Merganser has found that governance factors can present a meaningful risk as it relates to credit underwriting for asset backed securities. We have not developed a formal scoring system for ESG categories as it relates to subsectors and issuers in the asset backed market, however, we do integrate qualitative judgements in our decision-making process. This is because there is no clear framework to apply across asset classes and approaches we’ve studied tend to be highly subjective and not particularly useful. Furthermore, the lack standardization of reporting by issuers, sponsors and servicers make development of a quantitative framework difficult. The net result of this is our integration of a qualitative approach to ESG in evaluating opportunities and assessing risks in the asset backed sector which are generally applied at the issuer/sponsor/servicer and trustee levels. The key metrics in evaluating the securitization begins with a review of loan origination and servicing practices which directly factors into governance practices. The structure of the securitization also plays a key role in the evaluation process to ensure proper alignment of interests. We avoid those securitizations where inadequate governance creates unquantifiable risks or where assets have been originated and serviced in a predatory manner. To a lesser degree, we have also found that environmental factors can present idiosyncratic risk to asset backed securitizations, particularly within the auto and equipment subsectors, and we remain mindful of this during the underwriting and ongoing monitoring of our holdings.
We believe that a well governed company with a diverse, ethical, and an experienced leadership team in place is arguably the most important aspect to consider. With such a management team in place, a company will be able to effectively run their business while evolving to societies changing standards around environmental and social impacts of their business. We would support the standardization of data reporting but will continue with our bottom-up approach to risk management and incorporate ESG factors where appropriate.
Multi-borrower conduit transactions have historically (and continue to) face criticism over Governance issues. We favor conduit transactions with a “vertical” risk retention on the hypothesis that originators who retain risk for the life of a transaction should have better performance over time; but acknowledge it is too early to know if this holds true (risk retention began in 2017). Environmental data on “conduit” transactions is limited. Known contamination issues should be disclosed in the prospectus; and may be discussed in greater detail for the largest loans. The presence of LEED certifications may be disclosed in commentary that is provided on only the largest assets. Single Asset/Single borrower transactions on the other hand offer greater transparency and therefore offer relatively stronger Governance; often with 100% LEED certifications. Another sub-sector with relatively strong Governance is the Agency CMBS market. Fannie Mae’s “DUS” (Delegated Underwriting and Servicing) program, founded in 1987, was the original risk-retention model and has experienced very modest losses over time. This sub-sector offers consistent underwriting, with a strong social purpose in facilitating the ownership of affordable housing. Further, Agency CMBS pools often contain large “Green” loan components, where the borrower has committed to quantifiable energy/water/waste utilization improvement targets which are monitored by Freddie/Fannie. Loans originated under various “green” programs are disclosed in the annex/data tape. On a Social issue, Freddie Mac discloses in multi-borrower transactions the number of units that are deemed affordable to “low income” and “very low income” tenants. Fannie Mae makes this data available on individual DUS loans, but the data does not flow through to the annex/data tape on multi-borrower transactions (e.g. GEMS/MEGA issuance).
However, the worthy social goal of providing affordable housing has led to unintended consequences and generated losses for investors. King County, WA (Seattle metro area) has recently been utilizing eminent domain to acquire multifamily properties to preserve affordable housing; which has resulted in early prepayments without penalty. This is achieved by utilizing the condemnation process to exercise eminent domain thereby avoiding paying a penalty. This may have the unintended consequence of limiting capital for affordable housing in an area that is underserved, highlighting these issues are not black and white, but rather grey.
For all CMBS deal types we consider unique location attributes (i.e. floodplain or earthquake zone). We recognize that over time increased costs (all else equal) from environmental risks should reduce the value of real estate and increase risk of loss to lenders. We also believe that as increasing numbers of investors begin to focus on and better understand these risks, improved risk-based pricing may make refinancing (and/or selling) more difficult for certain assets. We are hyper-sensitive to idiosyncratic geographic concentration risks in areas that have seen significant natural disasters. Concentrations in California, Houston, or Gulf Coast areas will warrant closer scrutiny and lead us to require higher levels of compensation.