In August, Charlotte, N.C.-based First Union Capital Markets Corp. and New York's Chase Manhattan Corp. joined together in a successful $1.4 billion commercial mortgage-backed securities (CMBS) transaction. The issuance - comprised of 205 commercial mortgage loans secured by 217 properties - went to market with a 9.69-year, $816 million AAA-rated portion sold at 154 basis points over U.S. Treasuries with a comparable maturity.
This was the second time First Union and Chase paired to bring a CMBS issuance to securitization.
While it's true the two companies are fierce competitors on the origination side of the CMBS market, when it comes to securitization the two seem to be a perfect match. In fact, with the trend of "pairing" or "partnering" CMBS transactions, a whole host of strange bedfellows have made perfect matches.
A place for paired transactions Paired transactions began to pick up steam early last year, but after the great credit crunch of 1998, when the CMBS market was all but shut down, the concept has come to dominate the securitization side of the business. The conduits that got badly hurt when the credit markets collapsed were those that had warehoused loans for future. With a lesson learned, conduits now want to get to the market as quickly as possible.
"Due to the capital-market crash last year and the volatility that we are going through right now, you really can't afford to take that much balance sheet risk, which is why some people got into trouble last year," observes Tim Mazetti, executive vice president at Kansas City, Mo-based Midland Loan Services Inc. "The volatility is so great, you don't want to get caught with your pants down."
Given the buoyancy of the market at the present time, conduits try to reduce time exposure to market risk, explains David Tibbals, managing director in commercial mortgage finance at Salomon Smith Barney in New York. "As soon as the conduits can, they sell the product which means they are exposed to less risk."
However, one of the problems with coming to market so quickly is that it's harder to get greater diversity in the portfolio. Furthermore, portfolios need to be as diverse as possible in order to attain the best subordination levels from the rating agencies. "You have that trade-off in terms of optimizing the rating agency evaluation vs. getting to the market as quickly as you can," says Tibbals. "So, by teaming up with other originators where you can pool your loans into a much larger deal, you get diversity and you get to the market faster."
Prior to the crash of 1998, the mantra for CMBS was "bigger is better" because there was more liquidity for investment grade bond buyers and good economies of scale as far as cost distribution. There also seemed to be unlimited demand, so firms like New York-based Nomura were coming out with $2 billion issues and others tried to pool to get bigger deals. After the crash, the average size of the deal dropped to about a $1 billion and today, many issuers are coming out with $600-million to $800-million deals.
"The operative phrase right now is 'mitigating warehouse risk'," says Mazzetti, "Which means you have to come to the market at least once a quarter and most people don't have that kind of origination machine."
According to Mazetti, the optimum size for most firms on a CMBS transaction is about $800 million to $1 billion. "You don't want to get too much bigger, because you are exposing yourself to too much risk, plus the bond buying public is leery of larger transactions."
In July, Midland did a $730 million deal with Residential Funding Corp. and Canadian Imperial Bank of Commerce (CIBC).
It's a question of speed, adds Tibbals. "Most deals are being done in the $1 billion range, and companies are trying to go to market ideally every three to four months." Unfortunately, production is down, so it is difficult for any single firm to originate more than $1 billion worth of product.
Last year, CMBS securitization hit a record $78 billion. This year's estimates are in the $60 billion range - a serious decline in volume.
A growing trend? "The trend to partnered deals is a direct result of the lack of volume," says Brian Stoffers, executive vice president with Houston-based L.J. Melody & Co., a division of Los Angeles-based CB Richard Ellis. "The conduits are trying to get these loans off the books as quickly as possible so they don't suffer from spread widening, but with volume down they need to pair up to get the pools big enough for securitization."
"If you want to go to market as often as you did in the past," says Ken Rivkin, head of mortgage-backed trading at Bank of America (BofA) in Charlotte, N.C., then a partner is needed to get critical mass. "Even with partnerships, the size of these transactions are smaller than they were previously," he adds.
