AUTHOR: Iain Balkwill (Reed Smith)

The European commercial real estate (“CRE”) finance market currently exhibits the perfect conditions for the origination of a new CRE investment product that is structured using existing CMBS technology.  CMBS 2.0 investors are currently demanding a greater volume of note issuance and of the paper that is issued they require higher yields and more variety in the CRE assets securing such paper. Meanwhile those investors in non-performing loans (“NPLs”) clearly have an ever increasing appetite for NPL leverage.  Against this backdrop, it is surprising that the European CRE finance market is still yet to harness the opportunity of using CMBS as an instrument for financing NPLs.

The re-emergence of European CMBS

Following the onset of the global financial crisis in 2007, the role of CMBS as a funding tool in the European market has been subject to intense scrutiny. Seven years on, several issuances later and following a prolonged upswing in financial market sentiment, there is every indication that CMBS has an integral role as a financing instrument for European CRE. The re-emergence of CMBS is evidenced by the year on year growth figures, with approximately €9 billion of notes issued in 2013 and forecasts for 2014 primary issuance will be in (if not surpassing) the €10-15 billion range.

The immaturity of the CMBS 2.0 market has manifested itself in a variety of ways, of which the most striking (despite the clear demand) is the limited volume of issuance. Of the paper that has been issued, it currently suffers from a notable lack of variety given that the underlying collateral is confined to German multifamily, Italian retail and a small handful of prime UK office and shopping centre properties.

The European NPL Market

At the same time as we have witnessed the re-emergence of CMBS, the European CRE market has also seen the emergence of a significant NPL market that has been fuelled by deleveraging European banks selling off their non core assets (including a significant number of NPLs). The deleveraging process has ranged from single loan sales to mega pan European NPL portfolios secured by CRE across Europe. Whilst such sales have played an integral role in providing a mechanism through which the European Banks have been able to delever they have also provided a tremendous opportunity for value.

One of the notable features of the European CRE finance market compared to the market in the United States has been the lack of diversity in relation to CRE lending which is attributable to a smaller European CMBS market and fewer CRE loans held by insurance companies and other non-bank institutions. The lack of such diversity has manifested itself with a huge concentration of loans sat with the European banks (about 75%) which is a stark contrast to the United States (about 55%). Further, unlike in the United States, the European market is still in its relative infancy in the deleveraging process with many years yet to run. Given the high proportion of NPLs held by the banks coupled with the high likelihood that the European market is likely to stay active for a longer period compared to the United States, the European NPL market is proving to be an exciting prospect for the NPL investor (particularly investors from the United States).

To capitalise on the opportunities presented by NPL portfolios, over recent years Europe has seen a marked increase in the formation and expansion of funds. Although these funds have been deploying equity raised from all over the world to acquire these assets, to meet the level of returns demanded by their investors, it is usually necessary to leverage holdings in NPL portfolios. In the past eighteen months, Europe has therefore seen the formation of an active loan-on-loan lending market which is noted for the volume of such loans and also the range of such financing tickets given the size of some of the NPL portfolios that have traded.

Those lenders that have successfully landed these loan-on-loans will no doubt be richly rewarded, as most NPL portfolios are very granular with CRE located in a range of geographical locations, have a variety and number of tenants and include a range of different sponsors and asset managers. Furthermore, the investment fund that has been successful in acquiring an NPL portfolio (“NPL Sponsor”) will continue to have significant skin in the game and therefore be strongly incentivised to ensure that any borrowing entity will continue to meet its payment obligations under the loan.

CMBS and the NPL Portfolio – a perfect marriage?

In a market where investors in European CMBS are requiring greater volumes, yields and granularity of paper whilst at the same time Europe is also seeing the growth of an NPL financing market that is characterised by large loans secured by highly granular CRE, it is surprising that the European market has not seen a flurry of CMBS deals collateralised by NPL portfolios (an “NPL Bond”). On the face of it, the emergence of an NPL Bond would seem to be highly desirable: for the NPL Sponsor, it would  increase the source of funds available to finance their NPL portfolios which in turn is likely to drive down the cost of leverage and for the CMBS investors, these types of deals would give them the volume, yield and variety of CMBS paper which their investment portfolios so require.

