The CMBS industry is keeping a close eye on proposed regulatory reforms that could deal a harsh blow to its fragile recovery.
In the wake of the financial crisis, policymakers and regulators have introduced a slew of new and proposed rules and regulatory requirements aimed at banks and other financial institutions—most notably through the Dodd–Frank Wall Street Reform and Consumer Protection Act.
Reforms that have been years in the making are still a work in progress, with the details and timing of the new rules a constant moving target. Yet key issues that will move to the forefront in 2013 are new risk retention requirements, particularly those changes proposed through the Premium Capture Cash Reserve Account (PCCRA) provision.
“The PCCRA is probably our most immediate threat given the fact that we think that rule will come out this year. If that rule stays as proposed, it would have a devastating effect on our industry,” says E.J. Burke, chairman-elect of the Mortgage Bankers Association (MBA) and executive vice president and group head of KeyBank Real Estate Capital & Corporate Banking Services, a division of KeyBank N.A.
PCCRA takes aim at introducing new risk retention rules for CMBS. The fact that the residential mortgage industry received its announcement on the new Qualified Mortgage (QM) rule—which also focuses on risk retention—earlier this month is a sign that regulators will soon be releasing new rules for the commercial sector. The Commercial Real Estate Finance Council expects some form of the final PCCRA rule to be released during the second half of the year.
The industry is hopeful that the current proposal will be modified before a final version of the rule is released. However, what is making some in the industry nervous is that the current proposal on the table would introduce extreme measures that could cripple a key source of commercial real estate financing.
Keeping skin in the game
The current PCCRA proposal would require the economic return for structured securities to be placed in a first-loss position. Essentially, this would require lenders to keep some “skin in the game” with a minimum 5 percent stake.
Although that requirement might make sense for residential mortgage backed securities (RMBS), there are some inherent differences in how CMBS transactions are structured that make that risk retention requirement very challenging. Currently, a CMBS issuer pools mortgages and puts them out for sale. The first key piece is the B-piece investor, which is buying the first loss position. Risk retention is achieved with the B-piece buyer—not the issuer.
PCCRA would require that the issuer hold some level of risk retention. Some issuers, such as large banks, might have the ability to retain part of the deal on their balance sheets. Other issuers are working with a business model that does not even utilize a balance sheet. Their function is mainly to pool and issue CMBS loans before the securitization is sent out to the broader investor market. Simply put, some issuers don’t have the ability to retain part of the product that they are essentially making and selling.
“We are concerned that the PCCRA rule could frustrate the CMBS market, and as a result reduce a significant amount of issuance capacity at a time when the industry is just trying to get back on its feet and going again,” says Steve Renna, CEO of the Commercial Real Estate Finance Council. Although CMBS issuance in the U.S. totaled $48.4 billion in 2012, there is an estimated $600 billion in CMBS loans that will be maturing in the next five years. The concern is that the PCCRA will discourage some CMBS issuers from participating in the marketplace.
Handcuffs for B-piece buyers?
Another top risk retention concern for the CMBS industry is a reform included in Dodd-Frank that targets the ability to transfer B-piece investments. The proposed rule would prohibit a B-piece buyer from selling, leveraging or hedging its B-piece position. Ultimately, the B-piece or first loss buyer would be required to hold its position for the full life cycle of the mortgages in the pool, which for some securitizations could be up to 10 years.
The reform would not only lock up a B-piece buyer’s investment for up to a decade, but it essentially puts handcuffs on those investors by preventing them from taking steps to protect their investment from downside risk. “Who invests and holds for 10 years, which is virtually forever in an investment context?” says Renna.
The concern is that those limitations would discourage B-piece investment, which is a critical element in fueling CMBS issuance. “That raises the question in the marketplace, are there enough investors out there that want to invest in B-piece positions in CMBS? The issuance is only going to go as far as there is enough capital out there to support the B-piece segment,” says Renna.
It is important to note that the CRE Finance Council fully supports many aspects of Dodd-Frank, including risk retention, better disclosure and more transparency. However, the association is concerned that the proposed rules—especially when considered cumulatively—pose a threat to the continued recovery and on-going viability of CMBS and the credit it supplies.
The fact that the rules have been slow to materialize may be a positive sign that regulators are giving the rules thoughtful consideration. “I think the delay that we have seen is really a testament to how complicated and difficult these rules are,” says Burke. Regulators are listening. They are asking good questions and they don’t want their rules to have unintended consequences, he adds.