinks are the drivers of change going forward. I’m Amar Reganti, Fixed Income Strategist, and as of this month, the Global Insurance Strategist for Wellington Management. Alyssa, welcome to the Investor Exchange. It’s great to have you here.
ALYSSA IRVING: Thank you. Thanks so much for having me.
AMAR REGANTI: So really quick, what is the financial reserves management business?
ALYSSA IRVING: So the financial reserves management business is really another name for our insurance investing business here at Wellington. We realized after the global financial crisis that managing insurance portfolios is really different than managing for other clients. And so we built, back in 2010, we built a dedicated team of portfolio managers focused on investing for insurers. Today, the team manages about $165 billion on behalf of insurers.
AMAR REGANTI: And I’m going to just sort of throw out, like, as someone who’s worked both in the insurance and non-insurance side of the business, why should non-insurance clients and investors care about what insurers do or think about, I guess?
ALYSSA IRVING: Insurers globally are one of the biggest investors in fixed income markets. Their asset allocation decisions can drive the technicals of many of the global fixed income sectors.
AMAR REGANTI: All right, well going back to Penner’s world, what was the market like at the time? I mean, it seems like the Wild West in everything I read about it.
ALYSSA IRVING: Well, it’s exciting to be talking about it, because it’s not something I spend too much time thinking about. If I go back to 1996, it was a very formative time in my career. So just trying to remember those days is… there are a lot of fond memories in terms of being right out of undergraduate and being dropped on Wall Street at a Japanese bank with a group of commercial real estate professionals who were really among the best and were incredibly innovative. So if I think back to what was happening, it was right after the savings and loan crisis and the RTC had just been created in terms of these, government-supported, essentially CMBS.
AMAR REGANTI: And just to our listeners, the RTC was the Resolution Trust Corporation, which was formed by the government to help bail out assets effectively owned by savings and loan corporations.
ALYSSA IRVING: Exactly. So, those were sort of the first CMBS transactions that had ever been done. And I think the group that was hired at Nomura was really focused on creating similar bonds out of nongovernment guaranteed cash flows, which were, you know, the very first CMBS transactions that were brought to market. So I worked there in 1996 to 1998. They were doing, at the time, you mentioned mega-deals. We had mega-deals, which were kind of like today’s SASB. I think they were just called D-deals, that were actual what’s called today conduit and it was a large pool of diversified commercial mortgages that were sliced and diced.
AMAR REGANTI: Well, what I find incredible in my 25 years in fixed income is that so many individuals who had moved up in the world of securitization, and particularly in CMBS, had some connection or professionally with that team. And you see them sort of everywhere, just like the high-yield professionals often came and started at Drexel somehow. O, and as one further explainer, Alyssa also used a term called SASB, which is what means single asset, single borrower. It means the securitization of an individual property, rather than a conduit deal, which is an amalgamation of many properties. Did I say that and do that right?
ALYSSA IRVING: Yeah, that was perfect --
AMAR REGANTI: Okay.
ALYSSA IRVING: That was absolutely perfect.
AMAR REGANTI: Okay, you were there or present at the creation. Where have things evolved to now? And even like post-GFC, like what’s the big changes you’ve seen to get us to where we are now?
ALYSSA IRVING: One really interesting thought about back then compared to now is there are so many similarities, if I think back, in terms of this is not that well-known, but Nomura at the time was also doing other types of loans. They weren’t just originating commercial mortgage loans. And one of my responsibilities when I was there is trying to figure out ways to securitize other assets away from commercial mortgage loans. It was actually how I ended up finding my way from Nomura to Fitch was because of some of the loans that had been done at the time, trying to figure out if we could create private ABS structures back in 1998.
AMAR REGANTI: Now the hot topic.
ALYSSA IRVING: The hot topic. So, there’s so many similarities to what was being done in the ‘90s to what’s happening today. The evolution of CMBS is very long, so I’m not sure I could do the best job of every aspect of the details, but it’s commercial real estate’s boom bust, as we know. And so when you put a commercial mortgage loan into a discrete trust and there’s a long life for a commercial mortgage loan, therefore a long life for the bond, the bonds can be highly cyclical, I guess is what I was trying to say. We’ve seen tremendous growth in lending since 1996 for commercial mortgages, but we’ve seen changes in who the lenders are, really. And that’s driven a lot of the composition of the commercial mortgage-backed securities market.
