Risk Rule Seen Favoring Larger B-Piece Buyers

As the commercial MBS industry prepares for the risk-retention rules due to take effect in about two years, B-piece buyers face the prospect of raising more capital, from a broader range of sources, in order to stay in the game. The result, industry experts say, could be a different roster of players — likely fewer, larger firms, including new entities formed by combinations of high-yield and investment-grade bond buyers. “I think you’re going to see a lot of innovative structures,” said George Green, associate vice president of the Mortgage Bankers Association.

The reason is CMBS issuers are expected to rely on B-piece buyers to assume the risk-retention responsibility, and that will mean buying more bonds, farther up the capital stack, than those investors are accustomed to taking.

“[The rule] is going to benefit larger, more diversified investment managers,” said Stephen Renna, chief executive of the CRE Finance Council. “If you’re smaller, and your source of capital is more specific, it could be more difficult to participate in deals.”

At the heart of the voluminous final rules, adopted last month by six federal regulators to implement provisions of the Dodd-Frank Act, is the requirement that securitization issuers retain 5% of each deal. An exception for CMBS allows the issuer to instead sell bonds equivalent to 5% of the deal proceeds, from the bottom of the capital stack, to one or two “third-party purchasers.”

Whereas B-piece buyers now take the below-investment-grade portion of CMBS deals, that won’t be enough to satisfy the 5% rule. Industry pros say issuers will have to carve off a chunk of triple-B-minus bonds — maybe even some single-As — and wrap them into an expanded B-piece. The regulators rejected proposals to allow two investors to split that bottom piece into senior and junior portions. If there are two buyers, they must take pari-passu portions.

The resulting B-pieces won’t match the yield hurdle or the buying power of many current buyers. One source gave a back-of-the-envelope calculation that, where it might take $40 million to acquire a typical B-piece today, it could cost $60 million to buy enough bonds to satisfy the 5% risk-retention requirement.

“You have to get better-capitalized B-piece buyers,” said an executive at a major asset manager. “They need to be bigger so they can buy more.” And they’ll have to be willing to add investment-grade bonds to their usual diet of high-yield paper. That necessity is likely to lead to the invention of vehicles that bring together investors with varying risk appetites.

One of the main ideas being floated by industry experts would involve a B-piece buyer raising capital from a wide range of investors for a fund that would be structured with varying levels of risk for specific limited partners. As one current buyer described that scenario: “I can bring in another investor within the fund framework and create a return structure that works for him and also works for me. Maybe the fund would have a Class A for the senior risk and a Class B for the junior risk. I don’t think that would run afoul of the regulations.”

A slightly different approach would be for two or more parties to form a joint venture to buy B-pieces and split up the risks and rewards — including control of the special servicer — tied to specific senior and junior bonds. Securitization lawyers said such a joint venture could qualify so long as it was a single legal entity.

“I think [the regulators] are giving us flexibility to figure out how to make it work,” said Dechert partner Rick Jones.

Renna at the CRE Finance Council said that if the regulators were concerned about different sources of capital teaming up to purchase B-pieces, “they would have written something into the rule to prevent it, and they didn’t do that.”

Still, some investors said they’d be wary of using structures that would appear to directly flout the regulators’ prohibition of senior/junior B-pieces and might prompt the agencies to issue clarifications that would block such maneuvers. In adopting the rule, the regulators stated that “allowing the third-party purchasers to satisfy the risk retention requirement through a senior-subordinated structure would significantly dilute the effectiveness of the risk-retention requirements.”

A number of bond pros noted that the rule doesn’t prescribe penalties for failure to follow the risk-retention mandate. But presumably the individual agencies that collaborated on the rule will devise enforcement measures. There’s speculation the lead role would go to the SEC, which oversees disclosure and other rules for securities issuance. Jones pointed out that the ultimate responsibility for compliance lies with the issuer — raising questions about what would happen if a B-piece buyer doesn’t live up to its risk-retention obligations.

Many are forecasting that the number of firms competing for B-pieces — which in recent months has grown to as many as 17 — will shrink as the need for more capital gives large companies an advantage.

“I’m hearing people call this a ‘big institution rule,’ ” said one investor. “That means it’s good for the big guys, like BlackRock or Rialto Capital, and bad for the little guys. Their cost of capital is going to keep them out of the game.”

When it comes to forming new funds or partnerships, “the money will coalesce around the best-in-class guys,” one investor said. “The institutional guys — the pension funds, the endowments — will decide that a handful of [B-piece buyers] are good at this, and those will be the guys who survive.” That investor expects fewer than 10 competitors to remain.

Fewer bidders, larger buyers and the mandate that third-party purchasers hold the bonds for at least five years will add up to wider spreads on the new B-pieces, experts predict. That would reverse the recent trend that has seen yields shrink as more shops have competed to win deals.

