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.”
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.”
