A Well-Oiled Machine No More
For the last twenty years or so, the Commercial Mortgage Backed Securities (CMBS) market has pretty much functioned as a well-oiled machine.Originators made loans, bundled them into securitizations, sold the higher rated bonds to institutional investors and the lower rated ones to more sophisticated ‘B-piece’ buyers, and then started the process all over again.
This well-oiled machine is now definitely squeaking as the December deadline approaches for implementing risk retention. Risk Retention is a ‘skin in the game’ type rule that was a part of the Dodd-Frank legislation.
One lesson regulators took away from the Financial Crisis was that originators will be less concerned about the quality of loans they originate if they are fully offloading them from their Balance Sheet via securitization. As a safeguard against this practice, the concept of Risk Retention was added to Dodd-Frank.
Under Risk Retention, CMBS issuers will be required to hold at least 5 percent of the fair market value of transactions for five years without refinancing or reselling. Alternatively, a sponsor can find one or two B-piece buyers willing to hold the investment for five years. The rule is designed to ensure that the holders of the first-loss position perform the proper due diligence and refuse loans with questionable underwriting.
Given the capital charge to banks for holding the bonds, a number of issuers are exploring having a B-piece buyer retain the bonds instead. That however does not eliminate all the complexity since it is still the issuer who is responsible for ensuring that the B-piece buyer complies with the rules.
That means that B-piece buyers will need to create controls to make sure they are staying within the rules, while issuers will need to develop procedures to monitor the B-piece buyers over the entire five year retention period.
Some issuers, most notably Wells Fargo & Co., Bank of America Corp. and Morgan Stanley have said they are going to hold the bonds themselves using a vertical structure where they hold 5 percent of every tranche in the securitization. While the disadvantage here is the capital charge, the advantage of this approach is that it eliminates the Risk retention restriction for everyone else, so a B-piece buyer could acquire 95 percent of the below-investment-grade paper in the conventional fashion.
As Risk Retention comes into effect it presents CMBS issuers and B-piece buyers with a unique opportunity to refresh their processes and find efficiencies even within the Risk Retention framework to help CMBS revert back to a smoothly functioning market.