The bigger shops likely will be able to negotiate deeper discounts because they have the capacity to take down the thicker slices. In addition, buyers will demand a pricing premium for the loss of liquidity.

“B-piece buyers get a yield of around 14.5% now, and I wouldn’t be surprised to see that go up to as much as 17.5%,” said one sell-side executive. He added that loan kickouts will likely become more common under the new regimen.

“B-piece buyers can either ask for a price adjustment or they can kick out loans,” he said. “But if they price-adjust under the new rules, and the price drops, that will make it harder to [reach] the 5%-buy requirement. So instead of price adjustments they will probably be kicking out more loans.” That would promote one goal of the regulators: improving the credit quality of securitizations.

Several experts pointed out that the market has two years to figure out the details. And some expressed hope that the regulators would adjust or clarify their positions in response to questions and concerns raised by the industry.

“We’ve got two years . . . which is forever in Washington,” said Jones at Dechert. “Just because it’s final doesn’t mean we’ll stop talking.”

Risk Retention Rules Approved; Higher Pricing, Less Capacity for CMBS

The credit risk retention rules mandated by the Dodd-Frank Act and then the subject of fierce debate over the last two years by regulators and the industry as they were being written are now finalized. These rules will shape a number of financial products and lending activities, from mortgages to highly-leveraged corporate bonds to commercial mortgage-backed securities going forward.

The changes will be significant for the CMBS market, starting with higher pricing that could range from an additional 25 basis points (according to estimates by regulators) to between 35 to 50 basis points (according to industry associations). The new rules are also expected to limit capacity, as well.

Still, these final rules--adopted by the Office of the Comptroller of the Currency, the Department of Treasury, the Federal Reserve Bank, the Federal Deposit Insurance Corp., the US Securities and Exchange Commission, the Federal Housing Finance Agency and the Department of Housing and Urban Development—are not as bad as the industry originally feared.

"The whole process has been an evolution," says CREFC president and CEO Steve Renna. Over time this 'evolution' moved considerably more in direction that CREFC and other industry associations had advocated, he says.

Briefly, for the CMBS industry, the final rules eliminated the Premium Capture Cash Reserve Account that had been proposed in the earlier risk retention proposal. This onerous requirement, which would have required all issuer profits to be placed in a first-loss position, had been tentatively dismissed about a year ago, but to have it jettisoned from the final rules is a relief. Also gone from the final rules are cumbersome cash flow requirements.

The heart of the rules — a doubling of the amount of risk that has to be retained to 5% stayed in place — but further negotiations with regulators made this rule far more flexible to implement, Renna says.

The bottom line is that B piece buyers have a lot of flexibility in figuring out the best way to raise capital they need for the additional retention. In addition, the retention can be divvied up between the issuer and B piece buyer. "We asked for flexibility and optionality in fulfilling the risk retention rule and the regulators provided that," Renna says. "They also originally said the B piece would have to retain the risk for ten years. We said five and they agreed."

Unfortunately, they wouldn’t budge on the single-asset loan criteria, he says.

CREFC had been lobbying to keep certain loans that were conservatively underwritten—namely securitizations based on a single asset such as one building or a single credit—exempt from the risk retention rules. "No lenders want to keep that big of a loan on its balance sheet and it wasn’t necessary, from an investor protection standpoint, to apply risk retention to these loans," Renna says.

The regulators didn’t agree and Renna believes the consequence will be that these loans will be pushed into the cheaper – and less transparent -- corporate bond market.

"The regulators didn’t make a strong case for why they decided this," he says. "These loans don’t belong under risk retention."

Deloitte Forecasts Moderating Growth in 2014 Real Estate Market

Summary:  Commercial real estate prices are expected to grow at a slower pace next year, according to Deloitte.  While rents are low, so is development across property types, and fundamentals in multifamily properties are beginning to peak.  Regulation, says Deloitte, will also stifle growth, referring to the Dodd-Frank Act and the Terrorism Risk Insurance Act.




Protracted economic growth, combined with uncertainty regarding pending regulations and fiscal policy issues, will likely moderate the pace of recovery in the commercial real estate industry in the near future, according to a report on the 2014 industry outlook from consulting firm Deloitte.

The anticipated moderation in 2014 would follow a year in which asset prices, transactions and capital availability all saw a continued recovery. So far in 2013, asset prices have moved close to their 2007 peaks in major metropolitan markets and transaction activity has improved in secondary markets, the Deloitte report stated.

“We expect that the recovery will continue, we just expect that the pace of it will slow down in 2014,” said Bob O’Brien, U.S. real estate services leader at Deloitte.

Private equity and international investors have shown increased interest in U.S. commercial real estate, according to the outlook. The region is considered to be the most stable globally and to offer the best returns relative to risk, Deloitte said.

