Pari Passu: Credit Barbelling, Concentration Risk, and Conflicts of Interest

Viewpoints

September 12, 2017

The ability to split loans into equal-risk components – pari passu – affords CMBS issuers significant flexibility to financially engineer conduit pools that maximize securitization value, often with adverse consequences to bond investors. It is now a routine practice for CMBS lenders to originate larger loans with lower leverage and stronger credit metrics to then allocate pari passu across a number of conduit deals in an effort to subsidize weaker credits. The prevalence of this pari passu strategy may be evidenced by the material increase in split loan exposures – from a weighted average of less than 2.0% in 2011 to over 40% for the 2016-2017 vintages. CMBS investors should carefully review pari passu loans in conduits, not only to flag credit barbelling, but also to manage concentration risk and remain mindful of conflicts of interest.

Analyzing pari passu loans for financial engineering and hidden leverage is a prudent part of credit review. As previously mentioned, pari passu allocations of higher quality and lower levered credits are often used by CMBS issuers to subsidize the metrics of a collateral pool with significant exposure to weaker loans – a practice commonly referred to as credit barbelling. Many large loans are interest-only during the full term of the debt, naturally inflating their debt service coverage ratios (DSCRs), while today’s peak valuations artificially deflate loan-to-value (LTV) ratios. As a result, many of today’s “better credits” are not actually low-risk. Additionally, properties securing lower levered notes are often encumbered by subordinate debt, which increases default risk due to the higher interest burden on the property, limited sponsor equity in the asset (the proverbial “skin-in-the-game”), and larger balloon payment required at maturity. Furthermore, a number of credit-subsidizing loans only carry five-year terms, which means they will be retired from the trust well before the last cash flow (LCF) AAA certificates receive a dollar of principal repayment.

CMBS originators often securitize large fixed-rate loans by first tranching the mortgage into a senior notes (A-notes), typically sized to a 25-35% loan-to-value (LTV) ratio, and subordinate junior notes (B-notes). For very large loans, a Single Asset Single Borrower (SASB) CMBS is often issued with a portion of the A-notes (typically equal to the AAA certificates) and all of the junior B-notes (often with control provisions allocated to the most subordinate certificates). Then, the remaining balance of pari passu A-notes are distributed across a number of conduit deals, with the 25-35% LTV credits significantly improving the average conduit LTV of 55-65%1. Investors should be wary of the credit barbelling facilitated by pari passu A-notes as well as the concentration risk across SASB and CMBS securitizations.

Not all pari passu loans are structured off larger loans and better credits; indeed, a number of smaller loans are split into pari passu components, often in an effort to reduce pool exposure to weaker assets. In some circumstances, a B-piece investor might request a smaller exposure to a given credit if a complete removal (kick-out) of the loan is unnecessary and/or a conservative adjustment to the loan structure is insufficient. In other instances, issuers may split a loan into smaller pari passu components to ensure that the weaker credit falls outside the Top 10-20 largest loans, which warrant detailed write-ups in marketing materials (often with incremental disclosures) and tend to be the focus of investor review. Analyzing historical performance across various pari passu loan balances evidences the higher default risk for smaller loans, with pari passu loans less than $15MM carrying a 4-6x higher default probability than pari passu loans greater than $100MM (Exhibit 1)2.

Exhibit 1: Average Defaults by Pari Passu Component Size

Source: TCW; Intex

Another important investor consideration with respect to pari passu loans is the significant concentration risk that results from deal after deal sharing exposure to the same assets. The weighted average balance of split loans has risen dramatically in conduit 2.0 – from less than 2% in 2011, to 9% in 2012, doubling to 20% for 2013-2015, and doubling again to over 40% for 2016-2017 (Exhibit 2)3. One of the reasons for the higher balance of pari passu loans in recent vintages is the broader consolidation of the conduit market, as a number of participants exited due to higher costs and business risks related to compliance with new regulations, such as Regulation AB II and Risk Retention4. Another wave of consolidation occurred when many of the remaining conduit issuers ended partnerships with smaller (non-bank) lenders to focus on their own origination and securitization platforms. For issuers that remain committed to CMBS, smaller deal sizes can help manage warehouse risk by reducing the turnaround time between origination and securitization. Smaller deals are also easier to syndicate, which reduces pricing risk at new issue.

Exhibit 2: Weighted Average (WAvg.) Conduit Pari Passu Balance by Vintage

Source: MS Research; Trepp

Although pari passu notes share equal credit risk, one component is often assigned control, which designates the special servicer and controlling class representative (B-Piece buyer) for the asset. This control structure creates conflicts of interest for CMBS investors secured by the non-controlling pari passu components. If a loan defaults, the designated special servicer will coordinate with the respective directing certificate holder (B-piece buyer) to review the defaulted asset and identify a resolution strategy. Presented another way, the non-controlling pari passu components allocated across various CMBS trusts have limited ability to influence the special servicer and loan resolution strategy, though they are held equally responsible for any extraordinary and/or non-recoverable trust expenses (such as special servicing fees, legal fees, insurance premiums, and non-recoverable advances).

Risks relating to conflicts of interest are exacerbated when mortgaged properties are burdened with additional debt and/or preferred equity. As previously discussed, mortgage debt can be tranched into senior A-notes and junior B-notes. Additionally, some securitized properties are encumbered by mezzanine debt and/or debt-like preferred equity (Exhibit 3)5,6. If disagreements arise between the various capital providers on these large securitized assets, the layered rights and remedies of interested parties can result in longer workout timelines and costly litigation, increasing trust expenses and risking potential losses to the certificates.

Exhibit 3: Sample Property Capital Stack

In summary, bond investors should carefully review pari passu loans in CMBS deals for credit barbelling, concentration risk, and conflicts of interest. Comparing the credit metrics of larger pari passu loans to the balance of the pool may highlight meaningful discrepancies in loan quality. Additionally, any securitized senior mortgages (A-notes) should be reviewed for incremental financing from mezzanine debt and/or preferred equity. Not only does additional financing reduce sponsor “skin-in-the-game,” but it exposes the CMBS trust (and thereby investors) to meaningful conflicts of interest that can result in delayed loan resolutions and even litigation between capital providers. Lastly and importantly, the expanded use of split loans structures across deals – over 40% of the 2016-2017 vintages – creates material concentration risk for both programmatic conduit investors and the broader CMBS market.

1 Morgan Stanley Research; Trepp

2 TCW Research; Intex

3 Morgan Stanley Research; Trepp

4 Regulation AB II compliance required November 2015; Risk Retention compliance required December 2016

5 Mezzanine debt holders are subordinate to the mortgage and are secured by pledged equity interests in the respective borrower entity. If the borrower defaults, mezzanine owners have the right to foreclose on the pledged equity interests to become the new borrower of the mortgage. Specific rights are outlined in the intercreditor agreement.

6 Preferred equity represents a senior equity position in the borrower and can be structured as more debt-like (entitled to fixed-rate distributions and a mandatory redemption date, etc.) or more equity-like (simply entitled to payment before other equity holders). Preferred equity investors typically have contractual rights and remedies established by an operating agreement (or similar agreement) such as the ability to take over management of the asset.

 

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2017 TCW