Historically, BofA has sought to create brand identity by securitizing its own collateral and acting as the sole manager. The company's last four transactions were done in that manner.
BofA produces enough loans to make a go of it as a single issuer in a securitization. It's cross-town rival, First Union, is a big enough player in CMBS. In fact, throughout the first half of 1999, First Union was ranked no. 1 in conduit collateral.
"First Union is very attuned to its brand and having a positive image in the investor community," says Barry Reiner, managing director of First Union's commercial real estate finance unit. "We believe we have accomplished that both by ourselves such as in January when we were the sole collateral contributor on a deal, as well as in May - and August - with Chase Manhattan. The First Union brand is well received and rates well and at the same time when it is in a paired deal, it is also received very positively."
In its current deal with Chase Manhattan, First Union contributed a majority of the loans - almost $1 billion. "We could have done our own deal had we elected to," says Reiner. "But many others don't have that option because they would have only done $300 million to $400 million, and in order to limit aggregation risk, they partner up."
First Union's platform is to come to the market quarterly with a deal around $1 billion. If it has enough collateral to go to market by itself, it would. If the company needs a partner to go above the $1 billion market, then it will find another issuer similar to it.
"The process is slower with two or more issuers as there are too many cooks in the kitchen," says Reiner. "But, we have a good relationship with Chase in that we view the world in a similar way."
High- and low-quality originators Similarity of collateral quality is also important. "Two years ago you could partner with anybody and your bonds would sell the same as anybody else's within a basis point and nobody really distinguished originator quality," says Reiner. "Now originator practices and credit culture are looked at very closely by investors so we view the partnership selection process very carefully in order to find somebody that is similar to us in origination practices."
Apparently, if a high-quality originator teams up with a low-quality originator that's pushing the underwriting, it can hurt the brand of the high-quality underwriter. In addition, the bonds will trade at the lowest common denominator.
What's interesting about First Union is that it has historically teamed up with Wall Street investment banks such as Merrill Lynch and Lehman Brothers - both New York-based companies - to come to market. Those deals worked extremely well, Reiner says, but in today's market, investors are looking more closely at origination practices and the fact that Chase Manhattan and First Union have separate credit functions that report outside of the business unit.
Issuers look to choose another issuer to pair with on the basis of similar quality collateral, concurs Scott Davidson, head of Chase Manhattan's CMBS banking & trading unit. At the same time, collateral has to be slightly different. For example, if one issuer has severalloans, it would be wise to team up with someone who has no California loans.
"At Chase we have a slightly larger loan profile than First Union, so we don't find ourselves competing with them so much because we do larger stuff and they do smaller stuff. You try to have a good blend to create better diversification," says Davidson.
Although timing is an issue, Davidson says it would be sacrificed so as to come to market with the absolute right issuer. "We would be willing to wait a little bit and adjust our timing to transact with the right partner," says Davidson. "Of foremost importance is to choose a partner that is a particularly high quality provider of CMBS. We make loans to high-quality borrowers, we put together some of the better transactions and regardless of timing and risk, if we can't find a partner that shares the same or similar story about the quality of their loans, we would not partner with them.
"We may want to go to market in the third week of September," he adds. "You may want to go in the third week in September. But if I don't like the quality of your loans, I'm not going with you."
In June, New York-based Bear Stearns teamed up with San Francisco-based Wells Fargo in a $1.1 billion securitization. In the past, Bear Stearns had done a lot of stand alone securitizations as it wanted to make sure people understood what its collateral and program looked like. In its last issuance, "We were fortunate to find Wells Fargo," says Christopher Hoeffel, managing director at Bear Stearns. "Wells Fargo has a very comparable program to ours so we felt that we had a strong brand of our own and Wells Fargo had strong brand on their own so putting the two together was additive."
