04/01/2011

Risk-Retention Proposal Spooks CMBS Issuers

The proposed risk-retention rules that federal regulators unveiled this week include a surprise provision that market pros fear could derail the commercial MBS market.

The provision would effectively prevent CMBS lenders from capturing profits up front on transactions via the issuance of interest-only strips, which are funded with excess interest payments from the collateral pool. Under the proposal, excess interest couldn't be disbursed until all other bonds are paid off.

“This would materially change the current business model for CMBS,” said Rick Jones, co-head of Dechert's finance and real estate practice. “If you eliminate their profits, then bankers will not securitize loans, and a critical supply of capital for the commercial real estate industry will have been eliminated.”

CMBS specialists this week were poring over the 376-page regulatory proposal, which would implement a portion of the Dodd-Frank Act that requires securitization lenders to keep “skin in the game.” While the provision on interest-only strips attracted most of the initial attention, concerns were raised about some other guidelines and about unclear wording.

The CMBS industry will now mount a lobbying campaign during the comment period to persuade regulators to amend and clarify the proposal. “We need to go back to the regulators, and we need to ask questions,” said Lisa Pendergast, president of the CRE Finance Council, the CMBS industry's trade group.

Dodd-Frank, which became law last July, generally requires lenders to maintain a 5% stake in assets they securitize. But it included a possible escape hatch for CMBS transactions — allowing the B-piece holder to fulfill the retention requirement. The law gave federal regulators leeway in implementing the risk-retention mandate, such as determining specific guidelines on how the 5% stake should be calculated. The long-awaited proposed guidelines were issued jointly this week by the FDIC, Federal Reserve, Federal Housing Finance Agency, HUD, SEC and Treasury Department.

In a big win for CMBS players, the regulators opted to permit the B-piece position to fulfill the retention requirement. For transactions without a B-piece, issuers might be able to get around the retention requirement by employing stellar loan-underwriting standards or comprehensive representations and warranties. Otherwise, issuers would have to retain a 5% slice of each class, a portion of the junior class equal to 5% of the total deal amount, or a combination of the two.

Under the provision on interest-only strips, the regulators want issuers to bolster credit enhancement by re-directing both excess interest payments and any extra proceeds created by the issuance of bonds at above-par prices. Those cashflows would be channeled into a “premium capture cash reserve account” that would cover any losses in the collateral pool and couldn't be disbursed until all of the bonds with principal balances pay off. That would block the ability of issuers to take their profit up front as they do now by directing the excess interest into an interest-only class sold at issuance.

Critics complain that minor losses would wipe out the newly created reserve account, creating a disincentive for lenders even if they were willing to wait to collect their profits. It's possible that issuers alternatively could capture profits upfront by charging higher prices for B-pieces, since those subordinate bonds would no longer have to absorb initial losses. But B-piece investors might fear they will end up absorbing losses if insufficient funds have been accumulated in the reserve account. CMBS pros also argue that such a reserve is unnecessary because it goes beyond the risk-retention standard required by Dodd-Frank.

Another provision of the proposal might discourage the acquisition of B-pieces, according to some CMBS specialists. It requires the appointment of an operating advisor that could remove a special servicer for cause and must be consulted on all loan workouts. In order to protect their investments, B-piece buyers insist on control of the appointment of special servicers, which work out troubled CMBS loans. So the potential loss of that authority could cause investors to shy away from purchases, some market players said.

Operating advisors, also known as senior trust advisors, have already been introduced to CMBS deals. They have been assigned for half of the 22 private-label transactions that have hit the market since issuance revived in late 2009. But they have far less power to control servicers than under the proposal. For example, advisors on the outstanding transactions can't unilaterally replace the special servicers. They can only initiate calls for bondholders to do so. The regulatory proposal would allow advisors to make the switch unless a majority of bondholders objects.

Regulators will accept comments on the proposal until June 10 and likely implement final rules in the second half of this year. The rules will take effect for CMBS two years after they are finalized.

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