House Bill Seen Choking Off CMBS Revival

A sweeping proposal by U.S. lawmakers to overhaul the regulatory framework for financial institutions could be the kiss of death for a revival of the commercial MBS market, market pros are warning.

The latest volley from Congress would require CMBS lenders to retain 10% of the credit risk associated with loans they originate. The thinking is that securitization programs would be less willing to write risky loans if they would share in any resulting losses. When combined with accounting-rule changes under Financial Accounting Statement 167 that take effect at yearend, the proposed legislation would dramatically boost risk-based capital requirements for banks that run CMBS conduit platforms.

The likely result is that many banks would delay or possibly even rule out returning to the frozen CMBS market, which hasn't produced a new issue since mid-2008, said Rick Jones, a partner in the real estate finance practice at Dechert. "If I was designing a way to impair recovery, this and FAS 167 is what I would do," he said.

"It will dramatically affect the revival of CMBS," added Jan Sternin, a senior vice president of the Mortgage Bankers Association. "Anything that stymies the return of the capital markets is not a good thing."

While the proposed risk-retention requirement was spurred by the debacle in the home-loan market, legislators are also seeking to apply it to commercial mortgages. The Mortgage Bankers Association is lobbying to have commercial mortgages excluded. The Commercial Mortgage Securities Association said it is not against the idea in principle, but feels that the role of B-piece investors in the CMBS market addresses the legislators' concerns. It is calling for the legislation to be amended to permit the B-piece buyer's investment to fulfill the risk-retention requirement, thereby enabling the lender to avoid having to retain bonds.

The draft legislation, called the Financial Stability Improvement Act, was released on Oct. 27 by the House Financial Services Committee and the U.S. Treasury Department. The House panel, chaired by Rep. Barney Frank (D-Mass.), introduced a formal bill yesterday. Meanwhile, the Senate Banking Committee, led by Sen. Christopher Dodd (D-Conn.), is working on similar legislation and is expected to release a draft for discussion next week.

The House proposal aims to prevent institutions from becoming "too big to fail." Its backers want to block institutions from carrying so much risk that the government would have no choice but to bail them out if they ran into trouble in order to prevent a collapse of the financial system.

The House proposal surprised market players by setting the risk-retention standard at 10%. That was twice as high as had been expected, Jones said. "On its face, it would also apply to any loan sale, which is insane," he added.

Under the draft, regulators could adjust the percentage up or down on a case-by-case basis, but not below 5%. The 10% standard presumably would be applied to the face amount of a bond offering or the balance of the collateral pool, which in the case of CMBS is the same amount. But it's not yet clear which part of the capital structure a lender would have to retain - a critical question. It would be more onerous if the lender had to retain the bottom portion of a deal rather than higher-grade bonds. The legislation would provide broad guidelines and instruct the SEC and bank regulators to flesh them out with detailed regulations.

The CMSA contends that B-piece buyers, which typically acquire the bottom 2-10% of securitizations, effectively address legislators' desire for risk retention. B-piece buyers re-underwrite loans that collateralize CMBS deals and sometimes force issuers to remove mortgages of dubious quality. They also control the workout of loans that go sour.

The trade group is calling for legislators to formalize the role of B-piece buyers and to permit them to serve as the risk-retention party. "We're trying to get them to acknowledge the role that third-party investors play in CMBS," said Brendan Reilly, the CMSA's senior vice president of government relations in Washington. "We're not saying the B-piece buyer has to be the retaining entity. We want the flexibility for regulators to understand that an originator, issuer or third-party investor could satisfy the risk-retention requirement."

At the peak of the market, B-piece buyers actively resecuritized their CMBS portfolios. Critics contend that the trend undermined the motivation of B-piece buyers to be deal watchdogs, because the resecuritizations effectively reduced their economic interests in the bonds. The CMSA said it would support a requirement that the risk-retention entity be barred from selling or resecuritizing retained bonds.

The prospect for resecuritizations by B-piece investors seems remote now, in light of the market debacle. "That trade is now gone," said Jones, the Dechert lawyer. "You're not going to see that again in our lifetimes."

CMBS players are also weighing the potential impact of pending changes in accounting rules. Under FAS 166 and 167, which take effect at yearend, the Financial Accounting Standards Board is making it harder for lenders to move securitized assets off their balance sheets. In many cases, they will be forced to retain securitized assets on their books, thereby increasing their capital requirements.

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