Rents and occupancy levels have strengthened since the downturn across property types, the report noted. However, in historical terms, rents and occupancies are trending below their averages in most sectors, excluding multifamily and hotels, according to Deloitte. Furthermore, the report speculated that fundamentals in the multifamily sector are beginning to peak.

Development activity, meanwhile, remains subdued for most property types, Deloitte observed, again with the exception of multifamily and hotels. Lending standards for construction loans also remain stringent.

Turning to regulatory developments, Deloitte is forecasting that the uncertainty associated with measures such as the financial reforms of the Dodd-Frank Act and the Terrorism Risk Insurance Act (TRIA) will likely promote caution in the real estate industry. Deloitte noted, for example, that the “effects of a looming expiration would be felt long before TRIA’s actual demise.”

Meanwhile, the Deloitte report also highlighted that the commercial real estate industry is undergoing fundamental changes in business practices, including redesigning existing space to suit new tenant demands and the growing use of automation. Deloitte warned management teams and boards to factor in the influence of these new developments in order to achieve above-average growth and position themselves for the long term.

“We think real estate owners and investors would be well served to focus on operations and profitability and to look at making the necessary investments in their properties to respond to changes in the way tenants are using properties,” O’Brien said.

http://www.reit.com/Articles/Deloitte-Forecasts-Moderating-Growth-in-2014-Commercial-Real-Estate-Market.aspx

Rep. Frank: Revamped Mortgage Rules a ‘Grave Error”

Summary:  The Federal Reserve and the Federal Deposit Insurance Corp. are against a new rule in the Dodd-Frank law requiring those underwriting mortgage securities to retain 5% of the credit risk on their books.  Barney Frank, an author of the bill, believes this to be an error.

Washington, D.C.  --(WSJ Developments)--
An architect of the 2010 Dodd-Frank law is accusing federal regulators of watering down new mortgage rules in the face of opposition from the housing industry.

Former Rep. Barney Frank (D., Mass.) slammed federal regulators for their decision to dial back a proposal to impose new rules on the mortgage-securities market–a key piece of the Dodd-Frank law that bears Mr. Frank’s name.

“This is a grave error, and contrary to the assertion that it would best carry out the statutory intent, significantly repudiates it,” Mr. Frank wrote in a comment letter being sent to regulators Tuesday.

At issue is a proposal from August by six regulators — including the Federal Reserve and Federal Deposit Insurance Corp. — to revamp proposed rules requiring issuers of mortgage securities to retain 5% of the credit risk on their books. Supporters of this requirement, including Mr. Frank, argue it will force Wall Street to be more cautious when packaging assets such as mortgages into securities.

The regulators’ original proposal from 2011 contained a narrow exemption focusing on only high-quality loans, where the borrower brings a 20% down payment and meets other stringent criteria. But a proposal released in August for the so-called “qualified residential mortgage” exemption is much broader and covers most loans being made today.

Mr. Frank castigated the regulators, saying they are heeding a fierce lobbying campaign from the real-estate industry. Mortgage lenders, real-estate agents, home builders, civil-rights groups and consumer advocates formed a group, called the Coalition for Sensible Housing Policy, that lobbied heavily against the original proposal for tighter rules.

“If all of these people were correct in their collective judgment, we would not have had the crisis that we had,” Mr. Frank wrote. “More importantly, what their arguments reflect, and what I believe unfortunately is carried over in proposal, is the view that things must always be exactly as they are today.”

Lawmakers have offered competing interpretations about what they intended in drafting this piece of Dodd-Frank. Several Senators, including Sen. Johnny Isakson (R., Ga.) and Kay Hagan (D., N.C.) have argued the law calls for a broad exemption and were key players in a push to eliminate a 20% down-payment requirement from the original proposal.

Speaking on the Senate floor this month, Mr. Isakson said banking regulators “did a great job” in revamping the rule.

The new proposal largely adopts a separate mortgage definition put forward earlier this year by the Consumer Financial Protection Bureau that outlines steps banks must take to demonstrate that a borrower has the ability to repay a mortgage. Regulators also asked for comment on an alternative definition that would add a 30% down payment to the exemption requirement.

Some regulators also have been critical of the new proposal. Daniel Gallagher, a Republican member of the Securities and Exchange Commission, issued a 3,000-word dissent to his agency’s August vote, saying the proposed exemption was “unrealistic and dangerously broad.”

Mr. Frank argues regulators are ignoring the essential purpose of Dodd-Frank — to force changes in the financial market.

“I understand that since risk retention is a new concept, people in various phases of the business of housing are unused to it, and do not like the changes it will force in their operation,” he wrote, “But the very purpose of the statute was in fact to bring about changes in a number of areas in our financial life, residential mortgages foremost among them.”