Structure of an NPL Bond

Those investors that have been successful in buying an NPL portfolio will frequently use a newly formed special purpose vehicle to acquire the loans (“NPL Lender”). Funding for the acquisition will typically take the form of the NPL Lender using 100% equity or a combination of debt and equity. In the event that any debt finance is used then the third party lender (typically a bank) will lend directly to the NPL Lender.

Although it would be desirable to issue an NPL Bond contemporaneously with the acquisition of an NPL portfolio, in practice this would be difficult to achieve. NPL portfolios are often sold as part of an auction process with the seller keen to offload the NPL portfolio swiftly following conclusion of such a process. Given the time it would take to structure the NPL Bond and provide relevant disclosure, an NPL Bond would need to be issued following the acquisition of the NPL portfolio. An NPL Bond could therefore be structured in two ways:

  • Agency Deal – the NPL Lender would enter into a loan with another special purpose vehicle which in turn would directly issue NPL Bonds into the market (see figure 1).
  • True Sale – the financing bank would either securitise the acquisition loan or if pure equity has been used to acquire the NPL portfolio which is later refinanced, the bank would securitise the refinance loan (see figure 2).


Although both structures are viable, the agency structure would clearly be the most desirable and cost efficient as unlike a true sale structure the financing bank would not be required to use any of its balance sheet to lend. Further, implementing this structure would mean that the arranging bank would not be required to retain 5% of the NPL Bonds in order to satisfy the 122a retention requirements under the European Commission’s Capital Requirements Directive IV. It should however be noted that the NPL Sponsor or an affiliated entity as sponsor of the issuance would instead be required to retain a 5% interest of the NPL Bonds.

In both structures, amounts received under the NPL loans would be used to pay interest and principal on the NPL Bond. Security for these payment obligations would take the form of an assignment by way of security of the NPL Lender’s entire security interest in each underlying NPL loan and a pledge granted over the shares of the NPL Lender. All security would be held by the bond security trustee for the benefit of the NPL bondholders.

Other than with respect to special servicing, the securitisation structure would resemble that of a standard CMBS 2.0 transaction. There are likely to be several agents (account bank, cash manager, paying agent) appointed to manage cash flows and pay amounts on the NPL Bonds. A bond trustee and security trustee would respectively have the role of representing the interests of the NPL bondholders and holding security granted by the issuing vehicle and the NPL Lender. Finally, credit enhancement would be achieved through various hedging arrangements and the provision of a liquidity facility.

With regard to the day to day administration of the underlying NPL loans, a servicer would be appointed who would also be responsible for providing reporting on such loans. However a special servicer is unlikely to be appointed to maximise recoveries on the underlying loans as this is a role that the NPL Sponsor (or one of its affiliates) is likely to expect to assume.

Immediately following the acquisition of an NPL portfolio, the NPL Sponsor would deploy their expertise in maximising the value of the NPL portfolio through either restructuring or enforcing the underlying loans. In both circumstances the NPL Sponsor would look to increase the value of the CRE securing such loans through either working with the borrower or obtaining direct control of the CRE itself through enforcement. Given that a special servicer’s role is to maximise recoveries on underlying CRE loans following default, the NPL Sponsor’s active role in the transaction and it’s clear economic interest, would mean that in the case of an NPL Bond issuance there would not be a need to appoint a special servicer in relation to the underlying NPL loans – a clear deviation from the CMBS 2.0 standard.

In terms of enforcement rights following the occurrence of a bond event of default, the bond security trustee would be able to take control of the NPL portfolio by enforcing the pledge over the shares in the NPL Lender. Once such control has been obtained, the underlying loans could either be sold or action taken to maximise the recoveries on the underlying NPL loans for the benefit of the NPL bondholders.

So what is holding things up?

Despite the clear benefits of an NPL Bond and that there exists the capital markets technology to create such a product, to date there been no issuance of such a bond. This could be down to the current immaturity of the CMBS 2.0 market or there could be more fundamental issues that have caused industry participants to shy away from this product.

Potential Investor Reservations

From the perspective of a potential NPL Bond investor, then they are likely to have concerns with nuances associated with the structure.

