For years, the subordinated B-pieces of commercial mortgage securitizations were the domain of what conduits called “the cartel” — GMAC Commercial Mortgage Corp., LNR Property Corp., Allied Capital Corp., and ARCap REIT Inc.
These investors, along with the rating agencies, act as gatekeepers, deciding which loans would be allowed in securitizations.
There is some debate about whether the recent proliferation of B-piece buyers is a healthy development.
On the one hand, a deluge of loans from the mid-1990s will mature in a few years. Larry Duggins, ARCap’s president and chief operating officer, said the market would need more B-piece investors to provide enough capital to refinance those loans. “We’re going to need the buyers to absorb the flow.”
And many of the new buyers — such as Capital Trust Inc. and funds managed by BlackRock Inc. — are experienced in other types of real estate investing.
The conduits are of course glad that the buyer pool has expanded, not only because their pricing has improved but because having more buyers reduces the likelihood that they will get stuck with reject loans.
Some say that another reason there are fewer “kickouts” than a few years ago is that lenders have a better handle on what kinds of loans rating agencies and B-piece buyers will allow in pools.
But others fear that the influx (along with other factors) has caused underwriting standards to slip at a time when property prices are historically high relative to cash flows.
Many of the recent entrants finance their purchases by issuing collateralized debt obligations. They sell the investment-grade slices, keep the higher-yielding ones, and use the proceeds to buy more securities.
One real estate investment manager, who spoke on condition of anonymity, said this strategy depends on investors’ demand for senior CDO tranches. And if real estate fundamentals worsen, he said, leverage will magnify losses for B-piece holders that financed their investments this way.
Because of diversification and demand, an issuer can sell a CDO for more than the sum of its parts. That profit, combined with the fat yield on the residual retained tranches, lets the issuer recoup invested equity quickly.
As a result, the investment manager said, CDO issuers are less motivated to insist on high credit quality from conduits, because anything they collect after the first few years is gravy.
Allowing just one poorly underwritten loan into a pool can lead to sizable losses, said Jack Tolliver, the head of Dominion Bond Rating Service Ltd.’s U.S. commercial mortgage securities arm. “It’s the ones that you hate that are going to kill you.”
