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PAGE 2 | How Debt Funds Use Warehouse and Other Credit Lines
Repurchase or “Repo lines”
Repo lines are similar to warehouse lines of credit, with a few important differences. Repo lines tend to be larger than warehouse lines and are provided by many major Wall Street investment banks such as Deutsche Bank, Goldman Sachs and Credit Suisse. Also, their pricing is often lower than the pricing on warehouse lines, and their attachment point may be higher. For example, if a warehouse line allows for $70 million of borrowing when the value of the underlying loans is $100 million, a repo line may allow for $80 million to be borrowed, or in some cases, even more.
The disadvantage of these warehouse lines, especially those that work with BPL lenders, is that in many cases they have a daily mark-to-market feature. In our example, the non-bank lender pledged $100 MM of loans which may be secured by $135-150 million of real estate. With many repo lines, the repo lender (the Wall Street investment bank) has a trading desk where they trade whole loans. If there is some major disruption or financial crisis, many investors become obsessed with liquidity.
An underlying loan of $2 million–which is part of the $100 million pledged pool of loans– that was valued at $2 million might therefore temporarily be tradable for less than $2 million. The repo lender could then unilaterally ask the non-bank lender to post more collateral or pay down the repo line, with very little notice. If the non-bank lender failed to comply, the repo lender would have the right to liquidate the underlying loans until the line was rebalanced according to the repo lender’s assessment of fair market value of the underlying loans. In other words, a repo line works very much like a margin account in the stock market. If the value of the collateral changes, these lines can lead to very steep losses, even if the value of the underlying real estate hasn’t changed.
The difference is that in the stock market, we can all see how share prices move daily, whereas in this market, only a few trading desks on Wall Street know what is happening with the value of these loans, and they could collectively determine that the value has declined, regardless of whether there is any change in the actual safety or return of the underlying loans and/or real estate.
Another variation of the repo line does not feature a daily mark-to-market. In this case, the repo line structure is still used, because it has advantages in case of a bankruptcy declaration by the owner of the underlying loans, but the value of the underlying loans cannot be adjusted unless a third party appraisers determines that the value of the underlying collateral has actually changed so as to impair the value of the underlying loans. This removes the greatest disadvantage of the repo line structure, from the perspective of the repo line borrower. However, such lines are only available from a handful of banks who focus on very institutional property types with large loan sizes.
Securitization
Another form of structural leverage is called securitization. In this model, a pool of loans is pledged into a collateral pool. The loans and the income from those loans is divided into tranches, and the tranches are rated by a bond rating agency. These tranches are then purchased by fixed income investors.
Definitions
Tranches can be thought of as analogous to layers of a birthday cake. The whole birthday cake in this case is a portfolio of investor loans. The tranches are horizontal layers, each with different risk levels and correspondingly different returns.
Several companies have issued securitizations where the underlying loans are BPLs. These companies include Toorak Capital; Kiavi (formerly known as Lending Home); Angel Oak; and Civic Financial Services. Because BPLs pay off relatively quickly, some of these securitizations have been structured like bank warehouse lines of credit in that they allow for new investor loans to be contributed to the security over time, to replace similar loans that leave the security because they paid off.
Advantages of securitizations. For the non-bank lender that issues the securitization (the “issuer”), one advantage of this structure is that the cost of capital is fixed for the duration of the securitization. In the example above, the non-bank lender has raised $95 million that it does not need to pay back for the life of the securitization, which is typically several years. Also, even if interest rates rise, the non-bank lender does not need to pay more to the investors in the tranches of the security. Another advantage is that the cost of capital can be very attractive, in other words, investors in the various tranches do not typically demand a high yield, because they are buying a rated security.
Disadvantages of securitizations. One risk for the issuer is that the issuer is obliged to pay interest on all the tranches for the life of the security, no matter what. For example, suppose that half of the underlying loans pay off, and the issuer cannot originate new qualifying loans to replace them for some reason. Now there are $50 million of loans outstanding, but the issuer must still make interest payments on $95 million of capital borrowed through the securitization. A second issue with securitizations is that they tend to feature high fees and expenses that are paid to investment banks, lawyers and other agents as part of every transaction. On a $100 MM securitization, up front fees of $500,000 to $1 MM are not unusual. In contrast, the up front fee on a bank warehouse line of credit of the same size would typically be lower.