The Commercial Mortgage Backed Securities (CMBS) industry is bracing for the pending Dodd-Frank inspired risk retention legislation. The impact of the regulatory change will be far reaching, impacting all players, and every facet of the CMBS space.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010, and was aimed at attempting to prevent the recurrence of negative events that contributed to the financial crisis of 2008.
Part of the goal of the reforms being implemented under the umbrella of Dodd-Frank was to prevent market participants from engaging in activities that could lead to a repeat of the financial disarray of 2008. While all participants in the broader commercial real estate landscape have been impacted by regulatory reform in one way or other, the CMBS Market participants singularly will feel the brunt of the pending risk retention legislation, which is set to be enacted in December 2016.
Commercial lending by life insurance companies continues to be steady, and the GSEs (FNMA, FHLMC) continue to lend on multifamily assets at record levels. However, the CMBS space is being impacted by multiple factors, not the least of which is spread widening in the last 6-9 months that has brought origination and securitization levels down significantly from forecasted levels.
On top of that, the industry is now faced with a regulatory risk retention implementation that will reshape the marketplace, impacting all market participants, and modifying business models for originators, issuers, and investors.
How Did We Get Here?
Technically known as Section 15G of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the legislation is the brainchild of 6 regulatory agencies (FDIC, FHFA, Federal Reserve, HUD, SEC, and Treasury) who acted in concert to implement the new legislation.
The intent of the legislation was to attempt to reduce risky practices primarily seen in the residential MBS market that contributed to the global financial crisis.
Unfortunately, like so many well intentioned motivations of anything of this scale, the legislation will have unintended consequences that are still being vetted as the industry braces for the December 2016 implementation.
What are the Basics?
The rule requires that issuers of securities retain a 5% interest in the bonds they distribute.
The theory being that by forcing issuers to retain some of what they sold to others, origination and issuance discipline would improve.
…like so many well intentioned motivations of anything of this scale, the legislation will have unintended consequences that are still being vetted as the industry braces for the December 2016 implementation.
CMBS industry participants successfully lobbied to allow for issuers to sell their 5% strip, which was a major development, and allowed for the industry to keep with its long-standing market convention to distribute the below investment grade bonds in each security to “B-Piece Buyers”.
Distribution of the 5% strip can be accomplished via a horizontal strip (i.e. the lowest 5% of the issuance) or a vertical strip, (i.e. a 5% piece of all tranches in the security).
What is the B-Piece Buyer Involvement?
The CMBS market has long been driven by the B-piece investor community, and their ability to invest in the lowest rated tranches of CMBS securities, which improves market liquidity.
The below investment grade interests are purchased at deep discounts, butcome with significant risk, as the B-piece buyers absorb the first loss positions in their deals.
Being the most subordinate bondholder, the B-piece buyer is also the security’s “controlling class certificate holder”.
Traditionally the B-piece buyer was affiliated with the security’s “special servicer”, allowing them to be involved in the workout and ultimate resolution of troubled loans.
The investment in below-investment grade and unrated bond classes does not come without risk, and hence, B-piece buyers conduct thorough loan-level due diligence efforts prior to investing.
…the industry is now faced with a regulatory risk retention implementation that will reshape the marketplace, impacting all market participants, and modifying business models for originators, issuers, and investors.
While the list of B-buyer names has changed significantly in the last decade, (only LNR Partners remains in the top-5 of B-bond purchases) with buyers such as American Capital Strategies, J.E. Robert & Cos., ARCap, and CWCapital, which topped the list of buyers in 2006, making way for newer B-piece market leaders, including Seer Capital, Rialto Capital, and Ellington Management, among others.
Is There a Hold Period?
The law also imposes that the holder of the below investment grade strip is prevented from selling or otherwise transferring their interest for a period of 5 years.
There are ongoing discussions by market participants regarding specific language in the law that to some appears to suggest that the hold period can be interpreted to mean a longer than 5 year hold period.
Regardless, this is a dramatic change from industry practice to date, and an issue that will alter the existing methods deployed by investors in the CMBS space.
What are the Market Impacts?
Impacts of the legislation vary by industry participants, and their respective role in the marketplace.
Obviously, all of the parties (originators, securitizers, servicers, trustees, investors) are interrelated, however impacts that drive investor demand will be the most pressing, as they are the outlet for the loans, the negative impacts on which will be felt “upstream” by other participants.
Most recently, there has been talk of non-bank finance companies considering the idea of issuing CMBS directly, rather than contributing loans to a larger bank player for securitization via their shelf.
The primary driver behind this consideration is that unlike large banks, these entities would not be subject to the capital set aside requirements mandated through regulation.
For originators, this new regulation is already having an impact. Coupled with the spread widening that began in the 4th Quarter of 2015, the risk retention legislation has dramatically slowed origination and underwriting activity.
It remains to be seen whether volume projections for 2016 still appear reasonable, and whether existing staffing complements need to be revisited.
For issuers, this new regulation is also having an impact. Combined with Reg AB II, which requires the head of the depositor or issuer to certify as to the quality of the underlying data contained within a securitization, (including data from other parties contributing collateral) issuers are revisiting historical practices, and will have to amend processes in order to issue deals profitably.
For servicers, the pending legislation is driving up loan modification and loan extension requests, and at the same time forcing servicers to think strategically about new revenue streams to offset any downturn in market volume.
Lastly, for investors, this new regulation is compelling investors to weigh the impacts of this new legislation and its resulting impact on yield, against alternative investment options.
B-buyers will be attempting to raise funds in order to acquire their 5% interest, which is nearly twice that which they traditionally invested.
These and other considerations are currently being weighed, as market participants wrestle with this pending risk retention legislation and its long-term impact on the industry.
About The Author
William Vahey is a Senior Managing Director with RiskSpan, and leads advisory engagements for the firm at multiple financial services organizations throughout the country.