AMAR REGANTI: So the lenders once what were banks, and they wanted to move things off balance sheet. The lenders now are...?
ALYSSA IRVING: Today the lenders are specialty finance companies, and there’s a lot of private credit lenders out there as well. And so, the CMBS market historically was about moving assets off balance sheet into a structure and maybe in some cases a NIM realization, but there’s been a lot of accounting and regulatory changes since 1996 that today, we have risk retention within CMBS and there’s meant to be skin in the game and alignment along the way.
AMAR REGANTI: So the securitization itself isn’t achieving, kind of, the balance sheet or regulatory relief that the banks wanted when they first started doing this. So, then you have this private credit channel sort of stepping in. Is that the next big… is that the future? Like that a much larger portion of these securitizations is gonna be derived from, what I would call the nonbank lenders?
ALYSSA IRVING: I think it has to be. I think it is already. I think it’s just getting started. I guess what could change that is the current administration’s plans around deregulation. And so, frankly, I’m surprised that there isn’t more discussion around changes to Dodd-Frank or things that could be done on the regulation side that could make the banks and the securitization markets more competitive to private credit. But today, private credit is far more competitive as a lending.
AMAR REGANTI: Will it be to some degree the whale that swallows the fish kind of this giant pool of private credit becoming almost the standard way of lending into this market. versus the publicly-traded and available CMBS that I’ve grown up with across my lifetime and you as well?
ALYSSA IRVING: I think it all comes down to execution. And so if the trend that we see today, the amount of demand that is out there for private credit continues, then I think it absolutely could be. To me it’s sort of like, some people don’t like this term, but securitization used to be the shadow banking market and I think today private credit is the shadow banking market.
AMAR REGANTI: I don’t know why people actually get upset about that term. It just means a less regulated credit channel because there’s not the direct kind of prudential oversight that banks have.
ALYSSA IRVING: And I would say the securitized market is now heavily regulated post-GFC, and so there needed to be this creation of a new way to lend that’s less regulated.
AMAR REGANTI: When I look at my relative value charts in my book, the one thing that almost sticks out is the spreads on CMBS, even on the higher part of the stack. That kind of combined with the AAA bankruptcies we’ve seen, like the one at 1740 Broadway, a property in New York City, which was widely sort of publicized. Like, how do you view the valuation right now? It is a place where you’re sort of just selective deal by deal, or do you like the entire sector because it looks at least topically like the cheapest part of the credit markets? Where do you come out?
ALYSSA IRVING: It does look cheap.
AMAR REGANTI: It does look cheap.
ALYSSA IRVING: It does look cheap. But I would say there’s anumber of things going on there. So if we dissect it a little bit and talk about just the AAA part of the capital structure and we think about conduit specifically, you have to break it out into seasoned collateral and newer vintage or new origination collateral. The biggest reason you’re getting optically paid more, in my opinion, is for cash flow variability. So what historically we would have thought was a bulleted payment structure is not that bulleted because it turns out that loans can be modified and extended, and that the special servicer can do what’s in the best interest of ideally all bondholders, but really the first-loss position, to make workouts the highest recovery value. And oftentimes that decision, when you start to have a seasoned bond is to modify loans and then your cash flows are not what you expected.
AMAR REGANTI: That’s so different from corporate credit.
ALYSSA IRVING: So different.
AMAR REGANTI: Like that would probably trigger a selective default of some sort.
ALYSSA IRVING: Exactly. And this is one thing that really, really rubs me the wrong way about AAA CMBS.
AMAR REGANTI: You’re taking it personally.
ALYSSA IRVING: Is that there’s no protections for senior investors in the structure or in the documents that allows for cash flows to be what was expected.
AMAR REGANTI: So when you say cash flows as expected, like in other ABS deals, for example, if there’s underperformance of the collateral, the AAA will actually get paid faster almost.
ALYSSA IRVING: Exactly.
