FINANCIAL INNOVATION DONE BETTER

Tens years past the crisis, asset prices and the economy have recovered, but fear of Wall Street innovation has been more persistent. Yes, we want to avoid repeating the errors of the past. But the whole commercial real estate industry gains from smart financial innovation.

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Some people blame collateralized debt obligations (CDO) for helping to fuel the crisis. These financial instruments packaged large numbers of mortgage loans into pools, which could be divided and sold to investors in a variety of different ways. The failure of many CDOs left many investors shell shocked, but we should not throw out the baby with the bathwater.

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Collateralized loan instruments help efficiently connect capital with projects, which reduces the barriers to getting things done. At Alliance, we use more traditional debt and equity to fund our investments — we don’t need specialized instruments to raise money. But innovative financing offers useful tools for getting things done. As long as these financial tools are used wisely, they’re good for the industry.

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A big reason that so many CDOs failed is that banks combined fundamentally bad loans into pools, and wrongly assumed that by blending those bad loans together, they could offset the risks involved. This was a big mistake. You cannot start with bad loans and reprocess them into quality loans.

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Wall Street’s fear of collateralized debt instruments is finally dissipating, and collateralized loan obligations (CLO) are on the rise in commercial real estate. Analysts expect to see over $160 billion in CLOs issued by the end of 2018. This is good, as long as investors remember that fundamentals always matter. Each loan obligation needs to be sound, and I think things look much better in 2018.

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Compared to the (often subprime) mortgages that backed pre-crisis CDOs, today’s commercial real estate CLOs are far higher quality. Standards for commercial real estate lending are usually higher than for mortgages, and banks have learned valuable lessons about the persistence of risk.

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For investors, the lesson is simple. It’s important to understand the specific risks associated with assets. Good grades from the credit rating agencies are not enough. Overall, I’m happy that financial innovation is back. Innovation spurs investment, and investment expresses confidence in a bright future. Done wisely, this confidence becomes a self-fulfilling prophecy.

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