A year ago, the prospect of hundreds of new rules coming down the pike from government regulators had lenders worried over what the government would require of them. The massive Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed regulators to come up with new rules affecting consumer and commercial lending by April 2011.

At the same time, the Securities and Exchange Commission (SEC) was working up new requirements to restore investor confidence in asset-backed securities, a measure known as Regulation AB.

Fearing that they might need to increase cash reserves or hire additional staff to perform yet unknown procedures, many banks were reluctant to make loans in 2010. “Regulations cost money to comply with them,” explains James F. Smith, chief economist at Parsec Financial Management in Asheville, N.C. “If you're a bank spending your money to comply with regulations, you have less money to lend out.”

Such concerns are fading in 2011, however, says David Rifkind, principal and managing director of George Smith Partners, a Los Angeles-based financial intermediary. Rather than wait for regulations, commercial real estate lenders have policed their own policies and practices to help investors gain a clearer understanding of new investments.

In the process, the sector has provided government regulators with means to achieve financial reform goals without disrupting the securitized lending practices that have become vital to the commercial real estate industry.

“The capital markets participants themselves have made changes preemptively to meet market demands,” says Rifkind. “In doing so, it trumped any necessity of using government regulation to shore up some of these practices from the last cycle.”

Loan originations in the U.S. for commercial mortgage-backed securities (CMBS) are on track to top $12 billion in the first quarter this year, more than the $11.6 billion originated in all of 2010, according to the Commercial Real Estate Finance Council. Issuance is expected to total between $35 billion and $50 billion this year.

Lenders take action

What relieved the uneasiness over financial regulation? Certainly not the regulations themselves, which insiders say are behind schedule and unlikely to be published for several months.

The lopsided victory by Republicans in the U.S. Congressional midterm elections has given lenders confidence that new rules won't derail the CMBS machine on Wall Street.

Most important, however, are the changes that CMBS issuers are already incorporating into new securitizations. Transactions are simpler, with only six or seven tranches as opposed to a dozen or more, and standardized documents are making it easier for investors to compare one deal to another.

In all new CMBS transactions, investors who purchase the riskiest tranche in a CMBS deal, the B piece, are prohibited from selling their position and must therefore retain their risk.

Proponents of the CMBS model say that last point meets a key objective of the Dodd-Frank Act, which requires that either the lender or the B-piece investor retain at least 5% of the credit risk in a securitized transaction.

As the first quarter of 2011 nears its end, commercial real estate lenders have a general understanding of what the new federal rules will require, and they have already adjusted their practices. “There doesn't seem to be a lot of anxiety with regard to regulation,” Rifkind says. “We see the capital markets reloading now, and regulation doesn't seem to be one of the things standing in the way.”

Wheels turn slowly

When will lenders and investors know exactly what the new federal rules of the game are for commercial real estate? That depends on the rule in question.

“The Dodd-Frank legislation is really only the skeleton,” pointed out John Courson, president and CEO of the Mortgage Bankers Association (MBA), during last month's opening session of the Commercial Real Estate Finance and Multifamily Housing Convention & Expo in San Diego. “Now we're into the meat grinder of rule making where we really have to put meat on those bones.”

The Dodd-Frank Act requires federal agencies to jointly create risk-retention rules for asset-backed securities including CMBS by mid-April of this year. A comment period and formation of a final version will follow, with regulations finally taking effect one year later for residential asset-backed securities, and one year after that for CMBS. Sticking to the federal schedule means new CMBS regulations won't take effect until 2013 at the earliest.

That schedule is already off track, however, according to John E. D'Amico, CEO of the Commercial Real Estate Finance Council. Members of the New York-based trade organization traveled to Washington, D.C. in late January and met with representatives of the SEC, Federal Deposit Insurance Corp. (FDIC) and the Federal Reserve to discuss progress on the rules.

Those three agencies, together with the Office of Comptroller of the Currency, are jointly responsible for coming up with risk-retention rules under the Dodd-Frank Act. “April is impossible. They're just not going to get it done,” says D'Amico in relaying the message he received from regulators.

Members of Congress, too, told the Commercial Real Estate Finance Council delegation that it is more important to draft workable rules than to meet an arbitrary deadline. “They're going to spend the time they need to get it right,” says D'Amico.

A delay in the risk-retention rules would push back rules expected on other issues, according to Gail Cardwell, senior vice president of commercial/multifamily programs at the MBA.

Examples include the SEC's Regulation AB measure that will regulate asset-backed securities, as well as a proposed safe-harbor rule with risk-retention implications that the FDIC put out for comment but recently withdrew pending progress on the Dodd-Frank rules.

The SEC also tabled work on Regulation AB while it focuses on risk-retention rules mandated by Dodd-Frank.

Both the MBA and CRE Finance Council prefer that regulators take time to coordinate new rules and avoid duplication or, worse yet, contradictions between rules from one agency to another. That may prove to be a herculean task with so many proposals on the table.

The MBA submitted more than 100 opinions on financial regulatory reform to regulators in 2010 alone, which underscores the wide scope of issues under discussion.

“The biggest concern we're hearing (from MBA members) is the totality of the regulations. It's not just the individual regulations, but how they work with one another,” says Cardwell. “It is extremely important that there is a harmonization of regulations across regulatory agencies.”

Risk under the microscope

The mispricing of risk leading up to the Great Recession and the financial market meltdown make it imperative that investors understand the risks they assume. That's why ongoing financial reforms seek to improve the ways risk is identified and communicated to investors.

The commercial real estate finance sector's answer to that call from investors has been to boost transparency in lending and in securitized transactions.

The CRE Finance Council and lenders themselves are establishing standardized practices and model documents that will help investors compare one deal to another.

New CMBS transactions give senior investors a greater voice in appointing special servicers, who handle delinquent loans in the pool of collateral.

The Dodd-Frank Act directs federal agencies to remove any requirements in existing laws that rely on rating agency reports. Some observers say an overreliance on agency ratings gave some investors a false sense of security when it came to the securities they purchased.

MBA doesn't want to see the baby thrown out with the bathwater. Some institutions have the resources to conduct property site visits and assess the risk in a securitized transaction just as rating agencies do, but many smaller banks lack those resources, says George Green, associate vice president for commercial/multifamily at the MBA.

Bond buyers should be allowed to consider rating agencies' assessments of risk in CMBS tranches, so long as those investors review the ratings and decide whether the analysis is credible, the MBA contends.

“For small banks, the type of underwriting a rating agency does would cost hundreds of thousands of dollars, and it would be cost-prohibitive for some banks to do that internally,” says Green. “We're not saying you should blindly rely on ratings. You do your analysis, look at the ratings, and affirm your belief in them.”

Prospects brighten

Commercial real estate lenders and investors face the daunting prospect of adjusting to hundreds of new rules over the next few years.

While the specifics remain a mystery, there is a consensus that regulations will reflect many of the changes already taking place. There will be opportunities to provide feedback to regulators, who will make adjustments before new rules take effect.

That knowledge has given lenders and investors enough confidence to get back to work instead of waiting around to see what new rules will take effect, evidenced by the growing volume of CMBS originations.

“It's no longer having a chilling effect,” says D'Amico. “People are making their plans and going forward.”

Matt Hudgins is an Austin-based writer.