When Wells Fargo & Co. acquired Wachovia in 2008, as the latter bank teetered on the brink of collapse, Wells absorbed a major underwriter of real estate collateralized debt obligations. Though the CDO market ground to a halt during the financial crisis, Wells Fargo in recent years has built a thriving business raising capital for nonbank real estate lenders with a newer bundled-loan product.
In underwriting the latest offerings, which have key differences from pre-crisis CDOs that proponents say make them safer for investors, the bank is effectively helping to finance some of the more aggressive competitors to its commercial real estate lending business.
Pre-crisis real estate CDOs were securitized collections of a wide range of debt assets, including senior and mezzanine property loans, derivatives, corporate debt and preferred equity securities from real estate investment trusts, and first-loss tranches of other securitizations. They attracted debt investors with high yields, coupled with levels of risk that many market participants underestimated.
Now, more than a decade after the crisis, a successor to the real estate CDO is growing in popularity. Critically, the newer securitizations, known as collateralized loan obligations, are backed largely by whole loans on unstabilized properties — real estate that is not fully operational or leased. Each securitization typically includes loans originated by a single lender, with the lender, not the investment bank packaging the securitization, retaining a portion of the risk.
Wells Fargo finished 2018 as the leading CRE CLO underwriter, taking that title for the sixth year in a row. Total U.S. CRE CLO issuance nearly doubled in 2018 to about $13.88 billion, according to Commercial Mortgage Alert. A.J. Sfarra, managing director and head of CRE CLO and commercial mortgage-backed securities securitization at Wells Fargo, said he expects total volume to grow again in 2019, possibly to the $20 billion range.
Before the crisis, combined global issuance of real estate CDOs and re-securitizations peaked in 2007 at $41.22 billion, with about $40 billion of that total in the U.S., according to Commercial Mortgage Alert.
Wells Fargo's leaders have said they are comfortable with a dynamic that allows the bank to trim its direct lending in sectors such as commercial real estate, where some of its investors may be more cautious, while continuing to generate revenue indirectly from those same sectors through warehouse lending and structured finance issuance.
"Sometimes we're financing one of our competitors on a deal, and sometimes we're sharing the credit," CEO Timothy Sloan said during an October 2018 earnings conference call. "But that's okay. I mean, that's just part of the overall business to make sure that we're providing credit to all of our customers."
Rise of CLOs
Wells Fargo agreed with the SEC in 2011 to pay $11 million to settle securities fraud charges arising from Wachovia CDO deals. The bank's commercial real estate capital markets business, meanwhile, had been growing following the acquisition. In 2009 and 2010, the group began increasing its warehouse lending: making loans to other balance-sheet lenders, which in turn were making transitional bridge loans to owners, developers and operators of commercial real estate.
Many of Wells Fargo's warehouse lending clients are specialty finance companies, including private debt funds and mortgage real estate investment trusts, that have crowded into the commercial real estate lending space in recent years as banks have pulled back amid regulatory scrutiny.
"We view that as an attractive opportunity for Wells and its balance sheet, to lend at conservative levels on loans that we like and can underwrite, that are originated by lenders that have got strong credit backgrounds and asset management platforms," Sfarra, who joined the bank in 2010, said in an interview. "So it fit right into how we think about the world from a real estate credit perspective."
Some alternative lenders, though, have increasingly sought to finance their portfolios through public debt markets, which sometimes offer cheaper funding than warehouse loans. Many of the loans they originate would not fit into traditional commercial mortgage-backed securities transactions — which are usually backed by 10-year loans on properties with stabilized income — but debt investors, searching for yield, have grown more open-minded about bonds backed by shorter-duration, floating-rate loans on properties with more risk.
After the crisis, investors had little appetite for the old real estate CDOs, with their varied collateral. They have grown more interested, though, in CRE CLOs, which use similar structures but generally hold only whole loans. CRE CLO pools typically are not commingled, so each one contains loans from a single lender, and the lenders themselves retain about 20% of the first loss on their transactions, giving them a stake in the bonds' future performance.
As the market revived, Wells Fargo, which had an existing CMBS underwriting business and a history with real estate CDOs via Wachovia, saw an opportunity to extend its relationships with warehouse lending clients by structuring CRE CLOs for them.
"When the capital markets are open and functioning, the CRE CLO provides these lenders an additional avenue to fund their portfolios, provides them long-term financing, and allows them to recycle their capital," Sfarra said. "The businesses go hand in hand in a lot of ways."
A more crowded field
The busiest sponsors of CRE CLOs in 2018, according to Commercial Mortgage Alert, were TPG Real Estate Finance Trust, Benefit Street Partners LLC, Silverpeak Argentic, LoanCore Capital Markets LLC and KKR & Co., each of which issued more than $1 billion in the securities.
As the CRE CLO market gains momentum, questions remain about whether competition among private debt funds will lead to overly aggressive lending, and whether a push for higher yield will entice some CLO sponsors to include more esoteric collateral in their deals again.
Sfarra argued that recent-vintage CRE CLOs benefit from the fact that the "gamesmanship" involved in constructing pre-crisis CDOs is gone — markets no longer reward issuers for including high-yielding but risky pieces of eclectic collateral — and leverage levels are generally lower than in the past cycle.
"They're very transparent, they're very clean, they're very investor-friendly," he said. "The product is different, and I think it's important that investors in the world understand that."
As business has picked up, meanwhile, rival book runners have begun challenging Wells Fargo's dominance, with second-place JPMorgan Chase & Co., third-place Goldman Sachs Group Inc. and fourth-place Morgan Stanley all posting larger year-over-year growth in deal volume for 2018. Sfarra called competition among book runners healthy for the market.
For the bank's broader strategy, the recent surge in CRE CLO underwriting came at a convenient time. Wells Fargo's commercial real estate loan volume declined $2.5 billion sequentially in the second quarter of 2018, $2.8 billion in the third quarter, and $583 million in the fourth quarter.
"Our balance sheet, we may not be making quite as many loans — and I'm sure that our long-term investors are probably happy to hear this — in certain segments like multifamily housing, or maybe lending to developers who are building in certain markets," Petros Pelos, Wells Fargo's head of wholesale banking, said in a May 2017 investor presentation.
"The overall market may be more receptive to those assets than we are ourselves," he said. "We're going to help our customers access those markets, so they can continue to run their businesses as they see fit."