Understanding what it takes to kill a market…
by James Frischling, President, and by Ron D’Vari, CEOWeekly market view from NewOak
Collateralized loan obligations (CLOs), the securitization of bank loans to non-investment-grade companies, are on pace this year to match or exceed the record issuance levels of $91 billion in 2007. The resurgence of the CLO market is attracting a great deal of attention, particularly from regulators concerned that Wall Street’s memory of what precipitated the financial crisis is short and that history may repeat itself.
Is the scrutiny of the CLO market deserved? And does the return of this market with such a vengeance suggest that there’s excessive risk in the system?
To answer these questions, it’s important to remember that the securitization of corporate credit performed to a level far superior than that of residential mortgages. Despite the somewhat similar acronyms, a CLO was in fact very different than a collateralized debt obligation (CDO). The CLO market also benefited from the collapse of the CDO market by witnessing firsthand how the adoption of synthetics into the securitization machine and the inclusion of structured finance buckets, which often increased correlation and therefore added risk to a transaction, brought the CDO market to its knees.
Creating a synthetic market and adding structured finance buckets were topics of discussion for the CLO market before the financial crisis, but such ideas are now DOA. Market participants, including banks, CLO managers, investors, rating agencies and law firms, have seen what it takes to kill a market and that’s a vision no one in the CLO market wishes to recreate.
None of this is meant to suggest that this market isn’t getting a little frothy, as indicated by the demand from CLOs for banks’ loans and the tighter spreads they’re willing to pay than non-CLO buyers. It also doesn’t mean that covenant-lite lending isn’t increasing as a result of this demand for non-investment-grade floating rate credit.
The market pros believe that as long as all the sophisticated parties do their work, there are enough natural checks and balances to keep the CLO market from repeating the sins of the CDO market. However, we’ve seen what happens when parties don’t do their work and it gets ugly quickly.
Growth of Single-Family Rental Bonds: Cause for Concern?
Until now, a large segment of the single-family investment market has been dominated by local small/individual investors owning fewer than 20 single-family rental properties. However, the share of institutional investors in this market has been increasing rapidly. The growth of institutional single-family rental and the emergence of securitization of the revenues, while still in its infancy, have prompted some groups to call for regulatory oversight. The fear is that the securitization will shift the balance of power, with some predicting upwards of $70 billion in bond issuance.
In the last three years, institutional investors have acquired hundreds of thousands of distressed single-family properties at deep discounts for the purpose of fixing them up and renting them. The institutional investors have been purchasing these single-family properties from banks or individual investors who typically acquire them at auction to flip them to end users or larger investors. The emergence of the institutional single-family rental business has been driven by several factors: 1) a large supply of single-family homes available at a discount due to the great recession; 2) rising rents due to demand by more than four million new renters created during the great recession; 3) stringent requirements for obtaining mortgages resulting in suppressed home ownership demand; 4) faster rise in prices of the multi-family apartment sector due to more intense competition and cap rate compression; and 5) the development of a specialized infrastructure to manage single-family rental operations.
Tapping the securitization market
The institutional investors initially obtained leverage through banks and other private equity lenders. However, they are gradually tapping the securitization market to refinance these loans. So far, there have been two mortgage-backed securities tied to single-family rentals that have tested the market. These single-family rental securitizations are backed by the rental revenue stream from a portfolio of single-family homes. The loan is backed by all properties and it is non-recourse. Moody’s Investors Service, Morningstar, and Kroll Bond Rating have developed frameworks for rating these securities, while S&P and Fitch having expressed concern about a lack of historical operating data to rate them.
The major difference between the single-family rental securities and typical commercial mortgage-backed securities (CMBS) is that the homes financed are scattered across many states and neighborhoods with a single borrower/operator. In contrast, the properties under each loan of a CMBS are generally concentrated in a few large commercial buildings.
Regulatory oversight is not needed as local rental laws are already in place and are continually evolving. The fact that institutional investors will be operating these units as part of securitization should not require new rules, but could perhaps benefit from an ongoing operational advisor to represent the bond holders’ interests and maintain oversight of the operator and its potential replacement. Furthermore, the concern for refinancing of the single-family rental bonds in two to three years is also mitigated by naturally increasing rent rolls as well as home prices. Nevertheless, the institutional single-family rental business model and its long-term economics will evolve as distressed home prices normalize and demand for home ownership rises.