AMAR REGANTI: That pay down structure doesn’t exist in the CMBS world, is that --
ALYSSA IRVING: That’s a good point.
AMAR REGANTI: Broadly correct? I know deal-by-deal, yeah, okay. That’s interesting.
ALYSSA IRVING: And in SASB, it’s another conundrum where typically you’re buying a floating rate. They’re not all floating rate, but it’s a two-year non-call and then it has five one-year extension options. And so, are you buying a two-year, a three-year, a four-year, a five-year? Seven year?
AMAR REGANTI: Yeah, it’s funny. You don’t even own the option either.
ALYSSA IRVING: You don’t.
AMAR REGANTI: Someone else does.
ALYSSA IRVING: The borrower does.
AMAR REGANTI: The borrower owns the option.
ALYSSA IRVING: So I think you have to be paid extra for that cash flow variability. And then you also have to be paid for the complexity of the underwriting of understanding what the cash flow variability could be.
AMAR REGANTI: Are you paid for the liquidity?
ALYSSA IRVING: You should be. I mean, I think in theory, we all think that structured finance or securitized in general carries an illiquidity premium and a complexity premium. I mean, I think that in some places you’re not paid enough, and in others you’re paid more than you need to be.
AMAR REGANTI: So given your comments on the growth of the private side of the market, the challenges to what would have been the traditional bank-sponsored securitizations, what does that end up like from a client-facing perspective? Like, is it that people will just gravitate toward privates or are there people in your experience who need just only the publics even though that market might be shrinking? Is there some blending? Is that sort of like the next iteration of how people get exposure?
ALYSSA IRVING: I think so. I think it’s a little bit of all of the above. And I think having the ability of a fiduciary to be able to make the decision on what looks more compelling from either a credit underwriting standpoint or a valuation standpoint is pretty compelling from my seat. So the reason I say that is if I think about myself trying to find the best value for clients, looking across both publics and privates, I can observe that there are cases where there’s too much money chasing the privates, and you may see an example of a bond on the private side trading inside of a public in a given type of structure, say a data center.
AMAR REGANTI: Okay, as an example.
ALYSSA IRVING: As an example. But yeah, I think increasingly, it would make sense to me that investors be able to look across the spectrum and think about it holistically.
AMAR REGANTI: The last question I wanted to ask you, which was I guess is a little bit of a surprise question, because you brought it up initially, is that way back when you’re looking at things coming out of the RTC and there were interesting securitizations that were taking place. And now I see esoteric securitizations taking place. To people listening who aren’t as familiar with the world, how esoteric can it get? Like, what can you securitize?
ALYSSA IRVING: I mean, you can securitize anything with a cash flow. Esoteric ABS makes me smile because I do think back to those times where when I first started at Fitch in 1998, I mean, we were rating film securitizations. And I can’t name them because they were private and I can’t talk about who, but we were,
AMAR REGANTI: There was the famous Bowie Bonds of yesteryear.
ALYSSA IRVING: Yeah, but interestingly, Bowie Bonds got a lot of press, but it actually carried a guarantee from the record company, so it was essentially a corporate.
AMAR REGANTI: Oh!
ALYSSA IRVING: But later there were several securitizations of music catalogs.
AMAR REGANTI: I didn’t know that about the Bowie Bonds.
ALYSSA IRVING: A lot of people don’t. A lot of people don’t.
AMAR REGANTI: You can think those cash flows are timeless.
ALYSSA IRVING: Yeah.
AMAR REGANTI: But yeah.
ALYSSA IRVING: But there are heavy metal bands, that sold their music catalogs. There were several Motown greats that sold their music catalogs. And yeah, I think increasingly royalties, are well understood that they --
AMAR REGANTI: Royalties like pharma, intellectual property rights?
ALYSSA IRVING: Anything.
AMAR REGANTI: Wow. Well look, you satisfied the question I had there because it’s just really interesting. I wanted to thank you for taking the time away from a very busy schedule to talk with us. That was Alyssa Irving, Head of Financial Reserves Management here at Wellington Management, and this is the Investor Exchange. Alyssa, thanks again for joining us.
ALYSSA IRVING: Thanks so much for having me.
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