by: Charles G. Roberts and Angus Duncan, partners in the capital markets
department at Cadwalader, Wickersham & Taft LLP.
With the introduction of Basel II, many banks are concerned about the increase in capital charges for commercial mortgage loan positions. The Basel Regulatory Framework, among other things, sets forth the amount of capital charges that a bank must maintain against its individual positions. Therefore, an asset's risk weighting will also determine the cost of the investment for the bank. Prior to the introduction of Basel II, all commercial mortgage loan positions received the same risk weighting. However, with Basel II certain mortgage loan positions are expected to carry a higher risk weighting.
At the same time, as the changes are being introduced with Basel, Europe has seen an increase in the securitization of commercial mortgage loans and other commercial real estate investment assets. Last December saw the issuance of the Anthracite CRE CDO transaction, which was the first CRE CDO with pure European commercial real estate assets. This transaction was well received in the European markets by investors. It is widely anticipated that there will be several more such transactions from other issuers during the course of 2007.
The typical CRE CDO transaction is created to finance a portfolio of commercial real estate investments. These transactions are usually put together by nonbank investors that have a higher cost of capital than a bank. Therefore, they will utilize a CRE CDO transaction as a tool to finance their investment positions and will typically take the subordinate (or equity) and lower-rated position, in such a transaction. While the transaction exposes them to the first losses in the portfolio, they are comfortable with such risk since they originally underwrote an investment in the entire position. Also, in addition to fees they receive for managing the entire portfolio in the CRE CDO, the investors' first loss position has a higher yield given the greater risk exposure.
While the typical CRE CDO transaction is organized for a nonbank investor or asset manager, some regulated banks have started considering CRE CDOs as a method of minimizing the impact of Basel II on some of their commercial real estate lending positions. Currently, these banks are considering the full extent to which a CRE CDO transaction can be utilized to permit the bank to minimize such impact.
While Basel II will likely cause banks to experience an increase of cost when taking certain commercial real estate loan positions, banks are still the best source for locating and originating such loans. While CMBS transactions can be utilized by the banks to sell certain of their loan positions a CMBS transaction is not appropriate for the subordinate portions of commercial real estate loans or for certain types of loan. In particular, development or construction loans are not always well suited for a CMBS transaction. The rating agencies and investors in a CMBS transaction will be very focused on cash flow to make payment on the loan. These transactions require current interest payments to investors. While certain development loans and construction loans have been securitized in CMBS transactions, it is unusual for such loans to be originated in a manner that would work for the typical CMBS transaction. Typically, such loans have large reserves for current interest payments or actual lease commitments in place.
However, banks do not want to restrict themselves from being able to take positions in these types of loans. First of all, they will continue to have easy access to the borrowers for such loans. Second, their existing client base will continue to depend on them to finance these positions along with other less risky loan positions. The banks do not want Basel II to have the effect of pushing away their existing client base as well as their investment opportunities.
It is for these reasons that some banks are now considering whether CRE CDOs are an option. A CRE CDO transaction might be suitable for these other types of loans. It is also possible to utilize a CRE CDO transaction to hold loans for an interim period until the underlying property has stabilized or until the bank's next CMBS transaction will be launched.
A CRE CDO transaction might be more difficult for a bank that reports under U.S. GAAP to structure for true sale treatment. However, it may be possible for a European bank that reports under IFRS to achieve a certain amount of capital regulatory relief and also avoid consolidation of the entire loan position onto its balance sheet, even where the bank is holding some or all of the equity in the CRE CDO. Therefore, while Basel II might put pressure on banks in their origination of higher risk commercial real estate lending, a CRE CDO will permit a bank to continue originating such loans without taking the full loan and risk onto their balance sheet. While the loan itself would be sold to the CRE CDO vehicle, the bank would still manage to generate fee income, capital markets arbitrage and also keep at least a portion of the transaction on its balance sheet. It will also be able to continue to maintain a lending platform for such loans to its existing client base. At the same time, the bank will be offloading a substantial amount of the risk in such loan to other investors in the CRE CDO, thereby achieving the ultimate goal of Basel II.
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