Last week, six federal regulatory agencies approved a final rule governing “credit risk retention” for asset-backed securities. Implementation of these risk retention rules is mandated by Section 941 of the 2010 Dodd-Frank Act, requiring the “securitizer” of asset-backed securities (“ABS”) to retain at least 5% of the credit risk of the assets collateralizing the ABS. The final rule leaves the 5% retention requirement intact, with the calculation based on total proceeds (as opposed to face value). Consistent with the September 2013 re-proposal, the Premium Capture Cash Reserve Account (PCCRA) contrivance from the initial 2011 proposal is gone. For CMBS, a third party B-piece buyer is still able to fulfill the risk retention requirement. Under the new rules, a B-piece buyer would purchase a large portion of what is now the BBB- bond, to reach 5% of the deal’s total fair value. The rules become effective in two years for CMBS and other non-residential securities. For residential mortgages, the regulations have a one-year implementation period.
Potential Implications for CMBS
Based on preliminary analysis by a number of CMBS analysts, these new regulations are expected to raise the cost and reduce the availability of financing for commercial real estate borrowers — likely in the range of 20 to 25 basis points. Under the new regulations, securitized lenders will need to increase their origination spreads, resulting in increased borrowing costs. As a result, it is highly likely that these new regulations could have the unintended consequence of diminishing CMBS loan credit quality. At a time when legacy loan maturities are rising, the new retention requirements could also diminish the use of the CMBS in accommodating this wave of maturities, requiring substantially more equity. Over the two-year phase-in, origination trends and structures are not expected to change. Going forward, however, and given the potential for higher future lending costs, origination and refinance volumes might spike as we the enactment date approaches.
Potential Impact on Spreads
The new rules are expected to increase origination spreads for CMBS loans in the range of 20 to 25 basis points. Wider mortgage spreads raise financing costs and are not good for commercial real estate liquidity. The current low mortgage rate environment has clearly aided the recovery of the commercial real estate market. However, unlike a rise in interest rates, which affects the borrowing costs across all lending structures, the new risk retention rules are expected to affect the spread only on securitized lenders — not on portfolio lenders. As mentioned above, higher lending costs imposed on securitized lenders may force them to originate riskier, more highly leveraged commercial mortgages — trading credit quality for a higher spread — certainly not the legislative intention of the ambiguously worded Dodd Frank.
Despite our efforts to exempt “single-borrower” transactions from the risk retention rules, the regulators did not provide for an exemption for these types of transactions. Currently, these transactions are generally not structured with a B-piece. So, under the new rules, single-borrower transactions will be subject to the same risk retention requirements as conduit CMBS. As a result, the new rules are expected to impair such securitized transactions — reducing the volume and potentially giving an edge to portfolio lenders, if they can accommodate large-scale loans on their balance sheets. There is speculation that some of these transactions could still come to market with a third-party buyer retaining the bottom 5% of the risk, but such investors would likely demand additional yield for the restrictions placed on them.
Risk Retention Requirement Flexible
For CMBS, there is some flexibility in the combination of ways the risk retention pieces can be held, as outlined in the re-proposal. Overall, the rule appears to recognize the importance of the role of the B-piece buyer in CMBS. The risk retention requirement can be held as a horizontal slice (the bottom 5% of the transaction), a vertical slice (5% of the face amount of each tranche) or a combination of the two (an “L-shaped” option). The vertical/horizontal combination of this “L-shaped” option can be in any proportion. However, the final rules clarifies that if this structure is used, the sponsor holding the vertical slice must also retain a portion of the eligible horizontal first loss interest, or a piece of each tranche.
Further details on the new rules may be found here.