One of the major criticisms of European CMBS has been the complexity of many of the CMBS structures used prior to the onset of the financial crisis. These concerns have been addressed in new issuance, which has so far manifested itself with transactions featuring the securitisation of single loans backed by prime CRE with very straightforward securitisation and loan structures. In sharp contrast, an NPL Bond would be the complete antithesis of this with the underlying collateral comprising a portfolio of NPLs secured by secondary property.

The complexity with the NPL Bond product arises from the presence of multiple loans. Given these loans have not been originated or pooled together specifically for a securitisation, it is likely that many of their key payment terms (amortisation profile, payment dates, interest rate provisions and even currency) would vary and therefore have to be harmonised as part of any securitisation through the use of various hedging instruments. In addition the terms and conditions of the NPL Bonds are likely to feature complex redemption conditions as well as other structural features (non accruing interest (NAI) provisions and an available funds cap) to cater for the varying payment profiles of the underlying loans. Although none of these issues are insurmountable and there are plenty of examples of this type of structuring in the 2004 – 2007 vintage of CMBS notes, nevertheless getting comfortable with such a structure would constitute a huge structural leap of faith for an investor in a market where the last true multi-loan CMBS issuance was in August 2007.

An investor may also have concerns with the representations relating to the collateral, given that due to the limited knowledge of an NPL Sponsor and the distressed nature of the underlying loans, the representations that the NPL Sponsor would be prepared to give are likely to be limited and at best highly qualified. Further, an investor would be wary of a significant prepayment risk with such a product caused by the underlying loan sponsors seeking to exit the loan as soon as feasible and the NPL Sponsor reluctant to restrict such action given that they would want to realise their profit at the earliest possible opportunity.

Finally, given that the NPL Sponsor or an affiliate would be taking on a special servicing type role from the outset of an issuance then an investor would need to get comfortable with the NPL Sponsor’s ability to perform such a role. Clearly if the NPL Sponsor or its affiliate is a rated special servicer then this would be helpful in undertaking such analysis but this is unlikely to be always the case.

Potential Sponsor Reservations

From the NPL Sponsor’s perspective the main issue with an NPL Bond structure is likely to relate to those issues that are inherent in raising debt via the capital markets.

Driven by their business needs or their desire to maximise value of the NPL portfolio, the NPL Sponsor may need to amend a material term of the securitised loan. In these circumstances the NPL Sponsor would not have the luxury of sitting down with a lender or club of lenders, but instead they would be at the mercy of the capital markets. To the extent that they require modifications, the NPL Sponsor would therefore have to embark on a consent solicitation process. Compared to agreeing terms bilaterally with a lender such a process could take a notable period of time, is potentially  costly and unless they are able to “lock-up” individual bondholders there would be a level of uncertainty as to whether the requisite amount of bondholders would sanction such modifications. A possible solution to this, is allowing the bond issuer to retain a redemption option that could be exercised at anytime in order to collapse the structure and seize back control. Where it is likely that an NPL Sponsor’s financing requirements are likely to change with respect to an NPL portfolio, then an NPL Bond may not be the best financing tool.

An NPL Bond issuance also imposes on the NPL Sponsor a variety of onerous disclosure obligations. As part of the issuance process, the NPL Sponsor would be required to disclose material facts such as key terms with respect to the acquisition of the NPL portfolio (including possibly its price), different loan strategies being considered with respect to individual loans and material facts about the operations of its business. Equally, given that the underlying credit is the underlying loans themselves, then the NPL Sponsor would be forced to agree terms with an underlying borrower to allow disclosure of material information relating to the loan including the CRE securing such a loan. Although such disclosure is viable, ultimately the NPL Sponsor has to decide whether it is comfortable or possible for such information to enter the public domain and to the extent that they cannot get comfortable, then an NPL Bond structure would be unlikely to work for them.


An NPL Bond would appear to be the perfect marriage of CMBS as a financing tool providing much needed leverage to investors in NPL portfolios. However it is likely to be a while until we witness such a marriage given the structural seismic shift between an NPL Bond structure and those CMBS 2.0 structures that are currently in the market. As the CMBS market matures and structures undoubtedly become more complex, and assuming that it can be demonstrated to an NPL Sponsor that an NPL Bond provides a cheaper form of finance compared to a traditional bank loan, then it is likely to be simply a matter of time until the European market witnesses its first ever NPL Bond issuance.