Risk Retention: The New CMBS Rules
The Wall Street Reform and Consumer Protection Act (also known as Dodd-Frank) was written in part to address the 2007-08 systemic risk crisis in credit markets caused by the mispackaging and mislabeling of bonds made up of collections of mostly residential mortgages that went bust. The banks that performed the packaging, regulators reason, each contributed greatly to the giant and hidden risks by routinely selling off the bonds they packaged. These were sold in their entirety, meaning the bank’s risk was effectively zero if it happened that the contents of the bond were found later to be in default.
What if, instead of being allowed to ship off truckloads of possibly mislabeled product, the packager was compelled by law to own a percentage of each package (bond) themselves? The systemic risk of the bond — and of the mortgage-backed bond business generally, regulators reason, would then have a built-in limit by forcing the packaging bank to “have skin in the game” themselves.
Enter a provision of the 2010 Dodd-Frank law called “risk retention” set to come online December of this year that does just that by requiring the issuing bank to “eat its own dog food” — requiring 5% of the resulting bond to be held by the bank, so that default risk aftermarket is shared by the bank.
What might be news in the commercial real estate space is that the commercial equivalent to residential mortgage-backed securities, called, unsurprisingly enough, commercial MBS (CMBS), has an exemption from the above kind of risk retention under Dodd-Frank. This is detailed well in today’s Bloomberg piece by Sarah Mulholland “Wall Street Girds For Real Estate Debt It Must Invest In”:
The new requirement, dubbed risk retention, applies to all types of securitization, the process by which debt is pooled together and sliced into bonds of varying risk and reward. Such offerings backed by home loans were ground zero for the financial crisis.
The changes are creating an opportunity for real estate investors. Industry lobbyists won a concession from lawmakers to create an exemption for the CMBS market, allowing a third party to take on the risk on behalf of lenders as long as they agree not to sell their investment for at least five years. Banks will be held legally accountable if the firm they sell to violates the rules.
The CMBS market has a built-in cohort, called B-piece buyers, that buys the riskiest portions, absorbing losses first in exchange for a hefty yield. Firms including Ellington, DoubleLine Capital and KKR & Co. have entered the space in recent years, which was dominated by a handful of specialists prior to the financial crisis. Several B-piece buyers are seeking to raise funds to step in for the banks, though it may be difficult to find investors willing to lock up their cash for five years or more, said Warren Friend, an executive managing director at Situs, a commercial real estate consulting firm.
Securitization of real estate debt on the commercial side may never present the kind of systemic risk that brought us a giant recession, in part due to the underlying illiquidity that commercial properties tend to represent. That said, CRE investors living in the world of Dodd-Frank face a different landscape than before, hopefully not one where risk pitfalls are more hidden.
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