Two of a kind Issuers have to be careful because it is possible to be mispaired, says Hoeffel. "Rating agencies have different sensitivities about different types of collateral. If I have one type of collateral, maybe it's short end with low coverage, and I am pairing with high coverage, long amortization, different rating agencies may treat that differently and one firm will get the benefit and one firm won't. It's a lose-lose in the collateral sense," he says.
Pairing, Hoeffel notes, does sometimes bump up against the timing issue. "I may be ready to securitize and my partner from the last two transactions is not ready. If it does not have enough collateral and needs to wait. I can either go on my own, find a new partner or sit around and wait until my old partner has enough collateral. Not many people chose the latter option."
Donaldson, Lufkin & Jenrette (DLJ) of New York likes to go it alone and has gone solo on its last five securitizations. As with other issuers, for the big investment banker, it is simply a matter of establishing a brand name.
Don MacKinnon, DLJ managing director and group head of CMBS, says some of the hurdles of a joint venture include lead manager placement, shelf registration (whose shelf do you use), fundamental disagreements on credit quality which wasn't identified up front, and timing.
"When you work together it tends to be slower then when you work by yourself," says Mackinnon. "Coordinating with two is more difficult than coordinating with one. During difficult market conditions such as last autumn, if you had your own deal you could do what you wanted with it, but if you were with a partner you had to worry about the interest of the other partner."
In April, Phoenix-based Finova Group Inc. came to market in a single-issuer securitization of $760 million. The fact that Finova didn't team up with anyone was also a matter of timing.
"Since a lot of people had slowed down production in the fourth-quarter 1998, and we wanted to go to market in March or April, there were not a lot of likely players to team up with," says David Rogers, managing director of Finova. "Second, we had enough from our own deals that we didn't have to team up with anyone, although the issuance was a little on the small side. And, third, we had been involved in the CMBS market for a long time and contributed collateral to some 20 deals, and we now felt it was important for us to be able to tell the Finova story."
Finova had contributed collateral to deals done by Lehman Brothers, Morgan Stanley, Credit Suisse First Boston. "We were behind the scenes, originating good quality loans and contributing them to other people's transactions," says Rogers.
Finova did an extensive road show for its first securitization, telling the investment community about Finova, how it did business and the quality of loans, all of which might have gotten diluted had the company paired up. As it happened, the Finova deal "traded a little worse than it would have otherwise," because of liquidity and size. "Investors looked at the deal and said, 'It's $700 million and Finova is not a brand name, this is their first deal," says Rogers. "If I own a Lehman or a First Union, I can pick up the phone and get eight bidders because everyone knows it and is willing to buy it."
Having done a deal that was exclusively Finova's and having established market recognition, says Rogers, "There is a lot less incentive for us to continue to do that provided we can team up with the right partner. We will seriously consider doing paired offerings and will likely do a significant portion of our business that way."
In May, Newark, N.J.-based Prudential Securities was the lead underwriter for a securitization of Heller Financial and Prudential Mortgage Capital, a sister company that does mortgage originations. "Prudential Mortgage, as well as with other originators, spends a lot of time thinking about who a partner might be, all in the context of co-branding," says Clay Lebhar, managing director and group head of the Real Estate Debt Capital Group. The word, "co-branding" suggests partners in the offering carry both the quality name and quality collateral.
So, how does a company find another to co-brand with? First, it should look at the quality of the collateral that has been produced in the past and that which the other company is currently producing. Second, examine the general profile of the collateral to determine whether it's an appropriate fit with your collateral in terms of property type and geographic dispersion. Third, talk to market participants including institutional investors to get a bead on a future participant.
Sometimes a company thinks it has found a good partner, says Lebhar, but then finds out the two have the same geographic concentration in the collateral, or that both companies have a high concentration in a real estate asset such as hotels and both need to dilute that property type.
"There is not an extremely long list of originators one company would partner with," says Lebhar. "For most originators the list of potential partners is very short."